Module 5 - Chapter 7 - Equity Markets and Stock Valuation
order flow
The flow of customer orders to buy and sell securities.
inside quotes
The highest bid quotes and the lowest ask quotes for a security.
You do not include
dividends just paid in calculations, PV= fv of all FUTURE dividends
growing perpetuity
An asset with cash flows that grow at a constant rate forever
Unlike the NYSE DMM system, Nasdaq relies on multiple market makers for actively traded stocks. Thus, there are two key differences between the NYSE and Nasdaq:
(1) Nasdaq is a computer network and has no physical location where trading takes place, and (2) Nasdaq has a multiple market maker system rather than a DMM system. Notice that there is no direct trading in the crowd as there may be on the NYSE.
The Nasdaq network operates with three levels of information access.
-Level 1 is designed to provide a timely, accurate source of price quotations. These prices are freely available over the internet. -Level 2 allows users to view price quotes from all Nasdaq market makers. In particular, this level allows access to inside quotes. Inside quotes are the highest bid quotes and the lowest asked quotes for a Nasdaq-listed security. Level 2 is now available on the web, sometimes for a small fee. -Level 3 is for the use of market makers only. This access level allows Nasdaq dealers to enter or change their price quote information.
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:
-The right to share proportionally in dividends paid. -The right to share proportionally in assets remaining after liabilities have been paid in a liquidation. -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. -In addition, shareholders sometimes have the right to share proportionally in any new stock sold. This is called the preemptive right.
Some important characteristics of dividends include the following:
-Unless a dividend is declared by the board of directors of a corporation, it is not a liability of the corporation. A corporation cannot default on an undeclared dividend. 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. -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 aftertax profits. -Dividends received by individual shareholders are taxable. In 2021, the tax rate was 15 to 20 percent. However, corporations that own stock in other corporations are permitted to exclude 50 percent of the dividend amounts they receive and are taxed on only the remaining 50 percent (the 50 percent exclusion was reduced from 70 percent by the Tax Cuts and Jobs Act of 2017)
Constant Growth Model Conditions
1. Dividend expected to grow at g forever 2. Stock price expected to grow at g forever 3. Expected total return, R, must be > g
forward PE ratio
A PE ratio that is based on estimated future earnings
DMM's post
A fixed place on the exchange floor where the DMM operates.
Is Preferred Stock Really Debt?
A good case can be made that preferred stock is really debt in disguise, a kind of equity bond. Preferred shareholders are only entitled to receive a stated dividend, and, if the corporation is liquidated, preferred shareholders are only entitled to the stated value of their preferred shares. Often, preferred stocks carry credit ratings much like those of bonds. Furthermore, preferred stock is sometimes convertible into common stock, and preferred stocks are often callable.
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. We can actually use the dividend growth model to get the stock price at any point in time, not just today.
straight voting
A procedure in which a shareholder may cast all votes for each member of the board of directors. -Each time, Smith can cast 20 votes and Jones can cast 80. As a consequence, Jones will elect all of the candidates. The only way to guarantee a seat is to own 50 percent plus one share. This also guarantees that you will win every seat, so it's really all or nothing.
cumulative voting
A procedure in which a shareholder may cast all votes for one member of the board of directors. If cumulative voting is permitted, the total number of votes that each shareholder may cast is determined first. This is usually calculated as the number of shares (owned or controlled) multiplied by the number of directors to be elected. -permit minority participation -his 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.
dividend yield
A stock's expected cash dividend divided by its current price.
Introduced in 1971, the Nasdaq market is a computer network of securities dealers who disseminate timely security price quotes to Nasdaq subscribers. These dealers act as market makers for securities listed on Nasdaq.
As market makers, Nasdaq dealers post bid and asked prices at which they accept sell and buy orders, respectively. With each price quote, they also post the number of stock shares that they obligate themselves to trade at their quoted prices.
member
As of 2006, a member is the owner of a trading license on the NYSE.
Nasdaq is actually made up of three separate markets: the Nasdaq Global Select Market, the Nasdaq Global Market, and the Nasdaq Capital Market.
As the market for Nasdaq's larger and more actively traded securities, the Global Select Market lists about 1,200 companies (as of 2021), including some of the best-known companies in the world, such as Microsoft and Apple. The Global Market companies are somewhat smaller in size, and Nasdaq lists about 1,450 of these companies. Finally, the smallest companies listed on Nasdaq are in the Nasdaq Capital Market; about 550 are currently listed. Of course, as Capital Market companies become more established, they may move up to the Global Market or Global Select Market.
nonconstant growth
As we discussed earlier, the growth rate cannot exceed the required return indefinitely, but it certainly could do so for some number of years. To avoid the problem of having to forecast and discount an infinite number of dividends, we will require that the dividends start growing at a constant rate sometime in the future. -a company that is currently not paying dividends. You predict that, in five years, the company will pay a dividend for the first time. The dividend will be $.50 per share. You expect that this dividend will then grow at a rate of 10 percent per year indefinitely. The required return on companies such as this one is 20 percent. What is the price of the stock today?
