Chapter 7 Stocks (Equity) Characteristics and Valuation

EssentialsofChapter7
What is equity?
What factors affect stock prices?
How are stock prices determined?
How are stock returns determined?
What techniques do investors use to value
stocks?
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Valuation of Financial Assets Equity (Stock)

Common Stock
Preferred Stock:hybrid
similar to bonds with fixed dividend
amounts
similar to common stock as dividends
are not required and have no fixed
maturity date

Preferred Stock Features

Par Value
The nominal or face value of a stock or bond

Cumulative Earnings
Any preferred dividends not paid in previous periods
must be paid before common dividends can be
distributed

Maturity
Generally has no specific maturity date

Priority to Assets and Earnings

Dividends must be paid on preferred stock before they
can be paid on common stock

Preferred Stock Features

Control of the Firm (Voting Rights)
Almost all preferred stock is nonvoting stock

Convertibility
Most preferred stock may be converted to common
stock

Other Provisions
Call provision - Gives the issuing corporation the right
to call in the preferred stock for redemption
Sinking fund - Call for the repurchase and retirement
of a given percentage of the stock each year
Participating - Participates with the common stock in
sharing the firms earnings

Other Provisions of Preferred Stock

Call provision
Gives the issuing corporation the right to
call in the preferred stock for redemption

Sinking fund
Calls for the repurchase and retirement of a
given percentage of the stock each year

Participating
Participates with the common stock in
sharing the firms earnings

Common Stock Features

Par Value
Legally, represents a stockholders minimum financial
obligation in the event the corporation is liquidated

Dividends
The firm has no legal obligation to pay common stock
dividends

Maturity
Generally has no specific maturity date

Priority to Assets and Earnings

Dividends can be paid only after the interest on debt and
the preferred dividends are paid

Common Stock Features

Control of the Firm (Voting Rights)
Common stockholders have the right to elect
the firms directors and to vote on
shareholders proposals, mergers, and
changes in the firms charter

Preemptive Right
Some stockholders have the right to
purchase any additional shares of stock sold
by the firm

Types of Common Stock

Classified Stock
Common stock that is given a special
designation, such as Class A, Class B, etc.,
to meet special needs of the company

Founders Shares
A class of stock owned by the firms
founders who have sole voting rights

Equity Instruments in
International Markets
American Depository Receipts
Certificates created by banks that represent
ownership in stocks of foreign countries

Foreign Equity
Yankee stock
Euro stock

Stock Valuation Models - Terms

Expected Dividends
dividend the stockholder expects to
D
t
recieve at the end of Year t
D0 is the most recent dividend already paid
is the next dividend expected to be paid,
D
1

and it will be paid at the end of this year

is the dividend expected at the end of two years
D
2

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Stock Valuation Models - Terms

Market Price
P0 the actual market price of the stock today
Pt the expected price at the end of Year t
P0 = the intrinsic value as seen by the investor
P = the price expected at the end of year 1
1

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Stock Valuation Models - Terms

Growth Rate

g the expected rate of change

in dividends per share.

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Stock Valuation Models - Terms

Required Rate of Return

rs the minimum rate of return on a

common stock that stockholders
consider acceptable given its
riskiness and returns available on
other investments.

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Stock Valuation Models - Terms

Dividend Yield

D
1
the expected dividend divided
P0
by the current price of a share
of stock

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Stock Valuation Models - Terms

Capital Gain Yield

P1 P0
the change in price (capital gain)
P0
during a given year divided by its
price at the beginning of the year

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Stock Valuation Models - Terms

Expected Rate of Return
s the rate of return on a common
r
stock that an individual investor
expects to receive
P P
D
1 1 0
P0
P0
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Stock Valuation Models - Terms

Actual Rate of Return

rs the rate of return on a common

stock that an individual investor
actually receives, after the fact;
equal to the dividend yield plus
the capital gains yield.

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Expected Dividends as
the Basis for Stock Values
Value of Stock Vs P 0 PV of expected future dividends

P
0

D
1

1 rs

t1

D
2

1 rs

1 rs

D
t

1 rs

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Stock Values with Zero Growth

A Zero Growth Stock is a common
stock whose future dividends are
not expected to grow at all.

D
D
D
g 0, and D
2

0
1
P0

D
D
D
D
1
2 L

1 rs 1 rs
1 rs rs

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Normal, or Constant, Growth

Growth that is expected to
continue into the foreseeable
future at about the same rate as
that of the economy as a whole.

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Normal, or Constant, Growth

(Gordon Model)
D0 1 g D0 1 g
D0 1 g

P0

L
1
2

1 rs
1 rs
1 rs
1

D0 1 g
D
1

rs g
rs g

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Expected Rate of Return on a

Constant Growth Stock
Dividend yield
Expected growth rate, or capital
gains yield

rs

D
1

g
P0

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Valuing Stocks with

Nonconstant Growth
Nonconstant Growth: The part of
the life cycle of a firm in which its
growth is either much faster or
much slower than that of the
economy as a whole.

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Valuing Stocks with

Compute the value
of the dividends that
Nonconstant
Growth

experience nonconstant growth, and then find

the PV of these dividends,
Find the price of the stock at the end of the
nonconstant growth period, at which time it
has become a constant growth stock, and
discount this price back to the present, and
Add these two components to find the intrinsic
value of the stock P0.

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Other Stock Valuation Models

P/E Ratios
The higher the P/E ratio the more investors
are willing to pay for each dollar earned by
the firm
P/E ratio gives an indication of a stocks
payback period

Economic Value Added Approach

Percent cost invested
EVA = EBIT(1- T) -
x

capital
of funds

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Changes in Stock Prices

Prices move opposite to changes in
rates of return
They move in the same direction
as changes in cash flows expected
from the stock in the future

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Chapter 7 Essentials
What is equity?
The value of assets that are owned minus the amount of
debt that is owed

What factors affect stock prices?

They change because investors change their
expectations about the returns the firm will generate in
the future

How are stock prices determined?

The price is equal to the present value of the dividends
stockholders expect to receive during the companys life

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Chapter 7 Essentials
How are stock returns determined?
Returns are based on the dividend the
company pays and the change in the
market value of the stock during the year

What techniques do investors use to

value stocks?
P/E Ratio
Economic Value Added

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