PDF Chapter 5 Valuing Stocks - Cengage

Chapter 5

Valuing Stocks

Answers to Concept Review Questions

1. Why are common stockholders viewed as "residual owners?" What rights do they get in exchange for taking more risk than creditors and preferred shareholders take? Common stockholders are residual owners because they are entitled to receive cash only after all other creditors and preferred shareholders have been paid. Because common stockholders receive their compensation from "the residual" or whatever is left over after everyone else has been paid, their claim is especially risky. As compensation for taking that risk, common stockholders can earn much higher returns than can creditors and preferred stockholders, and common stockholders also have the right to vote on important corporate matters.

2. Most large Japanese corporations hold their annual shareholders meeting on the same day and require voting in person. What does this practice say about the importance and clout of individual shareholders in Japanese corporate governance? Since it is clearly impossible for a person who owns stock in more than one company to be present at more than one annual meeting, these practices indicate that individual shareholders have very little decision-making power in Japanese corporations.

3. What is the difference between a primary market and a secondary market? Differentiate between the organized exchanges and the over-the-counter market. The primary market refers to when a firm first issues a particular security. The secondary market is where the daily back and forth trading of that security takes place. Organized exchanges are physical locations where investors come together to trade, while the OTC market is a decentralized market of interconnected traders and dealers.

4. What do firms and their investment bankers hope to learn on the road show? The purpose of the road show is to obtain a preliminary assessment of how much demand there will be for the firm's stock at different possible prices. This helps the banker set the offering price.

5. How are underwriters compensated? Underwriters earn the underwriting spread which typically equals about seven percent of the money raised in a an equity IPO and about 0.5 percent in a large debt offering.)

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6. When you buy a stock in the secondary market, does the firm that issued the stock receive cash?

No. In a secondary market transaction, cash simply flows from the investor buying the shares to the investor selling the shares. The firm is not a party to the transaction. Firms receive money when they sell shares in the primary market.

7. List several differences between the NYSE and the Nasdaq.

The most obvious difference is that the NYSE is a physical market located in New York City, while the Nasdaq is an electronic market with no single central location. The NYSE usually has higher trading volume (in terms of dollars traded) and the value of securities traded there is greater than the value of stocks on the Nasdaq.

8. Why is it appropriate to use the perpetuity formula from Chapter 3 to estimate the value of preferred stock?

This formula applies to a level stream of cash flows that never ends. Preferred shares generally pay a fixed dividend, and they do not have a specific maturity date.

9. When a shareholder sells shares of common stock, what is being sold? What gives a share of common stock value?

What is being sold is the right to receive all future cash payments paid by the company to stockholders. It is the prospect of receiving cash payments over time that gives common shares their value.)

10. Using a dividend forecast of $2.15, a required return of 9 percent, and a growth rate of 3.8 percent, we obtained a price for People's Energy Corp. of $41.35. What would happen to this price if the market's required return on People's Energy stock increased?

The price would fall because the market would be discounting the firm's cash flows at a higher rate. This is the same inverse relationship between discount rates and security prices that we learned about in Chapter 4 for bonds.

11. How can the free cash flow approach to valuing an enterprise be used to resolve the valuation challenge presented by firms that do not pay dividends? Compare and contrast this model to the dividend valuation model.

The FCF model does not require any assumption about when a firm will distribute cash dividends to investors. Instead, the model examines the cash flow generated by a firm, making adjustments for cash flow that must be reinvested to generate growth opportunities. Like the dividend growth model, the FCF approach tries to measure how much cash a firm can distribute to shareholders over time.)

12. Why might the use of book value and liquidation value to value the firm be characterized as viewing the firm as "dead rather than alive?" Explain why those views are inconsistent with the discounted cash flow valuation models.

Book value measures the costs of a firm's assets, net of accumulated depreciation. Subtract off the historic value of the firm's liabilities and you have the book value of the

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firm's equity. Liquidation value measures how much cash a firm could raise from a onetime sale of its assets (again, subtracting off what is needed to pay creditors). Neither of these measures is forward looking as is the discounted cash flow approach. If the firm is a going concern, then a forward-looking approach is preferred because it can potentially capture the value of future growth opportunities.

13. Why is it dangerous to conclude that a firm with a high P/E ratio will probably grow faster than a firm with a lower P/E ratio?

The P/E ratio might be high simply because E is unusually small in a particular quarter or year. Also, the P/E ratio can be influenced by how risky the firm is. If we have two firms with identical expected growth rates and identical current earnings, the firm that is less risky may have a higher P/E ratio because investors discount its future earnings at a lower rate than they use to discount the earnings of the riskier firm. Finally, we have noted in several places in this chapter that growth rates are notoriously difficult to predict.

Answers to Self Test Questions

ST5-1. Omega Healthcare Investors (ticker symbol, OHI) pays a dividend on its Series B preferred stock of $0.539 per quarter. If the price of Series B preferred stock is $25 per share, what quarterly rate of return does the market require on this stock, and what is the effective annual required return?

The preferred stock valuation formula says that the price equals the dividend divided by the required rate of return. Therefore, using the quarterly dividend and the quarterly required rate, we have

$25 = $0.539/r

r = 0.02156 This means that the effective annual required rate on the stock equals (1.02156)41=0.089 or 8.9%.

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ST5-2. The restaurant chain Applebee's International Inc. (ticker symbol, APPB) announced an increase of their quarterly dividend from $0.06 to $0.07 per share in December 2003. This continued a long string of dividend increases. Applebee's was one of few companies that had managed to increase its dividend at a double-digit clip for more than a decade. Suppose you want to use the dividend growth model to value Applebee's stock. You believe that dividends will keep growing at 10 percent per year indefinitely, and you think the market's required return on this stock is 11 percent. Let's simplify by assuming that Applebee's pays dividends annually and that the next dividend is expected to be $0.31 per share. The dividend will arrive in exactly one year. What would you pay for Applebee's stock right now? Suppose you buy the stock today, hold it just long enough to receive the next dividend, and then sell it. What rate of return will you earn on that investment?

To calculate the price of the stock now, we simply divided next year's expected dividend, $0.31, by the difference between the required rate of return and the dividend growth rate. This yields a price of $0.31?(0.11-0.10) = $31.00. Next, we have to calculate the expected price a year from now after the $0.31 dividend has been paid. To do that, we need an estimate of the dividend two years in the future. If next year's dividend is $0.31, then the following year's dividend should be 10 percent more or $0.341 per share. This means that the price of Applebee's stock, just after the $0.31 dividend is paid should be $0.341?(0.11-0.10) = $34.10. Now calculate your rate of return. You purchase the stock for $31. One year later you receive a dividend of $0.31 and you immediately sell the stock for $34.10, generating a capital gain of $3.10. Your total return is therefore ($34.10 + $0.31 - $31.00)?$31.00 = 0.11 or 11%. That shouldn't be a surprise because this is exactly the market's required return on the stock.

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