Fin 300: Chapter 8 (Stock Valuation)

Nonconstant Growth

"Supernormal" growth rates over some finite length of time, the growth rate cannot exceed the required return indefinitely, but it can do so for a number of years

Under what two assumptions can we use the dividend growth model presented in the chapter to determine the value of a share of stock?

1. If dividends are expected to occur forever 2. If a constant growth rate of dividends occurs forever

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

1. Promised CF are not known in advance 2. The life of the investment is essentially forever because CS has no maturity 3. There is no way to easily observe the ROR that the market requires

What are the two ways to receive cash when buying shares of stock?

1. The company pays dividends 2. You sell your shares, either to another investor in the market or back to the company

Total Return

Dividend Yield + Capital Gains Yield

Under what circumstances might a company choose to not pay dividends?

If the company needs the cash they will forgo dividends since dividends are paid in cash. Ex. Young, growing companies or companies in financial distress

Law of One Price

If two things are similar, they should have the same price. If they don't, there is money on the table.

Preferred Stock

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

What do you do if the stock does no pay dividends?

-Assume similar assets have similar prices -Use multiples like P/E and Price/Sales ratios to compare firms -When firms are comparable in some sense, we can use the multiples approach to determine the value of the firm based on the value of another

What is the supernormal growth method?

-Dividend growth not consistent initially, settles down to constant growth eventually -"Behave Badly" initially, "Well Behaved" later

Dividend Characteristics

-Dividends are NOT a liability to the firm -A firm cannot go bankrupt for not declaring dividends -Dividends are NOT tax deductible (not a business expense) -Dividends received by individuals are taxed as ordinary income -Dividends received by corporations have a minimum 70% exclusion from taxable income

Features of Preferred Stock

-Dividends are paid before they are paid to common stockholders -Preferred dividends can be deferred indefinitely -Most preferred dividends are cumulative, any missed have to be paid before common dividends paid -GENERALLY does not carry voting rights -Financial Firms often offer preferred stock

What is the constant dividend method?

-Firm will pay a constant dividend forever -Like a preferred stock -Computed using the perpetuity formula!!!

Stock Price Sensitivity to Cost of Equity

-Know g, don't know r -As r increases, stock price decreases

Stock Price Sensitivity to Dividend Growth Rate

-Know r, don't know g -Need to assume g<r, very reasonable -As g increases, stock price increases -NOT linear

NYSE

-Largest stock market in the world -Stocks trade through Specialists -Broker

What is the constant dividend growth method?

-More realistic then constant dividend method -The firm will increase the dividend by a constant percent every period

NASDAQ

-Not a physical exchange, computer based quotation system (Quote Levels) -Multiple Market Makers -Dealer

Key Points of Zero Growth Dividends

-Price given for ONE PERIOD PRIOR to the first dividend -Numerator and Denominator periods need to be consistent -Not much value after a number of years

Key Points of Dividend Growth Model

-The stock price grows at the same rate as the dividends

Features of Common Stock

-Voting Rights (one share = one vote) -Proxy Voting (can allow others to use your votes) -Classes of Stock -Share proportionally in declared dividends -Share proportionally in remaining assets during liquidation -Preemptive right

Key Points of Non-Constant Growth Model

-With final lumps, use required rate to go back to time 0

3 Ways to Estimate Dividends

1. Constant Dividend 2. Constant Dividend Growth 3. Supernormal Growth

Proxy

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

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

Cumulative Voting

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

Why do investors buy shares in companies that don't pay dividends?

Because they think they will eventually pay them (or be sold to another company).

Dividend Yield

A stock's expected cash dividend divided by its current price = D1/P0

Broker

An agent who arranges security transactions among investors

Dealer

An agent who buys and sells securities from inventory

Why does the value of a share of stock depend on dividends?

Because the value of stock depends on the PV of Cash Flows. The cash flows from a share of stock are the dividends.

Two Stage Growth

Dividend will grow at a rate of g1 for t years and g2 thereafter forever.

Common Stock

Equity without priority for dividends or in bankruptcy

Preemptive Right

First shot at new stock issue to maintain proportional ownership if desired

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.

Some companies, such as google, created classes of stock with no voting rights. 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.

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

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

Cumulative Dividends

Not paid in a particular year, they will be carried forward as an arrearage. *Unpaid preferred dividends are NOT debts to the firm. Sometimes when preferred holders have not received dividends for some time, they are given voting rights.

Dividends

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

Evaluate the following statement: Manager 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.

Suppose a company has a preferred stock issue and a common stock issue. Not have just paid a $2 divided. Which do you think will have the higher price, a share of preferred or common stock?

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.

Capital Gains Yield

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

Constant Growth

The dividend has a constant growth rate of g

Zero Growth

The dividend has a zero growth rate, therefore the dividend paid is constant

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. In a previous chapter, we showed how the sustainable growth rate is determined, and in a future chapter we will discuss the required return. 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 what the ratio should be. 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.

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

Stated Value

The stated liquidated value given to preferred shares

What are the two components of the total return on a share of stock based on the dividend growth model? 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.

Dividend Growth Model: Is it true that the growth rate in dividends and the growth rate in the price of 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.

Why is it difficult to find the price of a stock?

You don't know what the company will decide, if they will pay their dividends or not. This makes estimating the future dividend payments difficult.