Zara Mahmood Roberts FE101 Chapter 7 Stock Valuation STOCK BASICS Stock market Reporting Stock Quotes Common Stock A share of ownership in the corporation which confers rights to any common dividends as well as rights to vote on election of directors mergers and other major events Ticker Symbol A unique abbreviation assigned to each publically traded company Traded in a market under ticker symbol NKE Nike Common Stock Rights of common stockholders voice in running of the corporation In proportion to the number of shares they hold Shareholder Voting Straight Voting Each shareholder has as many votes for each director as shares held Donna 600 shares and Jonathon 400 shares hold all company shares For each director Donna votes 600 times and Jonathan 400 o Donna would win every vote Jonathon would have no board representation Cumulative Voting Each shareholder s total vote allocation for all directors is equal to the number of open spots multiplied by number of shares 10 Directors up for election o Jonathon 10 x 400 4000 votes o Donna 10 x 600 6000 votes Use these votes across 10 director spots Even minority shareholders could have representation on board Class Different types of common stock for the same company often carrying different voting rights Class A and Class B stock o Nike Phil Knight founder carries most of class A stock Rights to elect 9 of company s 12 directors o Google Founders managers hold class B stock 10 times voting power of Class A stock Shareholder Rights Annual Meeting Meeting held once per year where shareholders vote on directions and other proposals as well as ask managers questions All shareholders have right to attend the meeting and cast their vote directly o Most allow board to vote for them or proxy Proxy A written authorization for someone else to vote your shares Proxy Contest matter up for shareholder vote eg director election When two or more groups are competing to collect proxies to prevail n a Common stock carries the right to share in the profits of corporation dividend o Paid in proportion to the number of shares they own Zara Mahmood Roberts FE101 o If company is liquidated after bankruptcy liabilities are handled and then excess assets are divided among shareholders Preferred Stock Preferred Stock Stock with preference over common shares in payment of dividends and in liquidation Directors can choose not to pay preferred shareholders a dividend o Cannot pay common stockholders unless they pay preferred shareholders first Cumulative vs Non Cumulative Preferred Stocks Two types of preferred stock cumulative non cumulative Cumulative Preferred Stock any common dividend may be paid p All missed preferred dividends must be paid before o Obligation to preferred shareholders builds Non cumulative Preferred Stock dividend is owed before common dividends can be paid Missed dividends do not accumulate Only current o Most preferred stock is cumulative Preferred Stock Equity or Debt Is preferred stock equity or debt It is like a perpetual bond promised cash flow to holders and there are consequences if the cash flows are not paid o Preferred shareholders cannot force the firm into bankruptcy o Ahead of common shareholders behind bondholders Interest paid before dividends THE DIVIDEND DISCOUNT MODEL Valuation principle to value securities we must determine expected cash flows that an investor will receive from owning it Start by considering 1 year investment cash flows A One Year Investor Two potential sources of cash flows from owning a stock Firm might pay out cash to is shareholders in a dividend Investor might generate cash by selling the shares at some future date o Amount will depend on investor s investment horizon One year investor buys a stock Will pay current market price for a share continues to hold stock o Entitled to any dividend from stock End of the year will sell stock at new market price Risky cashflows o Cannot discount using risk free interest rate Must use cost of capital for the firms equity Zara Mahmood Roberts FE101 Equity Cost of Capital The expected rate of return available in the market on other investments that have equivalent risk to the risk associated with the firm s shares Less than this amount cost would be less than PV of benefits o Investors would rush in and buy it stock price drive up Exceeds this amount cost would be more than PV of benefits o Selling would be attractive and stock price would fall Dividend Yields Capital Gains and Total Returns Need firm s equity cost of capital to determine stock price Investor return comes from dividend and selling stock Dividend Yield The expected annual dividend of a stock divided by its current price percentage return an investor expects to earn from the dividend paid by the stock Capital Gain the amount by which the selling price of an asset exceeds its initial purchase price Capital Gain Rate An expression of capital gain as a percentage of the initial price of the asset Total Return The sum of a stock s dividend yield and its capital gain rate Expected total return of stock should equal the expected return of other investments available in the market with equivalent risk o Firm must pay return commensurate with return they can earn elsewhere A Multiyear Investor Investor makes a multiyear investment Receives dividend in two years before selling 1 year investor indirectly cares about dividend and stock price in year 2 Affect the price for which she can sell the stock and year 1 end Formula for stock price for 2 year is same as two 1 year investors Dividend Discount Model Equation Can continue this process for number of years Replace final stock price with value that next holder of stock is willing to pay Dividend Discount Model A model that values shares of a firm according to the present value of the future dividends the firm will pay Firm pays dividends and is never acquired or liquidated hold the shares forever Price of stock is equal to the PV of all of the expected future dividends it will way Zara Mahmood Roberts FE101 ESTIMATING DIVIDENDS IN THE DIVIDEND DISCOUNT MODEL In the long run dividends will grow at a constant rate Implications of this assumption for stock prices Tradeoff between dividends and growth Constant Dividend Growth Simplest forecast for firm s future dividend grow at a constant rate forever Taken as constant growth perpetuity Calculate PV using formula for stock price Constant Dividend Growth Model A model for viewing its dividends as a constant