2. Ch 7 & 8

3. The Valuation of Common Stock

4.  Acquiring ownership in a corporation

5.  Formed by a state: A corporation is an artificial legal economic unit established (i.e., chartered) by a stat  Certificate of incorporation : A document creating a corporation.

6.  Charter – A document specifying the relationship between a firm and the state in which it is incorporated  Bylaws - specifies the relationship with stockholders

7.  Director:  A person who is elected by stockholders to determine the goals and policies of the firm.

8. Right of stockholder Preemptive rights Cumulative voting Voting authority Rights offering

9.  Voting authority to elect a board of directors  Cumulative voting: The alternative system, cumulative voting, gives minority stockholders a means to obtain representation on the firm’s board.

10.  Preemptive rights: The right of current stockholders to maintain their proportionate ownership in the firm.  Rights offering: Sale of new securities to existing stockholders.

11.  Dividends/earnings  Stability of the payout ratio  Stability of dividend payments

12. Dividends Stock Dividends Cash Dividends

13.  Distribution from earnings  Regular quarterly dividends  Extra dividends  Irregular dividends  Dividends paid in property

14.  Date of record  Stock trading ex dividend  Ex-dividend date  Distribution date

15.  The retention ratio: earnings retained/earnings or 1 - payout ratio

16. Date of record: The day on which an investor must own shares in order to receive the dividend payment. Stock trading ex dividend: Stock that trades exclusive of any dividend payment.

17.  Ex-dividend date is two trading days prior to the date of record  Distribution date: The date on which a dividend is paid to stockholders.

18.  Some firms pay stock dividends in addition to or in lieu of cash dividends.  Stock dividends are a form recapitalization and do not affect the assets or liabilities of the  firm.

19.  Does not affect proportionate ownership  Does not affect assets  Does not affect liabilities  Does not affect total equity

20.  Dilution of existing shares: A reduction in earnings per share due to the issuing of new securities.  Price adjusts for a stock dividend  A 10% stock dividend  Causes a $20 stock price to fall to $18.18 ($20/1.1)

21.  Does not affect proportionate ownership  Does not affect assets  Does not affect liabilities  Does not affect total equity

22.  Does affect the stock's price  A 2 for 1 stock split  Causes a $80 stock price to decline to $40 ($80/2)

23.  Cash dividends used to purchase additional shares  Additional cash contributions may be allowed  Expenses often paid by the firm  Are automatic; an easy means to save

24.  Corporations with cash may reduce the number of existing shares through buy back programs  The decrease in outstanding shares may ◦ Increase earnings per share ◦ Increase the price of the stock

25.  Stockholders do not have to sell their shares  Sales are ◦ Realized capital gains ◦ Subject to capital gains taxation

26. 25 Preferred Stock  Hybrid security.  Similar to bonds in that preferred stockholders receive a fixed dividend which must be paid before dividends can be paid on common stock.  However, unlike bonds, preferred stock dividends can be omitted without fear of pushing the firm into bankruptcy.  The dividends is % of the par value

27. 26 Expected return, given V ps = $50 and annual dividend = $5 V ps = $50 = $5 r ps ^ $5 $50 ^ == 0.10 = 10.0%

28.  Corporate liquidations are rare  Company ◦ Ceases operations ◦ Pays off its liabilities ◦ Distributes its remaining assets to stockholders

29.  THE LOGICAL PROCESS OF SECURITIES VALUATION

30. 1. Evaluate the economic environment Including estimates of economic growth, employment, inflation, and the geopolitical environment in which firms operate.

31. 2. Evaluate regulatory issues and the impact of government policy and intervention.

32. 3. Analyst then moves to the various sectors of the economy.  Within each industry the analyst needs to be aware of the degree of competition, cost structures, the pricing environment, and anticipated growth. Such background is necessary prior to analyzing an individual firm.

33.  4. The securities analyst progresses to consider specific firms.  Ultimately the purpose of the analysis is to determine if the firm’s securities (i.e., its stocks and bonds) are undervalued and should be purchased for inclusion in an individual’s or investment company’s portfolio.

34.  Investors purchase stock with the anticipation of a total return consisting of a dividend yield and a capital gain.  If a firm’s $0.93 dividend is expected to grow at 7 percent to $1.00 and the price of the stock is $25, the anticipated annual return on an investment in the stock is: R(E) = E(D) /P + E(g)

35.  An estimate of the firm's dividend growth rate is used in the dividend-growth model  Estimates often based on accounting data  Historical earnings or dividend payments

36.  Increased growth should increase a stock’s price  Increased growth at the expense of dividends may reduce a stock’s price

37.  Growth or income  Question of what is the best use of the funds - retention versus distribution

38.  Dividends: Regular, extra, and irregular.  Payout: The ratio of dividends to earnings.  Retention ratio: The ratio of earnings not distributed to earnings.

