Equity Markets and
Stock Valuation
Chapter 7

Common Stock Valuation

Cash flows from owning a share of stock come in the form of future dividends (vs. coupon pmts on a bond)

P
0
= D
1
/ (1 + R) 1 + D
2
/ (1 + R) 2 + . . .


Common Stock Valuation
In Certain special cases it’s possible to calculate the present value of all the future dividends to determine the value for the stock


Table 7.1, Pg 190
Constant $ Dividend
–
Zero Growth



Steady Dividend Growth
–
Dividend grows at a steady rate
– Known as the Dividend Growth Model
Required Return
Dividend Yield

Common Stock Valuation
0

Example: Not in Book

Suppose Smith, Inc. has just issued a dividend of
$2.90 per share. Subsequent dividends will remain at $2.90 indefinitely. Returns on the stock of firms like Smith, Inc. are currently running
15%. What is the value of one share of stock?

P
0
= $2.90 / .15

P
0
= $19.33

Common Stock Valuation
0
1
R
g





Example: Problem 4, Page 203
Motorheadache Corporation will pay a $4.00 per share dividend next year. The company pledges to increase its dividend by 4% per year indefinitely.
If you require a 13 percent return on your investment, how much will you pay for the company’s stock today?
P
P
P
0
0
0
= 4.00 / (.13 - .04)
= 4.00 / .09
= 44.44

Common Stock Valuation
R
1
0
g


Where: D
1
/ P0 = is the dividend yield
And: g = the capital gains yield
– The same as the growth rate in dividends for the steady growth case
Example: Problem 2, Page 203


The next dividend payment by BJG, Inc., will be $2 per share. The dividends are anticipated to maintain a 6 percent growth rate, forever. If BJG stock currently sells for $35.00 per share, what is the required return?
R = 2 / 35 + .06



R = .0571 + .06
R = .1171 or 11.71%
– Also work Problem 8, Page 203

Common Stock Valuation
R
1
0

Example: Not in Book
g

The current price of XYZ stock is $50.00
Dividends are expected to grow at 7% indefinitely and the most recent dividend was $1. What is the required rate of return on XYZ stock?

R = (1 x 1.07) / 50 + .07

R = 1.07 / 50 + .07

R = .0214 + .07

R = .091 or 9.1%

Common Stock Valuation
1
0






Example: Not in Book
Wilson Corporation Stock pays a constant dividend of $2.50 forever and currently sells for
$20.00. What is the required rate of return.

Remember: Required Return R = D
1
/P
0
+
– Where: D
1
/ P0 = is the dividend yield g
Here we are excluding the g rate
R = D
R
R
1
/P
0
= $2.50 / 20
= .1250 or 12.50%

Common Stock Features
Shareholder Rights

Shareholders
– Hold
Common Stock: Equity w/o priority for dividends or in bankruptcy

Directors
– Elected by a vote at the annual shareholders’ meeting
– Hire Management

Common Stock Features
Shareholder Rights

Straight Voting: A procedure in which a shareholder may cast all votes for each member of the board of directors.

Cumulative Voting: A procedure in which a shareholder may cast all votes for one member of the board of directors.

Common Stock Features

Straight Voting:

Directors are elected one at a time

# of Votes a Shareholder may cast:
• # of shares (owned or controlled)

Shareholders may cast all votes for each member of the board of directors
• If Smith has 20 votes and Jones has 80 votes, Jones will be able to elect all the directors
• 50 percent plus one share = control
 Can “freeze out” minority shareholders

Common Stock Features

Cumulative Voting:

Directors are elected all at once

# of Votes a Shareholder may cast is:
• # of shares (owned or controlled) x # of directors to be elect
• 20 shares x 4 directors = 80 votes

Shareholders can distribute votes as they wish
 The shareholder may cast all votes for one member of the board of directors

Permits minority participation

Mandatory in some states

Common Stock Features
N

In general:
1 / (N + 1) % of stock plus one share where N = the number of directors up for election
Will guarantee a seat

Example: If four directors are up for election, what % of the shares (plus one share), will guarantee election?
– 1 /( 4 +1)
– 1 / 5 = .20 or 20%

Common Stock Features


Example: Problem 9, Page 203
After successfully completing your corporate finance class, you feel the next challenge ahead is to serve on the board of directors of Huckaba Enterprises.
Unfortunately, you will be the only individual voting for you.
– If Huckaba has 100,000 shares outstanding and the stock currently sells for $60, how much will it cost you to buy a seat if the company uses straight voting ?
• (a) 50 percent plus one share = control
100,000 x .50 + 1 share = 50,001 x $60 =
$3,000,000

