Strong Form of Efficiency. The true believers in market efficiency have faith that stock prices reflect all public and private information. That intense faith has been proven unfounded in many instances. The criminal trials of Ivan Boesky, Michael Milken, and Martha Stewart were well-publicized cases in which insider information was used to make profits that the public had no chance of making.
Research indicates that the weak form of market efficiency has held true over time. Naive beliefs in complete efficiency are not warranted. Stocks are generally fairly valued, yet some people deny even the weak form of the efficient market hypothesis. As mentioned, chartists or technical analysts graph price movements seeking patterns that will indicate price movement in the future.
Investors that speculate that unforseen, hugely negative market events will happen are called Black Swan investors. When the market panics, they prosper.
INVESTMENT TYPES AND VALUATION METHODS
In the QA chapter the concepts of discounted cash flows and net present value were covered in detail. A dollar held today is worth more than a dollar received in the future. That simple concept, applied to the cash thrown off by an investment, is in most cases the method used to value investments.
THE BOND MARKET
A bond’s value comes from the present value of its future cash flows. Bonds are issued by companies or governmental agencies to raise money at fixed rates of interest. Most pay interest, a coupon, semiannually on the principal amount, called the face or par value. At the stated maturity date, the principal is repaid.
In most cases the longer the maturity, the higher the interest rate that a company has to pay investors. Higher rates compensate investors for tying up their money for lengthy periods. Investors could miss out on higher returns if the market rates go higher; therefore, they must be compensated for that risk. The basic concept that higher rates accompany longer maturities is graphically depicted in what the investment world calls the yield curve. In 1992, it was upward sloping with a 5 percent difference between short- and long-term interest rates. In January 1999, the curve was flat with only 3⁄4 of 1 percent difference in rates. In 2005 the yield curve was once again sloping upward with a 2.5 percent difference, but at a much lower level of interest rates. And in 2011 there was a 4 percent difference because the Federal Reserve artificially held short-term rates near zero.
THE YIELD CURVE FOR U.S. TREASURY SECURITIES
A Bond Valuation Example. In 1976, Caterpillar Inc., the maker of heavy construction equipment, issued $200 million worth of 8 percent coupon bonds maturing in 2001. In June 1992, while the issue was still outstanding, the price for the bond was quoted in the Wall Street Journal as $100 for every $100 of face value. The value was determined not only by the rate of interest paid, but by three other factors:
The Stated Interest Rate (the coupon rate)
The Length of Time Until Maturity
The Risk of Default of the Issuer (investment researchers publish ratings)
The fact is that the market quote was $100. That indicated that the market valued the $100 payable in 2001, paying an 8 percent semiannual coupon, from a stable company at $100. The Moody’s bond rating service confirmed a low default risk assessment by their A rating. Using the net present value concept, the cash thrown off by the bond, discounted at an 8 percent market discount rate in 1992, equaled the bond’s market value. Because the market rate equaled the coupon rate, investors paid neither a premium nor a discount on the face value of the Caterpillar bonds. The bonds had an 8 percent yield to maturity (YTM) on the $100 market value of the bonds.
CATERPILLAR BOND VALUATION OF DISCOUNTED CASH FLOWS
Above is the calculation in detail; normally, however, you should use a calculator to do the math. Seeing it in this form helps you visualize the time value of money. If the market thought Caterpillar was on the verge of bankruptcy, or if the market interest rates on all investments skyrocketed in a period of high inflation, then investors might have required a 20 percent rate of return on their money. If that were the case, the $100 bond would have been worth only $49.69. The increased riskiness of the cash flows would reduce the bond’s value. Conversely, a discount rate of 5 percent would have yielded a market price of $123.16. In that case an 8 percent coupon would be higher than the market rate and investors would pay a premium for the higher cash flows.
TIME AND DISCOUNT RATE EFFECTS ON PRESENT VALUE
Graphically, cash discounted at higher rates is worth less. The further out the cash is received, the less it is worth to an investor today.
