Chapter Organization 8.1. Common Stock Valuation 8.2. Some Features of Common and Preferred Stock 8.3. Stock Markets

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Roland Carr
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1 Chapter 8 Stock Valuation Chapter Organization 8.. Some Features of Common and referred Stock A share of common stock is more difficult to value in practice than a bond for at least three reasons:. with common stock, not even the promised cash flows are known in advance.. the life of investment is essentially forever, since common stock has no maturity.. there is no way to easily observe the rate of return that the market requires. Nonetheless there are cases in which we can come up with the present value of the future cash flows for a share of stock and thus determine its value. Cash Flows Cash Flows Imagine that you are considering buying a share of stock today. You plan to sell the stock in one year. You somehow know that the stock will be worth 7 at that time. You predict that the stock will also pay a per share dividend at the end of the year. If you require a 5% return on your investment, what is the most you would pay for the stock? 4

2 7 8 resent value 64,5,5 More generally, let be the current price of the stock, and assign to be the price in one period. If is the cash dividend paid at the end of the period, then: ( ) / (R) where R is the required return in the market on this investment. 5 6 If we wanted to determine the value of a share of stock today ( ), we would first have to come up with the value in one year ( ). What is the price in one period,? ( ) / (R) If we were to substitute this expression for into our expression for, we would have: R ( R) R R 7 8

3 ( ) / (R) If we substitute this back in for, we have: R We have illustrated here that the price of the stock today is equal to the present value of all of the future dividends Some Special Cases There are a few very useful special circumstances under which we can come up with a value for the stock. What we have to do is to make some simplifying assumptions about the pattern of future dividends. The three cases we are going to consider are:. the dividend has a zero growth rate,. the dividend grows at a constant rate,. the dividend grows at a constant rate after some length of time.

4 Zero Growth constant So, the value of the stock is: / R For example, suppose the aradise rototyping Company has a policy of paying a per share dividend every year. If this policy is to be continued indefinitely, what is the value of a share of stock if the required return is %? The stock in this case amounts to an ordinary perpetuity, so the stock is worth /, 5 4 Constant Growth Suppose we know that the dividend for some company always grows at a steady rate. Call this growth rate g. If we let be the dividend just paid, then the next dividend,, is: x (g) The dividend in two periods is: x (g) [ x (g)] x (g) We could repeat this process to come up with the dividend at any point in the future. We know that the dividend of t period into the future, t, could be expressed as: t x (g) t x (g) 5 6 4

5 The Hedless Corporation has just paid a dividend of per share. The dividend of this company grows at a steady rate of 8% per year. What will the dividend be in five years? x,8 5 x,469 4,4 If the dividend grows at a steady rate and if we take to be the dividend just paid and g to be the constant growth rate, the value of stock can be written as: ( g) ( g)... ( g) As long as the growth rate, g, is less than the discount rate, r, the present value of this series of cash flows can be written as: ( g) This result goes by a lot of different names. We will call it the dividend growth model. To illustrate, suppose is,, R is %, and g is 5%. The price per share in this case is: ( g), (,5),,5,45,8,9 9 5

6 In general, the price of the stock as of time t is: t t ( g) t Suppose we are interested in the price of the stock in five years, 5. We first need the dividend at Time 5, 5. Because the dividend just paid is, and the growth rate is 5% per year, 5 is: 5, x,5 5, x,76, ( g),8 8,5,8,95 (,5),,5 Gordon Growth Company Gordon Growth Company The next dividend for the Gordon Growth Company will be 4 per share. Investors require a 6% return on companies such as Gordon. Gordon s dividend increases by 6% every year. What is the value of Gordon s stock today? What is the value in four years? 4 6

7 4 4,6 -,6, 4 x (g) 4 x,6 4, ( g) 5,5 5,5, 4 4,764 (,6),6,6 In this example 4 is equal to x (g) 4 4 x (g) 4 4 x,6 4 5,5 To see why this is so, first notice that: 4 5 However, 5 is just equal to x (g) 4, so we can write 4 as: ( g) 4 ( g) 4 R g ( g) This example illustrates that the dividend growth model makes the implicit assumption that the stock price will grow at the same constant rate as the dividend. 4 What would happen with the dividend growth model if the growth rate, g, were greater than the discount rate, R. Then the constant growth rate exceeds the discount rate the stock price is infinitely large

8 The expression we came up with for the constant growth case will work for any growing perpetuity. If C is the next cash flow on a growing perpetuity, then the present value of a cash flows is given by: Vgrowing C C ( g) perpetuity _ Non-constant Growth Consider the case of a company that is currently not paying dividends. You predict that, in five years, the company will pay a dividend for a first time. The dividend will be,5 per share. You expect that this dividend will grow at a % per year indefinitely. The required return on companies such as this one is %. What is the price of the stock today? 9 Using the dividend growth model, we can say that the price in four years will be:,5,, If the stock is worth 5 in four years, then we can get the current value by discounting this price back four years at %: 5 5,4, 5,76 The problem of non-constant growth is only slightly more complicated if the dividends are not zero for the first several years. For example, suppose that you have come with the following dividends forecasts for the next three years: After the third year, the Year ividends dividends will grow at a, constant rate of 5% per year., The required return is %.,5 What is the value of the stock? 8

