6-1
Chapter 6, 13.1 &13.2
Valuing Stocks
Chapter Outline







Stocks and the Stock Market
Book Values, Liquidation Values, and Market Values
Valuing Common Stocks
Simplifying the Dividend Discount Model
Growth Stocks and Income Stocks
Market Efficiency
Corporate Financing: Common Stocks and Preferred
Stocks
Semih Yildirim
ADMS 3530
6-2
Stocks and the Stock Market
•
Definitions

Primary Market: Place where the sale of new
stock first occurs.

Initial Public Offering (IPO): First offering of
stock to the general public.

Seasoned Issue: Sale of new shares by a firm
that has already been through an IPO.

Secondary Market: Market in which already
issued securities are traded by investors.
Semih Yildirim
ADMS 3530
6-3
Stocks and the Stock Market
•
Definitions

Corporations can also raise long term money by issuing and selling
securities which are called stocks or shares.


Investors who purchase these shares are called stockholders or
shareholders.
Issuing stock is like taking on new partners.


Shareholders become part-owners of the issuing firm, electing a board of
directors to represent their interests.
The shareholders are entitled to the firm’s residual cash flow.
The residual cash flow is the remaining cash flow after all
employees, suppliers, lenders and the government have been
paid.
The stockholders, as owners, share in the fortunes of the firm.
Shares of stock can be risky investments!



Semih Yildirim
ADMS 3530
6-4
Stocks and the Stock Market
• Dividends

Dividends are periodic cash distributions from the firm to
its shareholders.


Profits can also be retained in the firm and reinvested in
its operations:


They represent that share of the firm’s profits which are distributed.
Profits which are kept in the firm are called retained earnings.
If you look at Table 6.2, you will see that different firms
have different dividends:

Some firms pay no dividends at all!
Dividends, unlike coupon payments, are not fixed -- they
represent a share in the profits and profits can go down …
 Though you hope that profits, and thus the dividend, will
grow with time!

Semih Yildirim
ADMS 3530
6-5
Stocks and the Stock Market
•
Dividends

The dividend yield is calculated the same way as the current yield
on a bond – divide the annual income by the price of the security:
Dividend Yield =




Dividend Payment
Stock Price
For Canadian Tire, the dividend is $0.58 on a price of $97.50.
Dividend Yield =$0.58/$97.50=0.59%
Note that investors will accept low, or zero, current yields if they
can look forward to:
 Higher future dividends.
 Rising share prices.
Note also, that like the current yield, the dividend yield calculation
ignores potential capital gains or losses.
 Therefore, like the current yield, it is a poor measure of total
return on your investment.
Semih Yildirim
ADMS 3530
6-6
Stocks and the Stock Market
•
Price-Earnings (P/E) Ratio
 The P/E ratio is the price of the stock divided by the
earnings per share (eps).
P/E Ratio = Stock Price
EPS
 For the Canadian Tire the P/E multiple is reported as
27.4.
 The P/E ratio measures how much an investor would
pay for every $1 of eps:
 For Canadian Tire, investors are willing to pay $27.4
for each $1 of earnings the company generates.
 Key questions:
Why does one stock sell for more than another?
How do we value a stock?
Semih Yildirim
ADMS 3530
6-7
Book Value, Liquidation Value,
and Market Value
There are three methods used for valuing a company’s shares:
• Book value: is the net worth of the firm according to its balance
sheet and records all of the money the firm has raised from selling
shares and from retained earnings.
• In Table 6.1, you can see a balance sheet dated January 1, 2005, for
Canadian Tire:
•


•
•
Assume Molson has 81.1 million shares outstanding.
That means the book value per share (bvps) for Molson is:

•
•
•
Molson has $5,218 million in assets. It has liabilities of $2,967.4 million.
Book Value = $5,218 - $2,967.4 = $2,251.2 million
$2251.2 million / 81.1 million = $27.75 per share
On the same day, its market value per share was $56.21
Investors do not equate book value and market value because they
know that book value is based on the historic cost of the assets.
Historic cost is not a good guide to the value of those assets today.
Semih Yildirim
ADMS 3530
6-8
Valuing a Stock
• Liquidation
Value
What if we were to liquidate all of the assets on
Canadian Tire’s balance sheet and pay off the liabilities.
 Key Question:
Would the remaining cash per share
equal the market value for Molson shares?
 No! A successful company ought to be worth more than
its liquidation value.
 The difference between liquidation value and market
value may be attributed to what is known as going
concern value.


