Finance Chapter 8: Stock Valuation
What is non-constant growth?
"supernormal" growth rates over some infinite time length
What is the dividend yield?
A stock's expected cash dividend divided by its current price D1/P0
What is the superDOT system?
an electronic NYSE system allowing orders to be transmitted directly to the specialist
Because the dividend is always the same, what can the stocked be viewed as?
an ordinary perpetuity with same cash flows coming in cash flow = D every period
What assumption does the dividend growth model make?
that the stock price will grow at the same constant rate as the dividend. as the cash flows on an investment grow at a constant rate through time, so does the value of the investment
What are ECNs?
electronic communications network a website that allows investors to trade directly with each other increase liquidity and competition
What is common stock?
equity without priority for dividends or in bankruptcy
What does staggering provide?
institutional continuity. continuity of the board of directors.
What is the only way to guarantee a seat in the straight line method?
nedd 50% plus one share
Why does preferred stock look like it could be debt?
often callable recieve a dividend only get stated value if liquidation occurs carry credit ratings convertible into common stock have obligatory sinking funds
What are staggered elections?
only a fraction of the dictatorships (often one third) are up for election at a particular time. thus if only two directors are up for election at one time, it will take 1/(2+1) or 33% of the stock plus one share to guarantee a seat
What else can we use the dividend growth model for?
ro get the stock price at any point in time, not just today. The pice of stock at time t Pt = Dt*(1+g) / R-g = Dt+1 / (R-g)
What is the stated value of preferred stock?
the value a preferred stockholder would receive upon liquidation (ex. 100 per share)
What are the two components of the required or total return?
Dividend Yield Capital Gains Yeild
What is the formula for determining the dividend for a period with growth rate g?
Dt = D0 * (1+g)^t
Upon the merger with which company did the NYSE become the "first global exchange"
Euronext a stock exchange based in amersterdam
suppose we are interested in the price of stock in five years P5
First we need to determine D5 D5 = 2.3 (1+.05)^5 = 2.93 P5 = 2.94*(1+.05) / .13-0.5 = $38.53
What are commission brokers?
NYSE members who execute customer orders to buy and sell stock transmitted to the exchange floor largest number of people on NYSE
Who are floor brokers?
NYSE members who execute orders for commission brokers on a fee basis used by commission broker when they are too busy to do it themselves.
What are floor traders?
NYSE members who trade their own accounts trying to anticipate temporary price flucuations
What is NASDAQ?
National Association of Securities Dealers Automated Quotations, "over the counter trading" with no floor dealers act as market makers by posting bid/ask prices to computer screens all over the world
What are the two most important stock exchanges?
New York Stock Exchange and the NASDAQ
What is the largest stock exchange in the worl measured in terms of the total value of share listed
The New York Stock Exchange
What is two stage growth rate?
The dividend will grow at a rate at a rate g1 for t years and then grow at a rate of g2. Thereafter, forever. In this case, the value of the stock can be written as Po = D1 / R-g1 * [1- (1+g1/ 1+R) ^t] + P/ (1+R)^t
A company currently does not pay dividends. In five years they will. it will be $0.50 per share. I expect that this dividend will grow at the rate of 10% per year indefinitely. the R is 20%, what is the price today?
The first dividend paid will be in five years and it will grow streadily from then on. The P4 years is P4 = D4*(1+g) / (R-g) P4 = D5 / (R-g) P4 = 0.50 / (0.2-0.1) $5 If the stock is $5 in four years, then we can get the current (present value) by discounting it backwards $5/(1+.2)^4 = $2.41 P0 = $5 /(1.20)^4 = $2.41
What does it mean to say that the dividend grows at a constant growth rate?
every period the dividend increases by the a specific rate
Why would dividends want to grow at a constant rate?
for many companies this is a specific goal.
What are target prices?
forecasted prices in the future
What does cumulative dividends mean?
if dividends are not paid to preferred stockholders in one year, they will be carried over
What happens to the present value of the stock if we push the sale stock far enough away into the future?
it is essentially zero no matter what the stock price is
What is the primary reason for making more than one class of stock?
management of a firm can raise equity capital by issuing nonvoting or limited-voting stock while maintaining control of the company
Would a company that never pays dividends work?
no because they would in all the money in and never put anything valuable out. "black hole" stock would be worthless.
