W HAT IS S TOCK ? Stock is a share in the ownership of a company. Stock represents a claim on the company's assets and earnings. As you acquire more stock, your ownership stake in the company becomes greater. Whether you say shares, equity, or stock, it all means the same thing.
D EBT E QUITY Requires regular interest payments. Must be repaid or refinanced. Company must generate cash flow to pay Interest payments are tax deductible. Debt has little or no impact on control of the company. No payment requirements. May receive dividends, but only out of retained earnings Equity providers are aggressive. They can accept downside risks because they fully share the upside as well. Dividend payments are not tax deductible. Equity requires shared control of the company and may impose restrictions
T YPES OF S TOCKS There are many different types of stocks which can be invested in based upon your financial position, your risk comfort level, and your investment goals. The basic two types of stock are common stock and preferred stock.
C OMMON S TOCK Common stock is the most typical type of stock. In fact, the greatest number of stock issued is in this form. Common shares represent ownership in a company and a claim (dividends) on a portion of profits. Investing persons or firms get one vote per stock share to elect the board members, who oversee the major decisions made by management.
P REFERRED S TOCK Same as with common stock, preferred stock represents some degree of ownership in a company but typically doesn't come with the same voting rights. With preferred stock investors are usually guaranteed a fixed dividend forever. This is different than common stock, which has variable dividends that are affected by the market and never guaranteed.
I NVESTMENT B ANK Investment banks are organizations through which companies can raise funds by selling stakes (stock) of the company in exchange for cash. In simpler terms, investment banks 'take companies public' by acting as middlemen; the investment bank provides cash from investors for the company, and in return provides new shares of that company to those investors.
I NVESTMENT B ANK ’ S R OLE IN E QUITY O FFERINGS SERVICES: Investment banks provide four primary types of services. Services. Smaller investment banks may specialize in two or three of these categories : RAISING FUNDS ADVISING IN MERGERS EXECUTING SECURITIES TRADING GENERAL ADVISORY SERVICES
INVESTMENT BANK SERVICES AND COST COST : With most fund-raising efforts, whether they be through debt or equity the investment bank keeps for themselves a nominal percentage of the funds raised in the underwriting process. The amount of money retained as the underwriting fee can range anywhere from 3% to 20% (or more) depending on the risk or difficulty of the fund-raising process.
SECONDARY MARKET The secondary market is trading in securities after the initial issue the sale of securities from one investor to other. Unlike the primary market, in secondary market investor can buy a security directly from another investor without the need of any issuing corporation.
NYSE The most important secondary markets are securities exchanges, such as stock exchanges. NYSE is the largest exchange in the world with almost 360 billion shares listed. The NYSE is the first type of exchange where much of the trading is done face-to-face on a trading floor.
NASDAQ The second type of exchange is the virtual sort called an over-the-counter (OTC) market, of which the NASDAQ is the most popular. These markets have no central location or floor brokers whatsoever. Trading is done through a computer and telecommunications network of dealers. It used to be that the largest companies were listed only on the NYSE while all other second tier stocks traded on the other exchanges
P REFERRED S TOCK
D EFINITION It is a part of equity that is expected to pay a fixed annual dividend to investor.
C HARACTERISTICS OF P REFERRED S TOCK Preferred stocks represent partial ownership in a company ownershipcompany A preferred stock pays a fixed dividend that does not fluctuatefixedfluctuate Preferred shareholders always receive their dividends first and, in the event the company goes ruined, preferred shareholders are paid off before common stockholdersreceiveruined Preferred stock shareholders do not enjoy any of the voting rightsshareholdersvoting rights
T YPES O F P REFERRED S TOCK Cumulative and non-cumulative preferred stock Convertible preferred stock Participating preferred stock Redeemable preferred stock
D IFFERENCE B ETWEEN P REFERRED & C OMMON S TOCK Preferred stock don’t have voting right while common stockholders do have Preferred stock is a stable investment. Common stock holder can seek the benefit of higher dividend Preference over the common stock in case of liquidation or payment of dividend
D IFFERENCE B ETWEEN P REFERRED S TOCK & B OND They are junior to the company’s debt obligations Unlike debt instruments, the company isn’t legally obligated to make dividend payments to its preferred stockholders Dividends don’t accrue between dividend payment dates.
