CHAPTER 5

STOCK VALUATION
Outline

1. Overview of equity market

2. Margin Trading
3. Market Efficiency
4. Equity valuation
Ref: Mishkin & Eakins, Financial Markets + Institutions,
Chapter 6 and 13
Berk & DeMarzo, Corporate Finance, Chapter 9
 I. OVERVIEW
Returns of asset classes
 I. OVERVIEW
Stock
 A share of stock represents ownership to one part of a company’s net
assets and income.
 Is not refundable except in some special circumstances.
 Two types: common and preferred. Three types of preferred shares:
voting rights preferred shares, puttable preferred shares, dividend
preferred shares.
(Ref: Mishkin 9th Chapter 13; Luật Doanh nghiệp 2020; Luật chứng
khoán 2019)
 I. OVERVIEW
Primary market trading
 Public offerings and private placements.
Secondary market trading
 Exchanges and over-the-counter markets.
 Quote-driven markets and order-driven markets.
Trends in Long-Term Financing
• Each year, the manager must answer the questions:
• Should we finance this year’s long-term projects with
debt or equity?
• Should we ration our capital and finance only the most
attractive projects with this year’s addition to retained
earnings?
• After the decision is made, the manager must decide the
external funds, if any, it will raise this year.
Trends in Long-Term Financing

• Internally generated funds

• Short-term and long-term borrowing.
• Selling equity
- Staying Private
- Going public
Primary Markets- Issuing Equity
Staying private
• Right Offering to Current Shareholders
• Private Placement of Equity
• Merger or Acquisition
Going public
• IPO (Initial Public Offering)
• Seasoned Equity Offerings (Right offerings, Public offerings)
• Private Placement of Equity
• Merger or Acquisition
 Private Placement of Equity
• A private placement raises funds by allowing outside
private investors to purchase shares in the firm.
• This may be difficult because new investors may
want to examine the original owner’s motives and
question their ability.
• To limit cost and ensure the compatibility of the new
owners, current shareholders may seek possible
investors among their friends, relatives, and other
contacts.
• Another possibility can be to seek financing from
venture capitalists, who invest funds in private
companies in return for ownership shares.
Roadmap of equity capital development
 Angel investors.
 Venture capital (VC).
 Private equity (PE).
 Public equity: by Vietnamese law at least VND30 billion
and at least 10% shares with voting rights are held by at
least 100 minority shareholders.
Private Equity Buyouts

• The private company is allowed to mature and then, with

profitability ensured, it sells shares to the public.
• In a private equity buyout, instead of a private company
going public, a public company goes private.
 Merger or Acquisition

• Another way to raise money is by selling all or part of the

firm to another corporation.
• Acquisitions can be negotiated to allow the firm’s managers
to retain their current position or to receive lucrative
consulting contracts.
• Another advantage to a merger or acquisition is when the
investor is a large corporation with deep pockets and a
willingness to help the firm grow.
• The drawback to a merger or acquisition is a loss of control.
 Rights offering
• Rights offering allows the firm’s current
shareholders to purchase additional shares in
proportion to their current ownership.
• So that the original shareholders remain in
control of the firm while raising the needed equity
capital.
• It was very popular among U.S. public
corporations but have become infrequent during
the 1980s and 1990s, but remains quite popular
in Europe, Asia and Vietnam.
Public offerings
• Corporations contract with an investment bank
to help them sell securities to the public.
2. Margin Trading

• Using only a portion of the proceeds for an investment

• Borrow remaining component
• Margin arrangements differ for stocks and futures
Margin Trading
• Greatest margin/ Initial margin
• Currently 30%
• Set by the securities companies
• Minimum margin
• Minimum level the equity margin can be
(called “maintenance” in USA)
• Margin call
• Call for more equity funds
 Margin Trading - Initial Conditions
X Corp $70
50% Initial Margin
30% Minimum Margin
1000 Shares Purchased
Initial Position
Stock $70,000 Borrowed $35,000
Equity $35,000
Margin Trading - Minimum Margin
Stock price falls to $60 per share

New Position
Stock $60,000 Borrowed $35,000
Equity $25,000

Margin% = $25,000/$60,000 = 41.67%

Margin Trading - Margin Call
• How far can the stock price fall before a margin call?

