Chapter 7

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  • Shareholders have the right to vote for the board of directors and other important issues. Cumulative voting increases the likelihood of minority shareholders getting a seat on the board. Proxy votes are similar to absentee ballots. Proxy fights occur when minority owners are trying to get enough votes to obtain seats on the Board or affect other important issues that are coming up for the vote. Different classes of stock can have different rights. Owners may want to issue a nonvoting class of stock if they want to make sure that they maintain control of the firm.
  • Dividend exclusion: If corporation A owns less than 20% of corporation B stock, then 30% of the dividends received from corporation B are taxable. If A owns between 20% and 80% of B, then 20% of the dividends received are taxable. If A owns more than 80%, a consolidated statement can be filed and dividends received from B are essentially untaxed.
  • Point out that there are a lot of features of preferred stock that are similar to debt. In fact, many new issues have sinking funds that effectively convert what was a perpetual security into an equity security with a definite maturity. However, for tax purposes, preferred stock is equity and dividends are not a tax deductible expense.
  • Dealer: maintains an inventory and stands ready to trade at quoted bid (price at which they will buy) and ask (price at which they will sell) prices. Make their profit from the difference between the bid and ask prices, called the bid-ask spread. The smaller the spread the more competition and the more liquid the stock. The move to decimalization allows for a smaller bid-ask spread. There will be more discussion of this later. Broker: a broker matches buyers and sellers. They perform the search function for a fee (commission). They do not hold an inventory of securities. Video: The Financial Markets video discusses how capital is raised in the market and shows the open-outcry market at the CBOT. www: Check out the NYSE and NASDAQ web sites by clicking on the hot links. Students are often amazed at all of the information that is available. NYSE: Specialists manage the order flow by keeping the limit order book. The limit order book lists the trades that investors have given to their brokers that include desired trading prices. The specialist is also a dealer that holds an inventory in their assigned stock, they post bid and ask prices and they are supposed to maintain and orderly market. Other participants on the floor of the exchange include floor traders that own exchange seats, commission brokers and floor brokers.
  • Dealer: maintains an inventory and stands ready to trade at quoted bid (price at which they will buy) and ask (price at which they will sell) prices. Make their profit from the difference between the bid and ask prices, called the bid-ask spread. The smaller the spread the more competition and the more liquid the stock. The move to decimalization allows for a smaller bid-ask spread. There will be more discussion of this later. Broker: a broker matches buyers and sellers. They perform the search function for a fee (commission). They do not hold an inventory of securities. Video: The Financial Markets video discusses how capital is raised in the market and shows the open-outcry market at the CBOT. www: Check out the NYSE and NASDAQ web sites by clicking on the hot links. Students are often amazed at all of the information that is available. NYSE: Specialists manage the order flow by keeping the limit order book. The limit order book lists the trades that investors have given to their brokers that include desired trading prices. The specialist is also a dealer that holds an inventory in their assigned stock, they post bid and ask prices and they are supposed to maintain and orderly market. Other participants on the floor of the exchange include floor traders that own exchange seats, commission brokers and floor brokers.
  • Remind the students that if dividends are paid quarterly, then the discount rate must be a quarterly rate.
  • Point out that D 1 / P 0 is the dividend yield and g is the capital gains yield
  • As the growth rate approaches the required return, the stock price increases dramatically.
  • As the required return approaches the growth rate, the price increases dramatically. This graph is a mirror image of the previous one.