A well-managed company is worth more than simples sum of its assets
Semih Yildirim
ADMS 3530
6-9
Valuing a Stock
• Going

Concern Value
Going concern value means that a well managed,
profitable firm is worth more than the sum of the
value of its assets.
ASSET 1
ASSET 2
ASSET 3
$3 million
$2 million
$6 million
ASSET 2
ASSET 3
$3 million $2 million
$6 million
ASSET 1
Assets sold separately
have liquidation value
of $11 million
The same assets
functioning as a firm have
going concern value of
$15 million
Semih Yildirim
ADMS 3530
6-10
Valuing a Stock
• Sources
 Extra
of Going Concern Value
earning power.
 If
Molson can use its physical assets more efficiently than
a competitor could, then those assets are worth more than
their resale value (book value).
 Intangible
assets.
 Molson
may have extremely valuable assets, such as
brand names, which do not appear on the balance sheet,
but are reflected in the market value.
 Value
of future investments.
 If
Molson shareholders believe that Molson has
opportunities to invest in lucrative projects which will
increase the company’s future earnings, they will pay
more for the company’s shares today.
Semih Yildirim
ADMS 3530
6-11
Valuing a Stock
•
Market Value  Book Value or Liquidation Value
 Stocks rarely sell at either book value or liquidation
value.


Unlike market value, book value and liquidation value do not
treat the firm as a going concern.
Market value is the amount investors are willing to pay
today for the shares of the firm.

This depends on the earning power of the existing assets and
the expected profitability of future investments.
HOW DO WE MEASURE MARKET VALUE?
Semih Yildirim
ADMS 3530
6-12
Valuing Common Stocks
• Expected

Return
In Chapter 5, you learned how to calculate the
expected return on a security:
Expected Return = income + price change
investment
= D 1 + P 1 – P0
P0
Assuming that:
The
current price of the shares is P0.
The expected price a year from now is P1.
The expected dividend a year from now is D1.
Semih Yildirim
ADMS 3530
6-13
Valuing Common Stocks
• Expected
Return
Note that expected return can be divided into two parts:
Expected return = Dividend Yield + Capital Gain
= D1 + P1 – P0
P0
P0
 Assume that for Blue Sky shares:




The current price of the shares is $75.
The expected price a year from now is $81.
The expected dividend a year from now is $3.
What is Blue Sky’s expected return?
Expected Return = $3 + 81 – 75 = 0.12 = 12%
$75
Semih Yildirim
ADMS 3530
6-14
Valuing Common Stocks
• Expected

Return
For Blue Sky:
Expected return = Dividend Yield + Capital Gain
= D1 + P1 – P0
P0
P0
= $3 + $81 - $75
$75
$75
= 0.04 + 0.08
= 4% + 8%
= 12%
Semih Yildirim
ADMS 3530
6-15
Valuing Common Stocks
• Expected Return vs Actual Return
 Expected return is a forecast of what the return
would be if your predictions about the price and the
dividend are correct.
 However, the actual return on a stock could be
more or less than what you expect!
 Calculate how well you did as versus the 12%
expected return if the following occurs to Blue Sky
stock:
 The actual price a year from now is $61.
 The actual dividend a year from now is $3.
Semih Yildirim
ADMS 3530
6-16
Common Stock Valuation
•
1.
2.
3.
Unlike bonds, valuing common stock is more
difficult. Why?
The timing and amount of future cash flows is
not known.
The life of the investment is essentially forever.
There is no way to observe the rate of return
that the market requires.
Semih Yildirim
ADMS 3530
6-17
Common Stock Valuation
•
Remember: The value today of any financial asset
equals the present value of all of its future cash flows.
• As with bonds, the price of the stock is then the present
value of these expected cash flows
• One method to determine the price of a share of stock is
to calculate present value of all future dividends.
(Dividend Discount Model-DDM)
P0 = Σ [Dt/(1 + r)t]
where t = 1 to ∞
•
How many future dividends are there? In principle,
there can be an infinite number.