Duration. Another way of evaluating a bond is by calculating a bond’s “average weighted maturity,” called its duration. Duration is the time a bond takes to return half of its market price to the investor. It also measures the sensitivity of a bond to changes in market interest rates. The further in the future a bond is paid out, the more volatile its value. If a bond matures in one year, it would be considered a short-term bond; all the proceeds would be paid quickly and the bond’s volatility would be low. Long-term bonds offer a fixed interest payout over many years. If market rates climb, an investor is locked into lower rates for a long time. As a consequence, the bond will be devalued dramatically.
In the case of the Caterpillar bond, it paid back $50 of the investors’ $100 investment in nine years. That’s the bond’s duration. This is a long time for a bond; as a consequence, its value responded dramatically to swings in interest rates, from $49.65 with a 20 percent rate to $123.16 with a 5 percent rate.
Don’t worry about the math—computers will do the calculations for you. As a Ten-Day MBA, you can now ask your broker not only for the bond’s yield, but also for its duration, and he or she will know that you are more than a retiree looking for a safe invest-ment.
Other Types of Bonds. There are five more types of bonds of note: zero coupon bonds, consuls, convertible bonds, callable bonds, and junk bonds.
A zero coupon bond bears no interest, but pays a lump sum at maturity. Investors value the bond the same way as one that pays interest, but there are no interest payments to discount.
A consul or perpetuity is a bond that never pays back the principal, but continues to pay interest forever. These bonds are unusual but they still are issued in the United Kingdom. The valuation technique is simple. The cash flow or interest payment is divided by the discount rate. A hypothetical example: London Telephone agreed to issue a $100 consul that pays $8 each year forever. If investors require a 10 percent rate of return, the value would be $80 ($8/.10)
Sometimes a company adds an even more exciting provision called a conversion feature to bonds. Convertible bonds are convertible to common stock at a predetermined conversion ratio. For example, let’s assume that Caterpillar’s $1,000 face value of bonds was convertible into ten shares of stock or $100 per share. If Caterpillar’s stock price rose above $100 per share, bondholders might consider converting their bonds into common shares of stock. Convertible bonds usually pay a lower interest rate than nonconvertible bonds, because they provide investors with an additional option.
The fourth type of bond is a callable bond. In some instances issuers want the option to buy back their bonds from the public if interest rates fall significantly after the issue date. In 1981, large corporations sold bonds paying 15 to 20 percent interest per year, the prevailing market rates. As interest rates fell later, in the 1980s and 1990s, the corporations that had included a call provision bought back their bonds at predetermined prices and issued new ones in the early 1990s paying 7 to 8 percent and bought even more in the late 1990s and 2000s for new issues at 5 to 6 percent. Because call provisions limit unusually high rates of return, corporations have to pay a higher interest rate for the privilege of calling back the bonds.
The last classification, a junk bond, is a bond that has a high risk of default. Often their risk lies in that they may be subordinated to the claims of other bonds issued by a company. Junk bonds pay higher rates to investors, and most still pay their in
terest and principal on time. If the company does not have enough money to make payments on its borrowing, the subordinated debt holders get paid last.
Junk bonds have been around as long as there have been bonds. During the Civil War the Confederacy issued risky bonds that could be termed junk bonds. Billions of junk bonds were issued for takeovers in the late 1980s, by such well-known firms as RJR Nabisco, MCI, Macy’s, and Metromedia. Junk bonds are not “junk”; they simply have a higher risk of default because they are issued by companies without stellar credit ratings.
BOND VALUATION SUMMARY
Higher Risk of Default or Higher Market Rates → Higher Disc. Rate → Lower Bond Value
Lower Risk of Default or Lower Market Rates → Lower Disc. Rate → Higher Bond Value
Higher Coupon Rate or Shorter Maturity → Shorter Duration → Value Less Volatile to Mkt. Rate Chgs.
