Learning Objectives
Chapter 8
Valuation and Characteristics of
Stocks
§ Identify the basic characteristics and features of
preferred stock.
§ Value Preferred Stock.
§ Identify the basic characteristics and features of common
stock.
Principles Used in this Chapter
Learning Objectives
• Principle 1:
• The Risk-Return Trade-off – We Won’t Take on Additional Risk
Unless We Expect to Be Compensated with Additional Return.
§ Value common stock.
§ Calculate a stock’s expected rate of
return.
• Principle 2:
• The Time Value of Money – A Dollar Received Today is Worth More
Than a Dollar Received in the Future
• Principle 3:
• Cash-Not Profits -Is King.
Reading Stock Listings
Reading Stock Listings
•
•
•
Yr Hi = 123 1/8: The highest price the stock has traded at over the last 52 weeks
•
Yr Lo = 93 1/8: The lowest price the stock has traded at over the last 52 weeks
The following newspaper stock listing is usually printed as a
horizontal string of information
•
Stock = IBM:
•
Sym = IBM: The stock’s symbol
The listing is for IBM, which is traded on the New York Stock
Exchange
•
Div = 4.84:
The last quarterly dividend multiplied by 4
Sym
IBM
•
Yld % = 4.2:
Dividend yield; (Annualized dividend ÷ stock price)
•
PE = 16:
Price-to-earnings; (Latest price ÷ last 4 actual dividends)
Vol 100
14591
•
Vol 100s = 14591*100; Volume of exchange traded shares
•
Hi = 115: Highest share price of the day
Net Chg
•
Lo = 113: Lowest share price of the day
•
Close = 114 3/4: Days closing share price
•
Chg = 1 3/8: Change in closing price from previous trading day
Yr Hi
Yr Lo
123 1/8 93 1/8
Div
4.84
Yld %
4.2
Stock
IBM
PE
16
Day Hi Day Lo Close
115
113
114 3/4 +1 3/8
The stock’s name
1
Stock
• Two types:
– Preferred and common
Preferred Stock
• Preferred stock is often referred to as a hybrid security
because it has many characteristics of both common
stock and bonds.
• Like common stocks
– No fixed maturity date
– Failure to pay dividends does not bring on bankruptcy
– Dividends are not deductible
•
Like Bonds
– Dividends are for a limited time
Features of Preferred Stocks
• Multiple series of preferred stock
• Preferred stock ’s claim on assets and income
• Cumulative dividends
• Protective provisions
Multiple Series
• If a company desires, it can issue more
than one series of preferred stock, and
each series can have different
characteristics.
– Convertible
• Convertibility
– Protective provisions
• Retirement Features
Claim on Assets and Income
• Preferred stock has priority over common
stock with regard to claim on assets in the
case of bankruptcy.
• Honored before common stockholders, but
after bonds.
Cumulative Dividends
• Cumulative features require that all past,
unpaid preferred stock dividends be paid
before any common stock dividends are
declared.
• Must pay dividends to preferred stockholders
before it pays common stockholder dividends.
2
Protective Provisions
• Protective provisions generally allow for
voting rights in the event of nonpayment
of dividends,
or
• they restrict the payment of common
stock dividends if sinking-funds
payments are not met or if the firm is in
financial difficulty.
Retirement Features
• Although preferred stock has no set
maturity associated with it, issuing firms
generally provide for some method of
retiring the stock.
Convertibility
• Convertible preferred stock can, at the
discretion of the holder, be converted into a
predetermined number of shares of common
stock.
• Almost one-third of preferred issued today is
convertible preferred.
• Reduces the cost of the preferred stock to the
issue
Callable Preferred
• A call provision entitles a company to repurchase its
preferred stock (or bonds) from their holders at stated
prices over a given time period.
• Call feature usually involves an initial premium of 10%
above par value
• Premium declines over time
• Allows the issuing firm to plan for the retirement of its
preferred stock at predetermined prices.
Sinking-Fund Provision
• Sinking-fund provision requires the firm
to set aside an amount of money
periodically for the retirement of its
preferred stock.
• Money used to purchase the preferred
stock in the open market or to call the
stock, whichever method is cheaper.
Common Stock
• Certificate that indicates ownership in a
corporation
• Common stockholders are the true
owners of the firm
3
Common Stock
Features of Common Stock
•
Common stock is a certificate that indicates ownership in a
corporation.
• Claim on income
•
Has no maturity date
• Claim on assets
•
No upper limit on dividends
•
Dividend payments must be declared each period (usually
quarterly) by the firm’s board of directors.
•
In the event of bankruptcy, common stockholders will not receive
any payment until the creditors, including the bondholders and
preferred stockholders, have been satisfied.
Claim on Income
• Voting rights
• Preemptive rights
• Limited liability
Claim on Assets
• Common shareholders have the right to
residual income after bondholders and
preferred stockholders have been paid.
• Common stock has a residual claim on
assets after claims of debt holders and
preferred stockholders.
• Can be in the form of dividends or
retained earnings.
• If bankruptcy occurs, claims of the
common shareholders generally go
unsatisfied.
Voting Rights
• Common shareholders are entitled to
elect the board of directors
• Most often are the only security holders
with a vote
• Can approve any change in the
corporate charter
Voting Rights
• Voting for directors and charter changes occur at the
corporation’s annual meeting.
