Chapter 8 Stock Valuation
secondary market
the market in which previously issued securities are traded among investors
Present Value (PV) for Stock Valuation
*P0 = (D1 + P1)/(1 + R)* *P0* = Current price of the stock *P1* = Price in one period *D1* = Cash dividend paid at the end of the period *R* = Required return in the market on this investment
designated market maker (DMM)
NYSE members who act as dealers in particular stocks. Formerly known as "specialists"
proxy
a grant of authority by a shareholder allowing another individual to vote his or her shares. Typical in large public corporations. Proxy wars
constant growth model
a valuation method based on constantly growing dividends *The Next Dividend Calculation = * *(D1 = D0 x (1 + g))* *g* = growth rate *D0* = Dividend just paid *D1* = The next dividend *Dividend Calculation At Any Point = * *(Dt = D0 x (1+g)^t)* • *Growing perpetuity* = An asset with cash flows that grow at a constant rate forever •Constant dividend growth rate is for many companies, an explicit goal
zero growth stock
stock that does not anticipate a dividend change assumes that the stock will pay the same dividend each year, year after year (dividend on a share of preferred stock as *zero growth*) *(P0 = D1/R)* --> *Per-share value* the equation shows that with zero growth, the value of a share of stock would equal the present value of a perpetuity of D1 dollars *discounted at a rate R (R is required return)* • A share of common stock with a constant dividend is like a share of preferred stock. •B/c dividend is constant, stock can be viewed as an *ordinary perpetuity* with a cash flow equal to *D* every period.
primary market
the market in which new securities are originally sold to investors
3 types of license holders for face-to-face trading
1. *Designated Market Makers: DMMs* 2. *Floor Brokers* 3. *Supplemental liquidity providers (SLPs)*
3 Reasons Common Stock Value is Difficult
1. Promised cash flows aren't known in advanced 2. Life of investment is essentially forever b/c common stock has no maturity 3. No way to easily observe the rate of return that the market requires.
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.
Classes of Stock (Dual or multiple classes)
The primary reasoning behind it; so management of a firm can raise equity capital by issuing nonvoting or limited-voting stock while maintaining control. • stock can be classified (ex. class A, B, C, H) when first issued as having more or less voting rights • dual classes of common stock -Many non-NYSE companies have dual classes of common stock
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 *P0 = D1/(R-g1) x [1-[(1+g1)/(1+R)]^t] + Pt/((1+R)^t)* *where Pt = D0 x (1+g1)^t x (1+g2)/(R-g2)* *or Pt = D{t + 1}] / (R - g{2})* • The first term in our expression is the present value of a growing annuity, where g can be greater than R. • The 2nd part is the present value of the stock price once the 2nd stage begins at Time t. example 8.5
2 voting methods with shares: Cumulatively or voted straight
1. cumulative voting a procedure in which a shareholder may cast all votes for one member of the board of directors • With cumulative voting, the directors are elected all at once. 2 Straight voting a procedure in which a shareholder may cast all votes for each member of the board of directors • Directors are elected one at a time.
preferred stock
Characteristics • stock with dividend priority over common stock & in the distribution of corporate assets in the event of liquidation • normally with a fixed dividend rate, sometimes without voting rights • preferred stock is a form of equity from a legal & tax standpoint. Stated Value • Preferred shares have a stated liquidating value, typically $100 per share. • The cash dividend id described in terms of $ / share. ex"$5 preferred" = dividend yield of 5% of stated value. A preferred dividend: • is NOT like interest on a bond. The B.O.D can decide not to pay dividends on preferred shares, & their decision may have nothing to do with the current net income of the corporation. • are NOT debts of the firm. Directors can defer preferred dividends indefinitely. If preferred dividends haven't been paid for some time, holders of the shares are often granted voting & other rights. -B/c preferred stockholders receive no interest on the accumulated dividends, some have argued that firms have an incentive to delay paying preferred dividends; • Preferred shareholders receive a stated dividend only; if the corporation is liquidated, preferred shareholders get a stated value. • Preferred stocks carry credit ratings like bonds. Sometimes they're even convertible into common stock. • Many preferred stocks have obligatory sinking funds. *Sinking funds*: A sinking fund is a means of repaying funds borrowed through a bond issue through periodic payments to a trustee who retires part of the issue by purchasing the bonds in the open market. This provision is really just a pool of money set aside by a corporation to help repay previous issues *Cumulative & noncumulative dividends for preferred stock* • If preferred dividends are cumulative and aren't paid in a particular year, they're carried forward as an *arrearage*
3 Special Cases that allow Stock Valuation
In some special cases, we can come up with a value for the stock. Make some simplifying assumptions about the pattern of future dividends *1. The dividend has a zero growth rate* *2. Dividend grows at a constant rate* *3. Dividend grows at a constant rate after some length of time*
floor brokers
NYSE members who execute customer buy and sell orders
Total return has 2 components:
P0 = D1/(R-g) thus *R formula: R = D1/P0 + g* 1. First component: *Dividend yield* the dividend per share divided by the stock price); aka current yield on a bond R = D1/P0 2. 2nd component: The growth rate, g *Capital gains yield*; The rate at which the value of the investment grows. • We know that the dividend growth rate is also the rate at which the stock price grows.
