Chapter 7
The price of a share of common stock is equal to the present value of all ___ future dividends.
Expected
(T/F) For investors in the stock market, dividends from stocks are fixed and guaranteed, while capital gains are variable and not guaranteed.
False (Neither dividends nor capital gains are fixed and guaranteed)
P0
Price today
The trading of existing shares occurs in the ___ market.
Secondary Market
If a company's growth for years 1 through 3 is 20% but stabilizes at 5% beginning in year 4, its growth pattern would be described as ___.
Non-Constant
When voting for the board of directors, the number of votes a shareholder is entitled to is generally determined as follows:
One vote per share held
The fundamental business of the New York Stock Exchange is to attract ___.
Order flow
Which of the following is generally not a right granted to common stock shareholders?
The right to directly elect the CEO of the company
A PE ratio that is based on estimated future earnings is known as a ___ PE Ratio.
Forward PE Ratio
The type of growth describes a company that grows quickly at first, then slower in the future years.
Non-Constant
Which of one the following is true about dividend growth patterns?
Dividends may grow at a constant rate
Suppose a firm's dividends are expected to grow at a rate of 15% (g1) for 3 years (t) then stabilize at 5% (g2) forever. If the firm just paid a $2 (D0) dividend and the discount rate is 10% (r), what is the value of a share of the firm's stock in year 3 (P3)?
$63.88 D3=D0 x (1+g1)^t D4=D3 x (1+g2) P3= D4/(r-g2)
NASDAQ
-A computerized exchange with no physical location -There are multiple dealers that have all posted their bid and ask prices -Investors can "shop" these prices and get the best execution -Competition helps to keep the prices competitive
In the dividend discount model, the expected return for investors comes from which two sources?
-Growth Rate -Dividend Yield
General Model
-We could continue to delay when we sell the stock -The stock price is present value of all expected future dividends -infinite sum of all the future dividends
Constant Dividends
-Zero Growth -If all future dividends are the same amount, the cash flow stream looks like a perpetuity
What is the total return for a stock that currently sells for $100, is expected to pay a dividend in one year of $2, and has a constant growth rate of 8%?
10% R=(2/100)+0.08
What is the total return for a stock that currently sells for $50, just paid a $1.75 dividend, and has a constant growth rate of 8%?
11.78% R=((1.75x(1.08))/50) +.08
A person who brings buyers and sellers together is called a ___.
Broker
An individual who maintains an inventory in a security and stands ready to buy and sell at any time is a ___.
Dealer
The ___ can be interpreted as the capital gains yield.
Growth Rate
How can we estimate all future dividends?
Three special cases 1) Constant Dividend -All future dividends will be the same amount 2) Constant Growth - All future dividends grow at a constant rate (constant % not $) 3) Supernormal Growth -Dividends may grow at an irregular rate but eventually settles down to a constant rate ~combine approaches
What is a primary market?
Where stocks are issued for the first time
If the growth rate (g) is zero, the capital gains yield is ___.
Zero
Preferred stock has preference over common stock in the :
-Payment of dividends -Distribution of Corporate Assets
Common Stock
-Represents the residual ownership of the company -In the event of bankruptcy, other investors are paid first and the shareholders get whatever is left over -Companies may pay periodic dividends but there is no stipulation amount and the dividend may be reduced or eliminated (no requirement for dividends to be paid)
Which of the following are reasons that make valuing a share of stock more difficult than valuing a bond?
-Stock has no set maturity -Dividends are unknown and uncertain -The required rate of return is unobservable
A benchmark PE ratio can be determined using:
-The PEs of similar companies -A company's own historical PEs
Cumulative Voting Example If a company with 1 million shares outstanding is electing four directors, you could guarantee election of one candidate with how many shares?
Shares required = (# of directors desired x Shares outstanding) / (# of directors elected + 1) +1 Shares Required = (1 x 1,000,000) / (4+1) +1 = 200,001 Shares
New York Stock Exchange Designated Market Makers (DMMs) were formally called ___.
Specialists
Which of the following are cash flows to investors in stocks?
-Capital Gains -Dividends
The NYSE differs from the NASDAQ primarily because the NYSE has:
-A face-to-face auction market -A physical location
Straight Voting System
-Candidates are nominated for specific seats on the Board of Directors -Plurality ~Candidate for each seat that receives the most votes wins ~Since directors often run unopposed, little chance of losing (receiving just one vote will make them elected) -Majority ~Candidates must receive a majority of votes to be elected even if they are the only candidate for that particular seat (if no one had the majority, then seat remains vacant)
If unpaid preferred dividends must be "caught up" before any common dividends can be paid, they are called ___ dividends.