For stocks we can make a simplifying assumption that the firm
will pay dividends (cash flows) in perpetuity.
Semih Yildirim
ADMS 3530
6-18
Common Stock Valuation
•
•
To help us value a share of stock, we need to make
some simplifying assumptions about the pattern of
future dividends.
The three cases we consider are:
1.
The dividend has a zero growth rate.
2.
The dividend grows at a constant rate.
3.
The dividend grows at a constant rate after some
length of time.
Semih Yildirim
ADMS 3530
6-19
1. Zero Growth Stocks
•
A share of common stock in a company with a constant
dividend is much like a share of preferred stock.
•
The firm will pay a constant dividend forever
•
As such, D1 = D2 = D3 = … = Dt
•
Since the dividend is always the same, the stock can be
viewed as an ordinary perpetuity with a cash flow equal
to D every period.
•
Thus, the price can be computed using the perpetuity
formula P0 = D1/r
Semih Yildirim
ADMS 3530
6-20
2. Constant Growth
•
•
Suppose we knew that the dividend for some company
always grows at a steady rate (g).
As long as the growth rate (g) is less than the discount
rate (r), the present value of the series of cash flows
can be written simply using the growing perpetuity
formula:
P0 = Do x (1 + g) = D1
r–g
r–g
where D0 = the most recent dividend paid
D1 = the next dividend to be paid
Semih Yildirim
ADMS 3530
6-21
2. Constant Growth
•
We can actually use the dividend growth model to get
the stock price at any point in time, not just today. In
general, the price of the stock as of time t is:
Pt = Dt x (1 + g) = Dt+1
r–g
r–g
•
Note: The model only works when the discount rate is
greater than the growth rate.
Semih Yildirim
ADMS 3530
6-22
2. Constant Growth
Example:
• ABC Corporation just paid a $2.50 per share dividend to its
common shareholders. An investment in ABC is considered
relatively risking and requires a discount rate of 20% per annum.
It is forecasted that dividends in ABC are going grow at a rate of
6% per annum indefinitely into the future. How much will an ABC
share be worth today? In 10 years?
Step 1: Solve for D0 and D10
D0 = $2.50
D10 = 2.50 x (1 + .06)10 = $4.48
Step 2: Solve for P0 and P10
P0 = (2.50 x 1.06)/(.20 - .06) = $18.93
P10 = (4.48 x 1.06)/(.20 - .06) = $33.92
Semih Yildirim
ADMS 3530
6-23
3. Non-Constant Growth
•
At times, a new company may pay no dividends
early in its life but start paying dividends that
grow at a constant rate some time in the future.
• At other times, a new company may pay small
dividends initially and, at some point in the
future, start paying dividends that grow at a
constant rate.
• However, as always, the value of the stock is the
present value of all future dividends.
• Many cash flow scenarios are possible in this
situation.
Semih Yildirim
ADMS 3530
6-24
3. Non-Constant Growth
Example 1:
• ABC Compan’s dividend this year is $1.20 per share and
dividends will grow at10% per year for the next 3 years, followed
by 6% annual growth. The appropriate discount rate (required
rate of return) for ABC stock is 12%. What is the value of a
share of ABC common stock?
D1= 1.32
D2= 1.4520
D3= 1.5972
D4= 1.6930
PV of D1 = 1.1786
PV of D2 = 1.1575
PV of D3 = 1.1368
P3 = D4 / (r-g) = 1.6930/(.12 – .06) = $28.2167
P0 = [28.2167(1.12)-3 ] +(1.1786+1.1575+1.1368
=$20.0841 + 3.4730
= $23.5571
Semih Yildirim
ADMS 3530
6-25
3. Non-Constant Growth
•
•
•
•
•
•
Example 2
Suppose a firm is expected to increase dividends by 20% in one year
and by 15% in two years. After that dividends will increase at a rate of
5% per year indefinitely. If the last dividend was $1 and the required
return is 20%, what is the price of the stock?
Remember that we have to find the PV of all expected future
dividends.
Compute the dividends until growth levels off
 D1 = 1(1.2) = $1.20
 D2 = 1.20(1.15) = $1.38
 D3 = 1.38(1.05) = $1.449
Find the expected future price
 P2 = D3 / (R – g) = 1.449 / (.2 - .05) = 9.66
Find the present value of the expected future cash flows
 P0 = 1.20 / (1.2) + (1.38 + 9.66) / (1.2)2 = 8.67
Semih Yildirim
ADMS 3530
6-26
Example
•
•
Metallica Bearings, Inc. is a young start-up company. No
dividends will be paid on the stock over the next 5 years. The
company will pay a $6 per share dividend in six years and will
increase the dividend by 5% per year thereafter. If the required
return on this stock is 21%, what is the current share price?
The current market price of any financial asset is the present
value of its future cash flows, discounted at the appropriate
required return. In this case, we know that:
D1 = D2 = D3 = D4 = D5 = 0
D6 = $6.00
D7 = $6.00(1.05) = $6.30
.
.
.
Semih Yildirim
ADMS 3530
6-27
Solution
•
•
This share of stock represents a stream of cash flows with
two important features:
First, because they are expected to grow at a constant rate
(once they begin), they are a growing perpetuity;
Second, since the first cash flow is at time 6, the perpetuity
is a deferred cash flow stream.
Therefore, the answer requires two steps:
1. By the constant-growth model, D7/(r - g) = P6;
i.e., P6 = $6.30/(.21 - .05) = $39.378.
2. And, P0 = (P6 +D6)/(1 .21)6 =(39.378+6)/(1 .21)6 =
$14.456.
Semih Yildirim
ADMS 3530
6-28
Valuing Common Stocks
• DDM vs Expected Rate of Return
 The DDM can be rearranged so that we can
calculate the expected rate of return on the
stock:
r =

