1 chapter 8 - stocks key sections how do common and preferred stocks differ? what factors affect...
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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 return
2
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
3
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
4
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
5
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
6
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
7
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
8
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
9
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
10
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
11
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
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 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?
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• 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
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