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Stock Valuation: Common Stock Features and Types

Learn about the features and types of common stock, including authorized shares, issued shares, and outstanding shares. Explore the different values associated with common stock, such as par value, liquidating value, book value, and market value. Understand the rights and voting procedures of common shareholders.

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Stock Valuation: Common Stock Features and Types

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  1. Chapter 20 and 4 Stock and Stock Valuation

  2. Common Stock and Its Features Basic Terms Authorized Shares Issued Shares Outstanding Shares Common Stock – Securities that represent the ultimate ownership (and risk) position in a corporation.

  3. Types of Common Stock Value • It is merely a recorded figure in the corporate charter and is of little economic consequence. • Stock should never be issued below par value as shareholders would be legally liable for any discount from par if the firm is liquidated. • Common stock that is authorized without par value (no-par stock) is carried on the books at the original market price or at some assigned (or stated) value. • The difference between the issuing price and the par or stated value is additional paid-in capital. A. Par Value– The face value.

  4. Example of Value FunFinMan, Inc. Common stock ($1 par value; 100,000 shares issued and outstanding) $ 100,000 Additional paid-in capital 400,000 Retained earnings 650,000 Total shareholders’ equity $1,150,000 The par value of FunFinMan, Inc., is $1 per share. This value is not likely to change over time from normal day-to-day operations.

  5. Types of Common Stock Value C. Liquidating Value (per share)– The value per share if the firm’s assets are sold separately from the operating organization. • This value may be less (or greater) than book value. Rarely are the two values identical. B. Book Value (per share)– Shareholders’ equity (as listed on the balance sheet) divided by the number of shares outstanding.

  6. Example of Book Value (per share) FunFinMan, Inc. Common stock ($1 par value; 100,000 shares issued and outstanding) $ 100,000 Additional paid-in capital 400,000 Retained earnings 650,000 Total shareholders’ equity $1,150,000 The book value (per share) of FunFinMan, Inc., is determined by dividing total shareholders’ equity ($1,150,000) by the shares outstanding (100,000), which yields a book value of $11.50 per share. This value is not likely to change over time from normal day-to-day operations.

  7. Types of Common Stock Value • This value is usually greater than book value (per share), but can occasionally be less than book value (per share) for firms that have been, are or expected to be in financial difficulties. Rarely are the two values identical. • Market value (per share) may be difficult to obtain from thinly traded securities. D. Market Value (per share)– The current price at which the stock is currently trading.

  8. Types of Common Stock Value • Typically, the shares of new companies are traded in the over-the-counter (OTC) market, where dealers maintain an inventory of the stock to provide additional liquidity. D. Market Value (per share)– continued.

  9. Rights of Common Shareholders • Right to Income– entitled to share in the earnings of the company only if cash dividends are paid (via approval by the board of directors). • Right to Purchase New Shares (Maybe)– the corporate charter of state statute may provide current shareholders with a preemptive right, which requires that these shareholders be first offered any new issue of common stock or an issue that can be converted into common stock. • Voting Rights– because the shareholders are owners of the firm, they are entitled to elect the board of directors.

  10. Voting Rights • SEC regulates the solicitation of proxies and requires companies to disseminate information to their shareholders through proxy mailings or via the Internet effective July 2007. • Most shareholders, if satisfied with company performance, sign proxies in behalf of management. • Shareholders are generally geographically widely dispersed. • Two methods of voting: (1) in person or (2) by proxy Proxy – A legal document giving one person(s) authority to act for another.

  11. Proxy Contest • Occurs usually when disagreement between management and an outside or minority party • Non-management group will register its proxy statement with the SEC and will often send an alternative proxy request to shareholders • Management, due to corporate resources and organization, is generally favored to win • eProxies are expected to provide a more cost-effective mechanism for non-management groups to communicate with shareholders and possibly reduce the management advantage.

