Stocks and Their Valuation
Bondholders are creditors
Stockholders are owners. They have residual claim.
Stockholders have ownership and control rights
Shareholders of a corporation use their control rights through voting:
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Stockholders elect directors
Directors elect & monitor management
Management’s goal: Maximize the stock price
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Shareholder Rights
voting:

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straight
cumulative
With both voting systems, a shareholder receives a total number
of votes that equals the number of directors to be elected times
the number of shares owned.
With straight voting, a shareholder may give any one candidate,
as a maximum, only a number of votes equal to the number of
shares owned.
With cumulative voting, a shareholder may give all the votes
he/she holds to a single candidate.
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Example
A corporation has two shareholders. Smith with 25 shares and John
with 75 shares. John does not want Smith to be a director. Assume
four directors will be elected.
John nominates four candidates, Smith nominates himself
Straight voting:
John can elect all four directors
Cumulative voting:
Smith has 4*25=100 votes
John has 4*75=300 votes
Smith will be elected a director
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Cumulative Voting
Minimum number of shares that must be owned in
cumulative voting to be able to win d positions on the board
n=
d *s
1
D 1
n: minimum number of shares that must be owned
d: number of directors the stockholder wants to be certain of electing
s: number of shares outstanding
D: number of directors to be elected
Continuing with the above example what is the minimum
number of shares Smith should own to be elected
1 * 100
 1  21
4 1
Smith 21 and John 79 is enough
Smith 20 and John 80 is not enough (a tie)
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internal control
Ownership and Control are separated when we have diverse
ownership
Consider 2 scenarios:

An individual who is the single owner of a firm

A corporation in which none of the owners have more than 1%
ownership
In the latter scenario who has the control of the firm
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internal control

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Small shareholders are not very likely to attend shareholders’
meetings
Instead they can transfer their voting rights to another person
with a proxy
If the current management collects those proxies, it can elect
the board members.
A board elected by the management can hardly have authority
on it.
This way, the monitoring of management by board may not be
possible.
proxy fight by shareholders is difficult
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external control mechanism
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If the incumbent management team is inefficient
if internal control mechanism fails to remove the management
team
then we must rely on external control mechanism i.e. the
market for corporate control
Takeover by another firm
friendly
hostile
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Shareholder rights other than voting
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dividends
preemptive right
stock split
preemptive right
The right of a company's existing common shareholders to have
the first chance to purchase shares in a company's future stock
issuance.
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New stock issuance
New stock issuance can be a bonus or a rights issue
Bonus issue
Firm issues free shares
Rights issue
Firm issues new shares. Cash flows into the firm.
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Price adjustment
Price adjustment following the issuance of new stock:
Where SB and SR show the amounts of bonus and rights issues
(in %),PR denotes the price at which the right will be used and
Div shows the amount of cash dividend to be paid to “old” shares
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Example
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Types of Common Stock
Some companies may have classified stock. In other words, there
can be more than one type of stock.
These will differ regarding: dividends and voting power
Most common: founders’ shares
Superior voting rights, inferior dividend rights
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Types of Stock Market Transactions
Based on number of stockholders, we can classify firms as:

Closely held corporation

Publicly owned corporation
Stocks of small publicly owned corporations are not listed, trade in OTC
We have previously defined

Secondary market: trading of existing shares among investors

Primary market: sale of new stock by publicly owned corporations
IPO market: stock of a closely held corporation is sold to public for the first time
Economically it is important to distinguish:
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Does company raise capital from public offering
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Does a large shareholder sell his/her stake to the public
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Valuation: dividend growth model
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Value of a stock is the present value of the future dividends expected
to be generated by the stock.
ks is required return
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Even if you hold stock for only two periods the above equation is valid
This equation is not usable in practice, there are  unknowns
Some simplifying assumption that fits the observed pattern is
necessary.
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Valuation: dividend growth model
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zero growth
constant growth
nonconstant growth
zero growth:
constant growth:
Dt= Dt-1
Dt= Dt-1(1+gt)
gt=constant
t
t
zero growth
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constant growth
PV of future dividends under constant dividend growth rate
assumption is:
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What happens if g > ks?

