Fin 3134: Chapter 8 Stock Valuation

what is the purpose of ECNs?

1. increase liquidity 2. increase competition

what makes the NASDAQ unique?

1. is a computer network 2. has no physical location 3. has a multiple market maker system

Cumulative Voting

A procedure in which a shareholder may cast all votes for one member of the board of directors.

Two-Stage Dividend Growth Model: One of the assumptions of the two-stage dividend growth model is that the dividends drop immediately from the high growth rate to the perpetual growth rate. What do you think about this assumption? What happens if this assumption is violated?

If this assumption is violated, the two-stage dividend growth model is not valid. In other words, the price calculated will not be correct. Depending on the stock, it may be more reasonable to assume that the dividends fall from the high growth rate to the low perpetual growth rate over a period of years, rather than in one year.

Voting Rights: When it comes to voting in elections, what are the differences between U.S. political democracy and U.S. corporate democracy?

In a corporate election, you can buy votes (by buying shares), so money can be used to influence or even determine the outcome. Many would argue the same is true in political elections, but, in principle at least, no one has more than one vote in political elections.

General Motors "$5 preferred" translates into a dividend yield of 5% of stated Value? This is a common feature of what type of stock?

Preferred Stock

Which type of stock has fixed dividends?

Preferred Stock

Stock Valuation: Evaluate the following statement: Managers should not focus on the current stock value because doing so will lead to an overemphasis on short-term profits at the expense of long-term profits.

Presumably, the current stock value reflects the risk, timing and magnitude of all future cash flows, both short-term and long-term. If this is correct, then the statement is false.

What ratio could you use to value newer companies that don't pay dividends and are not yet profitable?

Price-Sales Ratio

people who do not buy or sell securities for their OWN accounts. facilitating trades by others is their business This is a distinctive characteristic of what?

Security Brokers

Preemptive Right

The right of stockholders to buy new shares of stock before they are offered to the public.

Dividend Growth Model: Based on the dividend growth model, what are the two components of the total return on a share of stock? Which do you think is typically larger?

The two components are the dividend yield and the capital gains yield. For most companies, the capital gains yield is larger. This is easy to see for companies that pay no dividends. For companies that do pay dividends, the dividend yields are rarely over 5 percent and are often much less.

The present value of all future dividends is what?

The value of the stock

Zero Growth Stock

a share of common stock in a company with a constant dividend is much like a share of preferred stock

Dividend Yield

a stock's expected cash dividend divided by its current price

Electronic Communications Networks (ECNs) [NASDAQ]

a website that allows investors to trade directly with each other

What is Arca? [electronic Platform]

accounts or a substantial percentage of all trading on the NYSE

Broker

an agent who arranges security transactions among investors ex: real estate broker DOES NOT maintain an inventory

Dealer

an agent who buys and sells securities from inventory ex: used car dealer maintains an inventory

growing perpetuity

an asset with cash flows that grow at a constant rate forever

Members

as of 2006, a member is the owner of a trading license on the NYSE

Over-The-Counter (OTC) Market

securities market in which trading is almost exclusively done through dealers who buy and sell for their own inventories. [NASDAQ]

Who has the right to vote for directors?

shareholders

who has the right to share proportionally in assets remaining after liabilities have been paid in a liquidation?

shareholders

who has the right to share proportionally in dividends paid?

shareholders

who has the right to vote on stockholder matters of great importance, such as a merger? Voting is usually done at an annual meeting or a special meeting.

shareholders

Dividends

the cash flows from a share of stock

Capital Gains Yield

the dividend growth rate, or the rate at which the value of an investment grows

Two-Stage Growth

the dividend will grow at a rate of g1 for t years and then grow at a rate of g2 thereafter forever

Preferred stock have obligatory sinking funds. why do sinking funds exist?

the existence of a sinking fund effectively creates a final maturity because it means that the entire issue will ultimately be retired.

Order Flow

the flow of customer orders to buy and sell securities

inside quotes

the highest bid quotes and the lowest ask quotes for a security

Primary Market

the market in which new securities are originally sold to investors

Secondary Market

the market in which previously issued securities are traded among investors

Bid Price

the price a dealer is willing to pay for a security

Ask Price [asked, offered, or offering price]

the price at which the dealer will sell

What are some features of preferred stocks?

1. preferred shareholders get stated value is a company is liquidated. 2. preferred stocks carry credit ratings [like bonds] 3.preferred stock is sometimes convertible into common stock 4. preferred stock is callable

Why is a share of common stock more difficult to value than a bond?

1. with common stock, not even the promised cash flows are known in advance 2. the life of the investment is essentially forever because common stock has no maturity 3. there is no way to easily observe the rate of return that the market requires

Which type of stock has growing dividends?

Common Stock

Constant Growth

Dividend for some company always grows at a steady rate

Designated Market Makers (DMMs)

NYSE members who act as dealers in particular stocks. formally known as "specialists"

Floor Brokers

NYSE members who execute customer buy and sell orders. Generally employees of large brokerage firms.

Dividend Growth Model

a model that determines the current price of a stock as its dividend next period divided by the discount rate less the dividend growth rate

Straight Voting

a procedure in which a shareholder may cast all votes for each member of the board of directors.

Why are staggered boards also called classified boards?

because directors are placed into different classes with terms that expire at different times

Common Stock

equity without priority for dividends or in bankruptcy

Why would the dividend grow at a constant rate?

for many companies, steady growth in dividends is an explicit GOAL

Dividends

payments by a corporation to shareholders, made in either cash or stock

The value of any investment depends on the...?

present value of its cash flows

Preferred Stock

stock with dividend priority over common stock, normally with a fixed dividend rate, sometimes without voting rights

What is the goal of the NYSE?

to generate as much liquidity as possible

Hybrid Market

trading takes place BOTH electronically and face-to-face

Types of NYSE license holders

1. Designated Market Makers (DMMs) 2. Floor Brokers 3. Supplemental Liquidity Providers (SLPs)

Are unpaid preferred dividends debts of the firm?

