FIN3244 Chapter 11
Book value versus investment value
Book value indicates the amount of stockholder funds used to finance the firm. Investment value indicates what value an investor places on the stock based on expectations of the risk and return.
MV(share)
Current market price of last stock trade
Classified Common Stock: (2 benefits/privileges)
Different classes have different privileges & benefits 1. Voting rights (1 vote per share) 2. Dividend amounts & payment schedules
Stock Price Behavior
Directional; Economy and Stock Prices move together In general, stocks earn positive returns over long periods of time
Stock dividends
paid in additional stock shares NO REAL VALUE (book) Taxes deferred until shares are sold (Capital gains tax: long & short term)
Ex-dividend date
(2-3 days before date of record). determines who is eligible to receive the declared dividend Sold on or after date, stock sells without dividend. Allows time for bookkeeping. ***stock price falls by dividend amount***
Book Value
Amount of firm's equity belonging to stockholders' (the owners of the firm)
Income Stock. why limited capital gains potential?
An income stock is an equity security that pays regular, often steadily increasing dividends they pay out large amounts of their earnings in dividends and re-invest less of their earnings into the finance growth of the firm. = Returns come from div (current income), and not capital gains
MV(firm)
= (share price) x (# common shares outstanding) === Firm's MARKET CAPITALIZATION = changes moment to moment
Board of Directors
1 vote for C/S Represent shareholders and oversee company decisions 1. hiring/firing CEO
Why do firms repurchase shares? (2)
1. Belief that stock is undervalued (price will rise in future) 2. Way to return profits to shareholders (capital gains as opposed to dividends) (1 time only, holders don't expect more) Firm investing in itself because it thinks its a good buy
Stock Ownership Advantages (4)
1. Best probability for highest returns 2. Good inflation hedge 3. Highly liquid 4. Transaction costs relatively small
Two ways shareholders don't lose money from issuance of equity capital
1. Can buy lower price offering before public 2. Sell rights to buy Both offset loss in value of their existing shares
Foreign Market Return Risk
1. Due to exchange rates 2. Know less about whats going on in the countries 3. Accounting different 4. Political turmoil
Dividend Considerations (5) (whether or not to pay dividends)
1. EPS/current profits 2. Growth opportunities (do they need $ for expansion?) 3. Cash position (sufficient liquidity) 4. Contractual obligations? (restricted covenants) 5. Div expectations of shareholders
Results of rights offering (3)
1. Firm acquires more equity capital 2. Number of shares outstanding increases 3. Decrease of stock price to existing shareholders TO MAINTAIN EXISTING OWNERSHIP %
Why don't firm's issue C/S (2)
1. Firms too small 2. Family or privately controlled (Still C/S, just not public)
Possible uses of treasury stock (3)
1. In the course of a Merger/Acquisition 2. Companies pay other companies with shares of their own stock 3. May use as stock options for management/employees
Stock Split:
Specified # of 'new' shares (more) exchanged for 'old' shares Have more shares than you began with 1 share @ 1.00 to 2 shares @ .50
Cash dividends
1. Most common type 2. Tend to rise over time: as firm's earnings increase 3. Meets investor expectations Mature firms: less opportunities from new growth
Stock Spin-Off: Why? (2)
1. No longer a good fit (Chipotle-McDonalds) 2. More profitable on its own Might drag down parent company or not recognize its full potential (lack funding or management attention) 3. Don't have to issue an IPO
Why are costs relatively small per transaction for Stock? (2)
1. Price & market info easily obtainable 2. Unit cost per stock share relatively low: (Lets small investors invest) versus commercial paper w/ min $100,000 investment
Name some of the more important attributes of common stock
1. Profits (return) 2. Versatility 3. Simple & Straightforward 4. Liquid 5. Low Transaction Costs 6. Easy to get information
Publicly traded C/S (2)