9 Non-constant growth Constant growth 5% 4 5 5,5 ( g),5 (,5),,5,5,5,5 x,5 x,5,5 5,5,,,,,9,65,88 9,44 4,88 4 Components of the Required Return If we rearrange this to solve for, R, we get: R g 5 This tells us that the total return has two components. The first of these, is called the dividend yield. The second part of the total return is the growth rate, g. We know that the dividend growth rate is also the rate at which the stock price grows. Thus, this growth rate can be interpreted as the capital gains yield, that is the rate at which the value of the investment grows. 6 9

10 To illustrate the components of the required return, suppose we observe a stock selling for per share. The next dividend will be per share. You think that the dividend will grow by % per year more or less indefinitely. What return does this stock offer you if this is correct? The dividend growth model calculates total return as: R ividend yield Capital gain yield R g In this case, total return works out to be : R / % R 5% % 5% Some Features of Common and referred Stock Shareholder Rights A common stock is an equity without priority for dividends or in bankruptcy. Shareholders control the corporation through the right to elect the directors. irectors are elected at an annual shareholders meeting by a vote of the holders of a majority of shares who are present and entitled to vote. Shares must be voted cumulatively or voted straight. 8.. Some Features of Common and referred Stock A cumulative voting is a procedure in which a shareholder may cast all votes for one member of the board of directors. The effect of cumulative voting is to permit minority participation. 9 4

11 8.. Some Features of Common and referred Stock A corporation has two shareholders: Smith with shares and Jones with 8 shares. Both want to be a director. Jones does not want Smith. We assume there are a total of four directors to be elected. Smith will cast x48 votes, and Jones will cast 8x4 votes. If Smith gives all his votes to himself, he is assured of a directorship. 8.. Some Features of Common and referred Stock The reason is that Jones can t divide votes among four candidates in such a way as to give all of them more than 8 votes, so Smith will finish fourth at worst Some Features of Common and referred Stock A straight voting is a procedure in which a shareholder may cast all votes for each member of the board of directors. With straight voting, the directors are elected one at a time. Each time, Smith can cast votes and Jones can cast 8 votes. As a consequence, Jones will elect all of the candidates. The only way to guarantee a seat is to own 5% plus one share. 8.. Some Features of Common and referred Stock Buying the Election Stock in JRJ Corporation sells for $ per share and features cumulative voting. There are. shares outstanding. If three directors are up for election, how much does it cost to ensure yourself a seat on the board. The question here is how many shares of stock it will take to get a seat. The answer is 5, so the cost is 5 x $ $

12 8.. Some Features of Common and referred Stock Why 5? Because there is no way the remaining 7499 votes can be divided among three people to give all of them more than 5 votes. /(N)one share /()one share 5 share 8.. Some Features of Common and referred Stock roxy voting A proxy is the grant of authority by a shareholder to someone else to vote his/her shares. Shareholders can come to the annual meeting and vote in person, or they can transfer their right to vote to another party Some Features of Common and referred Stock Classes of stocks Some firms have more than one class of common stock. Often, the classes are created with unequal voting rights. The Ford Motor Company has class B common stock, which is not publicly traded (it is held by Ford family interests and trusts). This class has 4% of the voting power, even though it represents less than % of the total number of shares outstanding. 8.. Some Features of Common and referred Stock Other Rights In addition to the right to vote for directors, shareholders usually have the following rights:. The right to share proportionally in dividends paid.. The right to share proportionally in assets remaining after liabilities have been paid in liquidation

13 8.. Some Features of Common and referred Stock. The right to vote on stockholder matters of great importance, such as merger. 4. Stockholders have the right to share proportionally in any new stock sold. This is called the preemptive right. 8.. Some Features of Common and referred Stock The dividends are payments by a corporation to shareholders, made in either cash or stock. Some important characteristics of dividends include the following:.unless a dividend is declared by the board of directors of a corporation, it is not a liability of the corporation Some Features of Common and referred Stock.The payment of dividends by the corporation is not a business expense. ividends are not deductible for corporate tax purposes. ividends are paid out of the corporation s after tax profits..ividends received by individual shareholders are for the most part considered ordinary income and are fully taxable. 8.. Some Features of Common and referred Stock referred Stock Features A preferred stock is a stock with dividend priority over common stock, normally with a fixed dividend rate, sometimes without voting rights. 5 5

14 8.. Some Features of Common and referred Stock Stated Value referred shares have a stated value liquidating value, usually $ per share. The cash dividend is described in terms of dollars per share. For example, General Motors $5 preferred easily translates into a dividend yield of 5 % of stated value. 8.. Some Features of Common and referred Stock Cumulative and Noncumulative ividends ividends payable on preferred stock are either cumulative or noncumulative. If preferred dividends are cumulative and are not paid in a particular year, they will be carried forward as an arrearage. Unpaid dividends are not debts of the firm. Holders of preferred shares are often granted voting and other rights if preferred dividends have not been paid for some time The stock market consists of a primary market and a secondary market. rimary market is the market in which new securities are originally sold to investors. Secondary market is the market in which previously issued securities are traded among investors. The price the dealer is willing to pay is called the bid price. The price at which the dealer will sell is called the ask price (sometimes called the asked, offered, or offering price). The difference between the bid and ask prices is called the spread, and it is the basic source of dealer profits

Organization of the New York Stock Exchange (NYSE) The NYSE has about 4 exchange members, who are said to own seats on exchange. Collectively, the members of the exchange are its owners.