NO. directors elected by the common shareholders can defer preferred dividends indefinitely.

Price Ratio Valuation: What are the difficulties in using the PE ratio to value stock?

The major difficulty in using price ratio analysis is determining the correct benchmark PE ratio. Although not exact measures, the growth rate and required return have a solid economic basis. With the PE ratio, like any other ratio, it is difficult to determine the correct value for the ratio. Since a small difference in the PE ratio can have a significant effect on the calculated stock price, it is easy to arrive at an incorrect valuation.

What are the two most important U.S. Exchanges?

NYSE and NASDAQ

what are the two components of the required return?

1. Dividend Yield 2. Growth Rate [Capital Gains Yield]

Where could the benchmark PE ratio come from?

1. be based on similar companies 2. be based on a company's own historical values

Forward PE ratio

A PE ratio that is based on estimated future earnings

What do Designated Market Makers (DMMs) do?

As a dealer, a DMM maintains a two-sided market, meaning that the DMM continually posts and updates bid and ask prices. Promotes market liquidty.

Voting Rights: Why would investors want a board to be declassified? What are the advantages of a declassified board?

In a declassified board, every board seat is up for election every year. This structure allows investors to vote out a director (and even the entire board) much more quickly if investors are dissatisfied. However, this structure also makes it more difficult to fight off a hostile takeover bid. In contrast, a classified board can more effectively negotiate on behalf of stockholders, perhaps securing better terms in a deal. Classified boards are also important for institutional memory. If an entire board were voted out in a single year, there would be no board members available to evaluate the company's direction with regards to previous decisions.

Dividend Policy: Under what circumstances might a company choose not to pay dividends.

In general, companies that need the cash will often forgo dividends since dividends are a cash expense. Young, growing companies with profitable investment opportunities are one example; another example is a company in financial distress.

supplemental liquidity providers (SLPs)

Investment firms that are active participants in stocks assigned to them. Their job is to make a one-sided market (i.e., offering to either buy or sell). They trade purely for their own accounts.

Stock Valuation: A substantial percentage of the companies listed on the NYSE and NASDAQ do not pay dividends, but investors are nonetheless willing to buy shares in them. How is this possible?

Investors believe the company will eventually start paying dividends (or be sold to another company).

Voting Rights: Some companies, such as Alphabet, have created classes of stock with no voting rights at all. Why would investors buy such stock?

Investors buy such stock because they want it, recognizing that the shares have no voting power. Presumably, investors pay a little less for such shares than they would otherwise.

What is a primary reason for creating dual or multiple classes of stock?

It has to do with control of the firm. If such stock exists, management of a firm can raise equity capital by issuing nonvoting or limited-voting stock while maintaining control.

Corporate Ethics: Is it unfair or unethical for corporations to create classes of stock with unequal voting rights?

It wouldn't seem to be unfair or unethical. Investors who don't like the voting features of a particular class of stock are under no obligation to buy it.

Floor Traders

NYSE members who trade for their own accounts, trying to anticipate temporary price fluctuations

Which exchange is a hybrid market?

New York Stock Exchange (NYSE)

Are dividends tax deductible for corporations?

No. Dividends are paid out of the corporation's after-tax profits.

Can a corporation default on an undeclared dividend?

No. unless a dividend is DECLARED by the board of directors of a corporation, it is NOT a LIABILITY of the corporation.

"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 the first time. The dividend will be $0.50 per share. You expect that this dividend will then grow at a rate of 10 percent per year indefinitely. The required rate of return on companies such as this one is 20 percent." This is an example of what type of growth?

Non-constant Growth

Common versus Preferred Stock: Suppose a company has a preferred stock issue and a common stock issue. Both have just paid a $2 dividend. Which do you think will have the higher price, a share of the preferred or a share of the common?

The common stock probably has a higher price because the dividend can grow, whereas it is fixed on the preferred. However, the preferred is less risky because of the dividend and liquidation preference, so it is possible the preferred could be worth more, depending on the circumstances.

Dividend Growth Model: Under what two assumptions can we use the dividend growth model to determine the value of a share of stock?

The general method for valuing a share of stock is to find the present value of all expected future dividends. The dividend growth model presented in the text is only valid (a) if dividends are expected to occur forever, that is, the stock provides dividends in perpetuity, and (b) if a constant growth rate of dividends occurs forever.

Growth Rate: In the context of the dividend growth model, is it true that the growth rate in dividends and the growth rate in the price of the stock are identical?

Yes. If the dividend grows at a steady rate, so does the stock price. In other words, the dividend growth rate and the capital gains yield are the same.

Are dividends taxable?

Yes. dividends received by individual shareholders are taxable.

What type of growth do a share of preferred stock have?

Zero-Growth

what is the NASDAQ market?

a computer network of securities dealers and others that disseminates timely security price quotes to computer screens worldwide.

DMM's post

a fixed place on the exchange floor where the DMM operates

proxy

a grant of authority by a shareholder allowing another individual to vote his or her shares

What would happen if the growth rate (g) were GREATER than the discount rate (R)?

if g>R, the stock price is infinitely large. if the GROWTH rate is > the DISCOUNT rate, the PRESENT VALUE of the dividends keeps getting bigger. *Essentially, the same is true when growth = discount rate*

Price-Sales Ratio

price per share/sales per share