9-1 Stocks Revisited Dr. M.F. Omran, CFA Features of common stock Determining common stock values Preferred stock

9-2 Investments Tools Individual investors as well as institutions can buy common stocks in a particular company. For example, You can buy some of the stocks of Pioneer Corporation or another institution, say Sharp can buy some stocks of Pioneer. The main reason for buying stocks is to invest the excess cash that you have. Why companies sell common stocks? They may need finance to buy capital goods for the manufacturing process. For example, Pioneer may need extra cash for building a new factory in China. This cash can be raised from Bank loans, Common Stocks, Preferred Stocks, or Bonds.

9-3 Why should companies issue different types of securities? To satisfy the different needs of investors in the market Sometimes the capital required is so big that it may not be possible to get it from one source. For example Emaar cannot get all the finance they need from banks only. Also, if Emaar managed to get it from one source, the cost of capital is going to be very high since that source is taking huge risk.

9-4 Facts about common stock Represents ownership Ownership implies control Stockholders elect directors Directors elect management Management’s goal: Maximize the stock price

9-5 Common Stocks No guarantee of receiving dividends. If you want your money back, you have to sell your stocks in the market and you may get out far less than what you paid in. If the company turns out to be successful, you are rich as you are the residual owner of the company. However, if the company losses then you have the least priority in receiving any cash till everyone else has got his/her money. Hence Common stocks are far more risky than Preferred stocks, Bonds, and Bank Loans. Accordingly, you (the investor, the buyer of common stock) should require higher rate of return than other investors in Preferred Stocks, Bonds and Bank Loans.

9-6 Bonds The company can borrow money from the public by issuing corporate bonds. The public means individual investors as well as institutions. Institutions can be banks, insurance companies, and pension funds. Coupon interest rate – fixed interest rate paid by the issuer (the company). Maturity date – years until the bond must be repaid. Note that Governments also can issue bonds to finance public expenditures.

9-7 Preferred stock Like bonds, preferred stockholders receive a fixed dividend that must be paid before dividends are paid to common stockholders. Unlike bonds, companies can omit preferred dividend payments without fear of pushing the firm into bankruptcy.

9-8 Is preferred stock more or less risky to investors than debt? More risky; company not required to pay preferred dividends. However, firms try to pay preferred dividend. Otherwise, (1) cannot pay common stocks dividends, (2) difficult to raise additional funds, (3) preferred stockholders may gain control of firm.

9-9 Intrinsic Value (PV) and Stock Market Price (MP) Investors estimate intrinsic value (IV) to help determine which stocks are attractive to buy and/or sell. You can think of IV as the fair price that you should pay to buy the stock given the stock’s expected future cash flows. The stock’s expected future cash flows have two forms, distribution of some of the company’s net profit (dividends) and growth (g) in the stock price. Stocks with a market price MP below its IV are undervalued. You should buy them. Stocks with a market price MP above its IV are overvalued. You should not buy them.

9-10 Determinants of Intrinsic Value and Stock Prices (Figure 1-1)

9-11 PV (IV) versus Market Price The PV is what the company or the holder of the stock hopes to receive when they sell the stock in the market. However, what the company or the holder ends up getting could be totally different from what they were expecting. This depends on so many factors. Some of these factors could include supply and demand, economic conditions, and international situations.

9-12 What is market equilibrium? In equilibrium, stock prices are stable and there is no general tendency for people to buy versus to sell. In equilibrium, two conditions hold: The current market stock price equals its intrinsic value (MP = IV). Expected returns must equal required returns.

9-13 Dividend growth model The intrinsic value of a stock is the present value of the future dividends expected to be generated by the stock.

9-14 Constant growth stock A stock whose dividends are expected to grow forever at a constant rate, g. Suitable for large well established firms where their dividends tend to be more predictable and growing at a constant rate.

9-15 Three ways to determine the cost of common equity, r cs CAPM: r cs = r RF + (r M – r RF ) b DCF:r cs = (D 1 / P 0 ) + g Own-Bond-Yield-Plus-Risk-Premium: r cs = r d + RP

9-16 Market equilibrium Expected returns are determined by estimating dividends and expected capital gains. Required returns are determined by estimating risk and applying the CAPM.

