financial management ch8: Stock Valuation

common stock

Equity without priority for dividends or in bankruptcy Term used to describe the total amount paid in by stockholders for the shares they purchase. the most basic form of ownership, including voting rights on major issues, in a company

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. help add liquidity to the NYSE trading floor; they supplement the work of DMMs by buying and selling shares throughout the day

DMM's post

a fixed place on the exchange floor (trading station) where the DMM operates

dividend yield

a stock's expected cash dividend divided by its current price R= D1 /P0 + g

Components of Required Return

dividend yield and a capital gains yield R = Dividend yield + Capital gains yield R = D1 /P0 + g

straight voting

the directors are elected one at a time a system in which each shareholder votes the number of shares he or she owns on candidates for each of the positions open a procedure in which a shareholder may cast all votes for each member of the board of directors

order flow

the flow of customer orders to buy and sell securities (stocks)

inside quotes

the highest bid quotes and the lowest asked quotes for a NASDAQ-listed security

other rights

the value of a share of common stock in a corporation is directly related to the general rights of shareholders. In addition to the right to vote for directors, shareholders usually have the following rights: 1. The right to share proportionally in dividends paid. 2. The right to share proportionally in assets remaining after liabilities have been paid in a liquidation. 3. The right to vote on stockholder matters of great importance, such as a merger. Voting is usually done at the annual meeting or a special meeting

what are the two biggest stock markets in the United States

NYSE and the NASDAQ

proxy

a grant of authority by a shareholder to someone else allowing that individual to vote his or her shares. much of the voting in large public corporations is actually done by proxy

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 P0 = D0 × (1 + g)/(R − g) = D1/ R-g

classes of stock

unequal voting rights a primary reason for creating dual or multiple classes of stock has to do with control of the firm common stock and preferred stock

electronic communications networks (ECNs)

websites that allow investors to trade directly with one another

capital gains yield

The dividend growth rate, or the rate at which the value of an investment grows. the dividend growth rate = the rate at which the stock price grows

Nonconstant Growth

The part of the life cycle of a firm in which its growth is either much faster or much slower than that of the economy as a whole. The main reason to consider this case is to allow for "supernormal" growth rates over some finite length of time

three special case where we can come up with a value for the stock

1) The dividend has a zero growth rate 2) the dividend grows at a constant rate 3) the dividend grows at a constant rate after some length of time

A share of common stock is more difficult to value in practice than a bond for 3 reasons.

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.

two basic effects of staggering

1. Staggering makes it more difficult for a minority to elect a director because there are fewer directors to be elected at one time. 2. Staggering makes takeover attempts less likely to be successful because it makes it more difficult to vote in a majority of new directors

What do we do in such cases where a company doesn't pay dividends?

A common approach is to make use of the PE ratio, which is defined as the ratio of a stock's price per share to its earnings per share (EPS) over the previous year. Price at Time t = Pt = Benchmark PE ratio × EPSt

broker

An agent who arranges security transactions among investors. brings buyers and sellers together but does not maintain an inventory arranges transactions between investors, matching investors wishing to buy securities (stocks and bonds) with investors wishing to sell securities (stocks and bonds).

growing perpetuity

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

Two-Stage Growth Model

Non-constant growth that has , the idea is that the dividend will grow at a rate of g1 for t years and then grow at a rate of g2 thereafter, forever. Estimates cash flows for two different growth stages. Stage 1: dividends grow at above-average rates. Stage 2: dividends grow at the industry average rate. Value = PV(stage 1) + PV(stage 2) Pt = (Dt + 1)/(R − g2) = D0 × (1 + g1)^t × (1 + g2)/R-g2

present value of a stock

P0 = (D1 + P1 )/(1 + R) P1 = price D1 = cash dividend paid at the end of the period R = the required return in the market

The present value of the cash flows formula

Present value = C1 /(R − g) = C0 (1 + g)/(R − g)

cumulative voting

a system in which a shareholder can accumulate all of his or her votes and vote them all for one candidate or split them among several candidates This is usually calculated as the number of shares (owned or controlled) multiplied by the number of directors to be elected. with cumulative voting, the directors are elected all at once

constant growth model

a widely cited dividend valuation approach that assumes that dividends will grow at a constant rate, but a rate that is less than the required return Call this growth rate g. If we let D0 be the dividend just paid, then the next dividend, D1 , is: D1 = D0 × (1 + g)

dealer

an agent who buys and sells securities from inventory

Zero Growth Model

an approach to dividend valuation that assumes a constant, nongrowing dividend stream P0 = D/R where R is the required return. Because the dividend is always the same, the stock can be viewed as an ordinary perpetuity with a cash flow equal to D every period

proxy fight

an attempt by a person or group to gain control of a firm by getting its stockholders to grant that person or group the authority to vote its shares to replace the current management

members

as of 2006, a member is the owner of a trading license on the NYSE. (1,366 members)

preferred stock

it has preference over common stock in the payment of dividends and in the distribution of corporation assets in the event of liquidation tock with dividend priority over common stock, normally with a fixed dividend rate, sometimes without voting rights. a form of equity from a legal and tax standpoint.

staggered elections

only a fraction of the directorships (often one-third) are up for election at a particular time

dividends

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

Shareholder Rights

shareholders elect directors who, in turn, hire managers to carry out their directives. Shareholders, therefore, control the corporation through the right to elect the directors. Generally, only shareholders have this right. - Right to Evidence of Ownership, Vote, Receive Dividends - Right of Transfer & Inspection

stated value (of preferred stock)

stated liquidating value is usually $100 per share. The cash dividend is described in terms of dollars per share. For example,"$5 preferred" = dividend yield of 5 percent of stated value. the amount per share assigned by the board of directors to no-par stock

designated market makers (DMMs)

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

Floor brokers

NYSE members who execute customer buy and sell orders act as agents to execute customers' orders for securities purchases and sales.

preemptive right

a company that wishes to sell stock must first offer it to the existing stockholders before offering it to the general public Stockholder's right to maintain his or her proportionate ownership in the corporation.

over-the-counter (OTC) market

securities market in which trading is almost exclusively done through dealers who buy and sell for their own inventories. exchange that provides a means to trade stocks not listed on the national exchanges

primary market

the market in which new securities are originally sold to investors. market for selling financial assets that can only be redeemed by the original holder

secondary market

the market in which previously issued securities are traded among investors. market for reselling financial assets

important characteristics of dividends

1. Unless a dividend is declared by the board of directors of a corporation, it is not a liability of the corporation. As a consequence, corporations cannot become bankrupt because of nonpayment of dividends. The amount of the dividend and even whether it is paid are decisions based on the business judgment of the board of directors. 2. The payment of dividends by the corporation is not a business expense. Dividends are not deductible for corporate tax purposes. In short, dividends are paid out of the corporation's after-tax profits. 3. Dividends received by individual shareholders are taxable.