D1
+ g =
P0
Dividend Yield + Growth Rate
What is the expected return for Blue Sky if:



Next year’s dividend (D1) will be $3.
Dividends grow at 8% in perpetuity.
The current price is $75.
Semih Yildirim
ADMS 3530
6-29
Valuing Common Stocks
• DDM vs Expected Rate of Return
 The expected rate of return on Blue Sky would
be:
r =
D1
P0
=
$3
$75
+ g =
Dividend Yield + Growth Rate
+ .08
= .04 + .08
= 4% + 8% =
Semih Yildirim
ADMS 3530
12%
6-30
Valuing Common Stocks
• Calculating

“g” (growth rate)
How fast a firm grows depends on how much of
its profits are reinvested in operations:
 The
fraction of earnings retained by the firm is
called the plowback ratio.
 The fraction of earnings a company pays out in
dividends is called the payout ratio.

What is Blue Sky’s payout ratio and plowback
ratio if:
 It
has eps of $5.
 It pays a dividend of $3 and retains the balance.
Semih Yildirim
ADMS 3530
6-31
Valuing Common Stocks
• Calculating

“g” (growth rate)
What is the payout ratio? The plowback
ratio?
Payout ratio
= Dividend/ eps
= $3/ $5
= 0.60 = 60%
Plowback ratio
= 1 – payout ratio
= 1 – 0.60
= 0.40 = 40%
Semih Yildirim
ADMS 3530
6-32
Valuing Common Stocks
• Calculating

“g” (growth rate)
Assume that Blue Sky can earn a 20% return
on new equity investments.
 If
all of its earnings were reinvested, Blue Sky
would grow at 20% per year.
 If all of its earnings were paid out as dividends –
i.e., none of the earnings were reinvested – then
Blue Sky would forgo any growth (growth = 0%).
 If part of its earnings were reinvested, then Blue
Sky would grow at between 0% and 20% per year.
You should see that the higher the
plowback rate, the higher the growth rate.
Semih Yildirim
ADMS 3530
6-33
Valuing Common Stocks
• Calculating

You can calculate the growth rate for a company by
multiplying the return on equity by the plowback ratio:
g

“g” (growth rate)
= roe x plowback ratio
For Blue Sky, the growth rate would be:
g = roe x plowback ratio
= 20% x 40% = 8%
Growth rates calculated this way are known as
Sustainable Growth Rates
Semih Yildirim
ADMS 3530
6-34
Valuing Common Stocks
• Growth


Stocks vs Income Stocks
Let’s try a few problems with Blue Sky
and see what we can learn about growth
and stock value.
In all cases, assume that Blue Sky has:


Expected eps of $5 next year.
A discount rate of 12%.
Semih Yildirim
ADMS 3530
6-35
Valuing Common Stocks
•
Growth Stocks vs Income Stocks
Problem 1:

Assume that Blue Sky has: A payout ratio of 100%.
What is the value of Blue Sky stock?
Problem 2:

Assume now that Blue Sky has: A payout ratio of 60%.
 The roe on new investment is 10%.
What is the value of Blue Sky stock?
Problem 3:

Assume now that Blue Sky has: A payout ratio of 60%.

