How are earnings distributed to shareholders?
through dividends
What does the market price of a stock reflect?
Market price of a stock reflects the value the market has placed on the right to receive future dividends
Dividend yield
annual dividend / current price
-usually quoted on a trailing annual dividend basis
Are cash flow and earnings the same thing?
no!
How do investors evaluate companies?
they look at earnings
Price / earnings ratio
Closing Price/Annual Earnings (Usually the past 12 months)
Ratio indicates the number of years of current earnings the market is willing to pay to own the stock.
How are dividends for stock different than dividends for bonds?
Unlike bonds where the cashflows are known with certainty Stocks pay dividends which are uncertain
How is risk of stock dividends taken into account?
Valuation must take this uncertainty into account, and the Required Return must be higher than the YTM of a bond
What does the return to an investor in a stock come from?
-cash dividends
-capital gains
For what firms should the dividend discount model be used?
firms that do not grow at a constant rate
Dividend payout rate
the proportion of earnings paid out in dividends to shareholders
Retention rate
The proportion of a firm's current earnings that the firm retains
Why would a shareholder want the firm to retain earnings?
New Investment - If the projects return more than the required cost of capital, the projects will add value to the firm.
Reinvesting earnings into new growth opportunities only increases valuations, if
the returns of those growth opportunities exceed investor's required return.
Present Value of Growth Opportunities (PVGO)
The value added by the opportunity to reinvest in growth where the return exceeds the required return. (NPV of new investments)
Limitations of dividend growth models
Forecasting actual dividends is difficult.
-Dividend payout policies change over time.
-Earnings depend on interest which varies with debt.
-Shares are issued and repurchased over time.
These decisions are subject to management's discretion
How to apply project valuation techniques to stock
-Replace dividends with "free cash flow" (the amount of cash generated after required reinvestment is considered)
-Use the overall market-required rate of return (WACC) for similar risk companies.
-If a final or terminal value is expected use it as you wo
Free cash flow calculation
How do you calculate the value today of cash available to investors in the firm?
calculate the present value of free cash flows
this is the overall valuation of the future benefits of owning the firm
Comparison of stock valuation methods
Why are valuation multiples used?
Since no two firms are identically comparable valuation attempts to adjust for differences through the use of "multiples
Comparable" firms should have a share value of ____ times earnings
10
Pitfalls in comparable valuation
-growth messes up the measurement
-they rely on very strong assumptions about the similarities of firms
Efficient Markets Hypothesis
Capital markets reflect all relevant information. Competition among investors provides an incentive for investors to reveal information and works to eliminate positive NPV opportunities. You cannot consistently earn excess profits.
Efficient Capital Markets
Financial markets in which security prices rapidly reflect all relevant information about asset values
Random walk theory
Security prices change randomly, with no predictable trends or patterns
Empirical evidence about stock trends
-Statistically speaking, the movement of stock prices is random (skewed positive over the long term).
-The movement of stock prices from day to day DO NOT reflect any pattern.
Market transparency
Information reflected in market prices can only be revealed if transactions in the market are observable
Market transparency: negotiated price transactions
low
Market transparency: OTC markets
medium
Market transparency: exchange traded markets
high
Generally, the more uncertain the cashflows of a particular project the ______ the risk, and the ______ the risk, the _______ the required return
higher
Riskier projects have ______ present values than less risky projects with the same cashflows
lower
Any asset (real or financial) where there is uncertainty about the future cashflows must have a required return ________ than the Expected Return on Risk Free Assets
greater
When can we use empirical distribution to estimate the expected return from the average annual return?
If the probability distribution of the returns is the same over time, we can use the empirical distribution to estimate the expected return from the average annual return
Normal distribution
A normal distribution is a set of observations where the deviations above and below the mean are random and equally distributed.
Can be fully described using only the mean and SD
Observations more than 2 std deviations away from the mean should occur abou
What is the relationship between risk regarding individual stocks vs large portfolios?
There is no clear relationship between risk and return for individual stocks.
Large stocks seem to be less volatile than small stocks.
All individual stocks seem to have higher risk and lower returns than large portfolios
Independent/unsystematic risk
firm specific risk, can be offset by diversifying
Market/systematic risk
-risk that effects all firms like a recession, change law changes, interest rate changes, and new tech
Diversification
Diversification is the reduction in Unsystematic (Firm Specific) Risk an investor achieves by combining unrelated assets
Correlation
Correlations measure the degree to which movements in the price of one stock is reflected in another stock
Benefits of diversification
Spreads risk over more than one business, however there is little benefit beyond 20-30 stocks
Portfolio
Any combination of assets and their weightings. This definition includes a single asset.
How we use statistics to calculate variance and SD of a portfolio
Using the correlation coefficient between two securities we can calculate the covariance between two securities and therefore the resulting variance and standard deviation of a portfolio of the securities
Efficient portfolios
Combinations of assets that give the lowest risk for a given return
Risk/return graph for all combinations of securities with borrowing and lending
Risk/return graph of the market portfolio
CAPM (Capital Asset Pricing Model)
model states that the expected return for all assets is determined by the asset's correlation to the "market portfolio" and the risk free return
What is the market portfolio?
In theory, the Market Portfolio is all risky assets that are available to investors.
This would include every stock, bond, project and property available in the world.
In practice, we use a proxy for this portfolio (like S&P 500)
How is Beta calculated?
The Beta of an individual stock is calculated by using the correlation coefficient obtained from a regression of the returns of the stock with the returns of the market portfolio
What is beta?
A security's beta is related to how sensitive its underlying revenues and cash flows are to general economic conditions.
Stocks in cyclical industries are likely to be more sensitive to systematic risk and have higher betas than stocks in less sensitive i
How does CAPM use beta?
-expected return on any asset can be described by beta
-beta represents the correlation between the asset and the market portfolio
There is a linear relationship between beta and ?
the expected return of an asset (security market line)
CAPM and OCC
-CAPM can be used to represent OCC
-OCC refers to the RR for a project that has risk similar to the risk represented by the beta in the calcuation
Cost of capital
The return the firm's investors could expect to earn if they invested in securities with comparable degrees of risk
Weighted average of required debt and equity returns
Capital structure
The firm's mix of long term financing and equity financing
WACC (weighted average cost of capital)
expected rate of return on a portfolio of all the firm's securities
(adjusted for tax savings due to interest payments)
3 steps to calculating WACC
1. Calculate the value of each security as a proportion of the firm's market value or the weighted value of the security in the Capital Structure.
2. Determine the required rate of return on each security.
3. Calculate a weighted average of these required
When calculating WACC, do you use market or book value?
MARKET
What happens when debt increases?
1. Increased required returns on debt because of the increased risk of default.
2. Increased cost of equity demanded due to the increase in risk.
What is the impact of capital structure on risk?
-it changes equity beta
-it results in different costs of equity and debt
When to use WACC for a company
-If a project is Scale Expanding the associated risks are similar to the risks of the company.
-The WACC of the company is an appropriate measure of the Opportunity Cost of Capital
When to use WACC for a project
-If a project is Non-scale expanding the associated risks are likely to be somewhat different to the risks of the company.
-The WACC used should reflect the risk of similar projects or companies.
-The analyst must go to the capital markets and determine t
Key assumption implied by WACC
we assume the main effect from using debt follows from the interest tax deduction
(in practice this is too simple)
Costs of raising external captial
can be too costly especially for small firms
-instead use internal capital
-or include issuing costs in the project evaluation