Stocks, Market Values, and Valuation in Financial Accounting

Stocks and the Stock Market

Primary and Secondary Markets

The stock market is a platform for buying and selling ownership shares in corporations. It consists of two main types of markets: the primary market and the secondary market.

• Primary Market: The market for the sale of new securities by corporations. This is where companies raise capital by issuing new shares to investors.

• Initial Public Offering (IPO): The first offering of stock to the general public, allowing a corporation to sell shares in the firm.

• Secondary Market: The market in which previously issued securities are traded among investors. This is where most stock trading occurs.

Common Stock and Key Terms

Common stock represents ownership shares in a publicly held corporation. Investors in common stock may receive periodic cash distributions called dividends.

• Dividend: A periodic cash distribution from the firm to the shareholders.

• P/E Ratio: The ratio of stock price to earnings per share, used to assess valuation.

Bid and Ask Prices

Stock transactions occur at bid and ask prices, which reflect the prices buyers and sellers are willing to transact at.

• Bid Price: The price at which investors are willing to buy shares.

• Ask Price: The price at which current shareholders are willing to sell their shares.

Example: Calculating Purchase Cost, P/E Ratio, and Dividend Yield

• Purchase Cost: If you wish to purchase 100 shares of FedEx at an ask price of $167.43, the total investment is $16,743.

• P/E Ratio: $\frac{167.43}{4.90} = 34.17$

• Dividend Yield: $\frac{2.60}{167.43} = 0.0155$ or 1.55%

Stock Price History

Stock prices fluctuate over time, as shown in the price history chart for FedEx. These fluctuations are influenced by market conditions, company performance, and investor sentiment.

Market Values, Book Values, and Liquidation Values

Definitions

Understanding the different measures of a firm's value is essential in financial accounting and investment analysis.

• Book Value: The net worth of the firm according to the balance sheet (assets minus liabilities).

• Liquidation Value: The proceeds that could be realized by selling the firm's assets and paying off its creditors.

• Market Value Balance Sheet: A financial statement that uses market value of all assets and liabilities.

Market Value vs. Book Value Table

The following table compares stock price (market value) and book value per share for selected companies as of July 2020.

Ticker	Stock Price	Book Value per Share	Market-to-Book Ratio
FDX	129.28	70.03	1.8
JNJ	146.75	22.82	6.4
CPB	49.87	8.57	5.8
PEP	128.69	8.53	15.1
WMT	123.10	22.55	5.5
MSFT	182.33	14.07	13.0
AMZN	2,442.37	107.03	22.8
DOW	37.54	15.26	2.5
AEP	82.85	37.66	2.2
X	8.02	17.06	0.5

Going Concern Value

The difference between a firm's actual market value and its liquidation or book value is attributable to its "going-concern value." This reflects the firm's ability to continue operating and generating profits.

• Extra earning power

• Intangible assets

• Value of future investments

Valuing Common Stocks

Stock Valuation Methods

There are several approaches to valuing common stocks, including:

• Valuation by Comparables: Comparing a company's valuation ratios to those of similar firms.

• Ratios and Multiples: Common ratios include the price-earnings (P/E) ratio and market-to-book ratio.

• Intrinsic Value: The present value of future cash payoffs from a stock or other security.

• Dividend Discount Model (DDM): A discounted cash-flow model which states that today’s stock price equals the present value of all expected future dividends.

Valuation by Comparables Table

The table below shows market-to-book value ratios and price-earnings ratios for selected companies and their industries (May 2020).

Company	Industry	Market-to-Book Value Ratio	Company	Industry	Price-Earnings Ratio
FDX	7.3	1.8	FDX	23.7	12.4
JNJ	4.9	6.4	JNJ	21.3	18.9
CPB	2.9	5.8	CPB	22.8	17.3
PEP	10.0	15.1	PEP	22.5	24.4
WMT	4.0	5.5	WMT	23.2	23.2
MSFT	6.6	13.0	MSFT	31.2	32.3
AMZN	9.4	22.8	AMZN	17.4	138.9
DOW	3.5	2.5	DOW	20.0	40.5
AEP	1.9	2.2	AEP	22.0	20.6
X	2.3	0.5	X	8.0	12.4

Intrinsic Value and Dividend Discount Model

The intrinsic value of a stock is the present value of its expected future dividends and price appreciation, discounted at the required rate of return.

• Formula: $P_0 = \frac{DIV_1 + P_1}{1 + r}$

• Example: If expected dividends are $3 per share and the expected price in one year is $81, with a discount rate of 12%, then$P_0 = \frac{3.00 + 81.00}{1.12} = 75.00$

The Dividend Discount Model (DDM) can be extended for multiple periods:

• General DDM Formula: $P_0 = \frac{DIV_1}{1 + r} + \frac{DIV_2}{(1 + r)^2} + ... + \frac{P_n}{(1 + r)^n}$

Expected Return

The expected return is the percentage yield that an investor forecasts from a specific investment over a set time period. It can be broken into dividend yield and capital appreciation.

• Formula: $\text{Expected return} = \frac{DIV_1 + P_1 - P_0}{P_0}$

• Example: If the stock price started the year at $75, expected dividend is $3, and expected price is $81, then$\text{Expected return} = \frac{3.00 + 81.00 - 75.00}{75.00} = 12\%$

• Dividend Yield: $\frac{DIV_1}{P_0}$

• Capital Gain: $\frac{P_1 - P_0}{P_0}$

Simplifying the Dividend Discount Model

Perpetuity and Constant-Growth DDM

If dividends are expected to remain constant indefinitely, the stock can be valued as a perpetuity:

• Perpetuity Formula: $P_0 = \frac{DIV}{r}$

If dividends are expected to grow at a constant rate (Gordon Growth Model):

• Constant-Growth DDM: $P_0 = \frac{DIV_1}{r - g}$

• Example: If a stock pays a $0.86 dividend next year, growing at 4.75% per year, with a 7.0% expected return:$P_0 = \frac{0.86}{0.07 - 0.0475}$

Plowback and Sustainable Growth Rate

The sustainable growth rate is the firm's growth rate if it reinvests a constant fraction of earnings (plowback ratio) and maintains a constant return on equity (ROE).

• Formula: $g = \text{ROE} \times \text{Plowback Ratio}$

The present value of growth opportunities (PVGO) is the value added by future investments.

• PVGO Formula: $PVGO = P_{\text{with growth}} - P_{\text{no growth}}$

Valuing a Business by Discounted Cash Flow

Discounted Cash Flow (DCF) Model

The DCF model values a business by estimating the present value of all expected future cash flows, discounted at the appropriate rate.

• Formula: $PV = \sum_{t=1}^{n} \frac{CF_t}{(1 + r)^t}$

There Are No Free Lunches on Wall Street

Market Efficiency and Random Walk Theory

Market efficiency suggests that stock prices reflect all available information, making it difficult to consistently outperform the market.

• Random Walk Theory: Security prices change randomly, with no predictable trends or patterns.

• Forms of Market Efficiency:

  • Weak Form: Prices reflect all historical information.

  • Semi-Strong Form: Prices reflect all publicly available information.

  • Strong Form: Prices reflect all information, both public and private.

Market Anomalies and Behavioral Finance

Market Anomalies

Market anomalies are patterns or factors that seem to contradict the efficient market hypothesis.

• Momentum Factor

• Book-to-Market Factor

• Small Firm Effect

• January Effect

• P/E Effect

• Neglected Firm Effect

• Value Line Effect

Behavioral Finance

Behavioral finance studies how psychological factors and biases affect investor behavior and market outcomes.

• Attitudes towards risk

• Beliefs about probabilities

• Sentiment