1,000  P  $35,000
 30%
1,000  P
Therefore, P = $50

Note: 1,000xP – Amount Borrowed = Equity

Margin Trading
• Advantages
• Allows use of financial leverage
• Magnifies profits
• Disadvantages
• Magnifies losses
• Interest expense on margin loan
• Margin calls
 Margin Formulas
• Basic Margin Formula
Value of securities  Debit balance
Margin 
Value of securities
V  D

V
• Example : buy 100 shares of stock at $40 per share, initial
margin requirement is 70%. What happens when stock
price moves to $65?

V  D $6,500  $1,200
Margin    0.815  81.5%
V $6,500
Leveraging effect of margin purchases
• You buy 200 shares of XYZ at $100, :
• Initial margin: 50%
• Financed by a 9% loan for one year
• A 30% appreciation of the stock in one year
Rate of return=?
A 30% drop in the price Rate of return=?
Leveraging effect of margin purchases
• You buy 200 shares of XYZ at $100, expecting a 30% appreciation of
the stock in one year:
• Initial margin: 50%
• Financed by a 9% loan for one year
• Expected net return: 51%
• A 30% drop in the price, though, brings a negative rate of return of
-69%.
 Leverage ratio

• The leverage ratio is the ratio of the value of the position

to the value of the equity investment in it.
• The leverage ratio indicates how many times larger a
position is than the equity that supports to.
• Maximum leverage ratio= 1/minimum margin requirement
Problem 1
• A buyer buys stock on margin and holds the position for
exactly one year, during which time the stock pays a
dividend. Assume that the interest on the loan and the
dividend are both paid at the end of the year:
• Purchase price=$20/share; sale price=$15/share
• Shares purchased=1000; leverage ratio=2.5; interest
rate=5%; dividend= $0.1/share; commission= $0.01/share
What is the total return on this investment?
Short Sales
• Purpose: to profit from a decline in the price of a stock or
security
Mechanics
• Borrow stock through a dealer
• Sell it and deposit proceeds and margin in an account
• Close out the position: buy the stock and return it to the
owner
 Short Sale - Initial Conditions
Z Corp 100 Shares
50% Initial Margin
30% Minimum Margin
$100 Initial Price

Sale Proceeds $10,000

Margin & Equity $ 5,000
Stock Owed $10,000
Short Sale - Minimum Margin
Stock Price Rises to $110

Sale Proceeds $10,000

Initial Margin $ 5,000
Stock Owed $11,000
Net Equity $ 4,000
Margin % (4,000/11,000) = 36%
Short Sale - Margin Call

• How much can the stock price rise before a margin call?

$15,000  100  P
 30%
100  P
So, P = $115.38

Note: $15,000 = Initial margin + sale proceeds

 Short Selling
• Advantages
• Chance to profit when stock price declines
• Disadvantages
• Limited return opportunities: stock price cannot go below
$0.00
• Unlimited risks: stock price can go up an
unlimited amount
• If stock price goes up, short seller still needs to buy shares to
pay back the “borrowed” shares to the broker
• Short sellers may not earn dividends
 Problem 2
• Sell Short of 100 shares of Smart, Inc., at $50
per share.
• Initial margin at 50%
• Maintenance margin at 30%
• Initially, broker holds a deposit of $7,500 (100
shares sold at $50 per share, plus 50%
margin).
• What happens if price rise to $70 or falls to
$30 subsequently?
 3. Market Efficiency
 “Efficiency” implies external/ information efficiency.
 In an efficient market, securities market prices
incorporate all available information. Market prices
reflect intrinsic values.
 As new information comes randomly, estimates of
intrinsic value change, securities prices are not
predictable. Investors cannot consistently earn returns
higher than the average market return.
(Refer: CFAI 2012 Level 1 Volume 5 SS13)
Market value VS Intrinsic value

• Market value is the price at which an asset can

currently be bought or sold.
• Intrinsic value is the value that would be placed on
it by investors if they had a complete understanding
of the asset’s investment characteristics.
 INEFFICIENT MARKET
• If investors believe an asset market is relatively inefficient, they may
try to develop an independent estimate of intrinsic value. The
challenge for investors and analysts is estimating an asset’s intrinsic
value.
• Numerous theories and models can be used to estimate an asset’s
intrinsic value. They all require some form of judgment regarding the
size, timing, and riskiness of the future cash flows associated with the
asset.
• These complexities and the estimates of an asset’s market value are
reflected in the market through the buying and selling of assets. The
market value of an asset represents the intersection of supply and
demand—the point that is low enough to induce at least one investor
to buy while being high enough to induce at least one investor to sell.
 INTRINSIC VALUE OF
BOND
• Information would include its interest (coupon) rate,
principal value, the timing of its interest and principal
payments, the other terms of the bond contract (indenture),
a precise understanding of its default risk, the liquidity of its
market, and other issue- specific items.
• In addition, market variables such as the term structure of
interest rates and the size of various market premiums
applying to the issue (for default risk, etc.) would enter into a
discounted cash flow estimate of the bond’s intrinsic value
(discounted cash flow models are often used for such
estimates).
• The word estimate is used because in practice, intrinsic
value can be estimated but is not known for certain.
Market Efficiency(cont.)