Estimating Dividends Special Cases
Constant dividend/Zero Growth- Firm will pay a constant dividend forever- Like preferred stock- Price is computed using the perpetuity formula • Constant dividend growth- Firm will increase the dividend by a constant percent every period • Nonconstant growth- Dividend growth is not consistent initially, but settles down to constant growth eventually
Directors are elected each year at an annual meeting. Although there are exceptions (discussed in a moment), the general idea is "one share, one vote" (not one share holder, one page 222vote). Corporate democracy is thus very different from our political democracy. With corporate democracy, the "golden rule" prevails absolutely.2
Directors are elected at an annual shareholders' meeting by a vote of the holders of a majority of shares who are present and entitled to vote. However, the exact mechanism for electing directors differs across companies. The most important difference is whether shares must be voted cumulatively or voted straight.
Zero Growth
Dividend are assumed to be constant in amount, with no growth and take the form of a level perpetuity. -A share of common stock in a company with a constant dividend is much like a share of preferred stock. 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. The per-share value is thus given by:
In a very important development in the late 1990s, the Nasdaq system was opened to so-called electronic communications networks (ECNs).
ECNs are basically websites that allow investors to trade directly with one another. Investor buy and sell orders placed on ECNs are transmitted to Nasdaq and displayed along with market maker bid and ask prices.
common stock
Equity without priority for dividends or in bankruptcy.
What makes the NYSE somewhat unique is that it is a hybrid market.
In a hybrid market, trading takes place both electronically and face-to-face.
Unpaid preferred dividends are not debts of the firm. Directors elected by the common shareholders can defer preferred dividends indefinitely. However, in such cases, common shareholders also must forgo dividends.
In addition, holders of preferred shares are often granted voting and other rights if preferred dividends have not been paid for some time.
straight voting can "freeze out" minority shareholders; that is the reason many states have mandatory cumulative voting.
In states where cumulative voting is mandatory, devices have been worked out to minimize its impact. -Many companies have staggered elections for directors. With staggered elections, only a fraction of the directorships are up for election at a particular time.
A share of common stock is more difficult to value in practice than a bond, for at least three reasons. First, with common stock, not even the promised cash flows are known in advance. Second, the life of the investment is essentially forever because common stock has no maturity. Third, there is no way to easily observe the rate of return that the market requires.
Nonetheless, as we will see, there are cases in which we can come up with the present value of the future cash flows for a share of stock and thus determine its value.
You might wonder what would happen with the dividend growth model if the growth rate, g, were greater than the discount rate, R. It looks like we would get a negative stock price because R − g would be less than zero. This is not what would happen.
Instead, if the constant growth rate exceeds the discount rate, then the stock price is infinitely large. Why? If the growth rate is bigger than the discount rate, then the present value of the dividends keeps on getting bigger and bigger. Essentially, the same is true if the growth rate and the discount rate are equal. In both cases, the simplification that allows us to replace the infinite stream of dividends with the dividend growth model is "illegal," so the answers we get from the dividend growth model are nonsense unless the growth rate is less than the discount rate.
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. -The SLPs are essentially investment firms that agree to be active participants in stocks assigned to them. Their job is to regularly make a one-sided market (i.e., offering to either buy or sell). They trade purely for their own accounts (using their own money), so they do not represent customers. They are given a small rebate on their buys and sells, thereby encouraging them to be more aggressive. The NYSE's goal is to generate as much liquidity as possible, which makes it easier for ordinary investors to quickly buy and sell at prevailing prices. Unlike DMMs and floor brokers, SLPs do not operate on the floor of the stock exchange.
Floor Activity
It is quite likely that you have seen footage of the NYSE trading floor on television. If so, you would have seen a big room, about the size of a basketball gym. This big room is called, technically, "the Big Room."
The New York Stock Exchange, or NYSE, popularly known as the Big Board, was founded in 1792. It has occupied its current location on Wall Street since the turn of the twentieth century. Measured in terms of dollar volume of activity and the total value of shares listed, it is the largest stock market in the world.
Members Historically, the NYSE had 1,366 exchange members. Prior to 2006, the exchange members were said to own "seats" on the exchange, and, collectively, the members of the exchange were also the owners. For this and other reasons, seats were valuable and were bought and sold fairly regularly. Seat prices reached a record $4 million in 2005.
With electronic trading, orders to buy and orders to sell are submitted to the exchange. Orders are compared by a computer and whenever there is a match, the orders are executed with no human intervention.
Most trades on the NYSE occur this way. For orders that are not handled electronically, the NYSE relies on its license holders.
Each of the counters is a DMM's post. DMMs normally operate in front of their posts to monitor and manage trading in the stocks assigned to them. Clerical employees working for the DMMs operate behind the counter.