Cumulative Dividends
"Inside Quotes" represent the ___ and the ___.
Highest Bid Price and Lowest ask price
Cumulative Voting System
-Candidates are pooled for all of the seats -The candidates in the top N are elected -Shareholders do not have to vote for N candidates, but may cast multiple votes for a single candidate -It is possible to guarantee election of a director with a minority of the shares outstanding
Stock Market Operations
-Companies first sell securities to the public in the PRIMARY MARKET (company receives proceeds from sale) -Investors buy and sell securities to each other in the SECONDARY MARKET (the company that issued the security typically isn't a party to a secondary market transaction) -Both the NYSE and NASDAQ are SECONDARY MARKETS
NYSE
-Has a physical presence in New York City -There is only one dealer (called the SPECIALIST) for each stock -Brokers can find another broker with an order on the other side and agree to a price inside the dealer's bid-ask quotes -The specialist only trades if there is no other trader on the other side (i.e. no buyer to go with a seller) and then updates the quotes to reflect this information
Constant Growth
-If the dividends grow at a constant rate, we can forecast every future dividend -Dt=D0 x ((1+g)^t) -The infinite series will converge to the following simplified formula -P0= D1 / (ke-g) -There are 2 conditions for this formula to work: 1) Dividend growth rate can never change --> constant forever 2) Growth Rate (g) must be less than the required return (k) (cannot have negative stock price)
NASDAQ has which of these features?
-Multiple market maker system -Computer network of securities dealers
Which of the following represents the valuation of stock using a zero growth model?
D/r (Dividend / Discount Rate)
Someone who maintains an inventory of stocks and buys and sells those stocks is known as a ___.
Dealer
What is the formula for the present value of a growing perpetuity where C1 is the net cash flow, R is the required return, and g is the growth rate?
P=C1/(R-g)
Proxy Voting
-Many companies have millions of shares outstanding and hundreds of thousands of shareholders. It would be hard to find a suitable place to hold the annual meeting (and voting) that had enough capacity - Most shareholders don't attend the meeting. Instead, they give someone else their voting rights, usually with explicit instructions on how to cast their votes --> this
Which of the following are rights of common stock holders?
-The right to share proportionally in any residual value in the event of liquidation -The right to share proportionally in any common dividends paid -The right to vote on matters of importance
Common Stock Valuation
-When you buy a share of stock, you give up some cash today in order to receive future cash flows as a stockholder -Just like w/ bonds, the price of a share of stock should be equal to the present value of all of the future cash flows to be received (i.e. the dividends) -Shareholders may sell their shares by giving up the future dividends
Decomposing the Required Rate
-If the dividends grow at a constant rate, we can rearrange the constant growth pricing model to see the pieces of the required return -Ke = (D1/P0) + g (D1/Po) = Dividend yield ~how much of a return an investor would earn by receiving dividends g = Capital appreciation rate ~stock price should grow the same rate as the dividends
Preferred Stock
-Intermediate form between debt and common stock and shares characteristics of each -Like debt, preferred stock has a fixed payment / preferred dividend (unless it is participating --> preferred dividend may increase over time) -Like Equity, preferred stock has no maturity date -In bankruptcy, preferred shareholders are paid after debtholders but before common shareholders -To value preferred stock, we can use the perpetuity formula since the dividends do not change and last forever (P0= (Dp/Kp))
Proxy Voting
-Many companies have millions of shares outstanding and hundreds of thousands of shareholders. It would be hard to find a suitable place to hold the annual meeting (and voting) that had enough capacity - Most shareholders don't attend the meeting. Instead, they give someone else their voting rights, usually with explicit instructions on how to cast their votes --> this is called PROXY -The company usually sends out an Annual Report to Shareholders and a Proxy Statement each
Dealers/Specialist
-Marker Makers -Charged with maintaining an orderly market -Dealers buy and sell from their own account (in case there are more buyers than sellers or vice versa) -But they have a different price for both sides of the transaction -The BID PRICE is how much the dealer is willing to pay to buy (or what you would get from selling to the dealer) -The ASK PRICE is how much the dealer is willing to receive to sell (or what you would get from buying from the dealer) -The dealer makes a profit from this Bid-Ask Spread
Examples of secondary markets in the U.S. include which of the following?