  12. Voting Procedures • Plurality voting– a method of electing corporate directors, where each common share held carries one vote for each director position that is open; the highest vote count wins the open director position. Does not consider “withheld” or “against” votes. • Cumulative voting– a method of electing corporate directors, where each common share held carries as many votes as there are directors to be elected and each shareholder may accumulate these votes and cast them in any fashion for one or more particular directors. The board of directors are elected under either:

  13. Voting Procedures • Majority or Modified Plurality voting– a method of electing corporate directors, where each common share held carries one vote for each director position that is open; a majority of all votes cast must be received to be elected. • Common in Europe and gaining popularity due to advocacy groups in the United States • Must receive a majority of “for” plus “against” plus “withheld” votes cast • Approximately two-thirds of S&P500 have adopted by Nov 2007 versus only 16% in Feb 2006 A growing election method:

  14. Voting Procedures Example • Under majority-rule voting: You may cast 100 votes (1 per share) for each of the 9 director positions open for a maximum of 100 votes per position. • Under cumulative voting: You may cast 900 votes (100 votes x 9 positions) for a single position or divide the votes amongst the 9 open positions in any manner you desire. You are a shareholder of FunFinMan, Inc. You own 100 shares and there are 9 director positions to be filled.

  15. Minimum Votes to Elect a Director – Cumulative • For example, to elect 3 directors out of 9 director positions at FunFinMan, Inc., (100,000 voting shares outstanding) would require 30,001 voting shares. • (100,000 shares) x (3 directors) 10 Total number of voting shares Specific number of directors sought X + 1 Total number of directors to be elected + 1 + 1 = 30,001 shares

  16. Minimum Votes to Elect a Director – Cumulative • Notice that slightly over 30% of total voting shares are necessary to guarantee the election of three of the nine director positions – less than a majority. • Management can reduce the influence of minority shareholders by reducing the number of directors or staggering the election terms of directors so fewer positions are open at each vote. • Reducing the number of directors up for election from 9 to 4 would increase the votes necessary to elect 3 directors to 60,001 shares (twice as many)!

  17. Dual-Class Common Stock • This is used to retain control for founders, management, or some other specific group. • For example, 80,000 shares of Class A at $20/share and 200,000 shares of Class B at $2/share. Class A puts up 80% of the funds, but Class B has over 70% of the votes. • Usually Class B takes a lower claim to dividends and assets than Class A for this voting control. Dual-class Common Stock – Two classes of common stock, usually designated Class A and Class B. Class A is usually the weaker voting or nonvoting class, and Class B is usually the stronger.

  18. Common Stock Valuation • Pro rata share of future earnings after all other obligations of the firm (if any remain). • Dividends may be paid out of the pro rata share of earnings. Common stock represents a residual ownership position in the corporation.

  19. (1) Future dividends (2) Future sale of the common stock shares What cash flows will a shareholder receive when owning shares of common stock? Common Stock Valuation

  20. Dividend Valuation Model Basic dividend valuation model accounts for the PV of all future dividends. Div¥ Div1 Div2 V = + + ... + (1 +ke)1 (1 + ke)2 (1 + ke)¥ Divt Divt: Cash Dividend at time t ke: Equity investor’s required return ¥ = S (1 + ke)t t=1

  21. Adjusted Dividend Valuation Model The basic dividend valuation model adjusted for the future stock sale. Div1 Div2 Divn+ Pricen V = + + ... + (1 +ke)1 (1 + ke)2 (1 + ke)n n: The year in which the firm’s shares are expected to be sold. Pricen: The expected share price in year n.

  22. Dividend Growth Pattern Assumptions The dividend valuation model requires the forecast of all future dividends. The following dividend growth rate assumptions simplify the valuation process. Constant Growth No Growth Growth Phases

  23. Constant Growth Model The constant growth model assumes that dividends will grow forever at the rate g. D0(1+g) D0(1+g)2 D0(1+g)¥ V = + + ... + (1 +ke)1 (1 + ke)2 (1 + ke)¥ D1: Dividend paid at time 1. g: The constant growth rate. ke: Investor’s required return. D1 = (ke- g)

  24. Constant Growth Model Example Stock CG has an expected dividend growth rate of 8%. Each share of stock just received an annual $3.24 dividend. The appropriate discount rate is 15%. What is the value of the common stock? D1 = $3.24 ( 1 + 0.08 ) = $3.50 VCG = D1 / ( ke- g ) = $3.50 / (0.15 - 0.08 ) = $50

