2Key Concepts and Skills Understand how stock prices depend on future dividends and dividend growthBe able to compute stock prices using the dividend growth modelUnderstand how corporate directors are electedUnderstand how stock markets workUnderstand how stock prices are quoted
3Chapter Outline 7.2 Some Features of Common and Preferred Stocks 7.1 Common Stock Valuation7.2 Some Features of Common and Preferred Stocks7.3 The Stock Markets
4Cash Flows for Stockholders If you own a share of stock, you can receive cash in two waysThe company pays dividendsYou sell your shares, either to another investor in the market or back to the companyAs with bonds, the price of the stock is the present value of these expected cash flowsDividends → cash incomeSelling → capital gains
5One Period ExampleSuppose you are thinking of purchasing the stock of Moore Oil, Inc.You expect it to pay a $2 dividend in one yearYou believe you can sell the stock for $14 at that time.You require a return of 20% on investments of this riskWhat is the maximum you would be willing to pay?
6One Period Example D1 = $2 dividend expected in one year R = 20% CF1 = $2 + $14 = $16Compute the PV of the expected cash flows
7Two Period Example What if you decide to hold the stock for two years? D1 = $2.00 CF1 = $2.00D2 = $2.10P2 = $14.70Now how much would you be willing to pay?CF2 = $ $14.70 = $16.80
8Three Period ExampleWhat if you decide to hold the stock for three years?D1 = $ CF1 = $2.00D2 = $ CF2 = $2.10D3 = $2.205P3 = $15.435Now how much would you be willing to pay?CF3 = $ $ = $17.640
9Three Period Example Using TI BAII+ Cash Flow Worksheet Cash Flows:CF0 = 0CF1 = 2.00CF2 = 2.10CF3 = 17.64Display You Enter‘'C !#C !#F !#C !#F !#C !#F !# (I !#NPV %13.33
10Developing The ModelYou could continue to push back when you would sell the stockYou would find that the price of the stock is really just the present value of all expected future dividends
11Stock Value = PV of Dividends ^(1+R) (1+R) (1+R) (1+R)∞D D D D∞++…+How can we estimate all future dividend payments?
12Estimating Dividends Special Cases Constant dividend/Zero GrowthFirm will pay a constant dividend foreverLike preferred stockPrice is computed using the perpetuity formulaConstant dividend growthFirm will increase the dividend by a constant percent every periodSupernormal growthDividend growth is not consistent initially, but settles down to constant growth eventually
13Zero GrowthDividends expected at regular intervals forever = perpetuityP0 = D / RSuppose stock is expected to pay a $0.50 dividend every quarter and the required return is 10% with quarterly compounding. What is the price?
14Constant Growth Stock D1 = D0(1+g)1 D2 = D0(1+g)2 Dt = Dt(1+g)t One whose dividends are expected togrow forever at a constant rate, g.D1 = D0(1+g)1D2 = D0(1+g)2Dt = Dt(1+g)tD0 = Dividend JUST PAIDD1 – Dt = Expected dividends
17DGM – Example 1Suppose Big D, Inc. just paid a dividend of $.50. It is expected to increase its dividend by 2% per year. If the market requires a return of 15% on assets of this risk, how much should the stock be selling for?D0= $0.50g = 2%R = 15%
18DGM – Example 2Suppose TB Pirates, Inc. is expected to pay a $2 dividend in one year. If the dividend is expected to grow at 5% per year and the required return is 20%, what is the price?D1 = $2.00g = 5%r = 20%
19Stock Price Sensitivity to Dividend Growth, g D1 = $2; R = 20%
20Stock Price Sensitivity to Required Return, R D1 = $2; g = 5%
21Example 7.3 Gordon Growth Company - I Gordon Growth Company is expected to pay a dividend of $4 next period and dividends are expected to grow at 6% per year. The required return is 16%.What is the current price?
22Example 7.3 Gordon Growth Company - II What is the price expected to be in year 4?
23Example 7.3 Gordon Growth Company - II What is the implied return given the change in price during the four year period?50.50 = 40(1+return)4; return = 6%4 ,; 40 S.; ; 0 /; %- = 6%The price grows at the same rate as dividends
24Constant Growth Model Conditions Dividend expected to grow at g foreverStock price expected to grow at g foreverExpected dividend yield is constantExpected capital gains yield is constant and equal to gExpected total return, R, must be > gExpected total return (R):= expected dividend yield (DY)+ expected growth rate (g)= dividend yield + g
25Nonconstant GrowthSuppose a firm is expected to increase dividends by 20% in one year and by 15% in two years. After that dividends will increase at a rate of 5% per year indefinitely. If the last dividend was $1 and the required return is 20%, what is the price of the stock?Remember that we have to find the PV of all expected future dividends.