-NASDAQ -The Chicago Stock Exchange -The New York Stock Exchange
Rights of Common Stockholders
-Voting Rights ~Elect directors, approve other proposals ~Compensation plans, mergers, company name changes -Dividend Rights (only when board of directors declares them) -Liquidation Rights (share from proceeds from selling all of the firm's assets after all the debt holders have been paid) -Preemptive Rights ~Existing owners have first opportunity to buy shares (the same amount they already own) in a new offering so that they may avoid dilution
2 ways Stockholders earn a Return on their investment
1) Receiving Dividends 2) Selling their stock for a higher price than they purchased it for
The value of a firm is a function of its ___ rate and its ___ rate.
Growth Rate Discount Rate
Supernormal Growth
Dividends may grow at an irregular rate but eventually settles down to a constant rate
Websites that allow investors to trade directly with one another are termed ___.
ECNs
What information do we need to determine the value of a stock using zero growth model?
Dividend and Discount Rate
D1
Next expected Dividend
Constant Growth Example 1: Suppose Tiger Toys, Inc. just paid a dividend of $0.50. It is expected to increase dividends by 2% per year indefinitely. If the market requires a 15% return on assets of this risk, how much should the stock be worth?
P0= (0.50 x 1.02) / (0.15-0.02) P0=$3.92
The dividend yield is determined by dividing the expected divided (D1) by:
The Current Price (P0)
Supernormal Growth Example: Suppose a firm is expected to increase dividends 20% this year and 15% next year. After that, dividends will grow at a constant rate of 5%. If the company just paid a $1 dividend and the required return is 20%, what is the current price?
-We can use the constant growth formula to get the price at t=2 since we have constant growth after that time -D1= (1x((1.2)^1)=1.20 -D2=(1.2x((1.15)^1=1.38 -D3=(1.38x(1.05)^1=1.449 -We can use this third dividend to find the price at t=2 P2= D3 / (ke - g) P2=1.449/(.20-0.05)=9.66 We can find the price at t=0 now: P0=(1.20/(1.20^1) + (1.38+9.66)/((1.20)^2) P0 = $8.67
All else the same, an increase in the required return on a stock will cause a ___ in the stock price.
Decrease
All else constant, the dividend yield will increase if the stock price ___.
Decreases
R
Discount rate
D0
Dividend just paid
The constant-growth model infers that ____.
Dividends change at a constant rate
Common Stock Example (2 Period Model): What if you decide to hold the stock for two years? You expect the second year's dividend to be $2.10 and the stock price to be $14.70 at the end of that year. Now how much would you be willing to pay?
PV =(2/((1.20)^1) + (2.10+14.70)/ ((1.20)^2) PV = $13.33
P1
Price in one year
Proxy Fight
-Occasionally, a group of dissident shareholders may try to solicit proxies to vote against management
All else the same, an increase in the dividend growth rate on a stock will cause an ___ in the stock price.
Increase
Constant Growth Example 2: Suppose Centralized Spirits is expected to pay a $3 dividend next year. If the dividend is expected to grow at 5% per year and the required return is 20%, what is the price?
P0 = 3.00 / (0.20-0.05) P0 = $20.00 per share (Notice that in this problem, the next dividend is given so we do not have to calculate it ourselves) Gave us D1 instead of D0
Common Stock Example (1 Period Model): Suppose you want to buy some stock in Livingstone Oil Co. You expect them to pay a $2 dividend in one year and you believe that you can sell the stock for $14 at that time. If you require a 20% return, what is the most that you would pay?
PV = (2+14) / ((1.2)^1) PV = $13.33
Common Stock Example (3 Period Model): Let's say you decide to hold the stock for three years. The third year's dividend is expected to be $2.21 and the stock price will be $15.43. How much are you willing to pay?
PV = (2/((1.20)^1) + (2/((1.20)^2) + ((2.21+15.43)+((1.2)^3)) PV = $13.33
Constant Dividends Example: If the stock will pay $2 dividend every year and investors require a 10% return, how much is this stock worth?
PV = (2/0.10) PV = $20
Which of the following ratios might be used to estimate the value of a stock?
-The Price/Earnings Ratio -The Price/Sales Ratio
Voting System
For election of directors, there are Two Main Voting Systems 1) Straight 2) Cumulative
In the Dividend discount model, the expected return for investors comes from which two sources?
Growth Rate and Dividend Yield