CHAPTER 7 Stocks and Their Valuation

1. CHAPTER 7Stocks and Their Valuation Outline Features of Common Stock Different approaches for valuing common stocks Preferred stock

2. Features of Common Stock • Represents ownership • Right to elect directors • Directors appoint managers • Voting rights: One vote per stock • Can transfer voting rights to another person by a proxy. • Proxy is a document giving one person the authority to act for another • Preemptive Right: The provision that gives common stockholders the right to purchase on a pro rata basis new issues of common stocks.

3. Types of Common Stocks • Most companies have only one form of common stock. • There are some companies who classify their stocks into Class A and Class B to differentiate between the difference in special rights of each type of stocks. These are called Classified Stocks. • Founders’ Shares are stocks owned by firm’s founders that has sole voting rights but restricted dividends for specified number of years.

4. Stock Price VS Intrinsic Value • Stock Price - Current Market Price • Intrinsic Value - “True” value based on it’s ability to generate cash now and in the future. • “Stock Price = Intrinsic Value” when market is at equilibrium. • Consistent equilibrium leads to efficient market • Inefficient markets have “overvalued” and “undervalued” stocks.

5. Different approaches for valuing common stock • Discounted Dividend model • Zero Growth Dividend model • Constant Growth Dividend model • Variable or Non-Constant Growth Dividend model • Corporate valuation model • FCF valuation model

6. Discounted Dividend Model • Two types of cash flows are expected from Common Stocks: • The portion of the profit that investors receive periodically while he or she holds the stock. This constitutes the Dividend gain/yield. • The price received when the stock is sold. This constitutes the Capital gain/yield. • CAPM gives us the rate of the expected capital gain.

7. Dividend growth model • Value of a stock is the present value of the future dividends expected to be generated by the stock. • Assuming the stock will be held till eternity, so there is no Capital gain.

8. Zero Growth Stock • A common stock whose future dividends are not expected to grow at all. G=0. • So, D1= D2=…..= Dt • Dividends behave like perpetuity

9. Constant growth stock • A stock whose dividends are expected to grow forever at a constant rate or same rate, g. D1 = D0 (1+g)1 D2 = D0 (1+g)2 Dt = D0 (1+g)t • If g is constant, the dividend growth formula converges to Gordon Model:

10. Constant Growth Model • Rs = required rate of return • At market equilibrium required return is equal expected return. • Thus when market is at equilibrium stock price grows at the same rate the dividend grows

11. Dividend VS Growth • Dividends are paid out of profit • Growth in dividend depends on growth in profit. • But if dividend grows retained earnings reduces. • Without reinvestment of earnings growth in profit is not possible. • Thus higher the percentage of retained earnings the higher the profit growth. • In the long run Dividends become constant, i.e. g=0.

12. Required Conditions for Constant Growth Model • Rate of return should be greater than growth rate. rs > g. • Otherwise the stock price will have a negative value, which is meaningless. • Growth rate has to be constant throughout. g0 = g1 = g∞

13. Variable or Non-Constant Growth Stock • Supernormal (Nonconstant) Growth: The part of the firm’s life cycle in which it grows much faster than the economy as a whole. • Terminal (Horizon) Date: The date when the growth rate becomes constant. • Horizon (Terminal) Value: The value at the horizon date of all dividends expected thereafter.

14. Non-Constant Growth Stocks • The stock’s intrinsic value today is the present value of the dividends during the nonconstant growth period plus present value of horizon value.

15. Corporate Valuation Model • A valuation model used as an alternative to the discounted dividend model to determine a firm’s value, especially one with no history of dividends, or the value of a division of a larger firm. • This model first calculates the firm’s expected free cash flows, then finds their present values to determine the firm’s value.

16. Preferred Stock • Preferred stocks are a hybrid of common stock and bonds. • Like interest of bonds, the dividends of preferred stocks are also fixed periodic payments. • Thus they behave like perpetuity.

17. If a preferred stock with an annual dividend of $5 sells for $50, what is the preferred stock’s expected return? Vp = D / kp $50 = $5 / kp kp = $5 / $50 = 0.10 = 10%