BFM Midterm #2

Two-Stage Dividend Growth Model (DGM)

-A special case of non-constant growth where dividends grow at different constant rates over 2 periods. -The dividend will grow at rate g1 for t years and then grow at rate g2 thereafter. -We can value the first period as a GROWING ANNUITY y for t years. -We can value the second period as a DISCOUNTED PERPETUITY. -Don't use the formula -- do the 2 steps instead: 1)timeline; 2) chunks.

Special case II: Constant growth; dividend growth model (DGM)

-Assume we expect all future dividends to grow at a constant rate g. -Works only if g < r . -If g > r, the price is forever; price bubble. -D1 is NEXT YEAR's dividend.

Discounted Cash Flow (DCF) valuation / Present Value approach

-DCF approach: stock cash flows The price of any given security should be equal to the value of its future cash flows which are discounted at the appropriate interest rate. -*Exactly the same analysis used in valuing bonds. -Estimated value of a stock is equal to the discounted sum of the expected future cash flows. -In order to implement such a model, the investor must: 1. Estimate the amount and timing of the future stream of cash flows. 2. Estimate an appropriate rate of return -- this rate of return (or discount rate) is the MINIMUM rate of return required to justify the RISK associated with the uncertainty of the cash flows. -Cash Flow at time 1 = D1 + P1 -Price today (P0) is the PV of D1 + P1 -P0 = PV of ALL FUTURE EXPECTED DIVIDENDS. -For this, we must know the future expected dividends and at what rate to discount them. This is known as the Dividend Discount Model (DDM).

Common equity vs. debt

-Debt is borrowing money (e.g. bank loans, issuing bonds, etc). The borrower is legally obligated to pay the debt holder back. Otherwise, the borrower defaults and enters into bankruptcy and subsequent legal proceedings. **Debt-holders are paid before before equity-holders. -Equity is ownership. The shareholder buys a portion (share) of the firm and subsequent returns may be positive or negative depending on the outcome of the firm. In the event of bankruptcy or liquidation, equity-holders are the RESIDUAL CLAIMANTS: the individuals who receive the net income after all obligations are paid. That means debt-holders get paid before equity holders (and preferred stockholders over common stockholders). Order of payment: 1. Debt-holders 2.Preferred stockholders 2. Common stockholders *Equity holders are paid LAST; Debt holders are paid FIRST. *Dividends are tax deductible.

What is different when valuing common stocks as opposed to bonds (the simplest financial instruments)? How do we approach stock valuation?

-Discounted Cash Flow (DCF) approach/ Present Value approach. -Common stock has UNCERTAIN cash flows (might not be paid if there is no cash left over after paying debt holders and preferred stockholders). -There is NO MATURITY on common stock. -The rate of return on stocks is not easily observable. Valuing equity involves: 1. Time Value of Money: We prefer a dollar TODAY over tomorrow. 2. Uncertainty: We prefer a SAFE dollar over a risky dollar. The more uncertain the dividends, the bigger the DISCOUNT RATE.

Multiples approach to valuation Multiples (Comparables) Valuation Approach

-For a stock that doesn't pay dividends. -This is what MOST FIRMS rely on because dividends are hard to calculate. -This approach is based on using a target or benchmark financial ratio to infer the price of the stock. -Common financial ratios used in practice are the PRICE-EARNINGS RATIO or the PRICE-SALES RATIO. -The appropriate ratio to benchmark or target is determined by comparable firms in the market. The idea is that firms with similar ratios should sell at similar prices. In other words, when the firms are comparable, the value of one firm can be based on the value of a comparable firm. -Search firms based on some similar characteristic and calculate Price-Earnings or Price-Sales ratios for each and take the median (less influenced by outliers). This lets you see what comparable firms are doing to try to find a match and do a proportional arithmetic to find the missing parameters.

Dividend Discount Model (DDM)

-Main issue: The dividend stream is UNCERTAIN and the dividends for most firms are expected to GROW over time. -To solve this problem, some assumption must be made about the EXPECTED GROWTH RATE of the dividend stream given that we know the current dividend stream. One of 2 growth assumptions are used in valuing stocks: 1. The dividend stream has a ZERO GROWTH RATE (all future dividends are set equal to the current dividend); known as the CONSTANT dividend/ ZERO GROWTH version. *Similar to a perpetuity. 2.The dividend stream is assumed to grow at a CONSTANT RATE (g) starting with the current dividend; known as the CONSTANT GROWTH version; the model is referred to as the DGM or DIVIDEND GROWTH MODEL.

Classes of stock FEATURE

-Many firms have more than one class of stock. Classes are often created with unequal voting rights. -Management can raise $ through issuing shares that have limited voting rights while still maintaining control of the company. This can be through issuing shares without voting rights; only cash flow rights. Ex: A) voting right + cash flow right B) only cash flow right *Value of control is cheaper in firms with bad corporate governance (firms that are run poorly).

