1. © 2004 by Nelson, a division of Thomson Canada Limited Contemporary Financial Management Chapter 6: Common Shares: Characteristics and Valuation

2. © 2004 by Nelson, a division of Thomson Canada Limited 2 Introduction  This chapter describes: the characteristics of common shares common share valuation models

3. © 2004 by Nelson, a division of Thomson Canada Limited 3 Common Shares  Common shares are evidence of ownership.  Common shareholders own the firm.  Common shares are a form of long-term financing for a firm.  Common shares are often called a residual security as their value represents whatever assets are left after all prior claims against the assets have been settled.  Common shareholders elect the Board of Directors.

4. © 2004 by Nelson, a division of Thomson Canada Limited 4 Balance Sheet Accounts  Par Value of Common Shares (can ignore for all practical purposes)  Contributed Capital in Excess of Par Additional paid in capital Capital surplus  Retained earnings

5. © 2004 by Nelson, a division of Thomson Canada Limited 5 Book Value per Share  The book value of a company’s assets attributable to each share of common stock Example: ZBC Corporation reports a common share account balance of $10M and a retained earnings of $5M with 100M shares outstanding. The book value per share is $0.15.

6. © 2004 by Nelson, a division of Thomson Canada Limited 6 Common Shareholder Rights  Right to vote at shareholder meetings.  Right to share in the profits of an organization (paid either as a dividend or as reinvested profits).  Right to share in the residual assets of an organization after all other stakeholder (i.e. governments, creditors, employees) claims are satisfied.

7. © 2004 by Nelson, a division of Thomson Canada Limited 7 Voting for the Board of Directors  Majority voting Each share carries one vote Requires more than 50% of the votes to elect a Director  Cumulative voting Each share carries as many votes as there are Directors to be elected Shareholders may cast all votes for one candidate

8. © 2004 by Nelson, a division of Thomson Canada Limited 8 Voting by Proxy  Shareholders may elect to assign their voting rights to someone else.  Management actively solicits proxies.  A dissent shareholder group may attempt to solicit proxies to wrest control away from management.

9. © 2004 by Nelson, a division of Thomson Canada Limited 9 Common Share Features  Certificate of ownership  Classes Voting vs. non-voting  Amount shareholder invests in common shares is the maximum capital at risk (shares are said to be “fully paid and non-assessable”).  Common shares are marketable securities that can be transferred from one investor to another.

10. © 2004 by Nelson, a division of Thomson Canada Limited 10 Common Share Features  Advantages Flexible Reduces financial risk  Disadvantages Dilute Earnings Per Share Most expensive form of financing

11. © 2004 by Nelson, a division of Thomson Canada Limited 11 Common Share Transactions  Cash Dividend Firm pays a portion of retained earnings in cash to shareholders based upon number of shares owned (i.e. $0.60/share)  Stock Dividend Funds transferred from retained earnings to the common share account. Shareholders receive certificate for additional shares.

12. © 2004 by Nelson, a division of Thomson Canada Limited 12 Common Share Transactions  Stock Split Firm increases the number of shares outstanding by issuing a specific number of new shares for every old shares outstanding Example: stock splits 3 for 1.  Reverse Stock Split Firm decreases the number of shares outstanding by consolidating a specific number of old shares into one share. Example: stock reverse split of 1 for 3

13. © 2004 by Nelson, a division of Thomson Canada Limited 13 Common Share Transactions  Stock Repurchases Disposition of excess cash Repurchased shares are often cancelled Earnings power of remaining shares is increased Financial restructuring Future corporate needs (stock option plans) Reduction of takeover risk

14. © 2004 by Nelson, a division of Thomson Canada Limited 14 Valuation of Common Shares  Cash flows attributable to a common stock accrue from: Dividend stream (while owning the stock) Sale price (the future dividends that would have been received from sale date to perpetuity) The market value of a common stock is equal to the present value of its expected future cash flows!

15. © 2004 by Nelson, a division of Thomson Canada Limited 15 Dividend Valuation Models  Zero growth model  Constant growth model  Nonconstant growth model

16. © 2004 by Nelson, a division of Thomson Canada Limited 16 Dividend Valuation Models  Zero Growth Model The cash flow (dividend) is expected to remain the same over time. Identical to model applied to preferred shares D = Dividend at time period 1 k = Required Rate of Return

17. © 2004 by Nelson, a division of Thomson Canada Limited 17 Zero Growth: Example  Firm ABC currently pays a dividend of $1.00 per share. This is expected to remain the same into the foreseeable future. If shareholders require a return of 20% to hold the stock, what is each share worth in the market?

18. © 2004 by Nelson, a division of Thomson Canada Limited 18 Dividend Valuation Models  Constant Growth Model The cash flow (dividend) is expected to increase at a constant rate over time D 1 = Dividend in Next Period [D 1 = D 0 x (1+g)] k = Required Rate of Return g = constant growth rate

19. © 2004 by Nelson, a division of Thomson Canada Limited 19 Constant Growth: Example  Yesterday, Tinkerbell Corporation paid a dividend of $1.00 per share. The dividend is expected to grow at a rate of 5% per year for the foreseeable future. If the shareholders require a 15% return to hold Tinkerbell shares, what is each share worth in the market?

20. © 2004 by Nelson, a division of Thomson Canada Limited 20 Dividend Valuation Models  Nonconstant Growth Model Many firms grow rapidly for period of time. However, eventually, growth slows to a long- run sustainable constant rate To deal with the nonconstant growth example, we simply present value all dividends back to time period zero

21. © 2004 by Nelson, a division of Thomson Canada Limited 21 Nonconstant Growth: Example  Tiny Toys Inc. is a new firm that is expected to grow at a 20% rate for 3 years. From then on, growth is expected to be 10% per year. The firm paid a dividend of $1.00 yesterday. The dividend is expected to grow at the same rate as the firm’s growth rate. If the shareholders require a 15% return to hold the common stock, what is each share worth in the market?

22. © 2004 by Nelson, a division of Thomson Canada Limited 22 Nonconstant Growth: Solution  Draw a time line showing the expected cash flows. Each dividend must be calculated, using the growth rate for the period. 04321 ∞ $1.00 $1.20 $1.44 $1.73$1.90 20% 10%

23. © 2004 by Nelson, a division of Thomson Canada Limited 23 Nonconstant Growth: Solution

24. © 2004 by Nelson, a division of Thomson Canada Limited 24 Nonconstant Growth: Solution

25. © 2004 by Nelson, a division of Thomson Canada Limited 25 Nonconstant Growth: Helpful Hints  Draw a timeline  Calculate each dividend on the timeline  During the period of nonconstant growth, present value dividends back to time zero  Once growth has stabilized: Calculate the present value of all dividends from that point forward out to infinity. Calculated value must be brought back to time zero. Example: Dividend 4, multiply by:

26. © 2004 by Nelson, a division of Thomson Canada Limited 26 Sources of Growth Rate Forecasts  Value Line Investment Survey www.valueline.com  Thompson Financial/First Call www.tfn.com  Zacks Earnings Estimates www.zacks.com

27. © 2004 by Nelson, a division of Thomson Canada Limited 27 Major Points  Common shares are a form of long-term financing for a firm.  The value of a common share is equal to the present value of its future cash flows.  The value of a common share is determined using: Zero growth model (preferred shares) Constant growth model (blue chip stocks) Nonconstant growth model (growth stocks)