  • Chapter 7

    1. 1. Chapter 7 Equity Markets and Stock Valuation
    2. 2. Key Concepts and Skills <ul><li>Understand how stock prices depend on future dividends and dividend growth </li></ul><ul><li>Be able to compute stock prices using the dividend growth model </li></ul><ul><li>Understand how corporate directors are elected </li></ul><ul><li>Understand how stock markets work </li></ul><ul><li>Understand how stock prices are quoted </li></ul>
    3. 3. Feature of Common Stock <ul><li>Voting Rights </li></ul><ul><li>Proxy voting </li></ul><ul><li>Other Rights </li></ul><ul><ul><li>Share proportionally in declared dividends </li></ul></ul><ul><ul><li>Share proportionally in remaining assets during liquidation </li></ul></ul><ul><ul><li>Preemptive right – first shot at new stock issue to maintain proportional ownership if desired </li></ul></ul>
    4. 4. Dividend Characteristics <ul><li>Firm cannot go bankrupt for not declaring dividends </li></ul><ul><li>Dividends and Taxes </li></ul><ul><ul><li>Dividend payments are not considered a business expense, therefore, they are not tax deductible </li></ul></ul><ul><ul><li>Dividends received by individuals are taxed as ordinary income </li></ul></ul><ul><ul><li>Dividends received by corporations have a minimum 70% exclusion from taxable income </li></ul></ul>
    5. 5. Features of Preferred Stock <ul><li>Dividends </li></ul><ul><ul><li>Stated dividend that must be paid before dividends can be paid to common stockholders </li></ul></ul><ul><ul><li>Dividends are not a liability of the firm and preferred dividends can be deferred indefinitely </li></ul></ul><ul><ul><li>Most preferred dividends are cumulative – any missed preferred dividends have to be paid before common dividends can be paid </li></ul></ul><ul><li>Preferred stock generally does not carry voting rights </li></ul>
    6. 6. Stock Markets <ul><li>New York Stock Exchange (NYSE) </li></ul><ul><ul><li>Huge room with electronic “trading posts” </li></ul></ul><ul><ul><li>Each stock assigned to single “specialist” </li></ul></ul><ul><ul><li>Specialists = Employed by exchange to be “market makers” </li></ul></ul><ul><ul><li>Hold inventory of stocks, advertise prices to buy (bid) and sell (ask) at: </li></ul></ul><ul><li>Stock Bid Ask </li></ul><ul><li>YWEE $28.65 $28.75 </li></ul>
    7. 7. Specialists <ul><li> Bid Ask </li></ul><ul><li>YWEE $28.65 $28.75 </li></ul><ul><li>Specialist buys low, sells high </li></ul><ul><li>Specialists buys at $28.65, so you sell at $28.65. </li></ul><ul><li>Specialist sells at $28.75, so you buy at $28.75 </li></ul><ul><li>$28.75 - $28.65 = $0.10 = “spread” </li></ul>
    8. 8. Stock Markets <ul><li>NASDAQ </li></ul><ul><ul><li>Not a physical exchange – computer based quotation system </li></ul></ul><ul><ul><li>National Association of Securities Dealers Automated Quotation </li></ul></ul><ul><ul><li>Multiple dealers acting as “market makers” – Hold inventory of stock, post bid & ask prices </li></ul></ul><ul><ul><li>Large portion of technology stocks </li></ul></ul>
    9. 9. NASDAQ <ul><li>DULL Computers: three dealers </li></ul><ul><li>Joe Bob Englebert </li></ul><ul><li>Bid Ask Bid Ask Bid Ask </li></ul><ul><li>8.00 8.50 7.75 8.25 7.50 8.50 </li></ul><ul><li>NASDAQ reports: Bid Ask 8.00 8.25 </li></ul>