9-17 CAPM: r cs = r RF + (r M – r RF ) b Capital Asset Pricing Model r RF is the rate of return a depositor can get by leaving his/her money at a government supported bank for fixed period. RF stands for risk free since the probability of default (not getting your money back) is zero. Since Common Stocks have a probability of default (or bankruptcy) greater than zero, in order for you to buy the stock you need a higher rate of return than that offered by the government bank. How much higher depends on Beta (b). b is the measure of market risk in a particular stock. If b=1, then the investor should receive r M which is the required rate of return on an average stock in the market. If b > 1, then this stock is called aggressive since it has a higher market risk than the average stock in the market. Accordingly, you should ask for higher rate of return. If b < 1, then this stock is called defensive since it has a lower market risk than the average stock in the market. Accordingly, you should ask for lower rate of return.

9-18 If r RF = 7%, r M = 12%, and b = 1.2, what is the required rate of return on the firm’s stock? The required rate of return (r CS ) on Common Stocks (CS) is: r CS = r RF + (r M – r RF )b = 7% + (12% - 7%)1.2 = 13%

9-19 If r RF = 7%, r M = 12%, and b = 0.8, what is the required rate of return on the firm’s stock? The required rate of return (r CS ) on Common Stocks (CS) is: r CS = r RF + (r M – r RF )b = 7% + (12% - 7%)0.8 = 11%

9-20 DCF:r cs = (D 1 / P 0 ) + g Discounted Cash Flows Total return (r cs ) = Dividend Yield + Capital Gains Yield Dividend Yield = Expected Dividends at the end of the year divided by the market stock price today. g in the constant growth model is the expected appreciation in the stock price. It is also the expected appreciation in dividends and in the company as a whole. Capital Gains Yield = Constant growth rate (g) in the case of constant growth. g = ( 1 – Payout ratio) (Return on Equity) Return on Equity (ROE) = Net Profit / Equity The company’s board can decide every year on how much should be distributed in dividends (payout ratio) and how much should be kept in the company for reinvestment (retention ratio). For a constant growth company, the payout ratio and retention ratios tend to be constant overtime. Retention ratio = 1 – payout ratio.

9-21 What is the expected future growth rate? The firm has been earning 14.29% on equity (ROE = 14.29%) and retaining 35% of its earnings (dividends payout ratio= 65%). This situation is expected to continue. g= ( 1 – Payout ) (ROE) = (0.35) (14.29%) = 5.00%

9-22 Own-Bond-Yield-Plus-Risk-Premium: r cs = r d + RP This is a subjective approach where the investor estimates subjectively how much extra percentage of return he/she is requiring on top of the risk free rate of return for him/her to invest in a particular stock.

9-23 If r d = 10% and RP = 4%, what is r s using the own-bond-yield-plus-risk- premium method? This RP is not the same as the CAPM RP M (CAPM market risk premium). The CAPM RP M is an objective measure that is based on the difference between r M and r RF. You multiply the RP M by Beta (b) to get the stock’s risk premium. You add this RP M to the r RF to get R cs. The RP in the own bond yield plus risk premium is a subjective estimate. r cs = r d + RP r cs = 10.0% + 4.0% = 14.0%

9-24 If D 0 = $4.19, P 0 = $50, and g = 5%, what’s the cost of common equity based upon the DCF approach? D 1 = D 0 (1 + g) D 1 = $4.19 (1 +.05) D 1 = $ r cs = (D 1 / P 0 ) + g = ($ / $50) = 13.8%

9-25 What is the stock’s intrinsic value? D 1 =$2.12, r cs = 13%, & g = 6%

9-26 What are the expected dividend yield, capital gains yield, and total return during the first year? Dividend yield = D 1 / P 0 = $2.12 / $30.29 = 7.0% Capital gains yield = (P 1 – P 0 ) / P 0 = ($ $30.29) / $30.29 = 6.0% Total return (r cs ) = Dividend Yield + Capital Gains Yield = 7.0% + 6.0% = 13.0%

9-27 What would the expected price today be, if g = 0? The dividend stream would be a perpetuity (The case of a Preferred Stock) r s = 13%...

9-28 If preferred stock with an annual dividend of $5 sells for $50, what is the preferred stock’s expected return? PV P = D / r p $50= $5 / r p r p = $5 / $50 = 0.10 = 10% ^