• A proxy gives a designated party the temporary power
of attorney to vote for the signee at the corporation’s
annual meeting.
• Proxy fights - battles between rival groups for proxy
votes.
• Cumulative voting - each share of stock allows the
stockholder a number of votes equal to the number of
directors being elected.
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Preemptive Rights
Limited Liability
• Preemptive right entitles the common
shareholder to maintain a proportionate share
of ownership in the firm.
• Liability of the shareholder is limited
to the amount of their investment.
• Rights - certificates issued to the shareholders
giving them an option to purchase a stated
number of new shares of stock at a specified
price during a two- to ten-week period.
• Limited liability feature aids the firm
in raising funds.
Valuing Common Stock
• Two Methods:
Present Value of Future Dividends
• Growth factor
– Present value of all future dividends
– Free cash flow method
– Infusion of capital
• Financing, debt, common stock
– Internal growth
• Management retains some or all of the
firm’s profits for reinvestment in the firm
Valuation of stocks
• The Discounted Dividend Model
– A discounted dividend model is any model
that computes the value of a share of a stock
as the present value of the expected future
cash dividends
• Notation
• Pj is the stock value in year j
• Dj is the cash dividend in year j
• K is the required rate of return on the stock
P0 =
D1
+
D2
+
D3
D1
+
1
 D2
D1
+
1
{P1 } = D1 + P1
+
D4
(1 + k )1 (1 + k ) 2 (1 + k )3 (1 + k )4
+
D3
+ ...
+
D4
=
(1 + k )1 (1 + k )1  (1 + k )1 (1 + k )2 (1 + k )3
=
(1 + k )1 (1 + k )1

+ ...

1+ k
D + P −P
k= 1 1 0
P0
5
Expected Rate of Return
• The expected rate of return on a security is
the required rate of return of investors who
are willing to pay the market price for the
security.
• The price and dividend next year are expected
prices, so
• The expected rate of return in any period equals the market
capitalization rate, k
• Preferred Stock Expected Return:
k=
– Annual dividend/market price
• Common Stock Expected Return
D1 + P1 − P0
P0
– (Dividend in year 1 / market price) + dividend
growth rate
• Rate Relationship
k=
D1 + P1 − P0 D1 P1 − P0
=
+
P0
P0
P0
• Price is the present value of the expected
dividend plus the end-of-year price
discounted at the required rate of return
P0 =
• This relationship tells you that next year’s expected
dividend yield + the expected capital gain yield is
equal to the required rate of return
• But the problem is : how much is P1 ? (do we
know the next time period’s price?)
P1 =
D 2 + P2
1+ k
D1 + P1
1+ k
D 2 + P2
1+ k = D 1 + D 2 + P2
1+ k
1+ k (1+ k) 2 (1+ k)2
D1 +
P0 =
Continuing.. We get,
∞
P0 = ∑
t =1
Dt
(1 + k)t
6
• Thus
– Estimating next year’s dividend is straightforward, but estimating
next year’s price appears to be much more difficult
With this assumption
P0 turns out to be given by
– The problem is that next year ’s price is obtained (eventually) by
estimating, and discounting, every future dividend
P0 =
• So,
– We have to introduce a simplifying assumption that captures our
understanding of dividend behavior
D1
k -g
• Where:
– The second simplest assumption is that a dividend in any future
year is the dividend in the prior year times a constant growth
factor (1+g)
g=
P1 -P 0
P0
• is the stock price growth rate.
– Think of this as some kind of dividend inflation
Valuing Common Stock
Valuing Common Stock
Consider the valuation of a common stock
that paid $2.00 dividend at the end of the last
year and is expected to pay a cash dividend in
the future.
1. The dividend last year was $2. Compute the
new dividend by:
D1 = D0(1+g)
= $2(1+.10)=$2.20
Dividends are expected to grow at 10% and
the investors required rate of return is 15%.
2. Vcs = D1/ (k cs – g)
= $2.20/(.15-.10)
= $44
Valuing Preferred Stock
• Question:
• XYZ stock is expected to pay a dividend of $2 per
share a year from now, and its dividends are
expected to grow by 6% per year thereafter. If its
price is now $20 per share, what must be the
market capitalization rate?
• The value of a preferred stock is the present
value of all future dividends.
Since, P1-P0 = 0
k=
D1 + P1 − P0 D1 P1 − P0
=
+
P0
P0
P0
D1
k
• Value of preferred stock:
P0 =
= Annual dividend / required rate of return
7
Valuing Preferred Stock
Vps= annual dividend
=D
required rate of return k ps
Example:
Xerox’s Series C preferred stock pays an annual dividend of
$6.25 and the investors required rate of return is 5%.
Vps= D = $6.25 = $125.00
k ps
0.05
Internal Growth
g= ROE x r
Where
g = the growth rate of future earnings and the growth in
the common stockholder’s investment in the firm
ROE = the return on equity
(net income/common book value)
r = the company’ s percentage of
profits retained - profit retention rate
Valuing Common Stock
• Free Cash Flow Method:
Shareholder value = firm value – debt /
number of shares outstanding
• Where firm value is the present value of
free cash flows discounted a the company’s
cost of capital
8