1. Valuation and Characteristics of Common Stocks Financial Management B 642

2. Outline What are stocks? What are stocks? Types of Stocks Types of Stocks Preferred Stock Preferred Stock Common Stock Common Stock Characteristics of Preferred Stocks Characteristics of Preferred Stocks Characteristics of Common Stocks Characteristics of Common Stocks How to value a Preferred Stock? How to value a Preferred Stock? How to value a Common Stock? How to value a Common Stock?

3. What is a Stock? Stocks represent ownership capital Stocks represent ownership capital Stockholders are part owners of the company Stockholders are part owners of the company

4. Types of Stocks Preferred Stocks Preferred Stocks A stock that enjoys preference over common stockholders in terms of payment of dividend and in terms of distribution of assets in case of liquidation of the firm A stock that enjoys preference over common stockholders in terms of payment of dividend and in terms of distribution of assets in case of liquidation of the firm A hybrid security A hybrid security Has features of both common stock and a bond Has features of both common stock and a bond Pays a fixed rate of dividend each year (like coupon on a bond) and Pays a fixed rate of dividend each year (like coupon on a bond) and Has infinite life (like common stock) Has infinite life (like common stock) Non payment of dividend does not bring bankruptcy Non payment of dividend does not bring bankruptcy Dividends cannot be deducted from firm’s income for tax purposes Dividends cannot be deducted from firm’s income for tax purposes Cumulative Dividend Cumulative Dividend

5. How to value preferred stock? Present value of anticipated/expected cash flows when discounted at the required rate of return by the preferred stockholders Present value of anticipated/expected cash flows when discounted at the required rate of return by the preferred stockholders What cash flows are anticipated by preferred stockholders? What cash flows are anticipated by preferred stockholders? Dollar amount of dividend every year for an infinite time period Dollar amount of dividend every year for an infinite time period Value of Preferred Stock = PV of anticipated dividend discounted at the required rate of return Value of Preferred Stock = PV of anticipated dividend discounted at the required rate of return Examples Examples

6. Common Stocks Common Stock Common Stock Common stockholders are the true owners of the company Common stockholders are the true owners of the company Entitled to dividend if and when declared by the board of directors Entitled to dividend if and when declared by the board of directors Entitled to vote at the annual general meetings of the firm Entitled to vote at the annual general meetings of the firm They have the last claim on the assets of the firm after paying off creditors and bond holders and preferred stockholders They have the last claim on the assets of the firm after paying off creditors and bond holders and preferred stockholders They are also residual owners They are also residual owners

7. How to value common stock? PV of expected cash flows for common stockholders when discounted at the required rate of return for the common stockholders PV of expected cash flows for common stockholders when discounted at the required rate of return for the common stockholders What cash flows are expected by common stockholders? What cash flows are expected by common stockholders? An unequal stream of dividends for each year An unequal stream of dividends for each year Value of Common Stock = PV of dividends for common stock holders Value of Common Stock = PV of dividends for common stock holders Simplifying Assumptions to Value Common Stock Simplifying Assumptions to Value Common Stock Zero Growth Model Zero Growth Model Constant Growth Model Constant Growth Model

8. Zero Growth Model If we assume that dividend for common stockholder will be the same every year If we assume that dividend for common stockholder will be the same every year DIV 1 = DIV 2 =DIV 3 =……=DIV  DIV 1 = DIV 2 =DIV 3 =……=DIV  Under zero growth model, stockholders anticipate to receive the same amount of dividend per year forever Under zero growth model, stockholders anticipate to receive the same amount of dividend per year forever Thus, we have a perpetuity of dividends Thus, we have a perpetuity of dividends Price of Stock will equal the present value of this perpetuity Price of Stock will equal the present value of this perpetuity Examples Examples

9. Constant Growth Model If we assume that dividends grow at a constant rate of ‘g’ per year forever If we assume that dividends grow at a constant rate of ‘g’ per year forever DPS 1 DPS 1 P 0 = --------- r - g r - g