26Nonconstant Growth – Solution Compute the dividends until growth levels offD1 = 1(1.2) = $1.20D2 = 1.20(1.15) = $1.38D3 = 1.38(1.05) = $1.449Find the expected future price at the beginning of the constant growth period:P2 = D3 / (R – g) = / ( ) = 9.66Find the present value of the expected future cash flowsP0 = 1.20 / (1.2) + ( ) / (1.2)2 = 8.67
27Nonconstant + Constant growth Basic PV of all Future Dividends FormulaDividend Growth Model6
29Nonconstant growth followed by constant growth: 123rs=20%g = 20%g = 15%g = 5%D0 =1.00000.9583P2 =^0.20 – 0.05= $9.66$1.4496.7083= P018
30Quick Quiz: Part 1What is the value of a stock that is expected to pay a constant dividend of $2 per year if the required return is 15%?What if the company starts increasing dividends by 3% per year beginning with the next dividend? The required return remains at 15%.
31Using the DGM to Find RStart with the DGM:Rearrange and solve for R:
32Finding the Required Return Example A firm’s stock is selling for $ They just paid a $1 dividend and dividends are expected to grow at 5% per year.What is the required return?
33Finding the Required Return Example g = 5% per year.What is the required return?
34Finding the Required Return Example g = 5% per yearWhat is the dividend yield?1(1.05) / = 10%What is the capital gains yield?g =5%Dividend Capital GainsYield Yield
36Features of Common Stock Voting RightsStockholders elect directorsCumulative voting vs. Straight votingProxy votingClasses of stockFounders’ sharesClass A and Class B sharesReturn to Quick Quiz
37Features of Common Stock Other RightsShare proportionally in declared dividendsShare proportionally in remaining assets during liquidationPreemptive rightRight of first refusal to buy new stock issue to maintain proportional ownership if desiredReturn to Quick Quiz
38Dividend Characteristics Dividends are not a liability of the firm until declared by the Board of DirectorsA firm cannot go bankrupt for not declaring dividendsDividends and TaxesDividends are not tax deductible for firmTaxed as ordinary income for individualsDividends received by corporations have a minimum 70% exclusion from taxable income
39Features of Preferred Stock DividendsMust be paid before dividends can be paid to common stockholdersNot a liability of the firmCan be deferred indefinitelyMost preferred dividends are cumulativeMissed preferred dividends have to be paid before common dividends can be paidPreferred stock generally does not carry voting rightsReturn to Quick Quiz
40The Stock Markets Primary vs. Secondary Markets Dealers vs. Brokers Primary = new-issue marketSecondary = existing shares traded among investorsDealers vs. BrokersDealer: Maintains an inventorReady to buy or sell at any timeThink “Used car dealer”Broker: Brings buyers and sellers togetherThink “Real estate broker”
41New York Stock Exchange (NYSE) NYSE Euronext (merged 2007)Members (Historically)Buy a trading license (own a seat)Commission brokersSpecialistsSuperDOTFloor brokersFloor traders
42NYSE Operations Operational goal = attract order flow NYSE Specialist: Assigned broker/dealerEach stock has one assigned specialistAll trading in that stock occurs at the “specialist’s post”Trading takes place between customer orders placed with the specialists and “the crowd”“Crowd” = commission and floor brokers and traders
43NASDAQ NASDAQ OMX (merged 2007) Computer-based quotation system Multiple market makersElectronic Communications NetworksThree levels of informationLevel 1 – median quotes, registered representativesLevel 2 – view quotes, brokers & dealersLevel 3 – view and update quotes, dealers onlyLarge portion of technology stocks
44ECNsElectronic Communications Networks provide direct trading among investorsDeveloped in late 1990sECN orders transmitted to NASDAQObserve live trading online at Batstrading.com
45Reading Stock Quotes What information is provided in the stock quote? Click on the web surfer to go to Bloomberg for current stock quotes.
46Work the WebNot only are stock price quotes readily available online. Some online trading sites display their “order book” or “limit order book” live online.Batstrading is one of these.Follow the link and see current buy and sell orders for Microsoft (MSFT).
47Quick Quiz: Part 2You observe a stock price of $ You expect a dividend growth rate of 5% and the most recent dividend was $1.50. What is the required return?
48Quick Quiz: Part 2What are some of the major characteristics of common stock? (Slide 36 and Slide 37)What are some of the major characteristics of preferred stock?(Slide 39)