    10. 10. Cash Flows to Stockholders <ul><li>If you buy a share of stock, you can receive cash in two ways </li></ul><ul><ul><li>The company pays dividends </li></ul></ul><ul><ul><li>You sell your shares, either to another investor in the market or back to the company </li></ul></ul><ul><li>Value = PV of expected future CF’s </li></ul>
    11. 11. Estimating Dividends: Special Cases <ul><li>Constant dividend </li></ul><ul><ul><li>The firm will pay a constant dividend forever, like preferred stock </li></ul></ul><ul><ul><li>Perpetuity formula </li></ul></ul><ul><li>Constant dividend growth </li></ul><ul><ul><li>The firm will increase the dividend by a constant percent every period </li></ul></ul><ul><li>Nonconstant growth </li></ul><ul><ul><li>Dividend growth is not consistent initially, but settles down to constant growth eventually </li></ul></ul>
    12. 12. Zero Growth <ul><li>If dividends are expected at regular intervals forever, then this is like preferred stock and is valued as a perpetuity </li></ul><ul><li>P 0 = D / R </li></ul><ul><li>Suppose stock is expected to pay a $2 dividend every year and the required return is 10%. What is the price? </li></ul><ul><ul><li>P 0 = 2 / .1 = $20 </li></ul></ul>
    13. 13. Dividend Growth Model <ul><li>Dividends grow at a constant rate g… </li></ul><ul><li>D1 = D0 * (1 + g) </li></ul><ul><li>D2 = D1 * (1 + g) </li></ul><ul><li> </li></ul><ul><li>D2 = D0 * (1 + g) * (1 + g) = D0 * (1 + g) 2 </li></ul><ul><li>Dt = D0 * (1 + g) t </li></ul><ul><li>D43 = D0 * (1 + g) 43 </li></ul>
    14. 14. Dividend Growth Model (DGM) <ul><li>Dividends are expected to grow at a constant percent per period. </li></ul><ul><ul><li>P 0 = D 1 /(1+R) + D 2 /(1+R) 2 + D 3 /(1+R) 3 + … </li></ul></ul><ul><ul><li>P 0 = D 0 (1+g)/(1+R) + D 0 (1+g) 2 /(1+R) 2 + D 0 (1+g) 3 /(1+R) 3 + … </li></ul></ul><ul><li>With a little algebra, this reduces to: </li></ul>
    15. 15. DGM – Example 1 <ul><li>Suppose Big D, Inc. just paid a dividend of $.50. It is expected to increase its dividend by 2% per year. If the market requires a return of 15% on assets of this risk, how much should the stock be selling for? </li></ul><ul><li>What variable is $.50? </li></ul><ul><li>P 0 = .50*(1+.02) / (.15 - .02) = $3.92 </li></ul>
    16. 16. DGM – Example 2 <ul><li>Suppose TB Pirates, Inc. is expected to pay a $2 dividend in one year. If the dividend is expected to grow at 5% per year and the required return is 20%, what is the price? </li></ul><ul><ul><li>P 0 = 2 / (.2 - .05) = $13.33 </li></ul></ul><ul><ul><li>Why isn’t the $2 in the numerator multiplied by (1.05) in this example? </li></ul></ul>
    17. 17. Example <ul><li>Gordon Growth Company is expected to pay a dividend of $2 next year and dividends are expected to grow at 6% per year. The required return is 15%. </li></ul><ul><li>What is the current price? </li></ul>
    18. 18. Using the DGM to Find R <ul><li>Start with the DGM: </li></ul>
    19. 19. Components of R <ul><li>You can get your R in two forms: </li></ul><ul><ul><li>Dividend yield = D 1 /P 0 </li></ul></ul><ul><ul><li>Capital gains yield = g </li></ul></ul><ul><li>R = D 1 /P 0 + g </li></ul>
    20. 20. Example <ul><li>Suppose a firm’s stock is selling for $10.50. They just paid a $1 dividend and dividends are expected to grow at 5% per year. What is the required return? </li></ul><ul><ul><li>R = $1*(1.05)/$10.50 + .05 = 15% </li></ul></ul><ul><li>What is the dividend yield? </li></ul><ul><ul><li>$1*(1.05)/$10.50 = 10% </li></ul></ul><ul><li>What is the capital gains yield? </li></ul><ul><ul><li>g =5% </li></ul></ul>
