Finance Audio: Chapter 7 Preview: Equities and Valuation

Chapter 7 Preview: Equities and Common Stock

Introduction to Equities

Equities are the same as common stock, representing ownership in an organization.
All for-profit organizations have shares of ownership, whether public or private.
Example: You can buy a share of Nike stock.
The price of a share reflects market conditions and company performance.
Example: Nike's stock price was $97.90, down due to a general market downturn.

Key Metrics and Information (Using Nike as an Example)

Data is sourced from platforms like Yahoo Finance.
Stock Price Chart: Visual representation of a stock's price movement over time (e.g., Nike's price range over the past few years).
Average Shares Traded: The typical number of shares exchanged in a day (e.g., 7 million for Nike).
Market Capitalization: Total value of all outstanding shares, calculated by multiplying the current stock price by the number of shares outstanding. For Nike, it's 153,600,000,000.0. This represents the cost to buy the entire company.
Price-Earnings Ratio (P/E Ratio): The ratio of a company's current share price to its earnings per share (EPS). It indicates how much an investor is willing to pay for each dollar of a company’s earnings. Nike's P/E ratio is 26. If Nike stock costs 97.90, then this means you are paying approximately 26 times the company's earnings.
Earnings Per Share (EPS): A company's profit allocated to each outstanding share of common stock. Calculated as: EPS = {Stock Price} / {P/E Ratio}. Nike's EPS (last 12 months) is $3.75.
Forward Dividend & Dividend Yield:
- Dividend: A distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders. (e.g. Nike is expected to pay a forward dividend of 1.22).
- Dividend Yield: A financial ratio that shows how much a company pays out in dividends each year relative to its stock price. Displayed as a percentage. Calculate as: {Dividend Yield = (Annual Dividend Per Share / Price Per Share) * 100}. (e.g. if you bought Nike stock for 97.90 and received a dividend of 1.22, that's a 1.22 yield.).
Analyst Ratings: Assessments of a stock's potential, categorized as strong buy, buy, hold, underperform, or sell. Analysts provide target prices for a stock, reflecting their expectations for its future value (e.g., Analysts expect Nike stock to trade at about 129 one year from today).
Shares Outstanding: Total number of shares issued by a company (e.g., Nike has ~1,260,000,000.00 shares outstanding).
Float: The number of shares available for public trading (e.g. the float for Nike is ~1,250,000,000).
Institutional Ownership: Percentage of a company's shares owned by institutions like mutual funds and ETFs.

Stock Valuation: Foundational Principles

The inherent value of an investment is equal to the present value of the future cash flows it is expected to generate.
For stocks, the future cash flow stream primarily consists of dividends."
Dividend Discount Model: Determines the price you should pay for a share of stock based on the present value of those dividends. P0 = \frac{D1}{(1 + r)} + \frac{D2}{(1 + r)^2} + \frac{D3}{(1 + r)^3} + …
- P_0 = Current stock price
- D_i = Expected dividend in year i
- r = Discount rate (required rate of return on equity)

Discount Rate (Required Rate of Return on Equity, ROE)

The discount rate (ROE) reflects the risk associated with a particular stock. The riskier the stock, the higher the ROE.

Constant Growth Model

Constant Growth Model Formula: In this formula, P0 is the current price, D1 is the dividend expected next year, r is the required rate of return on equity, and g is the constant growth rate of dividends.
P0 = \frac{D1}{r - g}

Rearranging the Constant Growth Model:

r = \frac{D1}{P0} + g

Capital Gain: The capital gain is the capital appreciation, which is the growth rate. It’s the money you make from the price increasing. The basic idea is that the required rate of return is comprised of two components: cash return (i.e. dividend) and capital appreciation.

Practice Exercise 1: Longstroch Stores

Problem

Longstroch Stores is expected to pay a 0.56 per share dividend in the coming year and is expected to sell for 45.50 at the end of the year. The required rate of return on equity is 6.8%. How much should we pay for it?

Solution:

Cash flow in one year: 0.56 (dividend) + $45.50 (selling price) = 46.06
Present value calculation: 46.06 / (1 + 0.068) = 43.13. You should pay 43.13 for the stock today.

Decomposition of Required Return

Calculate the dividend yield (cash yield):

0.56 / 43.13 = 0.013, dividend yield 1.3%. Rate of return from the dividend is 1.3%.
Then, calculate the price appreciation:
45.5 - 43.13 = 2.37. Price is expected to grow by 2.37.
Calculate the return on a percentage basis:
2.37/ 43.13 = 0.055, 5.5%
Then, calculate the total expected rate of return:
1.3 + 5.5 = 6.8%.