15.
401
15.401 Finance Theory
MIT Sloan MBA Program
Andrew W. Lo Harris & Harris Group Professor, MIT Sloan School Lecture 7: Equities
20072008 by Andrew W. Lo
Critical Concepts
Industry Overview The Dividend Discount Model DDM with Multiple-Stage Growth EPS and P/E Growth Opportunities and Growth Stocks
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Reading Brealey, Myers and Allen, Chapter 4
Lecture 7: Equities
20072008 by Andrew W. Lo
Slide 2
Industry Overview
What Is Common Stock? Equity, an ownership position, in a corporation Payouts to common stock are dividends, in two forms: Cash dividends Stock dividends Unlike bonds, payouts are uncertain in both magnitude and timing Equity can be sold (private vs. public equity) Key Characteristics of Common Stock: Residual claimant to corporate assets (after bondholders) Limited liability Voting rights Access to public markets and ease of shortsales
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Lecture 7: Equities
20072008 by Andrew W. Lo
Slide 3
Industry Overview
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The Primary Market (Underwriting) Venture capital: A company issues shares to special investment partnerships, investment institutions, and wealthy individuals Initial public offering (IPO): A company issues shares to the general public for the first time (i.e., going public) Secondary or seasoned equity offerings (SEO): A public company issues additional shares Stock issuance to the general public is usually organized by an investment bank who acts as an underwriter: it buys part or all of the issue and resells it to the public Secondary Market (Resale Market) Organized exchanges: NYSE, AMEX, NASDAQ, etc. Specialists, broker/dealers, and electronic market-making (ECNs) OTC: NASDAQ
Lecture 7: Equities 20072008 by Andrew W. Lo Slide 4
Industry Overview
3500 3000 2500 2535 2581 2890 2859
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90 75 60 45 30 15 16 5 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 24 41 28 30 76 64 50 48 37 36 26 16
$ Billions
$ Billions
2000 1500 1000 500 312 0 '90 587 856 1063 716 722 979 1317
1868 1960 1851
43
'91
'92
'93
'94
'95
'96
'97 '98
'99
'00
'01
'02
'03
'04
Industry Underwrites Nearly $3 Trillion in United States for Second-Straight Year
Source: Thomson Financial
Initial Public Offerings* Rebound In 2004
Source: Thomson Financial *Excludes Closed-End Funds
1800 1500 Announced 1200 Completed
1735 1563 1314
1741
1768
1314 1160
$ Billions
1031 771 558 528 834 749
900
731 718
600 300 0
279 162 112 167 376 269
613 383
592
440
451
'92
'93
'94
'95
'96
'97
'98
'99
'00
'01
'02
'03
'04
Source: Thomson Financial
U.S. M&A Cycle Turns Up
Images by MIT OpenCourseWare.
Lecture 7: Equities
20072008 by Andrew W. Lo
Slide 5
Industry Overview
NYSE Daily Share Volume vs. NYSE Composite Index
1600 1400 1200 1000 800 600 400 2,426 2,540 1,908 179 202 2,739 5,000 1457 6,876 6,946 6,440 6,300 6,236 1441 1398 5,405 1042 1240 4,148 809 3,384 674 527 346 412 7,250 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 0
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Average Daily Volume in Millions of Shares
NYSE Composite
2,653
265 291
200 157 0 '90
'91
'92
NYSE Volume
NYSE Composite
NASDAQ Daily Share Volume vs. NASDAQ Composite Index
2000
Average Daily Volume in Millions of Shares
1800 1600 1400 1200 1000 800 600 400 200 0 '90 '91 '92 '93 '94 '95 '96 '97 '98 374 586 132 163 677 777 752 268 295 191 1,052 401 1,291 544 2,193 1,570 648 802
4,069
1757
1900
1753
1686
1801
4,500 4,000 3,500 3,000
NASDAQ Composite
1082
2,471 1,950 2,003
2,175 2,500 2,000 1,500 1,000 500 0
1,336
'99
'00
'01
'02
'03
'04
NASDAQ Volume
NASDAQ Composite
Images by MIT OpenCourseWare.
Lecture 7: Equities
20072008 by Andrew W. Lo
Slide 6
The Dividend Discount Model
Most Basic Valuation Model for Common Stock Applies PV formulas to common-stock payouts Two inputs: expected future dividends, discount rate Notation: Pt: Price of stock at t (ex-dividend) Dt: Cash dividend at t Et [ ]: Expectation operator (forecast) at t rt: Risk-adjusted discount rate for cashflow at t
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Lecture 7: Equities
20072008 by Andrew W. Lo
Slide 7
The Dividend Discount Model
Most Basic Valuation Model for Common Stock Two additional simplifying assumptions:
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In this case, we have the first version of the dividend discount model or the discounted cashflow (DCF) model
Suppose dividends grow at rate g over time (Gordon growth model):
Lecture 7: Equities
20072008 by Andrew W. Lo
Slide 8
The Dividend Discount Model
Most Basic Valuation Model for Common Stock This provides a convenient expression for the discount rate:
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Lecture 7: Equities
20072008 by Andrew W. Lo
Slide 9
The Dividend Discount Model
Example:
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Dividends are expected to grow at 6% per year and the current dividend is $1 per share. The expected rate of return is 20%. What should the current stock price be?
Note: DDM with constant growth gives a relation between current stock price, current dividend, dividend growth rate and the expected return. Knowing three of the variables determines the fourth.