Common Stock Features

Example: Problem 9, Page 203 continued
– Assume that Huckaba uses cumulative voting and there are four seats in the current election; how much will it cost you to buy a seat now?
• 1 / (
N + 1) % of stock plus one share
1 / (4 + 1) % of stock plus one share
.20 x 100,000 + 1 = 20,001 x $60 =
$1,200,000

Common Stock Features
Proxy Voting

Shareholders can vote in person or transfer their right to vote via Proxy

Proxy
– A grant of authority by a shareholder allowing another individual to vote that shareholder’s shares
– Large Corporations - convenience
 Proxies are solicited by “Existing Management”

Proxy Fight
– Outside group of shareholders solicit proxies to replace current management

Common Stock Features
Classes of Stock

Some firms have more than one class of common stock
– Different acquisitions – norm
•
At one time GM had its:GM Classic, Class E (GME) – EDS acquisition, Class H (GMH) Hughes Aircraft
– Unequal voting rights – exception
• Example: Ford Class B Common Stock
– Not publicly traded
– Held by Ford family interests and trusts
– Has about 40% of the voting power
– Even though it represents les than 10% of the total number of the shares outstanding

Common Stock Features
Other Rights

In addition to the right to vote for directors, shareholders usually have the following rights:

1. The right to share proportionally in dividends paid.

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 great importance, such as a merger. Voting is usually done at the annual meeting or a special meeting.

Common Stock Features
Other Rights

Shareholders sometimes have Preemptive
Right: The right to share proportionally in any new stock sold
– If the company wishes to sell stock it must first offer it to the existing stockholders before offering it to the general public.
– Gives stockholders the opportunity to protect their proportionate ownership in the corporation.

Common Stock Features
Dividends

Dividends: Payments by a corporation to shareholders, made in either cash or stock.

Represent a return on shareholder investment

Issued at the discretion of the board of directors
–
Not a liability until declared
–
Once dividends are declared, they are a liability of the corporation until paid.

Common Stock Features
Dividends


Dividends received by individuals are considered ordinary income and fully taxable.

Payment of dividends by the corporation is not a business expense.
–
Not deductible for corporate tax purposes
– Paid from after-tax profits
Corporations that own stock in other corporations are permitted to exclude 70% of the dividend amounts they receive and are taxed only on the remaining 30%.

Preferred Stock Features

Preferred Stock: Stock with dividend priority over common stock, normally with a fixed dividend rate, sometimes without voting rights.

Preferred Stock Features



Form of Equity – but a lot like debt
May carry a credit rating much like a bond
May be callable and convertible into common stock


May have a related sinking fund – final maturity
Preferred Dividends: normally pay a fixed dividend rate
– Paid at the discretion of the Board of director
– Cumulative Preferred Dividends – Unpaid stock dividends carried forward in arrearage until paid
• Preference over “common” stock holders
– Non-cumulative

Preferred Stock Features

Does not have voting rights

Preference in the distribution of corporate assets, over common stock holders, in the event of liquidation

Preferred Shareholders are only entitled to the stated value of shares in liquidation

Preferred Dividends are not tax deductible by the issuing corporation

The Stock Markets

Primary Market: The market in which new securities are originally sold to investors.
– Shares of stock are first brought to the market and sold to investors
– Companies sell securities to raise money

Secondary Market: The market in which previously issued securities are traded among investors
– Existing shares are traded among investors

The Stock Markets
Dealers and Brokers

Dealer: An agent who buys and sells securities from inventory
– maintains an inventory and stands ready to buy and sell at any time
• Like a car dealer
– Bid price – price dealer is willing to pay
–
Ask price
– price at which a dealer will sell
– Spread – difference between the Bid and Ask price
• Dealer Profit

The Stock Markets
Dealers and Brokers

Broker: An agent who arranges security transactions among investors
– brings securities buyers and sellers together, but does not maintain an inventory
• Like a real estate broker
– Do not buy or sell securities for their own accounts

The Stock Markets
Organization of the



NYSE is located on Wall Street (New York)
Largest stock market in the world
– In terms of $ volume of activity and total value of shares listed
Member: Owner of a
“seat” on the NYSE
– Collectively the members of the exchange are its owners
– Buy and sell securities on the exchange floor w/o paying commissions.
– Seat
• Valuable asset
• Regularly bought and sold
• Well over $2 million in recent years

