Chapter 8 - Stocks

							        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

                                       1
                 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
                                                   2
    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

                                                 3
   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


                                              4
         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
                                                  5
              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
                                            6
            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

                                                 7
             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
  Board of Directors
  – May have different classes with different rights
  – Stockholders must approve major changes

                                                       8
               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
                                                      9
Pay Dividends or Retain Earnings
• Retain earnings to reinvest in (grow) the
  business or pay out to shareholders?
  – Dividends as % of profits after tax and after
    preferred dividends is the payout ratio
• Dividends per share/ Price per share is
  the dividend yield. Currently about
  1.95%
• Microsoft example

                                                10
    Earnings Per Share (EPS)
After-tax earnings less preferred dividends
 divided by number of common shares.
Reflects level of earnings achieved for every
 share of common stock.
Tells investors how much they have earned
 on each share (but not how much the
 company will pay in dividends)
 Look at year-over-year changes
                                           11
   Price Earnings Ratio (P/E)
• Price per share/ Earnings per share
  – Price the market gives to $1 of earnings
  – EPS = $2, price = $30 then P/E = 15 X (30/2)
  – Currently around 20 X
• The higher expected growth, the higher P/E
• Also measures relative risk and stability of
  earnings
  – Is it too high or too low based on risk?
                                                   12
              Stock Markets
           NYSE, 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



                                      13
 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


                                                     14
    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
                                        15
             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

                                             16
          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.
                                                      17
Dividend Growth at Regular Rate
• Value = Next Year’s Dividend
           Required Rate less Growth rate
• Assume Required Rate = 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
  dividend?
                                                18
        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
                                              19
      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
                                               20
              Starting Points
•   Dividend Valuation   •   Free Cash Flow
•   Dividend growth      •   Cash flow growth
•   PV of dividends      •   Based on sales/ OPM
•   Uses required rate   •   Same
•   Constant growth      •   May be variable
•   Debt excluded        •   Debt included



                                               21
          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

                                            22