CHAPTER 6: Stocks and Stock Valuation

The Board of Directors

The committee that hires, evaluates, and monitors the senior managers of the firm. The main vote that shareholders have is to elect the Board of Directors.

Behavioral Finance

A growing body of research that focuses on investor behavior and its impact on investment decisions and stock prices.

Efficient Market Hypothesis (EMH)

A theory describing the behavior of an assumed "perfect" market in which securities are in equilibrium, security prices fully reflect all available information and react swiftly to new information, and because stocks are fully and fairly priced, investors need not waste time looking for mispriced securities.

Proxy voting

Allowing someone else to vote one's shares

Mutual funds are overseen by portfolio managers who:

Are highly trained, professional investors.

Mutual funds

Are investments that pool an investor's money together with other investors to purchase shares of a collection of stocks, bonds, or other securities, referred to as a portfolio, that might be difficult to recreate for individual investors.

Advocates are commonly referred to as "behaviorists" who

Argue that understanding human behavior and biases helps us to understand markets.

Under the cumulative voting system:

Board seats are awarded in proportion to the votes received. Therefore, if a small block of voters represents 10% of shareholders, they will be able to elect 10% of the board members. The cumulative voting arrangement tends to favor minority shareholders.

True or False: Manager of actively managed funds are investment professional who typically beat the market.

False

Dividend

Cash flows generated by the assets of the firm are often paid to the shareholder by a cash payment

Prospect theory

Closely related to regret theory and suggests that people express a different degree of emotion toward gains than losses.

Regret theory

Deals with the emotional reaction people experience after realizing they have made an error in judgment. Fear of regret can lead investors to become extremely risk-averse or motivate them to be risk-seekers (less risk-averse) and take excessive risks. When risk aversion increases for many investors market prices tend to fall.

Common stock can be valued using the perpetuity formula if the: discount rate is expected to remain constant dividends are not expected to grow growth rate in dividends is not constant investor does not intend to sell the stock

Dividends are not expected to grow

What are the characteristics of preferred stock?

Don't have voting right May carry some voting rights, but generally not as many voting rights as common stock Fixed dividend payment All debts must be paid before to bondholders before preferred stockholders are paid

In straight-line voting:

Each candidate for the board of directors is elected by a majority vote. Therefore, any voting block which controls 51% of the votes will be able to elect all board members. This method tends to favor large blockholders at the expense of small shareholders.

True or False: Large and active stock markets are not very efficient because they do not react to relevent market news.

False

This is similar to bond valuation, where the price of a bond was just the present value of the interest and principal payments

First, there is usually no principal amount or maturity date for a stock. Therefore, dividend payments are like perpetuities that continue indefinitely. This means that they do not have maturity (N) or future values (FV) for the TVM calculations. Second, dividend payments are not constant over time. They tend to change over time, usually by increasing.

Dividend Yield (D0/P0)

Its measures how much the dividend is, as a percent of the price

Market Value of Holding =

Market Capitalize x Holding %

Preferred stock makes a fixed dividend payment that continues indefinitely, its value is like that of a perpetuity:

P=D/R

Nonconstant Dividend Growth Rate Stock Valuation

PV of a growing perpetuity: Di+1/ r-g

Theories of behavioral finance

Regret theory Prospect theory Herding Anchoring Confirmation bias

Preferred stock

Represents a hybrid security, in that it has some characteristics like common stock and some characteristics that make it like debt.

The growth rate (r)

Represents how much the dividends increase over time

Herding

Some investors rationalize their decision to buy certain stocks with "everyone else is doing it."

The rules for voting in a corporation can vary, with two common methods:

Straight-line voting Cumulative voting being

True or False: All else equal, if investors view a firm's dividends as risky then there will be less demand for the stock, a lower stock price, and a higher discount rate of return.

TRUE

True or False: The value of a share of stock should be the present value of all future cash flows payable to shareholders, discounted at a rate that accounts for risk.

TRUE

The PV of a perpetuity

The PV of a fixed cash flow that continues forever PV = CF/r PV = D/r We are dealing with stocks, we will designate the cash flow as D for dividends

What do companies do with excess cash flows generated by their operations?

The cash flows can either: Be paid immediately to shareholders as a cash payment called a dividend. The cash flows can be reinvested in the firm in order to pay more dividends in the future.

Which of the following is a true statement regarding publicly traded stocks and bonds? The constant dividend growth model can be used to value stocks only if the dividend growth rate remains constant. A share of common stock is generally easier to value in practice than a bond. The price of a stock is greater than the present value of all future dividends. Market interest rates and bond prices move in the same direction.

The constant dividend growth model can be used to value stocks only if the dividend growth rate remains constant.

The return

The discount rate used on stock valuation

In the formula r=(D 1/ P 0) + g, what does g represent? the dividend yield from a preferred stock the interest payment from a bond the expected price appreciation yield from a common stock the expected dividend yield from a common stock

The expected price appreciation yield from a common stock

Capital gain (g)

The increase in the stock price over time. Sometimes called the capital gains growth rate or the capital gains yield.

Common stock

The most common type of shares of stock

When a firm needs to raise cash in order to paid for projects, the choice can be simplified to two options:

The owners can contribute their own money, referred to as equity The firm can borrow the money, referred to as debt.

Anchoring

The tendency of investors to place more value on recent or even irrelevant information.

Confirmation bias

The tendency to interpret new evidence as confirmation of one's existing beliefs or theories.

Preemptive right

This right to buy additional shares. In order to maintain their voting power, shareholders often get the first chance to buy any additional shares that the firm may issue, before they are sold to the public.

True or False: In addition to voting, shareholders also have a claim on the firm's assets, after all debts have been paid.

True

True or False: The main vote that shareholders have is to elect the Board of Directors

True

Index Fund

Type of mutual fund with a portfolio constructed to match the return performance of a financial market index

Share of stock

When investors contribute money in exchange for ownership, the security that is issued to reflect their ownership

You are considering investing in a firm The dividend on the company's stock has not changed in the past ten years and most likely will not change in the foreseeable future. In this case, the most appropriate stock valuation model would be the _________ model. constant growth negative dividend growth growing perpetuity zero growth

Zero growth

The procedure of computing stock values by computing the PV of expected dividends is

called the Dividend Discount Model, the Dividend Growth Model, or the Gordon Growth Model.

A stock's ______ is found by dividing the stock's annual dividend by its closing price. cost of capital yield to maturity investors' required rate of return current yield coupon rate

current yield

What are the possible patterns for future dividends?

grow at a constant rate decrease at a constant rate grow at a changing rate constant over time

Anchoring bias

occurs when people rely too much on pre-existing information or the first information they find when making decisions