Lecture 7: Equities
20072008 by Andrew W. Lo
Slide 10
The Dividend Discount Model
Example:
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Determine the cost of capital of Duke Power. In 09/92, the dividend yield for Duke Power was D0/P0 = 0.052. Estimates of long-run growth:
The cost of capital is given by
Thus,
Lecture 7: Equities
20072008 by Andrew W. Lo
Slide 11
DDM with Multiple-Stage Growth
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Firms May Have Multiple Stages of Growth Growth Stage: rapidly expanding sales, high profit margins, and abnormally high growth in earnings per share, many new investment opportunities, low dividend payout ratio Transition Stage: growth rate and profit margin reduced by competition, fewer new investment opportunities, high payout ratio Mature Stage: earnings growth, payout ratio and average return on equity stabilizes for the remaining life of the firm Example: A company with D0 = $1 and r = 20% grows at 6% for the first 7 years and then drops to zero thereafter. What should its current price be?
Lecture 7: Equities
20072008 by Andrew W. Lo
Slide 12
EPS and P/E
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Dividend Forecasts Involve Many Practical Challenges Terminology: Earnings: total profit net of depreciation and taxes Payout Ratio p: dividend/earnings = DPS/EPS Retained Earnings: (earnings - dividends) Plowback Ratio b: retained earnings/total earnings Book Value BV: cumulative retained earnings Return on Book Equity ROE: earnings/BV Using these concepts, different valuation formulas may be derived Note: these are mostly based on accounting data, not market values
Lecture 7: Equities
20072008 by Andrew W. Lo
Slide 13
EPS and P/E
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Example: (Myers) Texas Western (TW) is expected to earn $1.00 next year. Book value per share is $10.00 now. TW plans an investment program which will increase net book assets by 8% per year. Earnings are expected to grow proportionally. The investment is financed by retained earnings. The discount rate is 10%, which is assumed to be the same as the rate of return on new investments. Price TW's share price if TW expands at 8% forever TW's expansion slows down to 4% after year 5 Observe that Plowback Ratio b = (10)(0.08)/(1) = 0.8 Payout Ratio p = (1-0.8)/(1) = 0.2 ROE = 10%
Lecture 7: Equities
20072008 by Andrew W. Lo
Slide 14
EPS and P/E
Example (cont): Continuing Expansion Case:
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Lecture 7: Equities
20072008 by Andrew W. Lo
Slide 15
EPS and P/E
Example (cont): 2-Stage Expansion Case. Forecast EPS, D, BVPS by year:
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Question: Why are the values the same under both scenarios?
Lecture 7: Equities
20072008 by Andrew W. Lo
Slide 16
Growth Opportunities and Growth Stocks
What Are Growth Stocks? Stocks of companies that have access to growth opportunities are considered growth stocks Growth opportunities are investment opportunities that earn expected returns higher than the required rate of return on capital Example: IBM in the 60's and 70's. Note: The following may not be growth stocks A stock with growing EPS A stock with growing dividends A stock with growing assets Note: The following may be growth stocks A stock with EPS growing slower than required rate of return A stock with DPS growing slower than required rate of return
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Lecture 7: Equities
20072008 by Andrew W. Lo
Slide 17
Growth Opportunities and Growth Stocks Example:
ABC Software has: Expected EPS next year of $8.33; Payout ratio of 0.6; ROE of 25%; and, cost of capital of r=15%
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Following a no-growth strategy (g=0,p=1), its value is
Following a growth strategy, its price is
Difference of $100 - $55.56 = $44.44 comes from growth opportunities, which offers a return of 25%, higher than the required rate of return 15%
Lecture 7: Equities 20072008 by Andrew W. Lo Slide 18
Growth Opportunities and Growth Stocks
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Example (cont): At t = 1: ABC can invest (0.4)(8.33)=$3.33 at a permanent 25% rate of return. This investment generates a cash flow of (0.25)(3.33) = $0.83 per year starting at the t=2. Its NPV at t=1 is
At t = 2: Everything is the same except that ABC will invest $3.67, 10% more than at t = 1 (the growth is 10%). The investment is made with NPV being
The total present value of growth opportunities (PVGO) is
This makes up the difference in value between growth and no-growth
Lecture 7: Equities
20072008 by Andrew W. Lo
Slide 19
Growth Opportunities and Growth Stocks
Stock Price Can Be Decomposed Into Two Components 1. Present value of earnings under a no-growth policy 2. Present value of growth opportunities
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Terminology*: Earnings yield: E/P = EPS1/P0 P/E ratio: P/E = P0/EPS1
*Note: In newspapers, P/E ratios are often computed with the most recent earnings, but investors are more concerned with price relative to future earnings.
20072008 by Andrew W. Lo
Lecture 7: Equities
Slide 20
Growth Opportunities and Growth Stocks
If PVGO = 0, P/E ratio equals inverse of cost of capital
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If PVGO > 0, P/E ratio becomes higher:
PVGO is positive only if the firm earns more than its cost of capital
Lecture 7: Equities
20072008 by Andrew W. Lo
Slide 21
Key Points
The Dividend Discount Model The Gordon Growth Model Discount rate, cost of capital, required rate of return Estimating discount rates with D/P and g EPS, P/E, and PVGO Definitions of growth stocks and growth opportunities
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Lecture 7: Equities
20072008 by Andrew W. Lo
Slide 22
Additional References
Lefevre, E., 2006, Reminiscences of a Stock Operator. New York: John Wiley & Sons. Malkiel, B., 1996, A Random Walk Down Wall Street: Including a Life-Cycle Guide to Personal Investing. New York: W.W. Norton.
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Harris, L., 2002, Trading and Exchanges: Market Microstructure for Practitioners. New York: Oxford University Press.
Lecture 7: Equities
20072008 by Andrew W. Lo
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MIT OpenCourseWare [Link]
15.401 Finance Theory I
Fall 2008
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