    21. 21. Criticisms of P0 = D1  (R – g) <ul><li>Constant g </li></ul><ul><li>g > R  P < 0 </li></ul><ul><li>D1 = 0  P = 0 </li></ul><ul><li>Sensitive to R & g: </li></ul><ul><ul><li>1,2,&3 can be fixed (young firms) </li></ul></ul>
    22. 22. Stock Price Sensitivity to Dividend Growth D 1 = $2; R = 20%
    23. 23. Stock Price Sensitivity to Required Return D 1 = $2; g = 5%
    24. 24. Firms with D1 = $0 <ul><li>Firm expects to pay no divds until year 5 </li></ul><ul><li>That divd expected = $1 </li></ul><ul><li>g = 12%, R = 15% P=? </li></ul><ul><li>Solution: Throw D, R , & g into equation </li></ul>
    25. 25. Firms with D1 = $0 <ul><li>P = $1  (.15 - .12) = $33.33? </li></ul><ul><li>Formula  D1  (R – g) = P0 </li></ul><ul><li>What we did  D5  (R – g) = ???? </li></ul><ul><li>D = always one period ahead of P </li></ul><ul><li>(D5  P4) </li></ul><ul><ul><li>Stock Value = PV (expected divd payments) </li></ul></ul>
    26. 26. Firms with D1 = $0 <ul><li>P4 = $33.33  P0 = ??? </li></ul><ul><li>P4 = FV  P0 = PV </li></ul><ul><li>P0 = PV(P4) @ R% </li></ul><ul><li>4 N, 15 I/YR, 33.33 FV, PV=??? </li></ul><ul><li>P0 = $19.06 </li></ul>
    27. 27. Nonconstant Growth <ul><li>1. Compute PV(dividends that experience nonconstant growth) </li></ul><ul><li>2. Find the P stock the end of the nonconstant growth period, and discount P back to the present </li></ul><ul><li>3. Add these two components to find the value of the stock. </li></ul>
    28. 28. Nonconstant Growth <ul><li>TannerHater.com recently paid a dividend of $1.00. Analysts expect that dividend to grow at 20% annually for 3 years, then grow at 10% indefinitely. If R = 15%, what is the stock’s intrinsic value? </li></ul>
    29. 29. Nonconstant Growth <ul><li>1. Compute PV(dividends that experience nonconstant growth) </li></ul><ul><li>D1 = D0 * (1 + g) = $1.00*1.2 = $1.20 </li></ul><ul><li>D2 = D1 * (1 + g) = $1.20*1.2 = $1.44 </li></ul><ul><li>D3 = D2 * (1 + g) = $1.44*1.2 = $1.73 </li></ul><ul><li>Need PV of D1  D3? </li></ul>
    30. 30. Nonconstant Growth <ul><li>Use CFj button on calculator: </li></ul><ul><li>0 CFj (CF in year 0) </li></ul><ul><li>1.2 CFj (CF in year 1) </li></ul><ul><li>1.44 CFj (CF in year 2) </li></ul><ul><li>1.73 CFj (CF in year 3) </li></ul><ul><li>15 I/YR </li></ul><ul><li><color> NPV </li></ul><ul><li>$3.27 = PV (D1  D3) </li></ul>
    31. 31. Nonconstant Growth <ul><li>2. Find the P stock the end of the nonconstant growth period, and discount P back to the present. </li></ul><ul><li>D4 = D3 * (1 + g) = $1.73 * 1.10 = $1.90 </li></ul><ul><li>$1.90  (R – g) = $1.90  (.15 - .10) = $38 = P???? </li></ul>
    32. 32. Nonconstant Growth <ul><li>$38.06 = D4  (r– g) = P3 = FV3 </li></ul><ul><li>3 N </li></ul><ul><li>15 I/YR </li></ul><ul><li>38 FV </li></ul><ul><li>PV = ? </li></ul><ul><li>PV = $24.99 = PV(D4  D  ) </li></ul>
    33. 33. Nonconstant Growth <ul><li>P0 = PV(D1  D  ) </li></ul><ul><li>PV(D1  D3) = $3.27 </li></ul><ul><li>+ PV(D4  D  ) = $24.99 </li></ul><ul><li>PV(D1  D  ) = $28.26 = P0 </li></ul>
    34. 34. Nonconstant Growth Problem <ul><li>Suppose a firm is expected to increase dividends by 20% in one year and by 15% in two years. After that dividends will increase at a rate of 5% per year indefinitely. If the last dividend was $1 and the required return is 20%, what is the price of the stock? </li></ul><ul><li>Remember that we have to find the PV of all expected future dividends. </li></ul>

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