NYSE (New York Stock Exchange)
The world's largest physical stock exchange • Known as the 'Big Board' • Measured in terms of the total value of shares listed, it's the largest stock market in the world • Has 1,366 *exchange members* As of 2006, a member is the owner of a trading license on the NYSE. Having a license entitles you to buy & sell securities on the floor of the exchange. • In 2006 became a publicly owned corporation. • In 2007 it merged with Euronext to form NYSE Euronext (A stock exchange in Amsterdam, with *subsidiaries* in Belgium, France, Portugal, U.K. It became the world's "1st global exchange" *Subsidiaries* A subsidiary, subsidiary company or daughter company is a company that is owned or controlled by another company, which is called the parent company, parent, or holding company • In 2008 NYSE Euronext merged with the American Stock Exchange. • 2013: Acquisition of the NYSE by the Intercontinental Exchange (ICE) (ICE was originally a commodities exchange in 2000 but it rapidly grew and had the funds to acquire NYSE). The NYSE is a *hybrid market* = trading takes place both electronically & face-to-face. • Electronic trading: orders are submitted to the exchange & are compared by a computer to fix matches to execute the orders with no human intervention. (Most trades on the NYSE occur this way) • Else; relies on its license holders face-to-face trading.
Broker
an agent who arranges security transactions among investors • Does not have an inventory
dealer
an agent who buys and sells securities from inventory • Has an inventory at all times • *Bid price* = price at which the dealer will pay • *Ask/offer price* = price at which the dealer will sell • *spread* = Bid price - Ask price; it is the basic source of dealer profits.
Dividend Growth Model
valuation model for common stock that discounts future dividends •If dividend grows at a steady rate, then we fixed the problem of forecasting an infinite # of future dividends w/ *new problem* of: coming up with a single growth rate for simplification's sake. *THUS* • *As long as growth rate, g, is less than the discount rate, r*: *The present value (Price Per Share) of the constant growth series of cash flows can be written as:* *[Po = D0 x (1+g)/(R-g) ]* *or -->* *[P0 = D1/(R-g)]* *Stock Price at Time T* *[Po = D0 x (1+g)/(R-g) ]* *or -->* *[P0 = (D1+1)/(R-g)]*
Stock valuation using multiples (PE ratio and/or price-sales ratio)
• Many companies don't pay dividends or have erratic dividend growth rates, so we wouldn't be able to use our dividend-based approach to stock valuation 1. • Use the *PE ratio = Stock's price per share / earnings per share, EPS over the previous year * *Price at Time t = Pt = Benchmark PE ratio x EPS{t}* • The benchmark PE ratio could come from several sources: 1. Based on similar companies 2. On the company's historical values *Forward PE ratio* = A PE ratio based on estimated future earnings 2. *Price-sales ratio: price per share on the stock /sales per share (SPS) * • Price-sales ratios depend on company age & industry; They can typically be .8 - .20 range, but much higher for younger, faster-growing companies.
common stock
• Term used to describe the total amount paid in by stockholders for the shares they purchase. • Equity (stock) that has no special preference either in receiving dividends or in bankruptcy • Shareholder rights: Shareholders elect --> directors who hire --> managers. • Directors are elected each year at an annual meeting; one share, one vote. Other Shareholder rights: • Right to share proportionally in dividends paid • Right to share proportionally in assets remaining after liabilities have been paid in a liquidation • Right to vote in stockholder matters such as mergers. (Usually done at the annual meeting or special meeting) • Sometimes have right to share proportionally in any new stock sold. This is called *preemptive right* *Preemptive right* are a clause in an option, security or merger agreement that gives the investor the right to maintain his or her percentage ownership of a company by buying a proportionate number of shares of any future issue of the security.
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. This phenomenon occurs when the dividend grows steadily after t periods... • Allows us to consider cases of "supernormal" growth rates over some finite length of time. *P0 = D(t)/(1+R)^t + P(t)/(1+R)^t * *where P(t)= D1 x (1+g)/(R-g)* • Example 8.4
staggered elections
• only a fraction of the directorships are up for election at a particular time (often 1/3). • Staggered boards are often called *classified boards* b/c directors are placed into different classes with terms that expire at different times. • It provides "institutional memory" = continuity on the board of directors; this is impt for corporations with significant long-range plans/projects.
Dividends
• payments by a corporation to shareholders, made in either cash or stock • Corporations are authorized by law to pay dividends to their shareholders • Payment of dividends is at the discretion of the board of directors Characteristics of Dividends • Dividends are not deductible for corporate tax purposes. • The payment of dividends by the corporation is not a business expense. Dividends are paid out of the corporation's aftertax profits. • Dividends received by individual shareholders are taxable. (In 2018, tax rate was 15 - 20 %). However, corporations that own stock in other corporations are permitted to exclude 50% of the dividend amounts they receive & are taxed only on the remaining 50% (the 50% exclusion was reduced from 70% by the Tax Cuts & Jobs Act of 2017).
