Key Concepts. Some Features of Common Stock Common Stock Valuation How stock prices are quoted Preferred Stock

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Peregrine Bryant
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1 1 Key Concepts Some Features of Common Stock Common Stock Valuation How stock prices are quoted Preferred Stock 2 1

I. Common Stock 3 1. Basic Features of Common Stock Forms the major part of corporate equity. The owners are called stockholders, equity holders, or shareholders. Residual Claim.

2 I. Common Stock 3 1. Basic Features of Common Stock Forms the major part of corporate equity. The owners are called stockholders, equity holders, or shareholders. Residual Claim. No preference in receiving dividends or in bankruptcy. Some corporations have more than one class of common stock. Voting rights shareholders control the corporation through the right to elect directors Proxy voting 4 2

3 Pays dividends usually at regular intervals. Dividends are not liability of the corporation. Dividend amount can change U.S. upon board authorization Korea upon authorization in shareholder meeting Payment of dividends is not a business expense. Hence, dividends are paid out of after-tax profits of a corporation. Dividends are ordinary income to shareholders and, thus, fully taxable

4 7 Stock Issued by a corporations only Stock vs. Bond Forms the equity of a corporation Forms liabilities Entitles ownership Provides claim on interest and principal payment Pays dividends Residual claim Investment risk higher (than bonds) Perpetuity with an infinite maturity Bond Issued by a corporation, government, or municipality Interest and face value Senior claim (to shareholders) Investment risk lower (than stocks) Fixed maturity (other than a few exceptional cases) 4

5 2. Valuation of Common Stock When we invest in common stock, we can expect two sources of income form the investment: (1) the dividend income paid regularly until you sell the security (2) the capital gains from selling the shares at a certain point of time in the future. 9 Common Stock Valuation Again, the value of an investment is the sum of all the discounted expected future earnings (cash flows) from the investment. If a shareholder owns a share of the common stock of Firm A. If the shareholder will never sell the share, what do you think is the fair value of his investment? 10 5

equals the present value of all its future dividends.

6 Dividend Discount Model What does the above equation mean? According to the fundamental theory of value, the value of a firm s stock equals the present value of all its future dividends. 11 Life Cycle of a Firm Cash flow Infant Stage Growth Stock Growth Stage 12 No-Growth Stock (Cash Cow) Mature Stage Firm s Life 6

7 Expected Future Cash Flow Growth Stock time 13 Valuation of Growth Stock: Constant Growth Dividend Discount Model How do we compute the intrinsic value of a share of common stock if we know the expected growth pattern of future dividends and the appropriate market required rate of return? Let s assume that the firm grows at a constant rate r. 14 7

8 Constant Growth DDM Define: g = constant dividend growth rate D t = dividend at t Then, D 1 =D 0 (1+g) 15 Constant Growth DDM 16 8

9 You believe that Wellmart has just paid a dividend of $1 on its common stock. You expect future dividends to grow at a rate of 2 percent a year indefinitely. The company's common stock currently sells at $7.35. If you require a return of 16 percent on your investment, will you buy the stock? 17 Creamery Corp. has just determined to skip its dividends on common stock for the next four years. The firm will resume its dividend annual payments in year 5, starting with $4 a share and then increasing payments by 2% annually thereafter. Find out the fair value of the stock, assuming that the fair market return for the stock is 10%. Year 0 Year 4 Year 5 Year 6 $4 $

10 Q.) SKK Corp. is expected to pay $2 dividends at the end of this year. The dividends are predicted to grow at 4% every year until year four. Then, they are likely to grow at 2% per year thereafter. If the market requires 12% from the SKK common stock, what is the fair value of a share of the stock? 19 Q.) Second National Bank sells a perpetuity whose annual payments grow at 5% with the first annual payment of $10 made exactly one year from now. If the appropriate discount rate for the perpetuity is 8%, what is the fair value of the product? 20 10

11 Difficulties with common stock valuation Common stock valuation is very difficult in practice because. Cash flows are not known in advance (Dividends can change). The life of the investment is essentially forever. There is no way to easily observe the market required rate of return Where does r come from? If we rearrange the constant growth DDM formula with respect to r, we get : r = D 1 /P + g Market required rate of return Dividend Yield Dividend Growth Rate (Growth rate of stock) = Capital gains yield Dividend Yield: a stock s expected dividend divided by the stock price Capital gains yield: the rate at which the value of an investment grows 22 11

12 Q. Wellmart has just paid its common dividend of $1.00. The company s dividends are expected to grow at 2% per year. If the current market price of Wellmart s common stock is $7.29, what is the market s required rate of return for the stock? What is the company s dividend yield? 23 How can we value a no-growth stock? Expected Future Cash Flow time 24 12

13 4. Valuation of No-Growth Stock If all future dividends are the same, the present value of the dividend stream constitutes a perpetuity. 25 Example Corporation XYZ pays annual dividends of $9 per share on its common stock. The market s expectation is that the company s common dividend will stay at its current level in the foreseeable future. If investors require a 14% return on the stock, what is the fair price of this security? 26 13

14 5. Stock Quotes

15 29 WFE 2017 Statistics 15

II. Preferred Stock 31 1. Features of Preferred Stock Represents equity of a corporation.

16 II. Preferred Stock Features of Preferred Stock Represents equity of a corporation. Has preference over common equity in payment of dividends and in the distribution of assets in case of liquidation. Pays fixed dividends at regular intervals (like interest payments on bonds). Dividend payment can be either cumulative or noncumulative. Unpaid preferred dividends are not debts of the firm

17 Further Features of Preferred Stock No stated maturity (i.e., Perpetuity) Sometimes no voting rights Valuation of Preferred Stock Valuation Formula for preferred stock Where D = dividend paid on the preferred stock r = required rate of return for the preferred stock Ex.) Corporation XYZ pays annual dividends of $9 per share on its $100 par-value preferred stock. If investors require a 14% return on the preferred stock, what is the fair price of this security? 34 17

18 III. Korea Exchange Established in 1956 as the Korea Stock Exchange KOSDAQ established in 1996 KOFEX (Korea Futures Exchange) established in 1999 KRX was formed in 2005 by consolidating the KSE, KOSDAQ, and KOFEX KONEX established in 2013 Number of listings as of October 2018 KOSPI market: 880 stocks KOSDAQ market: 1,237 stocks KONEX market: 109 stocks Questions A substantial percentage of the companies listed on the NYSE and Nasdaq don t pay dividends. Under what circumstances might a company choose not to pay dividends? Respond briefly to the following statement. You say stock price equals the present value of future dividends? That s crazy! All the investors I know are looking for capital gains

Chapter 5. Topics Covered. Debt vs. Equity: Debt. Valuing Stocks

Chapter 5. Topics Covered. Debt vs. Equity: Debt. Valuing Stocks Chapter 5 Valuing Stocks Topics Covered Preferred Stock and Common Stock Properties Valuing Preferred Stocks Valuing Common Stocks - the Dividend Discount Model No growth Constant growth Variable growth