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Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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Cash Flows to Stockholders

• If you buy a share of stock, you can receive cash in two ways– The company pays dividends– You sell your shares either to another investor

in the market or back to the company

• the price of the stock is the present value of these expected cash flows – Dividends: cash income– Selling: capital gains

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Common Stock Valuation

• Difficult because:– Cash flows aren’t known in advance– Infinite life of stock– Can’t easily observe the rate of return

required by the market

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One-Period ExampleSuppose you are thinking of purchasing the

stock of Moore Oil, Inc. You expect it to pay a $2 dividend in one year You believe that you can sell the stock for $14

at that time. You require a return of 20% on investments of

this risk

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One-Period ExampleWhat is the maximum you would be willing to

pay?– Compute the PV of the expected cash flows

D1 + P1

1 + R

D1 = Cash dividend at the end of one periodR = Required Rate of Return

P1 = Stock price in one period

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Two-Period Example

• Now, what if you decide to hold the stock for two years? In addition to the $2 dividend in one year, you expect a dividend of $2.10 and a stock price of $14.70 both at the end of year 2. Now how much would you be willing to pay?

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Three-Period Example• Finally, what if you decide to hold the stock

for three periods? In addition to the dividends at the end of years 1 and 2, you expect to receive a dividend of $2.205 and a stock price of $15.435 both at the end of year 3. Now how much would you be willing to pay?

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Developing The Model

• You could continue to push back when you would sell the stock

• You would find that the price of the stock is really just the present value of all expected future dividends

• So, how can we estimate all future dividend payments?

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Estimating Dividends: Special Cases• Constant dividend

– The firm will pay a constant dividend forever

– This is like preferred stock

– The price is computed using the perpetuity formula

• Constant dividend growth– The firm will increase the dividend by a

constant percent every period

• Supernormal growth (Nonconstant Growth)– Dividend growth is not consistent initially, but

settles down to constant growth eventually

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Zero Growth – Constant Dividends

• If dividends are expected at regular intervals forever, then this is like preferred stock and is valued as a perpetuity

• P0 = D1 / R

P0 = Current stock Price

D1 = Dividend at the end of one year

R = Required Rate• Suppose stock is expected to pay a $2 dividend

every year and the required return is 10%. What is the price?

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Dividend Growth Model• Dividends are expected to grow at a

constant percent per period.

• Dividend at the end of the period = Dividend just paid x (1+ growth rate)

D1 = D0 X (1 + g)

D1 = Dividend in one year

D0 = Dividend just paid

g = growth rate

Growing perpetuity: asset that grows at a constant rate forever

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Dividend Growth Model• Dividend growth model: determines

current price of stock as next period’s dividend divided by difference between rate of return and growth rate

• With a little algebra, this reduces to:

g-R

D

g-R

g)(1DP 10

0

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DGM – Example 1

• 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?

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DGM – Example 2

• 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?

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Gordon Growth Company

• Gordon Growth Company is expected to pay a dividend of $4 next period and dividends are expected to grow at 6% per year. The required return is 16%.

• What is the current price?

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Gordon Growth Company

• Gordon Growth Company is expected to pay a dividend of $4 next period and dividends are expected to grow at 6% per year. The required return is 16%.

• What is the price expected to be in year 4?

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Nonconstant Growth Problem

Company is not currently paying dividends. In 5 years, it will pay a $ .50 dividends. Dividends will then grow at a rate of 10%. If the required rate is 20%, what is the stock price today?

Calculate price for the year before the dividends start

Discount the price back to today

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Using the Dividend Growth Model to Find R

R = D1 + g

P0

R = Required rate D1 = Dividends at the end of one year

P0 = Current stock price

g = growth rate

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Required Return

• Has 2 components1) Dividends yield

2) Capital gains yield

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Dividends Yield

D1 / P0

Expected cash dividend / Current Price

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Capital Gains Yield

• Rate at which the value of the investment grows

• Same as dividend growth rate

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Finding the Required Return - Example

• Suppose a firm’s stock is selling for $10.50. It just paid a $1 dividend and dividends are expected to grow at 5% per year.

• What is the dividend yield?

• What is the capital gains yield?