1. Readily available to the general public 2. Listed firms are subject to SEC regs.
Stock Ownership Disadvantages (4)
1. Volatile: Can be wide swings in earnings & performance (great upside, serious downside) 2. Subject to many types of risk (internal & external) & greater risk than debt investments (uncertainty) 2. Hard to predict the future (Future value of firm, stock market, economy) 3. Hard to analyze data even when right 4. Sacrifice current income
Reinvested dividends (DRIPs):
Allow shareholders to automatically reinvest their dividends into additional firm shares. Typically, no brokerage commissions 1. Convenient 2. Inexpensive Taxed as is it was cash dividend
Declaration date
Announcement
Stock repurchase (buyback): Impact on share price?
Announcement Actual occurrence
Book Value Formula
BV = (Firm's assets) - (Firm's liabilities + preferred stock)
When is lowering dividends more acceptable?
Bad economic times, shareholders understand its lower for all firms
Why would an investor hold a certain stock?
Believe that a firm's earnings will grow CEO job to maximize shareholder wealth Less growth as firms mature b/c they no longer need all its profits to pursue investment opportunities = if not using $ to grow firm, CEO must pay shareholders
Stock repurchase (buyback): Creates?
Buy back shares of own stock @ market price = Decreases # outstanding shares = Treasury Stock = "Retire" the stock to their treasury
Selling Stock Dividends
Can sell at MV and its basically a cash dividend Make investors wonder who the company isn't paying dividends in cash = Cash problems = stock price down = dividends worth less
Total Stock Returns formula
Capital Gains + Current Income === (Selling price - buying price) + Dividends
Stock: Internal Risks
Come from the firm itself; Management, the product, etc.
Dividends paid out? Special Dividend
Companies don't pay dividends until they think they can pay them consistently overtime Special Dividend = one time only, stockholders shouldn't expect to receive it again
Stock: External Risks
Company has no control over Oil prices, terrorism, etc. SYSTEMATIC RISK = affects ALL STOCKS
Capital Gains vs. Dividends
Dividend: 1. Returns less volatile than capital gains returns (more stable) 2. Dividends can offset cap losses or boost cap gains 3. Cant have negative return Capital Gains: 1. Majority of returns come from capital gains (Main source of returns for shareholders) 2. Only time you know what your capital gains will be is when you actually sell 3. Can have negative capital gains (loss) ~~~~~~ Despite capital gains unquestionably providing higher returns than dividends, capital gains are responsible for the wide swings in year-to-year total stock returns. Dividends, in contrast, provide an element of stability and tend to shore-up returns in off-years.
Effect of a Spin-Off
Firm gets smaller = DOES NOT CHANGE # C/S OUTSTANDING IN PARENT COMPANY = Existing share price MV FALLS = But, creates a brand new company = New firm stock distributed to existing shareholders based on % of shares in parent company
Stock Spin-Off:
Firm sells-off division/subsidiary which becomes a stand-alone company
Why Stock Split?
Firms that split their stock tend to have 10% abnormally positive return over the next year Nothing happens to existing shareholders market value
Dividend Reinvestment
Dividends offset capital losses and boost capital gains DIVIDENDS GROW OVERTIME **Assume the dividends are reinvested when received = Holdings are increased = More future dividends (like the compounding of interest)
Rights offering
Existing stockholders have 1st chance to buy 'new' issue shares (Proportionate to current firm ownership) Rights have value---can be sold Price ALWAYS set BELOW EXISTING SHARE PRICE **** if nothing is done/bought, price of stock will fall = Existing shareholders lose money = allows for selling of rights (makes up for difference in drop in share price
C/S: Equity capital
Funds the firm receives from the sale of stock SALE OF STOCK IN THE PRIMARY MARKET
Investing in Foreign Stocks
Globalization of financial markets is growing 1. U.S. equity market represents ~ 35% of world equity markets (worlds largest equity) 2. 6 countries = 80% of world equity market 3. Non-U.S. market returns: partly due to currency exchange rates
Reasons for Stock Classes
Help founders of corporation maintain control of the firm overtime Stock classes w/ multiple votes per share are issued to certain individuals/family members
Stocks: Why are they an inflation hedge?