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If g > ks, the constant growth formula leads to a negative stock
price, which does not make sense.
The constant growth model can only be used if:
 ks > g
 g is expected to be constant forever
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Expected rate of return
Total return from investing in stocks is the sum of
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Dividend yield
Capital gains yield
zero growth:
Capital gains is zero
constant growth:
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Nonconstant growth
To make the method useful in practice
Story 1: Profitable firm
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Growing market: high growth for a while
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Saturated market: constant lower level of growth afterwards
Story 2: Troubled firm.

A plan to increase operating efficiency.Losses will continue for a while
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Positive or zero growth thereafter
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Example
g1, g2, g3
g4=g5=gt
t>3
non constant growth
constant growth
use D0 and g1, g2, g3, g4 to find D1-D4
use D4 to find
use D1-D3 and P3 to find P0
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Valuation free cash flow method

What if the firm is not paying dividends. How to determine the
intrinsic value of its stock?
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Especially young, fast growing firms may prefer not to pay any
dividends so that they use all their earnings to finance growth.
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In that case, one can forecast the free cash flows (FCF) the firm
will generate in the next N years.
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Free cash flow is the amount of cash flow remaining after a
company makes asset investments necessary to support
operations. In other words, it is cash flow available for
distribution to investors. After N years, one can assume
constant growth of FCF. The present value found will be the
value of total firm. After subtracting the market value of debt,
the remaining figure will be the value of equity.
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Valuation Firm multiples method
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Analysts often use the following multiples to value stocks.
 P / E
 P / CF
 P / Sales
EXAMPLE: Based on comparable firms, estimate the appropriate
P/E. Multiply this by expected earnings to back out an estimate
of the stock price.
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What is market equilibrium?
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In equilibrium, stock prices are stable and there is no
general tendency for people to buy versus to sell.
In equilibrium, expected returns must equal required
returns.
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Market equilibrium
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Expected returns are obtained by estimating
dividends and expected capital gains.
Required returns are obtained by estimating risk and
applying the CAPM.
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How is market equilibrium established?

If expected return exceeds required return …
 The current price (P0) is “too low” and offers a
bargain.
 Buy orders will be greater than sell orders.
 P0 will be bid up until expected return equals
required return
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Factors that affect stock price

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Required return (ks) could change
 Changing inflation could cause kRF to change
 Market risk premium or exposure to market risk (β) could
change
Growth rate (g) could change
 Due to economic (market) conditions
 Due to firm conditions
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What is the Efficient Market Hypothesis (EMH)?
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Securities are normally in equilibrium and are “fairly priced.”
Investors cannot “beat the market” except through good luck or
better information.
Levels of market efficiency
 Weak-form efficiency
 Semistrong-form efficiency
 Strong-form efficiency
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Weak-form efficiency
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Can’t profit by looking at past trends. A recent
decline is no reason to think stocks will go up (or
down) in the future.
Evidence supports weak-form EMH, but “technical
analysis” is still used.
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Semistrong-form efficiency

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All publicly available information is reflected in stock
prices, so it doesn’t pay to over analyze annual
reports looking for undervalued stocks.
Largely true, but superior analysts can still profit by
finding and using new information
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Strong-form efficiency
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All information, even inside information, is embedded
in stock prices.
Not true--insiders can gain by trading on the basis of
insider information, but that’s illegal.
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Is the stock market efficient?
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Empirical studies have been conducted to test the three forms
of efficiency. Most of which suggest the stock market was:
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Highly efficient in the weak form.
Reasonably efficient in the semistrong form.
Not efficient in the strong form. Insiders could and did
make abnormal (and sometimes illegal) profits.
Behavioral finance – incorporates elements of psychology to
better understand how individuals and markets respond to
different situations.
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