Special case III: Non-constant growth in dividends

-Often, companies have a period of phenomenal growth when they are young and then settle into a normal, steady growth rate. To value stock with non constant growth: 1. Identify the period in the future when the stock begins paying a constant dividend or constant growth dividend. 2. Calculate the price at the beginning of that period in the future (FV). 3. Discount initial dividends and the future price back to today (FV --> PV).

Special case I: Constant dividend; zero growth

-Stream of constant cash flows forever. -Perpetuity formula. -*Assumes the payment starts in the NEXT PERIOD. -The price of the stock remains constant because the formula applies to all years. -The total return loads fully on dividend yield; nothing from capital gains because the stock price stays flat forever.

Dividends FEATURE

-The shareholder has the right to share proportionally in dividends paid. -Dividends: payments by a corporation to shareholders, made either in the form of CASH or STOCK. -Payment of dividends is at the discretion of the board of directors. -Dividends received by shareholders are considered ordinary income by the IRS and are FULLY TAXABLE (like cash). -Common stock comes with dividends -- which are taxed like income once they have been issued. -Cum-dividend: with a dividend. *When the dividend was announced, the stock price didn't change much because it was expected (it was the 157th dividend paid) and it has to do with expectations. *Dividends announced are good news (price appreciation), but they come with expectations of a high price. Companies don't increase price unless they are confident that they can sustain it in the future. -Ex-dividend: not including the next dividend. Stock price drops after dividend is issued (after Nov. 20th) because if you buy stock after that date, you won't get the dividend. The value of the dividend is subtracted from the stock price.

Shareholder rights FEATURE

-The structure of the corporation assumes shareholders elect directors who hire management to manage the day to day operations. -Shareholders control the corporation through the RIGHT TO ELECT directors. -SHAREHOLDERS elect a BOARD OF DIRECTORS which acts in shareholders' best interest. The board hires and monitors MANAGEMENT, which reports to the board. -The Board of directors bridges the gap between shareholders (owners) and management (managers). -Corporations have the agency problem because of the separation of ownership.

Multi-Stage Dividend Growth Model (DGM)

-We can generalize the 2-stage DGM to 3, 4, etc. stages. -Value the first period as a GROWING ANNUITY for t1 years. -Value the second period as a DISCOUNTED GROWING ANNUITY for t2 years. -Value the third period as a DISCOUNTED GROWING ANNUITY for t3 years. -... -Value the last period as a DISCOUNTED PERPETUITY.

Features of Common stock

1. Shareholder rights: to elect directors 2.Classes of stocks: some have voting rights; raise $ while maintaining control of the company 3.Dividends: Fully taxable (like cash)

Specialist

A NYSE member acting as a dealer and market maker in a small number of securities at the exchange. They are obligated to maintain a fiar orderly market in the securities assigned to them, 4. If routed through the broker's booth, order is given to a floor broker who competes with other brokers at the trading post for the best price. *(broker --> specialist) 5. If routed directly to the specialist, the order appears on the specialist's screen and she makes the trade seeking the best price for the customer. NOT through a broker. 6. After trade is completed, transaction report is sent to the brokerage firms and the trade and price is displayed on the consolidated tape world wide. 7. Within 3 days, the transaction is processed with funds placed in all individual accounts.

Proxy

A grant of authority by a shareholder allowing another individual (usually management) to vote with his/her shares. -Because most companies have millions of shareholders, often many shareholders don't feel the need to attend annual meetings to elect directors. -Consolidation and voting by proxy creates situations for companies to COLLUDE and keep prices high. -This is due to an incentive to lower competition because one company owes all of them.

Dividend yield

Annual dividend / Closing price Measures how much cash flow you are getting for each dollar invested in an equity position.

Job of financial markets

Clients are buying an exposure. The thing they sell them is supposed to give people the risk they want. Job of financial markets: -Ask -- SELL (high) -Bid -- BUY (low) Financial markets also sell products that don't have a counterpart in the real world -- buying volatility in financial markets if volatility price increases, you can't sell volatility as you can with potatoes because there is no supply to reduce the price of volatility.

Is preferred stock equity or debt?

From a legal and tax point of view, preferred stock is considered a form of EQUITY -- preferred dividends are treated like common stock dividends. Most people on Wall Street consider preferred stock to be DEBT. Preferred shares often carry credit ratings and NO VOTING RIGHTS. Given that most preferred shares don't have a mandatory maturity date, we know how to value preferred shares -- PV of its future dividend payments discounted at the required rate of return of the stock. In most cases, preferred stock is perpetual, so Price of a share of Preferred Stock = Periodic Dividend / Required Rate of Return

Closing price

Last reported trading price of the stock; typically 52 week high and low prices are also reported in addition to the change in price from the previous day. Last price at which a transaction was done in the day.

