Chapter 7
Stocks (Equity) – Characteristics
and Valuation
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Learning Outcomes
Chapter 7




Explain what equity is and identify some of the
features and characteristics of (a) preferred stock
and (b) common stock.
Describe how stock prices (values) are determined
when (a) dividends grow at a constant rate and (b)
dividend growth is nonconstant.
Describe some approaches (techniques) other than
strict application of time value of money models that
investors use to value stocks.
Identify factors that affect stock prices.
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Valuation of Financial Assets Equity (Stock)

Preferred Stock: hybrid security
• similar to bonds with fixed dividend amounts
• similar to common stock as dividends are not
required and have no fixed maturity date

Common Stock
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Preferred Stock Features

Par Value
 The nominal or face value of a stock or bond

Cumulative Earnings
 Any preferred dividends not paid in previous periods must be
paid before common dividends can be distributed

Maturity
 Generally has no specific maturity date

Priority to Assets and Earnings
 Dividends must be paid on preferred stock before they can
be paid on common stock
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Preferred Stock Features

Control of the Firm (Voting Rights)
 Almost all preferred stock is nonvoting stock

Convertibility
 Most preferred stock may be converted to common stock

Other Provisions
 Call provision - Gives the issuing corporation the right to call
in the preferred stock for redemption
 Sinking fund - Call for the repurchase and retirement of a
given percentage of the stock each year
 Participating - Participates with the common stock in
sharing the firm’s earnings
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Common Stock Features

Par Value
 Legally, represents a stockholder’s minimum financial
obligation in the event the corporation is liquidated

Dividends
 The firm has no legal obligation to pay common stock
dividends

Maturity
 Generally has no specific maturity date

Priority to Assets and Earnings
 Dividends can be paid only after the interest on debt and the
preferred dividends are paid
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Common Stock Features
 Control
of the Firm (Voting Rights)
 Common stockholders have the right to elect the
firm’s directors and to vote on shareholder’s
proposals, mergers, and changes in the firm’s
charter

Preemptive Right
 Gives stockholders the right to purchase any
additional shares of stock sold by the firm before
the shares can be offered to new investors.
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Types of Common Stock
 Classified
Stock
 Common stock that is given a special designation,
such as Class A, Class B, etc., to meet special
needs of the company

Founder’s Shares
 A class of stock owned by the firm’s founders who
have sole voting rights
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Equity Instruments in International
Markets

American Depository Receipts
 Certificates created by banks that represent
ownership in stocks of foreign countries

Foreign Equity
 Yankee stock
 Euro stock
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Stock Valuation Models - Terms

Market Price
P0 = the actual market price of the stock today
Pt = the expected price at the end of Year t
P0 = the intrinsic value as seen by the investor
P1 = the price expected at the end of Year 1
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Stock Valuation Models - Terms

Expected Dividends
Dt = the dividend the investor expects to
receive at the end of Year t
D0 = most recent dividend already paid
D1 = is the next dividend expected to be paid
and it will be paid at the end of this year
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Stock Valuation Models - Terms

Growth Rate
g = the expected rate of change in
dividends per share
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Stock Valuation Models - Terms

Required Rate of Return
rS = the minimum rate of return on a
common stock that stockholders consider
acceptable given its riskiness and returns
available on other investments
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Stock Valuation Models - Terms

Dividend Yield
The expected dividend divided by the
current price of a share of stock
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Stock Valuation Models - Terms

Capital Gain Yield
the change in price (capital gain) during
a given year divided by its price at the
beginning of the year
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Stock Valuation Models - Terms

Expected Rate of Return
The rate of return on a common
stock that an individual investor
expects to receive
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Stock Valuation Models - Terms

Actual Rate of Return
rs = the rate of return on a common stock
that an individual investor actually receives,
after the fact; equal to the dividend yield
plus the capital gains yield.
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Expected Dividends as
the Basis for Stock Values
Cash-flow Timeline
s
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Expected Dividends as
the Basis for Stock Values
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Valuing Stocks with Constant, or Normal,
Growth
 Growth
that is expected to continue into the
foreseeable future at about the same rate as
that of the economy as a whole.
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Normal, or Constant, Growth
(Gordon Model)
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Present Value of Dividends of a Constant
Growth Stock
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Expected Rate of Return on a Constant
Growth Stock
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Valuing Stocks with
Nonconstant Growth
 Nonconstant
Growth: The part of the life
cycle of a firm in which its growth is either
much faster or much slower than that of the
economy as a whole.
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Valuing Stocks with
Nonconstant Growth
1.
Compute the value of the dividends that experience
nonconstant growth, and then find the PV of these
dividends,
2.
Find the price of the stock at the end of the
nonconstant growth period, at which time it has
become a constant growth stock, and discount this
price back to the present, and
3.
Add these two components to find the intrinsic value
of the stock P0.
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Other Stock Valuation Models

P/E Ratios
 The higher the P/E ratio the more investors are
willing to pay for each dollar earned by the firm
 P/E ratio gives an indication of a stock’s “payback
period”
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Other Stock Valuation Models

Economic Value Added Approach
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Changes in Stock Prices
 Prices
move opposite to changes in rates of
return

They move in the same direction as changes
in cash flows expected from the stock in the
future
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