Chapter 8: Stock Valuation

Estimating Dividends: Special Cases

1. Constant dividend - zero growth -The firm will pay a constant dividend forever -This is like preferred stock -The price is computed using the perpetuity formula P0 = D/R 2. Constant dividend growth -The firm will increase the dividend by a constant percent every period -The price is computed using the growing perpetuity model D1 = D0 (1+g)^t 3. Supernormal growth -Dividend growth is not consistent initially, but settles down to constant growth eventually -The price is computed using a multistage model - Growth rate can't exceed required return indefinitely (otherwise negative denominator) but it certainly can do so for a number of years - require some sort of dividend growth at constant rate sometime in the future

Stock Markets: New York Stock Exchange

1. Largest stock market in the world 2. License holders (1,366) 1. Commission brokers 2. Specialists 3. Floor brokers 4. Floor traders 3. Operations --> business of NYSE attracts and process order flow (flow of customer orders to buy/sell stocks) - well over a billion shares to change hands on NYSE/day 4. Floor activity --> one big room with number of stations DMMs behind their post to monitor and manage trading in stocks assigned to them - want to sell at highest price for your client if you're a broker Used to be organized almost completely as a dealer market Specialists owned all stock that was flowing through their books → you bought "chairs" and owned these chairs/inventory of stocks Now you buy trading licenses, allowing you to buy and sell securities on the floor of exchange NYSE is now closer to how NASDAQ operates

NASDAQ

1. Not a physical exchange - computer-based quotation system 2. Multiple market makers 3. Electronic Communications Networks 4. Three levels of information: -Level 1 - median quotes, registered representatives -Level 2 - view quotes, brokers & dealers -Level 3 - view and update quotes, dealers only → dealers buy sell directly to one another Levels are not on test! 5. Large portion of technology stocks → thought to themselves "why do we want a manual stock system where one person is responsible for buying/selling each stock" Decided to list online exchange → idea: if you want to buy/sell Microsoft stock, as a "market maker" you file your financial statements with NASDAQ to get approved, you then post bid (sell for)/ask (buy for) prices on your Microsoft stock Instead of having one specialist, you can have 30 specialists trying to sell one stock → brings much more traffic through NASDAQ (multiple market maker system) Surpassed NYSE in terms of activity Over the counter: securities market largely characterized by dealers who buy and sell securities for their own inventories → NASDAQ

Using the DGM to Find R

Can calculate required returns R = Dividend yield + Capital gains yield D1/P0 = Dividend Yield (expected cash dividend / current price) g = growth rate (rate at which stock price grows) --> can be interpreted as capital gains yield (rate at which value of investment grows)

Features of Common Stock

Common Stock: usually applied to stock that has no special preference either in receiving dividends or in bankruptcy 1. Voting Rights - shareholders elect board of directors and can control the corporation through their right to elect the directors (directors hire managers to carry out their directives) 1. Cumulative (total number of votes that each shareholder may cast is determined first - number of shares*number of directors to be elected) - all at once, can put all votes towards one person and 0 towards another 2. Straight voting (directors elected all at once) --> can put all cumulative votes towards one director 2. Proxy voting: hire someone to represent your interests - Managers try to get as many proxies as possible (more say without shareholders there) - Shareholders can also hire proxies to overturn managers/board of directors --> proxy fight 3. Classes of stock: unequal voting rights to maintain voting power - Dual classes of common stock to maintain control of the firm - Issue one with greater voting rights for family members (for Ford who like to keep majority family say) - Issue another type of stock for the public to participate in dividends - Historically, NYSE didn't allow companies to create classes of publicly traded common stock with unequal voting rights (Ford was an exception) 4. Other Rights Shareholders have these rights in addition to voting the board of directors 1. Share proportionally in declared dividends paid 2. Share proportionally in remaining assets after liabilities (debt-holders) have been paid during liquidation 3. Preemptive right - first shot at new stock issue to maintain proportional ownership if desired - Right to buy any new stock that's issued (before being offered to the public) --> opportunity for shareholders to protect their proportionate ownership in the corp - right to vote on stockholders matters of great importance (such as mergers)

Common Equity

Common equity is the amount that all common shareholders have invested in a company - Not just a shareholder you're a stakeholder → you're an OWNER - You have VOTING RIGHTS (unlike common stock) → not always true though - No voting rights → if the company declares bankruptcy and then creditors (new owners)/preferred stockholders have priority/take over Most importantly, this includes the value of the common shares themselves. However, it also includes retained earnings and additional paid-in capital.

