Valuation and Characteristics
of Common Stocks
Financial Management
B 642
Outline
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What are stocks?
Types of Stocks
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Preferred Stock
Common Stock
Characteristics of Preferred Stocks
Characteristics of Common Stocks
How to value a Preferred Stock?
How to value a Common Stock?
What is a Stock?
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Stocks represent ownership capital
Stockholders are part owners of the
company
Types of Stocks
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Preferred Stocks
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A stock that enjoys preference over common stockholders in
terms of payment of dividend and in terms of distribution of
assets in case of liquidation of the firm
A hybrid security
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Has features of both common stock and a bond
Pays a fixed rate of dividend each year (like coupon on a bond) and
Has infinite life (like common stock)
Non payment of dividend does not bring bankruptcy
Dividends cannot be deducted from firm’s income for tax purposes
Cumulative Dividend
How to value preferred stock?
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Present value of anticipated/expected cash flows
when discounted at the required rate of return
by the preferred stockholders
What cash flows are anticipated by preferred
stockholders?
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Dollar amount of dividend every year for an infinite
time period
Value of Preferred Stock = PV of anticipated
dividend discounted at the required rate of
return
Examples
Common Stocks
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Common Stock
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Common stockholders are the true owners of the
company
Entitled to dividend if and when declared by the
board of directors
Entitled to vote at the annual general meetings of the
firm
They have the last claim on the assets of the firm
after paying off creditors and bond holders and
preferred stockholders
They are also residual owners
How to value common stock?
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PV of expected cash flows for common stockholders
when discounted at the required rate of return for the
common stockholders
What cash flows are expected by common stockholders?
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An unequal stream of dividends for each year
Value of Common Stock = PV of dividends for common
stock holders
Simplifying Assumptions to Value Common Stock
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Zero Growth Model
Constant Growth Model
Zero Growth Model
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If we assume that dividend for common stockholder
will be the same every year
DIV1 = DIV2 =DIV3=……=DIV
Under zero growth model, stockholders anticipate to
receive the same amount of dividend per year
forever
Thus, we have a perpetuity of dividends
Price of Stock will equal the present value of this
perpetuity
Examples
Constant Growth Model
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If we assume that dividends grow at a
constant rate of ‘g’ per year forever
DPS1
P0 = --------r-g