Finance Chapter 8 Stocks and their valuation

Building a framework  Predicting cash flows from bonds is simpler than forecasting cash flows from common stocks  Estimating the “true” value of stock  Dividend growth model  Total corporate value model  Buy a stock if the intrinsic value exceeds market price, sell if market price exceeds a corporation’s intrinsic value

Control of the firm  Common stockholders are the owners of a corporation  Elect the firm’s Board of Directors (BOD)  BOD hires and fires management  Proxy = one person given the authority to act for another, typically the power to vote shares of common stock  Management solicits and usually gets proxies unless stockholders dissatisfied

Control of the firms  Proxy fight = an attempt by a person/group to gain control of a firm by convincing shareholders to grant them the authority to vote their shares to replace current management  Takeovers – a person/group succeeds in replacing the firm’s management and takes control of the firm  Agency conflict – the possible result of the separation of ownership (shareholders) and control (management) because of conflicting interests

Control of the firm— management efforts Management efforts to fight off a take over  Elect only 1/3 BOD members at a time  Require 75% approval for a take-over  “Poison pill” provisions A take-over defense tactic to make the take- over prohibitively expensive. E.g., allow all existing shareholders of the target company except the acquirers to buy additional shares at a bargain price. This raises the cost of acquisition and causes dilution of stock value.

Control of the firm— stockholder efforts Stockholders’ counter to management control efforts:  Large investors can work together to force management changes  Keeps management focus on shareholders’ concerns  Preemptive Right

Control of the firm—stockholder efforts  Preemptive right = a provision in the corporate charter or bylaws that gives common stockholders the right to purchase on a pro rata basis new issues of common stock (or convertible securities)  Pro rata = in a rights offering, rights are distributed to stockholders on the basis of the number of shares already held by each stockholder. Thus, the pro rata distribution enables the stockholders to purchase new shares in proportion to the old shares they already own.

Control of the firm—stockholder efforts The purpose of the preemptive right  Enables current stockholders to maintain control since management would not be able to buy the stocks themselves to take control  Protects stockholders against a dilution of value (poison pill). Selling stock at a price below market value would dilute its price and transfer wealth from the present stockholders to those who were allowed to purchase the new shares.

Types of common stock  Classified stock = common stock given a special designation, such as Class A (sold to the public and paid a dividend) and Class B (retained by organizers of the firm)  Founders’ shares (e.g., Class B)= stock owned by the firm’s founders that has sole voting rights but restricted dividends for a specified number of years

The market for common stock  Closely held corporation = a corp. owned by a few individuals typically associated with the firm’s management  Closely held stock  Publicly owned corporation = owned by a large number of individuals not actively involved in its management  Publicly held stock  Smaller firms are traded OTC (unlisted)  Larger firms are listed

Stock market transactions Three types of market transactions  Primary market = handles new securities to raise corporate capital  Secondary market = handles stock trades after being issued by corporations  Going public = the act of selling stock to the public at large by a closely held corporation or its principal stockholders  Initial Public Offering (IPO) market = market for stocks of companies in the process of going public

Features of common stock  Common stock entitles its owners to dividends, but only if:  The company has earnings to pay dividends  Management chooses to pay dividends (vs. retain and re-invest earnings)  Cf. bonds that contain a promise to pay  Stocks can be sold at a future date. If above the purchase price = capital gain

Stock valuation model terms  Market Price, the market price of the stock  Intrinsic Value, value of an asset in the investor’s mind justified by the facts  Growth rate, the expected rate of growth in dividends per share  Required Rate of Return, the minimum rate of return on a common stock that the stockholder considers acceptable  Expected Rate of Return, ROR expected by the stockholder ^

Stock valuation model terms  Actual Realized Rate of Return  Dividend Yield, the expected dividend divided by the current price of a share of stock  Capital Yields Gain, the capital gain during a given year divided by the beginning price  E Expected Total Return, the sum of the expected dividend yield and the expected capital gains yield

Constant growth stock  The value of a share of stock is calculated as the present value of the stream of dividends the stock is expected to provide in the future  Value of a constant growth stock equation

Constant growth stock  The expected total rate of return from a stock consists of an expected dividend yield plus an expected capital gains yield  Expected rate of return on a constant growth stock equation

Additional stock growth rates  Zero growth stock = stock whose future dividends are not expected to grow  Supernormal growth stock = earnings and dividends are expected to grow much faster than the economy for some specified period of time, then grow at the “normal” rate  Apple Jan 09 = 85 Jan 11 = 350

Corporate value model Total company (corporate value) model  A valuation model alternative to the dividend growth model to determine the value of a firm  Firms that do not pay dividends  Privately held firms  This model discounts a firm’s free cash flows at the WACC to determine its value  Free cash flows = weighted average cost of debt, preferred stock, common stock (WACC)

Total company vs. dividend growth models Factors to keep in mind when valuing a firm:  Stock value estimates are very sensitive to the assumptions used to generate them  In practice, intrinsic value estimates often deviate considerably from actual stock price  It is dangerous to bet against the “market” Corporate value model  Projecting future financial statements can reveal useful information about operations and financial needs  Provides insights into actions that might increase the firm’s value

Marginal investor  Marginal investor = a representative investor whose actions reflect the beliefs of those people who are currently trading a stock. The marginal investor determines a stock’s price.  Equilibrium = the condition where the expected ROR = required ROR and:  The stock’s intrinsic value must equal its market price  the price is stable.

Efficient market hypothesis  Efficient markets hypothesis (EMH) = hypothesis that securities are are typically in equilibrium and are fairly priced reflecting all publically available information on each security.  Corollary: the price of stock will adjust almost immediately to any new development. You can’t beat the market.

Efficient market hypothesis  Levels of market efficiency  Weak-form efficiency = all information contained in past price movements is fully reflected in current market prices.  Semi-strong efficiency = current market prices reflect all publically available information  Strong-form efficiency = current market prices reflect all pertinent information, whether public or private  Studies show the stock market is highly efficient in the weak-form is, reasonably efficient in the semi- strong form and the strong-form does not hold  Recent studies question the validity of the EMH

Preferred stock  Preferred stock is a hybrid security having characteristics of debt and equity  Most preferred stocks are perpetuities. Some have a maturity date (50 years).  Preferred stock has a par value and fixed dividend amounts that must be paid before dividends can be paid on common stock.  Dividends are paid at the discretion of the directors