Lower Coupon Rate or Longer Maturity → Longer Duration → Value More Volatile to Mkt. Rate Chgs.
THE STOCK MARKET
Stocks have no contractual terms of payment and no maturity. If earnings are adequate, most companies regularly pay dividends to stockholders. But there are no guarantees. Building on the teachings of accounting, equity ownership of a company entitles the owner to the residual claim on earnings and assets after all the other obligations, such as bonds, have been met. If there are no earnings, there’s little value to the stock. With adequate profits, bonds are paid on time and hopefully there is a portion left for stockholders.
Stocks are called by many names, depending on the company’s characteristics.
CLASSES OF STOCKS
CLASS: Growth Stocks
DESCRIPTION: Rapidly Growing Companies
EXAMPLES: Google, Netflix
CLASS: Blue-Chip Stocks
DESCRIPTION: Very Large Companies
EXAMPLES: Coca-Cola, Microsoft
CLASS: Cyclical Stocks
DESCRIPTION: Fluctuate Greatly with Economy
EXAMPLES: Ford, United Airlines
CLASS: Penny Stocks
DESCRIPTION: Risky, Small Companies with Low Share Prices
EXAMPLES: Jet Electro
The Dividend Growth Model. One way that investment analysts try to value stocks is by valuing the dividend cash flow. This value model heavily weights dividend growth in its formula. However, it does not always yield a reasonable answer.
The stock of Caterpillar Inc. is a good example. In 1992 the company paid a $1.20 yearly dividend per share. Using the CAPM equation, the required rate for Caterpillar’s beta of 1.2 was 16.8 percent, the same as IBM’s at the time. Caterpillar’s board of directors had raised their dividend an average 12 percent for the last few years. With those inputs in the dividend growth model, the stock should have been worth $25.
But Caterpillar actually traded at $56 per share in May 1992. Either there must have been more than just dividends to the company, or the market had gone nuts. But probably not. Investors must also have valued the company’s assets and future earnings as well.
What is an analyst to do with Wal-Mart stores, the discounter that pays small dividends? How do analysts value Internet firms that have no earnings and no dividends? There are no easy formulas, but the following are a few additional methods used by securities analysts to calculate value.
Price-Earnings Ratio. Analysts compare the ratio of the current stock price to the current or projected earnings per share (EPS). This price-earnings ratio (PE ratio) is probably the most widely used valuation method. It is simple. Everyone can divide price by earnings per share. Best yet, the EPS of most companies are widely published. If that ratio is in line with the industry of the business and with the market, then it may indicate the propriety of its current stock price. To illustrate the wide use of the PE ratio, the following was a stock picker’s recommendation:
Corestates Financial at $44, the old Philadelphia National Bank, has a low price-earnings multiple relative to other banks, and its dividend yield is higher than other banks mentioned. Strong buying interest exists.
The PEG ratio is a twist on the price-earnings ratio that factors in earnings growth. The PEG ration is calculated by dividing a company’s PE by its projected long-term earnings growth rate. That growth projection is subject to a great deal of uncertainty. PEGs near or below 1.0 are considered possible bargains. In January 2005, Sina, an Internet software and service provider, traded at $30 and had an attractive PEG ratio of 0.6. By July 2011, the market had recognized the value, and Sina traded at $110 and had a PEG ratio of 5.
Multiple of Book Value per Share. This calculation using balance-sheet information divides the share price by the book value of assets per share. In 1992, ImClone Systems, a biopharmaceuticals company, sold at 331 times its book value. Forbes highlighted it as possibly overvalued, but the ratios of small, new companies are often unusual. Investors often value the potential success of start-up companies, not their current size. In this case, ImClone’s stock plummeted from a high of $26 in 1992 to $.31 in 1995, when biotechnology fell out of favor with investors. When sales materialized in 1998, it traded at $10 a share, five times its book value. When Martha Stewart allegedly heard bad news about ImClone’s failed FDA drug application in December 2000, she sold her stock at $60 a share, when it traded at thirty-six times book value.