What are dividends?
payments by a corporation to shareholders, made in either cash or stock this payment is at the discretion of the board
What is an over the counter market?
securities market in which trading is most exclusively done through dealers who buy and sell for their own inventory
What are the two basic effects of staggering a board?
staggering makes it more difficult for a minority to elect a director because fewer directors to elect at once staggering makes takeover attempts less likely to be successful in a majority of new directors.
What does it mean to say the dividend has zero growth?
the amount is costant through time I.E preferred stock D1 = D2 = D3 .... etc
What is the spread?
the difference between the bid price and the offering price. source of dealer profit
What is straight line voting?
the directors are elceted one at a time. Each time, Jones smith can cast 20 votes and Jones can cast 80 votes. As a consequence jones can elect all the candidates.
What is the capital gains yield?
the dividend growth rate or the rate at which the value of the investment grows
What are shareholders rights?
the elect directors who hire managers "one share, One vote"
what is orderflow?
the flow of customer orders to buy and sell securities
What is proxy?
the grant of authority by a shareholder to someone else to vote on his/her shares done for convenience in large corporations
What is a primary market?
the market in which new securities are originally sold to investors
What is the secondary market?
the market in which previously issued securities are traded among investors
what is market cap?
the number of share outstanding * current price per share
What is market depth?
the number of shares traded today, followed by the average daily volume over the past three months
What is a member of the NYSE?
the owner of a trading license on the on the NYSE said to own "seats" also the owners
What does the color of the coat indicate?
the persons job/position
What are the jobs of specialists?
the post bid prices and ask prices for securities assigned to them make the market by standing ready to buy at bid prices and sell at ask prices
What is preferred stock?
the preference of the payment of dividends and payment following liquidation goes to them before common stock holders,
What is the bid price?
the price a dealer is willing to pay
What is the ask/offering price?
the price at which the dealer is willing to sell
What is the PE ratio?
the ratio of a stock's price per share to its earnings per share over the previous year.
What is a preemptive right?
the right of stockholders to share proportionally in any new stock sold must first be offered to existing stockholders before to public helps give protection of ownership to stockholders
What would happen if the growth rate g > then discount rate R?
the stock price is infinitely large the present value of the dividends keeps getting bigger, this is "illegal" and nonsense
What is the rule of thumb for floor traders?
they buy low and sell high
What is important to note about preferred stock?
they often have no voting rights
What does having a license allow you to do on the NYSE?
to buy and sell securities on the floor of the exchange
what is the primary responsibility to customers for the commission brokers?
to get the best possible price for customer orders
What is the first important characteristics about dividends?
unless a dividend is declared by the board of directors, it is not a liability of the corporation You cannot default on an undeclared dividend cannot become bankrupt due to not paying dividends
What do we do if the company is new (not earning profit yet) and don't pay dividends
we find the price per share/sales per share
If the dividend grows at a steady rate, what problem have we replaced?
we have replaced the problem of forecasting an infinite number of future dividends with the problem of coming up with a single growth rate
What do we use when companies don't pay dividends?
we use the PE ratio
To avoid the problem of having to forecast and discount an infinite number of dividends what do we do
we will require that the dividends start growing at a constant rate at some point in the future
Suppose Smith with 20 shares and Jones with 80 shares both take place in a cumulative vote where four director positions are available. Both want to be a director, but Jones does not want smith. Can Smith win?
yes, all smith needs is 1/(1+N) percent of the stock plus one share to win 1/(1+4) = 20%
Price at rime t = Pt = benchmark PE * EPS
...
What are the two key difference between NASDQ and NYSE?
1. NASDAQ is a computer network that has no physical location where trading takes place 2. NASDAQ has multiple market maker system rather than a specialist system.
Why is common stock more difficult to value in practice than a bond? (three reasons)
1. promised cash flows are not known in advance 2. the life of investment is forever because stock has no maturity 3. no easy way to determine the rate of return the market require
What are the three cases of simplifying assumptions we must make about the pattern of future dividends to come up with a value for stock?
1. the dividend has zero growth rate 2. the dividend grows at a constant rate 3. the dividend grows at a constant rate after some length of time
What are three additional rights of shareholders beside voting?
1. the right to share proportionally in dividends 2. The right to share proportionally in assets remaining after liabilities have been paid in a liquidation 3. The right to vote on stockholder matters of grave importance such as a merger. Done at annual or special meeting
What is the record seat price in the NYSE?
4 million
Who are specialists?
A NYSE member acting as a dealer in a small number of securities on the exchange floor "market maker" represent the second largest number of people on NYSE
What is a broker?
