Chapter 8 - Stocks

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 stocks 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 wont 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 dont mature
• May have multiple classes
• Dividends usually cumulative
• Arrearages paid before common dividends
• Protective rights usually dont 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 Board
  of Directors
• 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
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

11
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

12
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?

13
Stock MarketsNYSE, Nasdaq, ECNs

• 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

14
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

15
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

16
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

17
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.

18
Dividend Growth at Regular Rate

• Value Next Years 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?

19
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

20
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

21
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