  25. Zero Growth Model The zero growth model assumes that dividends will grow forever at the rate g = 0. D1 D2 D¥ VZG = + + ... + (1 +ke)1 (1 + ke)2 (1 + ke)¥ D1 D1: Dividend paid at time 1. ke: Investor’s required return. = ke

  26. Zero Growth Model Example Stock ZG has an expected growth rate of 0%. Each share of stock just received an annual $3.24 dividend per share. The appropriate discount rate is 15%. What is the value of the common stock? D1 = $3.24 ( 1 + 0 ) = $3.24 VZG = D1 / ( ke- 0 ) = $3.24 / (0.15 - 0 ) = $21.60

  27. Growth Phases Model The growth phases model assumes that dividends for each share will grow at two or more different growth rates. ¥ n Dn(1 + g2)t D0(1 + g1)t V =S S + (1 + ke)t (1 +ke)t t=1 t=n+1

  28. Growth Phases Model Note that the second phase of the growth phases model assumes that dividends will grow at a constant rate g2. We can rewrite the formula as: n D0(1 + g1)t Dn+1 1 V =S + (ke– g2) (1 +ke)n (1 +ke)t t=1

  29. Growth Phases Model Example Stock GP has an expected growth rate of 16% for the first 3 years and 8% thereafter. Each share of stock just received an annual $3.24 dividend per share. The appropriate discount rate is 15%. What is the value of the common stock under this scenario?

  30. Growth Phases Model Example Stock GP has two phases of growth. The first, 16%, starts at time t=0 for 3 years and is followed by 8%thereafter starting at time t=3. We should view the time line as two separate time lines in the valuation. 0 1 2 3 4 5 6  D1D2D3D4D5D6 Growth of 16% for 3 years Growth of 8% to infinity!

  31. Growth Phases Model Example Note that we can value Phase #2 using the Constant Growth Model 0 1 2 3 Growth Phase #1 plus the infinitely long Phase #2 D1D2D3 0 1 2 3 4 5 6  D4D5D6

  32. Growth Phases Model Example Note that we can now replace all dividends from year 4 to infinity with the value at time t=3, V3! Simpler!! D4 k-g We can use this model because dividends grow at a constant 8% rate beginning at the end of Year 3. V3 = 0 1 2 3 4 5 6  D4D5D6

  33. Growth Phases Model Example Now we only need to find the first four dividends to calculate the necessary cash flows. 0 1 2 3 New Time Line D1D2D3 0 1 2 3 D4 k-g Where V3 = V3

  34. Growth Phases Model Example Determine the annual dividends. D0 = $3.24 (this has been paid already) D1 = D0(1 + g1)1 = $3.24(1.16)1 =$3.76 D2 = D0(1 + g1)2 = $3.24(1.16)2 =$4.36 D3 = D0(1 + g1)3 = $3.24(1.16)3 =$5.06 D4 = D3(1 + g2)1 = $5.06(1.08)1 =$5.46

  35. Growth Phases Model Example Now we need to find the present value of the cash flows. 0 1 2 3 Actual Values 3.764.365.06 0 1 2 3 5.46 0.15–0.08 Where $78= 78

  36. Growth Phases Model Example We determine the PV of cash flows. PV(D1) = D1(PVIF15%, 1) = $3.76 (0.870) = $3.27 PV(D2) = D2(PVIF15%, 2) = $4.36 (0.756) = $3.30 PV(D3) = D3(PVIF15%, 3) = $5.06 (0.658) = $3.33 P3 = $5.46 / (0.15 - 0.08) = $78 [CG Model] PV(P3) = P3(PVIF15%, 3) = $78 (0.658) = $51.32

  37. Growth Phases Model Example Finally, we calculate the intrinsic value by summing all of cash flow present values. V = $3.27 + $3.30 + $3.33 + $51.32 V = $61.22 3 D0(1 +0.16)t D4 1 V = S + (1 +0.15)t (0.15–0.08) (1+0.15)n t=1

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