15 Organization of the New York Stock Exchange (NYSE) The NYSE has about 4 exchange members, who are said to own seats on exchange. Collectively, the members of the exchange are its owners. Exchange seat owners can buy and sell securities on the exchange floor without paying commissions Commission brokers are a NYSE members who execute customer orders to buy and sell stock transmitted to the exchange floor. A commission broker s primary responsibility to customers is to get the best possible prices for their orders. Specialist is a NYSE member acting as a dealer in a small number of securities on the exchange floor. Specialists are also called market makers because they are obligated to maintain a fair, orderly market for the securities assigned to them

16 Floor brokers are a NYSE members who execute orders for commission brokers on a fee basis. Floor brokers have become less important on the exchange floor because of the efficient SuperOT system (the OT stands for esignated Order Turnaround), which allows orders to be transmitted electronically directly to the specialist. Broker Booth Support SystemSM (BBSSSM): This highly sophisticated computer system is used to receive orders on the Trading Floor. The system is connected to the specialist s post and the broker s handheld computer. 6 6 Operations Fundamentally, the business of the NYSE is to attract and process order flow. The term order flow means the flow of customer orders to buy and to sell stocks. Floor Activity Specialist s post is a fixed place on the exchange floor where the specialist operates. Specialists normally operate in front of their posts to monitor and manage trading in the stocks assigned to them

A specialist and brokers at a post on the Trading Floor NASAQ Operations 65 66 NASAQ stands for National Association of Securities ealers Automated Quotations system.

.nasdaq has a multiple market maker system rather than a specialist system.

17 A specialist and brokers at a post on the Trading Floor NASAQ Operations NASAQ stands for National Association of Securities ealers Automated Quotations system. There are two key differences between the NYSE and Nasdaq:.Nasdaq is a computer network and has no physical location where trading takes place..nasdaq has a multiple market maker system rather than a specialist system. A securities market largely characterized by dealers who buy and sell securities for their own inventories is called an over-the-counter (OTC) market. The Nasdaq is actually made up of two separate markets, the Nasdaq National Market (NNM) and the Nasdaq SmallCap Market

18 As the market for Nasdaq s larger and more actively traded securities, the Nasdaq National Market lists about 45 securities, including some of the bestknown companies in the world. The Nasdaq SmallCap Market is for small companies and lists about 8 individual securities. Nasdaq articipants The Nasdaq has historically been a dealer market, characterized by competing market makers. In the late 99 s, the Nasdaq system was opened to so-called electronic communications networks (ECNs). ECNs are basically web sites that allow investors to trade directly with one another The Nasdaq System The Nasdaq network operates with three levels of information access. Level terminals are designed to provide registered representatives with a timely, accurate source of price quotations for their clients. Level terminals connect market makers with brokers and other dealers and allow subscribers to view price quotes from all Nasdaq market makers and ECNs. In particular, they have access to inside quotes, which are the highest bid quotes and the lowest asked quotes for a Nasdaq-listed security. Level terminals are for the use of market makers only

7 74 5-week high and low: The highest and lowest prices paid for the stock during the past year. Stock: The name of the company.

Many financial websites let you type in the stock symbol or the company s name to find out its symbol. iv: Short for dividend.

19 week high and low: The highest and lowest prices paid for the stock during the past year. Stock: The name of the company. Every stock traded on a securities market also has a symbol. Some newspapers list an abbreviation of the company s name instead of the symbol. Many financial websites let you type in the stock symbol or the company s name to find out its symbol. iv: Short for dividend. A dividend is when a public company decides to pay a portion of its profits to stockholders. For each share of stock owned, a shareholder should receive $.76 from the company s annual profits

20 Yld%: The yield, or rate of return, on a stockholder s investment. It is figured by dividing the annual dividend by the current price of the stock. /E: Short for price/earnings ratio. The price of a share of stock divided by the company s earnings per share for the last year. Sales s: The total amount of stock traded during the previous day. This example shows that,558,4 shares of this stock changed hands. High: The highest price paid for the stock during the previous day. Low: The lowest price paid for the stock during the previous day Last: The last price paid for the stock at the end of the previous day. Change: The difference between the last trade and the previous day s price. 79

2) Which NYSE member is typically an employee of a brokerage company such as Merrill Lynch?

2) Which NYSE member is typically an employee of a brokerage company such as Merrill Lynch? Questions in Chapter 8 concept.qz 1) A is an owner of a seat on the New York Stock Exchange. [A] broker [B] dealer [C] member [D] floor trader [E] specialist [A] :This is an individual who arranges security