Moving from the many workstations lining the walls of the exchange out to the exchange floor and back again are swarms of floor brokers, receiving customer orders, walking out to DMMs' posts where the orders can be executed, and returning to confirm order executions and receive new customer orders.
designated market makers (DMMs)
NYSE members who act as dealers in particular stocks. Formerly known as "specialists." -Typically, each stock on the NYSE is assigned to a single DMM. As a dealer, a DMM maintains a two-sided market, meaning that the DMM continually posts and updates bid and ask prices. By doing so, the DMM ensures that there is always a buyer or seller available, thereby promoting market liquidity.
floor brokers
NYSE members who execute customer buy and sell orders. -The job of a floor broker is to execute trades for customers, with an emphasis on getting the best price possible. Floor brokers are generally employees of large brokerage firms such as Merrill Lynch, the wealth management division of Bank of America. The interaction between floor brokers and DMMs is the key to nonelectronic trading on the NYSE. We discuss this interaction in detail in just a moment.
In 2006, all of this changed when the NYSE became a publicly owned corporation called NYSE Group, Inc. Naturally, its stock is listed on the NYSE.
Now, instead of purchasing seats, exchange members must purchase trading licenses, the number of which is limited to 1,366. In 2021, a license would set you back a cool $50,000—per year. Having a license entitles you to buy and sell securities on the floor of the exchange. Different members play different roles in this regard.
Stock Value =
PV of Dividends
dividend
Payments by a corporation to shareholders, made in either cash or stock.
Preferred stock differs from common stock because it has preference over common stock in the payment of dividends and in the distribution of corporation assets in the event of liquidation.
Preference means only that the holders of the preferred shares must receive a dividend (in the case of an ongoing firm) before holders of common shares are entitled to anything.
Stated Value
Preferred shares have a stated liquidating value, usually $100 per share. The cash dividend is described in terms of dollars per share. For example, General Motors "$5 preferred" easily translates into a dividend yield of 5 percent of stated value.
Classes of Stock
Some firms have more than one class of common stock. Often, the classes are created with unequal voting rights. The Ford Motor Company, for example, has Class B common stock, which is not publicly traded (it is held by Ford family interests and trusts). This class has about 40 percent of the voting power, even though it represents less than 10 percent of the total number of shares outstanding.
Overall, staggering has two basic effects:
Staggering makes it more difficult for a minority shareholder to elect a director when there is cumulative voting because there are fewer directors to be elected at one time. Staggering makes takeover attempts less likely to be successful because it makes it more difficult to vote in a majority of new directors.
preferred stock
Stock with dividend priority over common stock, normally with a fixed dividend rate, sometimes without voting rights.
The customers of the NYSE are the millions of individual investors and tens of thousands of institutional investors who place their orders to buy and sell shares in NYSE-listed companies.
The NYSE has been quite successful in attracting order flow. Currently, it is common for more than one billion shares to change hands in a single day.
Constant Growth
The assumption that dividends or free cash flows will grow forever at a constant rate.
A preferred dividend is not like interest on a bond.
The board of directors may decide not to pay the dividends on preferred shares, and their decision may have nothing to do with the current net income of the corporation. Dividends payable on preferred stock are either cumulative or noncumulative; most are cumulative. If preferred dividends are cumulative and are not paid in a particular year, they will be carried forward as an arrearage. Usually, both the accumulated (past) preferred dividends and the current preferred dividends must be paid before the common shareholders can receive anything.
Shareholder Rights
The conceptual structure of the corporation assumes that shareholders elect directors who, in turn, hire management to carry out their directives. Shareholders, therefore, control the corporation through the right to elect the directors. Generally, only shareholders have this right.
capital gains yield
The dividend growth rate, or the rate at which the value of an investment grows.
electronic communications networks (ECNs)
Websites that allow investors to trade directly with one another.
A proxy is the grant of
authority by a shareholder to someone else to vote that shareholder's shares. For convenience, much of the voting in large public corporations is actually done by proxy.
dealer An agent who buys and sells securities from inventory. (car dealer)
broker An agent who arranges security transactions among investors. (real estate agent)
There are three different types of license holders—
designated market makers (DMMs), floor brokers, and supplemental liquidity providers (SLPs)
primary market The market in which new securities are originally sold to investors.
secondary market The market in which previously issued securities are traded among investors.
Cash Flows
the amount of money that is available to a business at any given time
NASDAQ,
which stands for National Association of Securities Dealers Automated Quotations system
Features of Preferred Stock
• Dividends - Must be paid before dividends can be paid to common stockholders - Not a liability of the firm - Can be deferred indefinitely - Most preferred dividends are cumulative • Missed preferred dividends have to be paid before common dividends can be paid • Preferred stock generally does not carry voting rights
Dividend Characteristics
• Dividends are not a liability of the firm until declared by the Board of Directors - A firm cannot go bankrupt for not declaring dividends • Dividends and Taxes - Dividends are not tax deductible for firm - Taxed as ordinary income for individuals
Features of Common Stock 2
• Other Rights - Share proportionally in declared dividends - Share proportionally in remaining assets during liquidation - Preemptive right • Right of first refusal to buy new stock issue to maintain proportional ownership if desired
Features of Common Stock
• Voting Rights - Stockholders elect directors - Cumulative voting vs. Straight voting - Boards are often staggered, or "classified" - Proxy voting • Classes of stock- Founders' shares - Class A and Class B shares