Inflation = loss of purchasing power. With stock, the firms can raise prices to compensate for inflation. Meaning they have good change to maintain stock prices ex. Stockholder w/ fixed salary is hurt by inflation but will get higher returns on their investments = hedge against inflation
Who loses money through seasoned offerings?
Investors who do nothing; don't buy/sell rights Its important to investors with large share of C/S to buy & maintain ownership position
C/S Disadvantage
RISKY NATURE returns are not guaranteed and debt holders have first claim to a firm's assets stock prices are subject to wide swings that make valuation difficult Important: Sacrifice of current income (ex. would be making interest $ if bonds instead)
Restricted Covenants
Limits a firms dividend payments unless profits exceed a certain smount
Payment date
Mailing date of dividend checks
Stocks: Best probability of returns
Of all asset classes (bonds, real estate, etc) Returns 2x the size of corporate bonds ALSO MOST RISKY
Trading Range Theory
People get used to/comfortable trading a stock in a given price range (ex. $20-$60) At some point, 1. the price of the stock becomes too high 2. people get nervous about the run up and start to sell, which the company doesn't want So, the company decides to split the stock to cut the price in half = 2 shares of $30
Investment Value (Intrinsic value)
Price an investor believes a firm should trade at What they think it's worth (different for different people) If you think a firms intrinsic value > what its currently selling for, you would BUY It is the maximum price the investor will be willing to pay for the share.
What is meant by the statement that holders of common stock are the residual owners of the firm?
Residual: remaining after the greater part or quantity has gone. common stockholders are entitled to dividend income (if paid) and a prorated share of the firm's earnings *after all other obligations of the firm have been met* Investors have no guarantee that they will ever receive any return on their investment.
Dividends
Return of profit to owners of the firm (shareholders) Pay out only if profits stable so that they will continue to pay them out in future years Board of Directors make all dividend decisions
Why do shareholders invest in dividend paying firms?
See them as lower risk than rapidly growing firms BOD doesn't initiate dividend payments until they have a $$$ cushion in reserve Older, established companies
Date of record
Shareholders registered by close of business day receive declared dividends
Issue with Stock Repurchase
Since people know that when a repurchase is going to occur, and that it raises prices, why wouldn't they run out and buy shares before the company does it? To solve, company authorizes a DOLLAR VALUE of shares to be repurchased OVER PERIOD TIME = May or may not go through with it "if price is reasonable" (even though they announced it)
Preferred Stock
Stated fixed dividend rate (like bonds) Dividends paid before those of common stock (also have to make up payments missed before C/S sees any) Paid first if firm gets into financial trouble = Slightly safer/less risky than C/S
Treatment of dividends
Stock Div = Capital Gains DRIPS = current income
Effect of a stock buyback
Stock Price Rises
Stock Split & Trade Range Theory
Stock Split: Enhance the stock's trading appeal (Trading Range Theory) since it makes stock shares more affordable to small investors while also lessening the likelihood that they will view the stock as overpriced due simply to a higher cost per share.
Stocks: Why are they highly liquid?
Stocks listed on a reputable exchange already have high enough liquidity to be sold there = Easy to find other people to buy/sell = Always at a fair price (part of what liquidity means) = Wouldn't be a transaction if prices were unfair = Determined by the marketplace
C/S Advantage
The return; capital gains have unlimited potential Annual current income thru Dividends
Signaling Theory
When a company announces that its going to split its stock, it is a BIG DEAL (positive, investors like this) = By splitting their stock, the company believes that their stock is UNDERVALUED/UNDERPRICED = Use the stock split to call attention to themselves = result in the re-examination of a firm
Common Stock Details
Together, C/S own the company Each share entitles owner to an equal ownership position ==Equal vote ==Equal voice in management These C/S have little control over CEOs and Moral Hazard