The roe on new investment is 12%.
What is the value of Blue Sky stock?
Problem 4:

Assume now that Blue Sky has: A payout ratio of 60%.

The roe on new investment is 20%.
What is the value of Blue Sky stock?
Semih Yildirim
ADMS 3530
6-36
Valuing Common Stocks
• Growth
Stocks vs Income Stocks
You should get the following results:
g
Prob. #
Plowback
Ratio
1
0%
**
0.0%
$5.00
$41.67
2
40%
10%
4.0%
$3.00
$37.50
3
40%
12%
4.8%
$3.00
$41.67
4
40%
20%
8.0%
$3.00
$75.00
ROE
(Sustainable
growth rate)
Div1
P0
* Since the plowback ratio = 0%, sustainable growth rate will
equal 0% regardless of the ROE. Thus, ROE is irrelevant.
Semih Yildirim
ADMS 3530
6-37
Valuing Common Stocks
In Problem 1 If Blue Sky does not reinvest any of its earnings, then its stock price would be
$41.67.
o This price represents the value of earnings from assets which are already in place
In Problem 2 If Blue Sky invests in projects which generate a return less than its discount
rate, then its stock price would drop to $37.50.
o With zero growth, Blue Sky stock was worth $41.67.
o The share price is $4.17 lower because of investing in projects with an unattractive rate of
return!
Successful financial managers do not invest in projects which earn less than the discount
rate – it would reduce the value of the company’s shares!
In Problem 3 If Blue Sky invests in projects with a return equal to its discount rate, then its
stock price would be $41.67.
o But, this is the same price as for zero growth …why didn’t growth translate into a higher
share price?
• Plowing earnings back into a company does not add value unless investors believe the
reinvested earnings will earn more than the discount rate.
In Problem 4 If Blue Sky invests in projects with a return which is greater than its discount
rate, then its stock price would rise to $75.
o We know from Problem 1, that $41.67 is the value of the earnings from assets which are
already in place.
o Thus, $33.33 ($75 - $41.67) represents the value to investors of the superior return on future
investments. This is know as the Present Value Of Growth Opportunities (PVGO)
Semih Yildirim
ADMS 3530
6-38
Valuing Common Stocks
•
Growth Stocks vs Income Stocks
 The earnings potential of Blue Sky will be reflected in
its Price-Earnings ratio.
 Blue Sky has expected earnings of $5.
 With high growth prospects, its price is $75:
 Its P/E ratio = P/eps = $75 / $5 = 15x15.0 x
 With no growth prospects, its price is $41.67:
 Its P/E ratio = P/eps = $41.67 / $5 = 8.3X8.3 x
 Successful financial managers know that to justify a
high P/E ratio on their company’s stock, they must
deliver …
… lots of growth opportunities!
Semih Yildirim
ADMS 3530
6-39
What is an Efficient Market?
• Market

Efficiency
In efficient capital markets security prices
rapidly reflect all relevant information about
asset values.
 Thus,
all securities are fairly priced in light of the
information which is available to investors.


If securities are fairly priced, then selling
securities at prevailing market terms is never
a positive NPV transaction.
Likewise, when buying securities, it is
impossible to consistently earn excess profits.
Semih Yildirim
ADMS 3530
6-40
What is an Efficient Market?
•
Random Walk


Studies of the market have shown that market prices follow a random
walk.
A random walk means that security prices change randomly without
predictable trends or patterns.

That is, stock prices seem to wander randomly, just as likely to go up as
down, on any particular day, regardless of what has occurred on
previous days.

Many studies of the market have shown that studying past price
information provides little information about future price changes.

Does the fact that stock prices follow a random walk mean that they are
just “plucked out of a hat”?
No, that is not the correct conclusion! What the Random Walk Theory
means is this:
 If the stock of ABC jumps up today, you cannot assume that it will
do the same thing tomorrow.
 However, ABC’s price change didn’t just pop out of nowhere!
 There must have been a good reason for the change in price …


Did they report increased earnings? Or, a new product line which
investors expect will boost profits? Or, …
Semih Yildirim
ADMS 3530
6-41
What is an Efficient Market?
•
Technical Analysis

Technical analysts are investors who attempt to identify over- or undervalued
stocks by searching for patterns in past prices.
However, if stock prices follow a random walk then technical trading rules are
useless.
Technical analysis may not work, but technical analysts can help keep the markets
efficient!