Earnings per share

Net income / Shares outstanding

NASDAQ

Not a physical exchange. Computer network of securities dealers. Dealers post bid and ask prices at which they accept buy & sell orders. Unlike NYSE, NASDAQ has a MULTIPLE MARKET MAKER system rather than a specialist system. Large portion of technology stocks.

Volume

Number of shares that were traded. Convert it to $. Closing price x volume = Estimate of daily closing value Estimate of daily closing value x market capitalization on day --> liquid measure *Not all outstanding shares are traded on the market, so the free flow of what fraction of shares are being traded is better to use than the daily closing value of shares. -Bonds are traded OTC and stocks are traded on a market.

One share =

One vote

One share =

One vote *NOT one shareholder = one vote

Price/Earnings Ratio (multiple)

Price per share / Earnings per share Attempts to measure growth prospects of the firm; earnings used to calculate the ratio are either 1)the most recently available -- typically referred to as the trailing P/E ratio *earnings reported backward-looking. 2)estimated earnings over the next 4 quarters -- referred to as the forward P/E ratio *earnings reported forward-looking

Stocks and bonds

Represent the major sources of financing for corporations

Risk vs. Uncertainty

Risk: -Used more in FINANCE -KNOWN probabilities and outcomes; just not sure which one you will get/which one you will land on. -Ex: playing at a casino or taking a draw from a bag of marbles -Type I chaos: like climate. Ince you understand the model, you can expect outcomes. Uncertainty: -BROADER than risk; harder to quantify. -r^2 (goodness of fit) is LOW -Don't know the distribution of outcomes (probabilities) of the outcomes -UNKOWN probabilities & outcomes -Ex: You don't know what is in the bag -- might be marbles, might be a crocodile. -Ex: Coronavirus because not much is yet known about the disease. -Type II chaos: The knowledge of the virus in one country is not applicable to other countries because people and circumstances react differently.

Common stock/Common equity

Shares of ownership that have no special preference either in paying dividends or in bankruptcy.

Required Rates of Return

Solving for r from the CGM, r = g + D1/P0 D1/P0 = dividend yield -Dividend yield is a stock's expected cash dividend divided by it's current price -D1/P0 is a constant so if D1 increases every year, P0 should also increase. g= capital gain yield -The rate at which the value of an investment grows; rate at which the price of a stock appreciates. -Capital gains = Dividend growth rate -r-g is a constant

Preferred stock

Stock with DIVIDEND PRIORITY over common stock, normally with a fixed dividend rate, sometimes without voting rights. Stock (C/S) or equity (Bond) ? -Different from common stock in 1)the preference of payment of dividends or in the distribution of corporation assets in the event of liquidation. -Different from bonds in that preferred dividend is not like interest on a bond. 1)Directors may decide not to pay dividends over a specific period; if preferred dividends are not paid during a specific period, all past dividends must be paid before common shareholders receive anything. 2)Preferred stock has no mandatory maturity dates like bonds do. Preferred stock -SYNTHESIS between stock and equity. -PV of coupons = Annual dividend payment / r ; where r = yield of preferred stock Equity (C/S): -Like a perpetuity; lives forever. -No vote. Debt (Bond): -Fixed income security: payment you receive is fixed and will be paid every year (dividend), similar to a bond. -Has a FACE VALUE.

The case of no dividends

The DGM assumes a corporation pays dividends, but what if a company does not currently pay out dividends? -If the corporation never pays dividends, the value is zero. -We expect the corporation to return cash to shareholders at some point in the future. 1. Dividend when no more growth available (cash cow). 2. Special dividends. 3. Share repurchases or sale of the firm. -Not just dividends give value to stockholders but also, sooner or later, they'll pay dividends to shareholders. Until then, shareholders enjoy capital gains. -Capital gains: A profit from the sale of property or an investment. Where today's dividend is zero or small, the DGM may be inaccurate. Why? -Small dividends today results in most of the value coming from distant payouts. -The DGM is very sensitive to the growth rate and it is hard to forecast growth long into the future. -Be CAREFUL in interpreting the DGM for ZERO-DIVIDEND firms.

NYSE

The largest stock market in the world. Trades are completed through member/brokers who own seats on the exchange and have the right to make trades. -Brokers: don't know the inventory -Dealer: knows the inventory How does it work? 1. Investor places an order to buy or sell shares in a NYSE company through his/her NYSE member broker. 2. Brokerage firm transmits the order to the NYSE trading floor. 3. Depending on the order retails (size, etc.) the order goes to a broker's booth (for direct human interaction) or through the computer system directly to the tradings post specialist in the stock.

CDS (Credit Default Swap)

To ensure against the eventuality of default. -If it's high, that's a measure of RISK.

VIX

Volatility of Return; index of volatility measure of risk st. deviations High for risky companies' returns. More risky: HIGHER YTM. Option prices: the amount an investor must pay for an option contract; dependent on the underlying security as well as the left until the options' expiration date. Forward-looking volatility