CH: 9

Present value of common stocks

The price of share equals
n
The PV of the sum of next period’s The PV of all future dividends
dividends + next period’s stock price

FR PER Po
P
É.FI
Valuation of different types of stocks

zero growth Constant growth Differential growth

based
Po
p.sk g 844
R must be > g
Otherwise, discount using this formula

B I Useful for firms paying steady dividends

Estimates of parameters in the dividends discount model

g= retention ratio x return on retained earnings

= (retained earnings/earnings) x ROE

R= dividend yield + capital gains yield

go

Comparables
Different ways to value stock by comparable:

Price - earning ratio Enterprise value ratios

EV equity value + debt value - cash
• Suggest that similar firms has similar P/E ratio • EV-EBITDA ratio = EBITDA EBITDA

• Affected by three factors: • Similar firms have similar EV/EBITDA ratio

◦Investments opportunities • Advantage to PE ratio: leverage
◦Risk • Ignore depreciation and amortization: not cash flow
◦Accounting practices
• If earnings negative, could use price-sales ratio

Useful for firms with similar investments opportunities

 Valuing stocks using free cash flow
Investors may estimate
Free cash flow = net operating profit after tax - investment
terminal value using a
• Calculate net operating profit after tax
multiple rather than
• Decrease investments (net working capital and capital spending less depreciation)
• Find FCF for each year growing perpetuity
• Find FCF after given years using perpetuity or growing perpetuity (based on data) Value = earning at last
and discount it to y0
given year x PE multiple
• Discount other CFC to year zero and add it to the discounted perpetuity.

Helpful for non-dividend -paying firms with external financing needed

The stock market

Market
Primary Market Secondary Market
new-issue market: companies sell securities to raise money existing shares are traded among investors

dealer broker
I
maintains an inventory and stand brings buyers and sellers together
ready to buy and sell at any time but doesn't maintain an inventory

willing to pay at bid price

i
willing to sell at ask price/offer price
bid price - ask price = Spread

Organization of the NYSE

• the largest stock market in the world
• before 2006, exchange members 1366, own seats, seats were bought and sold, in 2006
NYSE became publicly owned corporation, members purchase trading licenses, those are entitled
to buy or sell on the exchange floor.
• hybrid market: trading take place electronically (Arca platform) and face-to-face.
• types of license holders:
◦designated market makers (DMMs): specialists, act as dealers, each stock assigned to
single DMM, maintain two-sided market, promote liquidity.
◦floor brokers: execute trades for customers, employees of large brokerage firms.
◦supplemental liquidity providers (SLPs): investment firms agree to be active participant
in stocks assigned to them, one-sided market, using their own money, given small rebate on
their buys and sells. (do not operate on the floor)
Types of orders
• market orders: specify ticker and quantity to sell or buy, buy lowest ask, sell highest bid.
• limit orders: specify ticker, quantity, and price at limit or better. buy or sell at limit price or better.
• stop order: if stop price reached or passed, the order becomes a market order, dose no guarantee to have the
stop price.

NASDAQ operations
• second largest stock market in USA.
• computer based quotation system with no physical location (NYSE hybrid)
• multiple market maker system (NYSE DMM system)
• operate with three level of information access:
◦level 1: timely, accurate source of price quotations (freely available at internet)
◦level 2: view quotes from all NASDAQ market makers, small fees(inside quotes) highest bid, lowest ask
◦level 3: view and update quotes, market makers only.
• electronic communication networks (ECNs) system: allow for investors to trade also, not only DMMs