The Stock Markets
Organization of the NYSE

Commission Brokers: NYSE members who execute customer orders to buy and sell stock transmitted to the exchange floor
– Responsible to customers to get the best possible prices for their orders
– Usually about 500 NYSE members are commission brokers
– NYSE Commission Brokers are typically employees of brokerage companies such as
Merrill Lynch

The Stock Markets
Organization of the NYSE

Specialist: an NYSE member acting as a dealer in a small number of securities on the exchange floor; often called a market maker
– Each security is assigned to a single specialist
– Obligated to maintain a fair, orderly market for the securities assigned to them
– Post bid and ask prices
– Specialist’s post – a fixed place on the exchange floor where the specialist operates

The Stock Markets
Organization of the NYSE

Floor Brokers: NYSE members who execute orders for commission brokers
(who are too busy to handle certain orders themselves) on a fee basis (sometimes called $2 brokers)

The Stock Markets
Organization of the NYSE

In recent years, floor brokers have become less important on the exchange floor because of the efficient SuperDOT System:
– an electronic
NYSE system allowing orders to be transmitted directly to the specialist
– DOT stands for: D esignated O rder T urnaround
– Accounts for a substantial percentage of all trading on the NYSE, particularly on smaller orders

The Stock Markets
Organization of the NYSE

A small number of NYSE members are
Floor Traders : NYSE members who independently trade for their own accounts trying to anticipate price fluctuations
– Profit from buying low and selling high
– # of Floor Traders has declined in recent decade
• Suggesting that is has become increasingly difficult to profit from short-term trading on the exchange floor.

The Stock Markets
Organization of the NYSE

The business of the NYSE is to attract and process Order Flow: The flow of customer orders to buy and sell securities.
– The customers of the NYSE are the individual and institutional investors who place their orders to buy and sell shares in NYSE-listed companies.

The Stock Markets
Organization of the NYSE


Floor Activity:

On the floor of the exchange are a number of stations – figure-eight shape
Specialist’s Post:
A fixed place on the exchange floor where the specialist operates.

Commission brokers receive telephoned customers orders and move to the specialists’ posts where the orders can be executed and return to telephones to confirm order executions and receive new customer orders.

The Stock Markets


Organization of the NYSE
Floor Activity Con’t:
Commission Brokers are obligated to get the best possible price and must
“work” the order.
– Look for another broker at the specialist post where that particular stock trades, who represents a customer that wants to buy the particular stock they’re selling.
– For a very actively traded stock, there may be many buyers and sellers around the specialist’s post , and most of the trading will be done directly between brokers: called trading in the “crowd”.
–
The specialist’s responsibility is to maintain order
•
Functions as a referee
• Make sure that all buyers and sellers receive a fair price

The Stock Markets
Organization of the NYSE
 Floor Activity Con’t:

If the Commission Broker is unable to quickly find another broker in the crowd with a matching offsetting order, he must sell to the specialist at the posted bid price
– The specialist provides the liquidity necessary to allow immediate order execution.

The colored coats worn by many people on the floor indicates the person’s job or position.
– Clerks, runners, visitors, exchange officials, etc.

The Stock Markets
Operations

NASDAQ Computer network of securities dealers who disseminate timely security price quotes to Nasdaq subscribers
– N ational A ssociation of S ecurities D ealers A utomated
Q uotations system
– Dealers – act as market makers for securities listed on
NASDAQ and post bid and asked prices at which they accept orders along with the number of stock shares that they obligate themselves to trade at their quoted prices.
–
Nasdaq is a computer network and has no physical location where trading takes place
– All trading is done through dealers (vs. NYSE specialist system )

The Stock Markets
Operations


NASDAQ requires that there be multiple market makers for actively traded stock ( vs. the NYSE specialist system )
Level 2 access – connects market makers with brokers and other dealers allowing subscribers to view price quotes from all Nasdaq market makers

Level 2 allows access to Inside Quotes: The highest bid quotes and the lowest ask quotes for a security
– Necessary to get the best prices for member firm customers.

The Stock Markets

The Wall Street Journal
– Page 199

Internet

CNBC

Bloomberg

Chapter 7
Suggested Homework

Know chapter theories, concepts, and definitions
– Re-read the chapter and review the Power Point Slides
–
Suggested Homework:
• The Chapter Review and Self-Test Problems: Page 201
–
7.1 (first question only) and 7.2 (first question only)
•
Answers are provided in the book just after the problems
• Critical Thinking and Concepts Review: Page 202
–
Review questions 1 through 11
• Answers are provided in the solutions manual
•
Questions and Problems: Page 203
– 1 (first question only), 2, 4, 5, 8, 9, and 12
• Refer to the Solutions Manual to confirm your answers