• Market efficiency concerns the extent to which market

prices incorporate available information.
• If market prices do not fully incorporate information,
then opportunities may exist to make a profit from the
gathering and processing of information.
• The subject of market efficiency is, therefore, of great
interest to investment managers.
 INEFFICIENT MARKET
• In an efficient market, a passive investment strategy (i.e.,
buying and holding a broad market portfolio) that does not
seek superior risk- adjusted returns can be preferred to an
active investment strategy because of lower costs (for
example, transaction and information- seeking costs).
• By contrast, in a very inefficient market, opportunities may
exist for an active investment strategy to achieve superior
risk- adjusted returns (net of all expenses in executing the
strategy) as compared with a passive investment strategy.
• In inefficient markets, an active investment strategy may
outperform a passive investment strategy on a risk- adjusted
basis.
• Understanding the characteristics of an efficient market and
being able to evaluate the efficiency of a particular market
are important topics for investment analysts and portfolio
managers.
Categories of Market Efficiency
• Weak-Form Efficiency / Lack of Predictability
• Semi-Strong Form / “Events” Reflected Immediately
• Strong-Form / All Private Information is Reflected
 Weak-Form Efficiency

• Price reflects all information which refers to all historical

price and trading volume information
• If markets are weak- form efficient, past trading data are
already reflected in current prices and investors cannot
predict future price changes by extrapolating prices or
patterns of prices from the past.
Weak-Form Efficiency

 Technical analysis: Refers to the practice of using past patterns in stock

prices (and trades) to identify future patterns in prices.
 Time patterns in security return:
 Day of week pattern: Returns on Monday are much lower on return on
other days of the week.
 Monthly pattern: Returns on January are higher than returns on other
months.
 Filter rule: Purchase the stock when it rises by X% from the previous low
and hold it until it declines by Y% from the subsequent high.
 Momentum strategy: buy winners and sell losers (investors buy
securities that are rising and sell them when they look to have
peaked)
Semi-Strong Form
• Price reflects all publicly available information.
• An investor can not use publicly available information to identify mispriced
securities.
• Fundamental analysis:
 Refers to the practice of using financial statements, announcements, and other
publicly available information about firms to pick stocks.
 Is not profitable in a market which is at least semi-strong form (i.e., semi-strongly)
efficient.
• If a market is semi-strong form efficient, then it is also weak form efficient since
past prices and other past trading data are publicly available.
Semi-Strong Form
 Fundamental analysis:
• Size effect: equities of small- cap companies tend to
outperform equities of large- cap companies on a risk-
adjusted basis.
• Value Effect: value stocks, which are generally referred to
as stocks that have below- average price- to- earnings
(P/E) and market- to- book (M/B) ratios, and above-
average dividend yields, have consistently outperformed
growth stocks over long periods of time
Strong-Form
• A strong- form efficient market also means that prices
reflect all private information, which means that prices
reflect everything that the management of a company
knows about the financial condition of the company that
has not been publicly released.
• If a market is strong- form efficient, insider trading
cannot earn abnormal returns.
• If a market is strong form efficient, then it is also semi-
strong and weak form efficient since all available
information includes past prices and publicly available
information.
Insiders, associates and affiliates
 Insiders are those holding important positions in a
firm’s management and governance system.
 Associates and affiliates are those socially or
economically related to insiders as defined by law:
shareholders with at least 10% ownership,
subsidiaries/parent/sister firms, father, mother,
father/mother-in-law, siblings, siblings-in-law,
children, children-in-law…
4. EQUITY VALUATION
• The Dividend Discount Model
• Total Payout and Free Cash Flow Valuation Models
• The Discounted Free Cash Flow Model
• Valuation Multiples
Market value VS Intrinsic value