Price-to-Sales Ratio. Stock price divided by sales is the formula. In 1999, eBay, Inc., an Internet auction site, had a price-to-sales ratio of 1,681. With few sales, the multiple was large. Investors were buying the future of the Internet. When sales materialized in 2004, eBay had a somewhat more reasonable twenty-three sales-to-price ratio.
Asset Value per Share. When a company’s assets value divided by the outstanding shares is more valuable than the price of the stock indicates, then analysts might overlook other ratios. The buyout binge in oil stocks was due their share prices being below the value of their oil and gas reserves. As a result, Getty, Gulf, Mesa, and Phillips engaged in a bidding war that made their shares soar in the 1980s.
Multiple of Cash Flow per Share. Some analysts value companies because of their ability to generate cash as measured by the company’s cash flow statement. In Caterpillar’s case, it produced $5.90 for each share outstanding in 1992. At $56 per share, the stock was priced at 9.5 times cash flow. Looking forward, analysts projected $11.10 in 1993 and $17.80 in later years, or three times the projected cash flow. That is where some bullish investors saw the value of Caterpillar. If a group of analysts valued the $17.80 cash flow per year in perpetuity at a 16.8 percent discount rate, the stock would have a net present value of $100 (17.80/.168). To them, at $56 Caterpillar was still cheap. It traded at $60 in 1999 and $83 in 2004 and 2011; they were all wrong.
In a stock market there are always buyers and sellers. Imbalances cause price movements. Many yardsticks of value exist, but the only one that truly matters is the current quote, no matter how crazy it may appear. If the market is willing to buy Caterpillar at $200, then that is its value. Of course, if there is more supply than demand, prices fall. But that’s for our economics chapter.
Preferred Stock. This is the privileged cousin of common stock. Preferred shares, a hybrid of a bond and a common stock, are issued by many utilities, banks, and steel companies. Preferreds have the characteristics of a bond inasmuch as they pay a fixed dividend rate and have no voting rights. As in the case of common stocks, their dividends can only be paid if debt payments are made first, and there is no maturity. However, most issuers make provisions to purchase and retire their preferred stock over time. A preferred stock’s claims on the assets of the firm are superior to common stock but are subordinated to debt.
Companies issue preferred stock when they want to borrow money but don’t want to be contractually obligated to pay interest on time. Most preferred issues are cumulative, meaning that the total of all unpaid dividends must be paid before dividends on common stocks can be paid. Investors who like a more secure dividend, but like to have the benefits of partial
equity ownership, choose preferred stocks.
THE OPTIONS MARKET
Options are contractual rights to buy or sell any asset at a fixed price on or before a stated date. Options can be traded on real estate, bonds, gold, oil, currencies, or even mortgages. An option is a way to gain control of a great deal of assets with little money. The opportunity for profits is high, and, accordingly, so are the risks.
Because these option rights are not the asset itself, they are called derivatives. Any security that is created that is valued based on the value of another is a derivative. Stock options, stock warrants, index options, commodity options, and commodity futures are examples.
Imagine G. R. Quick, a house buyer, who believes that prices are about to skyrocket in Beverly Hills. However, he needs six months to raise the down payment and get financing. A willing owner agrees to sell him his bungalow at $1,000,000, but wants $5,000 for the option to hold it off the market for six months. For six months Mr. Quick, the option holder, has the right, but not the obligation, to purchase the house for $1,000,000. If the real estate market falls, Mr. Quick can let his $5,000 option expire at a 100 percent loss.
But options can also be very profitable. If the bungalow increases in value to say $1,050,000, the return on the $5,000 option would be 1,000 percent. If he buys the house outright for $1,000,000, his return would be only 5 percent. The essence of options is to control the destiny of an asset with an investment of a fraction of that asset’s value. The payoff is a leveraged payoff or a possible total loss if the underlying asset’s value fluctuates.
The Ten-Day MBA 4th Ed. Page 19