F ACTORS E FFECTING M ARKET P RICE OF PS DIVIDEND RISK INTEREST RATE
V ALUATION OF P REFERRED S TOCK It is calculated by the formula; PS = D/r Ps = market price of the preferred stock D = next period`s dividend payment r = discount rate
D IVIDENDS A taxable payment declared by a company's board of directors and given to its shareholders out of the company's current or retained earningstaxablepaymentcompany board of directors shareholderscurrentretained earnings
C HARACTERISTICS OF D IVIDENDS Dividends are not liability Dividend and taxes Firm cant go bankrupt
C OMMON S TOCK
A share of common stock represents an ownership position in the firm. Typically, the owners are entitled to vote on important matters regarding the firm, to vote on the membership of the board of directors, and (often) to receive dividends. In the event of liquidation of the firm, the common shareholders will receive a share of the assets remaining after the creditors (including employees) and preferred stockholders have been paid off. If the liquidation is bankruptcy related, the common shareholders typically receive nothing, though it is possible that they may receive some small amount.
C OMMON S TOCK V ALUATION As with any other security, the first step in valuing common stocks is to determine the expected future cash flows. Finding the present values of these cash flows and adding them together will give us the value:
For a stock, there are two cash flows: Future dividend payments The future selling price
E XAMPLE Assume that you are considering the purchase of a stock which will pay dividends of $2 (D 1 ) next year, and $2.16 (D 2 ) the following year. After receiving the second dividend, you plan on selling the stock for $ What is the intrinsic value of this stock if your required return is 15%? ?
S OME N OTES In valuing the common stock, we have made two assumptions: –We know the dividends that will be paid in the future. –We know how much you will be able to sell the stock for in the future. Both of these assumptions are unrealistic, especially knowledge of the future selling price. Furthermore, suppose that you intend on holding on to the stock for twenty years, the calculations would be very tedious!
S OME A SSUMPTIONS We cannot value common stock without making some simplifying assumptions. These assumptions will define the path of the future cash flows so that we can derive a present value formula to value the cash flows. If we make the following assumptions, we can derive a simple model for common stock valuation: –Your holding period is infinite (i.e., you will never sell the stock so you don’t have to worry about forecasting a future selling price). –The dividends will grow at a constant rate forever. Note that the second assumption allows us to predict every future dividend, as long as we know the most recent dividend and the growth rate.
T HE D IVIDEND D ISCOUNT M ODEL With these assumptions, we can derive a model that is variously known as the Dividend Discount Model, the Constant Growth Model, or the Gordon Model:
T HE D IVIDEND D ISCOUNT M ODEL
E STIMATING T HE DDM I NPUTS The DDM requires us to estimate the dividend growth rate and the required rate of return. The dividend growth rate can be estimated in three ways: –Use the historical growth rate and assume it will continue –Use the equation: g = br –Generate your own forecast with whatever method seems appropriate The required return is often estimated by using the CAPM: k i = k rf + i (k m – k rf ) or some other asset pricing model.
F ORMULAS T O B E U SED IN N UMERICAL Value of Preferred stock Dividend per year Ps = Dp Rate of return ke Value Common stock = p ₀ = D1+ D2+ D3+……...D5 (1+i) (1+i) 2 (1+i) 3 (1+i)5 or P◦=D1+P1 (1+r)1
F ORMULAS T O B E U SED IN N UMERICAL Dividend discount models = D1+ D2+ D3+……………….+D◦(1+g)∞ (1+i) (1+i) 2 (1+i) 3 (1+Ke)∞ Assumptions 1) When dividend increase at zero rate…..Growth rate is zero D = D ₁ I Ke 2)When dividend increase with a constant rate the formula used to calculate the intrinsic value of common stock is: V= D ₁ / (ke-g)
Q UESTION NO.1 Wayne’s Steak,Inc. has a 9 %,non- callable,$100 par value preferred stock issue outstanding. On January 1 the market price per share is $73.Dividends are paid annually on Dec 31. If you require a 12% annual return on this investment, what is this stock intrinsic value to you on Jan,1?
Q UESTION NO.2 Delphi products corporation currently pays a dividend of $2 per share, and this dividend is expected to grow at a 15% annual rate of three years, and then at a 10 % rate of the next 3 years, after which is expected to grow at 5% rate forever. What value you would place on the stock if an 18 % rate of return required?
Q UESTION NO.3 XYZ company currently paid a dividend of Rs.5.5 per share. This dividend is expected to grow at 15% for the first 4 years,13% for next 3 years,7% forever. The rate of return currently prevailing in the market is 10%.Calculate the value of common stock.