39.  Difference in short and long-term capital gains taxation favor capital gains  Transaction costs (e.g., commissions) favor dividend income

40. Capital gainDividends' Low taxationHigher taxation Long termShort term Pay commission for selling and buying No commission for selling and buying

41. 40 Different Approaches for Valuing Common Stock  Dividend growth model ◦ Constant growth stocks ◦ Nonconstant growth stocks  Free cash flow method.  Using the multiples of comparable firms

42. 41 Stock Value = PV of Dividends What is a constant growth stock? One whose dividends are expected to grow forever at a constant rate, g. P 0 = ^ (1 + k s ) 1 (1 + k s ) 2 (1 + k s ) 3 (1 +k s ) ∞ D 1 D 2 D 3 D ∞ + ++ … +

43. 42 For a constant growth stock: D 1 = D 0 (1 + g) 1 D 2 = D 0 (1 + g) 2 D t = D 0 (1 + g) t If g is constant and less than r s, then: P 0 = ^ D 0 (1 + g) k s – g = D1D1

44. 43 Dividend Growth and PV of Dividends: P 0 = ∑(PV of D t ) $ 0.25 Years (t) D t = D 0 (1 + g) t PV of D t = DtDt (1 + r) t If g > r, P 0 = ∞ !

45. Valuation is  V=D/k  If a stock pays a dividend of $1 and the investor’s required rate of return is 12 percent, then the valuation is = 1/12%= 8.33$

46. Valuation is  V=D 0 (1+g)/(k - g)

47. 46 Intrinsic Stock Value: D 0 = $2.00, r s = 13%, g = 6% Constant growth model: = = = $30.29. 0.13 – 0.06 $2.12 P 0 = ^D 0 (1 + g) k s – g = D1D1

48. 47 Expected value one year from now: P 1 = ^ D2D2 k s – g = $2.2472 0.07 = $32.10  D 1 will have been paid, so expected dividends are D 2, D 3, D 4 and so on.

49.  Value depends on the ◦ the required return ◦ the dividend ◦ the growth in the dividend

50. value the required return the dividend the growth in the dividend

51.  Depends on ◦ the risk-free rate (r f ) ◦ the return on the market (r m ) ◦ the stock's beta

52. The Required Return (k) the stock's beta the risk- free rate (rf) the return on the market (rm)

54.  P/E ratio is a price-earnings multiple times earnings  P=(m)(EPS)  if the analyst determines that the appropriate P/E is 10 and the firm’s per-share earnings are $4.50, the value of the stock is 45

55.  Different definitions of earnings  Differences in estimated earnings  Question of the appropriate multiple

56.  Conceptually the same as using P/E ratios  Same weaknesses apply

57.  Standardizes the P/E ratio for growth P/E Earnings growth  Low PEG ratios (below 1.0) suggest undervaluation

58.  Emphasis on firm’s ability to generate cash  May be applied when firm does not pay a dividend

59.  May be applied if firm operates at a loss  Value investing employs all of the alternative methods

60.  Hard to beat the market on a risk- adjusted basis consistently  Earning a higher return is not necessarily outperforming the market  Considering risk is also important

61.  Large number of competing participants  Information is readily available  Transaction costs are small

62.  Another term for efficient markets  Does not imply security prices are randomly determined  Implies day-to-day price changes are random

63.  Successive prices changes are independent  Today's price does not forecast tomorrow's price  Current price embodies all known information

64.  New information must be random IF NOT  An opportunity to earn an excess return would exist

65. Undervaluation  drives prices up  returns decline Overvaluation  drives prices down  returns increase

67.  Prices change quickly to new information  By the time most investors know the information the price change has already occurred

69.  The forms of the efficient market hypothesis: ◦ the weak form ◦ the semi-strong form ◦ the strong form

70.  Even if financial markets are efficient, that does not answer the question "How efficient?”

71.  Studying past price and volume data will not lead to superior investment results  While the weak form suggests that using price data will not produce superior results, using financial analysis may produce superior returns

72.  Studying economic and accounting data will not lead to superior investment returns  Studying inside information may lend to superior returns

73.  Using inside information will not lead to superior investment returns

74. The Strong Form The Semi- Strong Form The Weak Form

75.  Empirical results generally support ◦ the weak form ◦ the semi-strong form  Possible exceptions to the efficient market hypothesis, called anomalies, appear to exist

76.  Low P/E stocks  The small firm effect  The January effect  The neglected firm effect

77.  The day-of-the-week effect  The Value Line effect  The overreaction effect  Drifts in security prices

78.  Empirical evidence of the existence of an anomaly, however, does not mean the individual can take advantage of the anomaly  The anomaly can still exist and the market be effectively efficient from the individual investor's perspective

79.  Security prices embody known information  The playing field is level  Specifying financial goals may be more important than seeking undervalued stocks

80.  Other markets may not be efficient  Importance of reducing transactions costs: the argument for a buy-and-hold strategy