Ch 7. Stocks, Stock Valuation, and Market Equilibrium

1. Ch 7. Stocks, Stock Valuation, and Market Equilibrium

2. Goals • To understand characteristics of common and preferred stocks • To understand stock valuations

3. 1. Legal Rights and Privileges of Common Stockholders 1) Control of the Firm • Common stockholders have the right to elect a firm’s directors who, in turn, elect the officers who manage the business. • Each shares of stocks has one vote • Proxy: A document giving one person the authority to act for another, typically the power to vote shares of common stock. Managers always solicits stockholders’ proxies and usually gets them

4. Proxy fight: An attempt by a person or group to gain control of a firm by getting its stockholders to grant that person or group the authority to vote their shares to replace the current management. • Takeover: An action whereby a person or group succeeds in outstanding a firm’s management and taking control of the company.

5. 2) Preemptive right: a provision in the corporate charter or by laws that gives common stockholders the right to purchase pro rata basis new issues of common stock (or convertible securities) • 2 Purposes: 1) to maintain control 2) to protect stockholders against a dilution of value

6. 3) Different type of common stocks • Classified Stock: Common stock that is given a special designation, such as class A, Class B and so forth to meet special needs of company • Tracking Stock: stock with dividends tied to a particular part of a company • 2. The market for common stock • 1) Two types of firms in market: • (1) Closely held corporation: A corporation that is owned by a few individuals who are typically associated with the firm’s management. • (2) Publicly owned corporation: A corporation that is owned by a relatively large number of individuals who are not actively involved in its management

7. Institutional investors owned about 46% of all publicly held common stocks. (pension (26%), mutual funds (10%), foreign investors (6%), insurance companies (3%) and brokerage firm (1%)) 2) Types of stock market transactions • Secondary market: the market in which “used” stocks are traded after they have been issued by corporations.

8. Primary market: the market in which firms issue additional securities to raise corporate capital. • IPO market: the market for stocks issued by the privately held corporation for the first time. • Going public: the act of selling stocks to the public at large by a closely held corporation or its principal stockholders. • 3) Stock Market Reporting • http://finance.yahoo.com/

9. 3. Common stock valuation: Cash flow patterns from holding a stock: Dividend payment & Capital gains Basic starting formula (here K is a required rate of return):

10. Dividend Yield = D1/P0 P hat: expected price of stock at the end of each year t. Dt: dividend payment at time t Pt: stock price at time t Expected Total Return = expected dividend yield + expected capital gain yield

11. As shown before, stock prices mainly rely on the dividend payments. And depending on the patterns of dividend payments, we can come up with three types of stock pricing models. • (1) Constant Growth Model (Gordon Model) • This model assumes that dividend payments will grow at a certain % every period

12. Ex) Assume that allied food products just paid a dividend of $1.15. Its stock has a required rate of return of 13.4% and investors expect the dividend to grow at 8 % in future. Price =1.15(1.08)/(0.134-0.08)=23.00 • Necessary condition for the model is k>g.

15. (2) Zero Growth Model. • It assumes that dividend payment is constant. • P= D/k • It is used to evaluate the price of preferred stock (3) Nonconstant Growth Model • It assumes no consistent patterns • Summation of present values has to be used to calculate the stock price

16. 4. Valuing the entire corporation New or small growth oriented companies tend not to pay dividends. In this case, we have to use different approach to evaluate equity value. It is called as a total company valuation model. In this model, at first calculate the total value of firm and then subtract the market value of the debt and preferred stocks. Then divide by the number of shares outstanding

17. (1) Free Cash Flow Approach • Terminal value is calculated assuming constant growth rate after Year N. Terminal Value is the sum of the PVs of the FCFs for N+1 and all subsequent years.

18. Terminal Value = FCFN+1/(WACC-g) (2) Comparing the total company and dividend growth models. • Dividend growth model: - values of mature companies whose dividends are expected to grow steadily. • Total company model: • companies in the high-growth stage of its life cycle • A new company going public • A division which is supposed to be sold

19. (3) Market Multiple Analysis • E.g) Price = average of P/E ratios of comparable firms * target firm’s EPS • Entity multiple = EBITDA multiple = an average of [(market value of equity and debts) / EBITDA] for a group of similar publicly traded companies.

20. 5. Stock Market Equilibrium • In equilibrium, two condition should be satisfied. • (1) A stock’s expected rate of return as seen by the marginal investor must equal its required rate of return (SML) • Ex) under/over priced • (2) The actual market price of the stock must equal its intrinsic value as estimated by the marginal investor

21. Evidence suggests that stocks, especially those of large companies adjust rapidly to disequilibrium situations

22. 6. Efficient Market Hypothesis • 1) Weak form efficiency • All information contained in past price movements is fully reflected in current market prices. Technical analysis or chartists can not make money. • 2) Semi-strong form efficiency • Current market price reflect publicly available information. Investors can not make money using public information such as annual report. They will earn returns predicted by SML.

23. 3) Strong form efficiency • Current stock price reflects all pertinent information, whether publicly or privately held. • Most studies suggest that the stock market is highly efficient in the weak form and reasonably efficient in the semi-strong form, at least for the larger and more widely followed stocks.