1 Chapter 8 - Stocks Key Sections How do common and preferred stocks differ? What factors affect value? How do you value stocks? Calculate the expected.

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Chapter 8 - Stocks

• Key Sections

• How do common and preferred stocks differ?

• What factors affect value?

• How do you value stocks?

• Calculate the expected return

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Overview

• IPO – first time stock sold to the public; incurs flotation costs

• Intrinsic value – PV of future cash flows

• Managers seek to maximize stock’s value

• If value understood, can determine cost of capital, essential to good investment choice

• Limited liability – greatest loss is what paid

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Preferred Stock Features

• Hybrid security similar to stocks and bonds

• Re stock: no fixed maturity; pay dividends not interest; failure to pay won’t cause BK; dividends not deductible by payer

• Re bonds: dividends are generally fixed ($ or % par value); usually do not share in residual earnings

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Preferred --Usual Features

• Perpetuities – don’t mature

• May have multiple classes

• Dividends usually cumulative– Arrearages paid before common dividends

• Protective rights – usually don’t vote unless dividends not paid

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Occasional Features

• Adjustable rates tied to an index or auction• Sometimes participating – bonus dividend• PIK (Payment in Kind) – initially dividends

may be paid in new shares, not cash (rare)• Retirement features: sinking funds, callability

-at stated price after a certain date• May be convertible into common stock

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Valuation

• Same as a perpetuity – PV of all future dividends

• Market Value = Annual Dividend

Required Rate

• Steps: estimate timing, riskiness and required rate; calculate present value

• Basics: Risk/Return, TVM, Cash is King

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Common Stock

• Certificate (paper or electronic) indicating an ownership interest in a corporation

• Has rights to residual income/assets after bondholders and preferred shareholders

• No maturity or upper limit on dividends

• Dividends set by BoD; usually paid quarterly; 75% of companies pay dividends

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Usual Features

• Earnings paid out as dividends or reinvested hopefully to increase value of the firm

• Advantages/Disadvantages: potential return unlimited but lower status in distress

• Voting rights – common shareholders elect BoD– May have different classes with different rights– Stockholders must approve major changes

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More Features

• Proxy – shareholder gives temporary voting rights– Proxy battles – rival groups compete for votes– Often associated with distress or takeovers

• Majority voting – each shareholder has one vote for each director

• Cumulative – each share has votes equal to number of directors to be elected– Minority can elect a director

• Pre-emptive right – right of first refusal

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Growth – Internal and External

• May be through external sources (new stock, borrowing, acquisitions) or internally generated through retention of earnings and reinvestment of profits to increase future profits and price

Internal Growth Rate =Return on Equity * % of Profits Retained

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Significance of Payout RatioAssume ROE = 16%

• All earnings paid out - no internal growth

• Payout half of earnings:– 16% * .5 = 8% growth– 50% payout halves internal growth rate

• No dividends (100% retained)– 16% * 1 = 16% internal growth

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Stock MarketsNYSE, Nasdaq, ECN’s

• New York Stock Exchange– 2,800 listed stocks– Most liquid market– Humans match bids and offers– Physical floor on Wall Street– Owned by 1,366 seat holders

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Nasdaq or Over-the-Counter

• National Association of Securities Dealers Automated Quotation System– Trades 3,400 stocks– No formal listings– Traders at hundreds of locations– Loose federation of electronically connected

traders

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Electronic Communications Networks

• Trade exchange listed and Nasdaq stocks

• Collect and post bids and offers

• Match orders electronically

• Execution is immediate

• Have 7% of the trading volume in NYSE stocks and 83% of OTC stocks

• Biggest: Instanet, Island and ArcaEx

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Valuing Stock

• Intrinsic value – PV of cash flows at RR– Common stock does not guarantee a

dividend, price or maturity payment

• Market value – value observed in the market

• Dividends based on profitability and decision to pay or reinvest– Tend to increase as earnings rise

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Expected Returns

• Increased stock price provides returns– Earnings retained, profit and dividends grow– Should increase price if earnings reinvested at

rate greater than required rate

• Expected return – rate an investor expects to earn from buying at the current price. Would not buy a current price if his required rate is higher.

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Dividend Growth at Regular Rate

• Value = Next Year’s DividendRequired rate less Growth rate

• Assume RR = 15%• Div last year = $2.00 and will grow 10%

– Next year dividend = $2.00 * 1.10 = $2.20

• Value = $2.20/ (.15 -.10) = $44• Read problems carefully – last or next

div?

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FinCoach Formulas

• Value or market price – prior slide

• Required Rate = Dividend + Growth Rate

Value

• Growth Rate = Req Rate minus Dividend

Value

• Value of fixed rate pfd = Dividend/ Req R

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PV of Free Cash Flows

• Alternative to dividend model

• Does not require a constant growth rate– Like Microsoft, companies mature and the

growth rate falls– Assumes company has competitive

advantage period of supernormal growth

• Cash flows driven by sales and profit margin and then present valued

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Starting Points

• Dividend Valuation• Dividend growth• PV of dividends• Uses required rate• Constant growth• Debt excluded

• Free Cash Flow• Cash flow growth• Based on sales/ OPM• Same• May be variable• Debt included

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Concluding Note

• Required rate of return is equal to dividend plus a growth factor

• Growth applies to dividend but price assumed to increase at the same rate

• Return implied by a market price is the required rate of the investor “at the margin” – only willing to pay current market price