Brings buyers and sellers together without maintaining their own inventory.
How would we determine D1 when we have a growth rate g per period?
D1 = D0 * (1+g)
How would we determine D2 when we have a growth rate g per period?
D2 = D0 * (1+g)^2
What is a forward PE?
a Price per share that is based on potential future earnings
What is a specialists post?
a fixed place on the exchange floor where the specialist operates maintain order and make sure that all buyers and sellers receive a fair price
What is an asset that has cash flows that grows at a constant rate?
a growing perpetuity
What is the dividend growth model?
a model that determines the current price of a stock dividend next period divided by the discount rate less the dividend growth
What is the definition of straight-line voting?
a procedure in which a shareholder may cast all votes for each member of the board of directors
What is cumulative voting?
a procedure in which a shareholder may cast all votes for one member of the board of directors encourages minority participation because make there vote matter directors elected all at once
What is a dealer?
an agent who buys and maintains and inventory. and sells securities from inventory
Where could the benchmark Price per share come from?
based on similar companies based on a company average based on historical values for the company
What are staggered boards often called?
classified boards. because directors are placed into different classes with terms that expire at different times
The third important characteristics of dividends?
dividends by an individual shareholder are taxable
When are directors elected?
elected each year at an annual meeting by a vote of holders with majority of the shares and who have the right to vote
What is a proxy fight?
It is when unhappy stockholders can act to replace existing management. A proxy is the authority to vote someone elses stock.
Are unpaid preferred dividend debts of the firm?
NO
Suppose D0 is $2.3 and R is 13% and g is 5% What is the price per share?
P0 = (2.3*1.05) / 0.12-0.05 30.19
What is the generic formula for determining buying price (PV) of a stock today?
P0 = (D1 + P1) / (1+R) P0 is current price of stock P1 is the price of stock in one period D1 is the dividend to be paid in one period R is the required return in the market on the investment
Suppose Paradise Prototyping Company has a policy of paying $10 per share dividend every year. If this policy continues indefinitely what is the value of the a share of stock if the R is 20%?
P0 = 10/.2 = $50
What is the per share value for zero growth Dividend?
P0 = D/R where R is required return
To simplify...as long as the growth rate (g) is less than the discount rate (r) the present value of the stock is
P0 = D0*(1+g) / R-g = D1 / (R-g)
What would be the value of the stock for a zero growth dividend?
P0 = D1/ (1+R) + D2/(1+R)^2 + D3 /(1+R)^3 + D4/(1+R)^4
If we take D0 to be the dividend just paid, and g to be the growth rate, the value of a share of stock can be written...
P0 = [D0(1+g)^1/ (1+R)] + [D0(1+g)^2/(1+R)^2] + [D0(1+g)^3 /(1+R)^3] + [D0(1+g)^4/(1+R)^4]
How would we determine the price of the stock TODAY if we have the price of stock and dividend payout for period 2?
P1 = (D2 + P2) / (1+R) Then we subsitute P0 = D1/ (1+R) + D2/(1+R)^2 + P2 / (1+R)^2
For the above example, what would be in the P1?
P1 = D1 * (1+g) (R-g) P1 = $1 * (1+.1) (.15-.10) P1= 1.10/.05 $22
If we need to get a price in three periods?
P2 = (D3 + P3) / (1+R) Then we substitute P0 = D1/ (1+R) + D2/(1+R)^2 + D3 /(1+R)^3 + P3/(1+R)^3
I plan to buy stock and sell in one year at $70 per stock. The stock will pay a $10 dividend at the end of the year. If I require a 25% investment, what is the most i would pay today? (what is the present value)
PV = ($70 + 10) /1.25 = $64
Formula for two stage growth?
Po = D1 / R-g1 * [1- (1+g1/ 1+R) ^t] + P/ (1+R)^t
what is the formula for any growing perpetuity?
Present Value = C0(1+g)/(R-g)
Suppose we observe a stock selling for $20 a share. The next dividend will be $1 per share. You think the dividend will grow by 10% per year more or less indefinitely. What return does this stock offer if this is correct?
R = dividend yield + the capital gains yeild R = D1/PO + g R= $1/20 + .1 R=.15 or 15%
How is the number of votes casted for cumulative voting determined?
The number of shares * the number of directors to be elected
Second important characteristic of dividends?
The payment of dividends by the corporation is not a business expense dividends are not deductible for corporate tax purposes paid out of after tax profits