Stock Market: Dealer vs. Broker

Dealers vs. Brokers Dealer owns inventory and looks to buy and sell - Car dealer - stands ready to buy securities from investors wishing to sell them and sell securities to investors wishing to buy them - bid price: price dealer is willing to pay - ask price: price dealer is willing to sell (offered, offering price - what is is offered for) Broker matches buyers with sellers - Real estate broker when buying a house shows you houses on the market (doesn't own these houses) - arranges transactions between investors, matching investors wishing to buy securities with investors wising to sell securities - don't buy or sell securities for their own accounts! NYSE: used to be like a car dealer where each party owned its inventory of stock Housing market: broker market

Features of Preferred Stock

Dividends - Stated dividend that must be paid before dividends can be paid to common stockholders - Dividends are not a liability of the firm and preferred dividends can be deferred indefinitely - Most preferred dividends are cumulative → any missing preferred dividends have to be paid before common dividends can be paid - accrued unpaid preferred dividends are called arrearage - preferred shareholders receive no interest on accumulated dividends (incentive for company to forgo dividend payments but could lead to sacrificed control) Preferred stock generally does not carry voting rights (if preferred dividends are forgone too much, preferred shares are often granted voting and other rights however) - preferred stock has preference over common stock in payment of dividends (paid first) and in distribution of corporation assets in event of liquidation (payout first) - preferred stock can sometimes be converted to common stock and are often callable - many issues of preferred stock have obligatory sinking funds which creates a final maturity (signals entire issue will ultimately be retired) --> making preferred stock seem a lot like debt

2. Dividend Growth Model

Dividends are expected to grow at constant percent per period → plug and chug on exam Company just paid dividend of $1 (D0) Company plans to pay dividend next year (D1)

1. Zero Growth

If dividends are expected at regular intervals forever, then this is a perpetuity and the present value of expected future dividends can be found using the perpetuity formula

Cash Flows for Stockholders

If you buy a share of stock you can receive cash in two ways 1. Company pays dividends 2. You sell your shares, either to another investor in the market or back to the company As with bonds, the price of the stock is the present value of these expected cash flows

Dividend Characteristics

Not a liability of a firm until a dividend has been declared by the Board (have to be declared by the Board) → if you don't declare every dividend at board meetings it won't be paid out, dividends don't have a contract like debt/interest payments so you must declare/approve them to make them a "liability" and ensure they will be paid out - Not like debt interest - Dividends are under RE → equity Consequently a firm can't go bankrupt for declaring dividends Dividends and Taxes → NOT TAXABLE (paid out of corporation's after tax profits) - Dividend payments aren't considered a business expense and therefore aren't tax deductible for both individuals and firms - Taxation of dividends received by individuals depends on the holding period (dividends received by individual shareholders are taxable based on their tax rate 15-20% in 2018) - Dividends received by corporations have a minimum of 70% (now 50%) exclusion from taxable income (tax break for corporations that own stock in other corporations)

Overfunded vs. Underfunded Pension Plan

Overfunded pension plan More money in your pension plan than needed to meet you actual liabilities 3 people retiring and you have more than enough to pay out their retirement How to figure this out? Do an annuity problem → realize your overfunded Underfunded pension plan State of CA pension plans are severely underfunded We've made promises to fighter fighters, school teachers, nurses, police in terms of their retirement but the state of CA (and most other states) haven't put enough money away to make these promises good Short-run you get away with this by assuming an inappropriate discount rate that's too low to sum up to the amount you need in 20 years

Reading Stock Quotes

What information is provided in the stock quote? Last trade occurred on costco: 73.28 Today's range is between 70.67-74.75 → measure of standard deviation/volatility 52 week range: 54.85-75.23 Volume → normal trades 6 million shares compared to average volume today of 5 million PE → 27.63 (a little compared to average PE ratio) Ask: those willing to sell stock are trying to get 73.28 Bid: those trying to buy stock are willing to pay 73.27 When you have 40 people bidding for Microsoft stock (NASDAQ) they have to keep bid/ask prices as low as possible to get the volume they want - Only good for low amounts in terms of volume of the stock (great for individual traders) - NASDAQ aims for more individual traders

Stock Price Sensitivity to Dividend Growth, g

What's wrong with this model? As the growth rate gets closer to 20 the stock price blows up (hard to decipher precise prices)

Developing the Model

You could continue to push back the year in which you will sell the stock You would find that the price of the stock is really just the present value of all expected future dividends So, how can we estimate all future dividend payments? --> Note: if you don't plan to pay dividends back the stock is really worth nothing as it's based on the PV of all future dividends

Stock Price Sensitivity to Required Return, R If required return increases, will stock price always decrease? - yes

x-axis should be required return (not growth rate) For r that are very low, it's hard to decipher exact stock price