•
Fundamental Analysis




Fundamental analysts are investors who attempt to find over- and undervalued
securities by analyzing fundamental information, such as earnings, asset
values, and business prospects.
Can fundamental analysts “beat the market” and deliver excess returns to
investors?
Researchers have looked at various types of fundamental information –
earnings and dividend announcements, plans to issue securities or to merge,
and other types of macroeconomic news.
Their conclusions?


Market prices already reflect all publicly available information.
Thus it is impossible to make superior returns by studying such information.
Semih Yildirim
ADMS 3530
6-42
Efficient Market Theory
•
There are 3 forms of the efficient-market theory:
1. Weak form (the random walk theory)


Market prices reflect all information contained in past market prices.
You can’t make superior profits by studying past stock prices
2. Semi-strong form



Market prices reflect all publicly available information.
Many researchers have looked at various types of fundamental information
such as earnings and dividend announcements, plans to issue securities or
to merge, or other types of macroeconomic news
And found that market prices already reflect all publicly available
information. It is impossible to make superior returns by studying such
information.
3. Strong form


Market prices reflect all known information potentially available to
determine true value.
If markets are strong-form efficient, then it is impossible to beat the
market’s performance by studying any kind of information.

Your best solution as an investor would be to hold a diversified portfolio of
securities such as an index
Semih Yildirim
ADMS 3530
6-43
Corporate Financing
• The Types of Long-Term Finance
 Firms promise to repay their debt, plus interest.
 If
they don’t keep that promise, the debtholders can
force the firm into bankruptcy.

No such commitments are made to the equity
holders.
 They
are entitled to whatever is left over after the
debt holders have been paid off.
 For this reason, equity is called a residual claim on
the firm.
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Common Stock
• Equity

Most major corporations are far too large to be
owned by one investor.
 For
example, you would need billions of dollars to
purchase BCE.


As a consequence, companies like BCE are
owned by many investors, each of whom holds
a number of shares of the firm’s common
stock.
These investors are known as shareholders or
stockholders.
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Common Stock
•
Terminology
•
Par Value
 The value of the security as shown on the share certificate.
 The par value was an arbitrary monetary value put on the shares before issue.
 It was almost always lower than the actual sales price of the new shares.
 Canadian companies no longer issue par value shares.
Authorized Share Capital
 The maximum number of shares which a company is permitted to issue as specified
in the firm’s articles of incorporation.
Issued Shares
 The shares that have been issued by the company.
Outstanding Shares
 Issued shares which are in the hands of investors.
Additional Paid-In Capital
 The difference between the par value and the original selling price of the share.
 Also called paid-in surplus, capital surplus or contributed surplus.
Retained Earnings
 Money plowed back into the company rather than being paid out as dividends.
•
•
•
•
•
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Common Stock
• Treasury

Shares
Sometimes a company repurchases
shares it issued in the past from its
shareholders.
 In
the US, these shares are recorded on the
Balance Sheet as Treasury Shares.
 In Canada, repurchased shares must be
cancelled, reducing the company’s net equity
by the amount paid for the repurchased
shares.
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Common Stock
•
Book Value vs Market Value

You have already learned that book value is not the same as
market value.




Book value is not a measure of the value that investors place on
those shares today.
Market value is forward looking.


Book value is a backward-looking measure.
It tells you how much capital the firm raised from its shareholders in
the past.
It depends on the future dividends which shareholders expect to
receive.
Market value usually exceeds book value because:


Inflation has driven the value of many assets up above their historic
cost.
Firms raise capital to invest in projects.

If these projects have a positive NPV, then the value of the firm
increases.
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Common Stock
• Dividends

Shareholders hope to receive dividends on
their investment.
 However,
there is no obligation on the firm to
pay dividends.
 The decision to pay dividends is up to the Board
of Directors.

Because dividends are discretionary, they
are not considered a business expense.
 Thus
companies are not allowed to deduct
dividend payments to calculate taxable income.
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Common Stock
• Shareholder



Rights
Shareholders own the company and thus,
ultimately, they have control of the company’s
affairs.
On most matters, shareholders have the right to
vote on appointments to the Board of Directors.
On a few matters, the shareholders have a direct
say before a company may take action.
 For

example, mergers need shareholder approval.
The Board of Directors are supposed to manage the
company in the interests of the shareholders.