• Market value is the price at which an asset can currently be

bought or sold.
• Intrinsic value is the value that would be placed on it by
investors if they had a complete understanding of the asset’s
investment characteristics.
• Numerous theories and models can be used to estimate an
asset’s intrinsic value. They all require some form of
judgment regarding the size, timing, and riskiness of the
future cash flows associated with the asset.
Computing the Price
of Common Stock—QUIZ
If you require a 15% return to compensate you
for the risk of owning stock, you expect
company XYZ to pay $0.15 in dividends this
year, and expect the company to sell for $30 at
the end of the year, how much would you be
willing to pay for the company today?
Suppose you decide the stock is more risky
than you originally thought. How does this
affect the price you are willing to pay?
The Dividend Discount Model
• A One-Year Investor
• Potential Cash Flows
• Dividend
• Sale of Stock
• Timeline for One-Year Investor

• Since the cash flows are risky, we must discount them at

the equity cost of capital.
The Dividend Discount Model
• A One-Year Investor
 Div1  P1 
P0   
 1  rE 
• If the current stock price were less than this amount, expect
investors to rush in and buy it, driving up the stock’s price.
• If the stock price exceeded this amount, selling it would cause
the stock price to quickly fall.
 Dividend Yields, Capital Gains,
and Total Returns
Div1  P1 Div1 P1  P0
rE   1  
P0 P P
0 0
Dividend Yield Capital Gain Rate
• Dividend Yield
• Capital Gain
• Capital Gain Rate
• Total Return
• Dividend Yield + Capital Gain Rate
• The expected total return of the stock should equal the expected return of
other investments available in the market with equivalent risk.
EXAMPLE
A Multi-Year Investor

• What is the price if we plan on holding the stock for

two years?

Div1 Div2  P2
P0  
1  rE (1  rE ) 2
The Dividend-Discount Model Equation
• What is the price if we plan on holding the stock
for N years?
Div1 Div2 DivN PN
P0      
1  rE (1  rE ) 2
(1  rE ) N
(1  rE ) N


Div1 Div2 Div3 Divn
P0 
1  rE

(1  rE ) 2

(1  rE ) 3
   
n 1 (1  rE ) n
Applying the Discount-Dividend Model
• Constant Dividend Growth
• The simplest forecast for the firm’s future dividends states
that they will grow at a constant rate, g, forever.

Div1 Div1
P0  rE   g
rE  g P0
Problem 1

Consolidated Edison, Inc. (Con Edison), is a regulated utility

company that services the New York City area. Suppose Con
Edison plans to pay $2.60 per share in dividends in the coming
year. If its equity cost of capital is 6% and dividends are expected
to grow by 2% per year in the future, estimate the value of Con
Edison’s stock.
Problem 2

• AT&T plans to pay $1.44 per share in dividends in

the coming year.
• Its equity cost of capital is 8%.
• Dividends are expected to grow by 4% per year
in the future.
• Estimate the value of AT&T’s stock.
Increase of share price
The firm’s share price increases with the current dividend
level, Div1, and the expected growth rate, g.
To maximize its share price, a firm would like to increase
both these quantities. Often, however, the firm faces a trade-
off: Increasing growth may require investment, and money
spent on investment cannot be used to pay dividends. We can
use the constant dividend growth model to gain insight into
this trade-off.
Dividends Versus Investment and
Growth
• A Simple Model of Growth
• Dividend Payout Ratio
• The fraction of earnings paid as dividends each year

Earningst
Divt   Dividend Payout Ratet
Shares Outstanding
       t
EPSt
Dividends Versus Investment and Growth
• A Simple Model of Growth
• Assuming the number of shares outstanding is constant,
the firm can do two things to increase its dividend:
• Increase its earnings (net income)
• Increase its dividend payout rate
• A firm can do ONE of two things with its earnings:
• It can pay them out to investors.
• It can retain and reinvest them.
Dividends Versus Investment and Growth
• A Simple Model of Growth
Change in Earnings  New Investment  Return on New Investment
New Investment  Earnings  Retention Rate

• Change in earnings= Earnings * retention rate * Return

on New investment
• Change in earnings/ Earnings= Retention rate * Return on
New investment= g
• Retention Rate: Fraction of current earnings that the firm
retains
 Dividends Versus Investment and Growth
• A Simple Model of Growth
Change in Earnings
Earnings Growth Rate 
Earnings
 Retention Rate  Return on New Investment
g  Retention Rate  Return on New Investment

