Ch 8. Stocks and Their Valuation

Goals To understand characteristics of common and preferred stocks To understand stock valuations

1. Common stock valuation: Cash flow patterns from holding a stock: Dividend payment & Capital gains Basic starting formula:

As shown before, stock prices mainly rely on the dividend payments. And depending on the patterns of dividend payments, we can come up with three types of stock pricing models. (1) Dividend Growth Model (Gordon Model) This model assumes that dividend payments will grow at a certain % every period

Ex) Assume that allied food products just paid a dividend of $1.15. Its stock has a required rate of return of 13.4% and investors expect the dividend to grow at 8 % in future. Price =1.15(1.08)/( )=23.00 Necessary condition for the model is R>g.

The dividend growth model is often appropriate for mature companies with a stable history of growth From the model, we are able to extract expected rate of return= expected dividend yield + expected growth rate (or capital gain yield)

(2) Zero Growth Model. It assumes that dividend payment is constant. P= D/R It is used to evaluate the price of preferred stock (3) Nonconstant Growth Model It assumes no consistent patterns Summation of present values has to be used to calculate the stock price

4) Two stage growth Dividend will grow at a rate of g1 for t years and then grow at a rate of g2 thereafter forever

5) Stock valuation using multiples Price at time t = Benchmark PE ratio * EPS t Benchmark: industry average or median, company’s own historical value.

2. Components of the required rate of return R= D 1 /P 0 + g = dividend yield + capital gains yield 3. Some features of common and preferred stocks 1) Common stock: equity without priority for dividends or in bankruptcy.

Common stockholders with votes have the right to elect a firm’s directors who, in turn, elect the officers who manage the business. Each shares of stocks has one vote. Two different voting procedures: - Cumulative voting: after determining the number of votes for each shareholder (usually number of shares * number of director candidates), then shareholders cast votes. If there are N directors up for election, then 1/(1+N) percent of the stock plus one share will guarantee you a seat. It is a common practice.

- straight voting: a shareholder casts all votes for each director up for election. The only way to guarantee a seat is to own 50% + one share. It ignores the minority. Proxy: A grant of authority by a shareholder allowing another individual to vote his or her shares. Proxy fight: An attempt by a person or group to gain control of a firm by getting its stockholders to grant that person or group the authority to vote their shares to replace the current management.

Classes of stocks: these classes (e.g. A, B) were created with unequal voting rights. Dividends: payments by a corporation to shareholders, made in either cash or stock. - the payment is at the discretion of board of directors. It is not a liability of the corporation. - the payment is not business expense. - dividends received are taxable.

Other rights; - right to share proportionally in dividend paid - right to share proportionally in assets remaining after liabilities have been paid in a liquidation. - right to vote on stockholder matters of great importance, such as merger - sometimes, right to share proportionally in any new stock sold (preemptive right)

2) Preferred stock: stock with dividend priority over common stocks, normally with a fixed dividend rate, sometimes without voting rights. - stated value: it has a stated value, usually $100 per share. The cash dividend is described in terms of dollars per share. - cumulative and noncumulative dividends: if dividend is cumulative, unpaid dividend will be cumulative to next dividend payment. Common stock holders also must forgo dividends. Unpaid dividends are not debts.

4. The stock market: Primary market: the market in which new securities are originally sold to investors. Secondary market: the market in which previously issued securities are traded among investors. Dealer: an agent who is ready to buy and sells securities and maintains inventory. Source of profit to dealers is a bid-ask spread. Broker: an agent who arranges security transactions among investors. Brokers do not maintain an inventory.

1) NYSE (New York Stock Exchange Market). Since 2006, it has become a public owned corporation. Instead of purchasing seats, exchange members must purchase trading license whose number is limited to 1,366. Commission brokers: NYSE members who execute customer orders to buy and sell stock transmitted to the exchange floor. Specialists: NYSE members acting as dealers in a small number of securities assigned. They are market makers who has obligation to maintain a fair, orderly market for securities assigned to them, posting buying and selling prices.

Floor brokers: NYSE members who execute order for commission brokers on a fee basis. Sometime, called $2 brokers. SuperDOT system: a system transmitting orders electronically directly to the specialists. Reducing the role of floor brokers. Floor traders: NYSE members who trade for their own accounts, trying to make profit over price fluctuation. Recently the number of floor traders dramatically reduce.

2) NASDAQ (National Association of Securities Dealers Automated Quotations System): computer network of securities dealers and others. NASDAQ dealers act as market makers with their own inventories, posting bid and ask prices. Differences between NASDAQ and NYSE: - computer network and no physical location. - multiple market maker system rather than specialist system

Over-the counter (OTC) market: securities market in which trading is almost exclusively done through dealers who buy and sell for their own inventories. NASDAQ was referred as OTC market before. NASDAQ is composed of three separate markets: NASDAQ Select Market (well known firms), NASDAQ Global Market (smaller size firms), and NASDAQ Capital Market (smallest size firms).

ECNs (Electronic communications network): website that allows investors to trade directly with each other through NASDAQ. 3) Stock market reporting: Page 255