They are elected as the agents of the shareholders.
They appoint and oversee the management of the firm.
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6-50
Common Stock
•
Voting Procedures


Shareholders control the firm by the vote attached to their
common shares.
In most companies, the Directors are elected by a a majority
voting system.
 Shareholders cast one vote for each share they own.



Let’s say there are 5 candidates for the Board.
If you owned 100 shares, you would cast in total 500 votes, but to
a maximum of 100 votes for each candidate.
Some companies operate a cumulative voting system.
 This is a system in which all the votes one shareholder is
allowed to cast can be cast for one candidate.



For example, you own 100 shares and there are 5 candidates.
Thus you have in total 500 votes.
You may cast up to all 500 votes for your favourite candidate.
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Common Stock
• Voting



A cumulative voting system makes it easier for a
minority group of shareholders to elect a director to
represent their interests.
Thus minority shareholders tend to favour this type
of systems as versus a majority voting system.
Shareholders can vote in person or appoint someone
else to represent their interests.


Procedures
This is known as appointing a proxy to vote.
In proxy contests, outsiders compete with the firm’s
existing managers and directors for control of the
company.

They do this by requesting the shareholders’ proxies.
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Common Stock
• Classes


Most companies issue just one class of stock.
However, some companies have two or more
classes of shares outstanding.




of Stock
They differ in their right to vote and/or to receive dividends.
Often these classes of shares will be labelled Class A, Class
B, etc.
Common shares without full voting rights are
called restricted shares.
There are various types of restricted shares:



Non-voting (nv)shares have no vote at all.
Subordinated voting (sv) shares have fewer votes per share
than another class of common shares.
Multiple voting (mv)shares carry multiple votes.
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Common Stock
•
Corporate Governance
 The shareholders may own the company, but they
usually do not manage it.




Generally, management is delegated to a team of professionals.
Though the details of corporate governance vary
somewhat, this principal of separation of ownership and
control of a firm is found around the world.
In Chapter 2 you learned separation of ownership and
control creates potential conflict between the shareholders
(owners) and their agents (the managers).
Several mechanisms have evolved to mitigate this conflict:



The Board oversees management and can fire them.
Management remuneration can be tied to performance.
Poorly performing firms may be taken over and the managers
replaced by a new team.
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Preferred Stock
•
Preferred Equity

Preferred stock takes priority over common stock in regard to dividends.


Preferred equity is like debt in that it promises a series of fixed payments
to investors.


It also ranks ahead of the common shareholders in the distribution of assets if
the firm goes bankrupt.
It is rare for these payments not to be paid in full and on time.
Like common stock, the preferred dividend is paid at the discretion of the
Board.

Thus, if there are cash flow problems, the preferred dividend, unlike interest
payments, may be skipped.

The only obligation is that no common dividends can be paid if the
preferred dividend has not been paid.

The net worth of a company is equal to the book value of its
common equity plus preferred stock.
For most companies, preferred stock is much less important than
common stock in the firm’s capital structure.
Like common shares, there is more than one type of preferred
share available.


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Preferred Stock
•
Types of Preferred Equity

Cumulative Preferred Shares




Non-Cumulative Preferred Shares


If the preferred dividend is not paid, it will be in arrears.
All such past dividends accrue.
In such a situation, a firm may not pay the common dividend until all
preferred dividends in arrears have been paid.
If the preferred dividend is not paid, it does not go into arrears and is lost
forever.
Redeemable Preferred Shares

A company has the right to repurchase these shares from the
shareholders at a pre-specified price.


Retractable Preferred Shares


This price is known as the call price.
The investor can force the company to buy back his/her shares at a
specified date.
Convertible Preferred Shares

May be converted into another type of security, usually common shares.
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Preferred Stock
• Types

of Preferred Equity
Floating Rate Preferred Shares
 Most
preferreds, like debt, make fixed
payments.
 So, like debt, the price of a preferred will
fluctuate with interest rates.

Its value falls as interest rates rise and vice versa.
 Some
preferreds have their dividend linked to
interest rates.

Any change in interest rates is offset by a change
in the dividend, thus protecting the market value
of the investment.
Semih Yildirim
ADMS 3530