• If the firm keeps its retention rate constant, then

the growth rate in dividends will equal the growth rate
of earnings.
 Dividends Versus Investment
and Growth
• Profitable Growth
• If a firm wants to increase its share price, should it cut its
dividend and invest more, or should it cut investment and
increase its dividend?
• The answer will depend on the profitability of the
firm’s investments.
• Cutting the firm’s dividend to increase investment
will raise the stock price if, and only if, the new
investments have a positive NPV.
 Problem
• Crane Sporting Goods expects to have earnings per share of $6 in
the coming year. Rather than reinvest these earnings and grow, the
firm plans to pay out all of its earnings as a dividend. With these
expectations of no growth, Crane’s current share price is $60.
Suppose Crane could cut its dividend payout rate to 75% for the
foreseeable future and use the retained earnings to open new stores.
The return on its investment in these stores is expected to be 12%.
Assuming its equity cost of capital is unchanged, what effect would
this new policy have on Crane’s stock price?
Problem

• Suppose Crane Sporting Goods decides to cut

its dividend payout rate to 75% to invest in new
stores. But now suppose that the return on
these new investments is 8%. Given its
expected earnings per share this year of $6 and
its equity cost of capital of 10%, what will
happen to Crane’s current share price in this
case?
Problem
• Dren Industries is considering expanding into a
new product line. Earnings per share are expected
to be $5 in this year (year 0) and are expected to
grow annually at 5% without the new product line
but growth would increase to 7% if the new
product line is introduced. To finance the
expansion, Dren would need to cut its dividend
payout ratio from 80% to 50%. If Dren’s equity cost
of capital is 11%, what would be the impact on
Dren’s stock price if they introduce the new
product line? Assume the equity cost of capital will
remain unchanged.
Changing Growth Rates

• We cannot use the constant dividend growth

model to value a stock if the growth rate is not
constant.
• For example, young firms often have very high initial earnings
growth rates. During this period of high growth, these firms
often retain 100% of their earnings to exploit profitable
investment opportunities. As they mature, their growth slows.
At some point, their earnings exceed their investment needs
and they begin to pay dividends.
Changing Growth Rates

DivN  1
PN 
rE  g
• Dividend-Discount Model with Constant Long-Term Growth

Div1 Div2 DivN 1  DivN  1 

P0        
1  rE (1  rE ) 2
(1  rE ) N
(1  rE ) N  rE  g 
Problem

• Small Fry, Inc., has just invented a potato chip that looks
and tastes like a french fry. Given the phenomenal market
response to this product, Small Fry is reinvesting all of
its earnings to expand its operations. Earnings were $2
per share this past year and are expected to grow at a rate
of 20% per year until the end of year 4. At that point,
other companies are likely to bring out competing
products. Analysts project that at the end of year 4, Small
Fry will cut investment and begin paying 60% of its
earnings as dividends and its growth will slow to a long-
run rate of 4%. If Small Fry’s equity cost of capital is
8%, what is the value of a share today?
Valuation Multiples
• Valuation Multiple
• A ratio of firm’s value to some measure of the firm’s scale
or cash flow
• The Price-Earnings Ratio
• P/E Ratio
• Share price divided by earnings per share
Valuation Multiples
• Trailing Earnings
• Earnings over the last 12 months
• Trailing P/E
• Forward Earnings
• Expected earnings over the next 12 months
• Forward P/E
EXAMPLE
Valuation Multiples

• Enterprise Value Multiples

V0 FCF1 / EBITDA1

EBITDA1 rwacc  g FCF

This valuation multiple is higher for firms with high

growth rates and low capital requirements (so that
free cash flow is high in proportion to EBITDA).
EXAMPLE
Valuation Multiples
• Other Multiples
• Multiple of sales
• Price to book value of equity per share
• Enterprise value per subscriber
• Used in cable TV industry
Limitations of Multiples
• When valuing a firm using multiples, there is no clear guidance
about how to adjust for differences in expected future growth
rates, risk, or differences in accounting policies.
• Comparables only provide information regarding the value of a
firm relative to other firms in the comparison set.
• Using multiples will not help us determine if an entire
industry is overvalued
Comparison with Discounted
Cash Flow Methods
• Discounted cash flows methods have the advantage that
they can incorporate specific information about the
firm’s cost of capital or future growth.
• The discounted cash flow methods have the
potential to be more accurate than the use of a
valuation multiple.
End of Chapter 5