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Features of Common Stock

• Voting Rightsvote to elect directors at annual meeting

different ways to structure the vote– Cumulative– Straight

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Cumulative voting

• Directors are elected all at once

• Shareholder can cast all votes for one director – # of votes shareholder can cast in the election

= # of shares owned X # of director seats up for election

Ex. : 3 directors are being elected

Shareholder A has 100 shares, so she can cast 300 votes

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Cumulative voting

• With N directors up for election, shareholder who has

1 % of stock + one additional share to

N+1 avoid a tie

Can elect one director

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Cumulative voting

Example: 100 shares of company stock; when 3 seats are up for election, shareholder who has

1 x 100 shares + one additional share

3+1

¼ X100 = 25% + 1 share

Can elect one director

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Cumulative voting

Example: 100 shares of company stock; when 3 seats are up for election

Shareholder with 100 shares X 25% = 25 shares +1 = 26 shares

26 shares x 3 votes = 78 votes

Other shareholders have 74 shares X 3 votes = 222 votes in total

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Cumulative voting

Example: 100 shares of company stock; when 3 seats are up for election

If the shareholder votes all 78 votes on one director, that director will be directed

the other 222 votes cannot be split to give all 3 seats 78 or more votes

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Straight Voting

• Directors are elected one at a time• Shareholder may cast votes for one Directors• Can freeze out minority shareholders

• If you have 20 shares, you can cast 20 votes for one director

• The only way one shareholder can elect a director is with 50% ownership + one share

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Features of Common Stock

Proxy voting• Proxy: grant authority to someone else

to vote your shares

• Proxy fight: group of shareholders tries to obtain votes by proxy so that enough directors can be elected that will replace management

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Features of Common Stock

Classes of stock• Different classes of stock can have

different voting rights

• Ex.: class of stock held by family members can have more voting power

• Nonvoting stock may be issued

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Features of Common Stock

Other Rights– Share proportionally in declared dividends– Share proportionally in remaining assets

during liquidation– Preemptive right – first shot at new stock

issue to maintain proportional ownership if desired

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Dividend Characteristics• Dividends are not a liability of the firm until a

dividend has been declared by the Board• Consequently, a firm cannot go bankrupt for

not declaring dividends• Dividends and Taxes

– Dividend payments are not considered a business expense; therefore, they are not tax-deductible

– Dividends received by individuals have historically been taxed as ordinary income

– Dividends received by corporations have a minimum 70% exclusion from taxable income

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Features of Preferred Stock• Dividends

– Stated dividend that must be paid before dividends can be paid to common stockholders

– Dividends are not a liability of the firm and preferred dividends can be deferred indefinitely

– Most preferred dividends are cumulative – any missed preferred dividends have to be paid before common dividends can be paid

• Preferred stock does not generally carry voting rights

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Stock Market

• Dealers vs. Brokers– Dealer: buys and sells securities from

inventory; ready to buy and sell securities at any time

• Bid price: price dealer is willing to pay• Ask price: price dealer is wiling to sell for• Spread: source of dealer price;

Ask price – bid price

– Broker: brings buyer and seller together

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Stock Market• New York Stock Exchange (NYSE)

http://www.youtube.com/watch?v=TPUDPhpCecA

• NASDAQhttp://videos.howstuffworks.com/howstuffworks/412-how-nasdaq-

works-behind-the-scenes-video.htm

http://videos.howstuffworks.com/howstuffworks/420-how-nasdaq-works-market-makers-video.htm

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NYSE Largest stock market in the world

Became publicly traded corp in 2006

Members: purchase trading licenses which allow you to buy and sell securities on the exchange floor

Commission brokers: execute customer orders to buy and sell which are transmitted to exchange floor; get best possible price for customer

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NYSE

• Specialists: dealer in a small number of securities

maintains fair and orderly market for assigned security

post bid and ask prices

will buy or sell at bid and ask prices to keep flow of transactions

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NYSE

• Floor brokers: execute orders for commission brokers for a fee when commission brokers are busy

• Floor traders: trade their own accounts

• SuperDOT system (Designated Order Turnaround)

orders transmitted electronically to specialist

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NYSE Operations

• Specialists post: place on floor where specialists monitor and manage their assigned stocks;

shows what stock last traded for and specialists bid price

• Commission brokers work the phones and go to specialists post to execute orders

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NYSE Operations

• If a commissions broker needs to sell stock for customer:– Go to specialist post to see specialist’s bid

price; – Can sell shares to specialist OR– Find another broker who wants to buy the

stock

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NASDAQ

• Not a physical exchange, but a computer- based quotation system– Large portion of technology stocks

• Dealers post bid and ask prices and # of shares they will sell at a quoted price

• Electronic Communications Network (ECN)– Websites that allow investors to trade

directly with each other– Individual investors can enter orders

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Reading Stock Quotes

• Shows:– Abbreviated stock name– Symbol– YLD: dividend yield (annual dividend / closing price)

– PE: $ investors are willing to pay for $1 of earnings

– LAST: closing price– NET CHG: how much closing price changed

from previous day’s closing price