Equity Markets and Stock Valuation Chapter 7 Equity Markets and Stock Valuation

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 As with bonds, the price of the stock is the present value of these expected cash flows

Estimating Dividends Constant dividend Constant dividend growth The firm will pay a constant dividend forever This is similar to 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 Dividend growth is not consistent initially, but settles down to constant growth eventually

Asset Pricing The price of an asset is the present value of all future cash flows

Zero Growth If dividends are expected at regular intervals forever, then this is like preferred stock and is valued as a perpetuity P0 = D / R

Dividend Growth Model Dividends are expected to grow at a constant percent per period. P0 = D1 /(1+R) + D2 /(1+R)2 + D3 /(1+R)3 + … P0 = D0(1+g)/(1+R) + D0(1+g)2/(1+R)2 + D0(1+g)3/(1+R)3 + … Rewritten:

Features of Common Stock Voting Rights Proxy voting Classes of 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

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

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

Stock Market Dealers vs. Brokers New York Stock Exchange (NYSE) NASDAQ Members Operations Floor activity NASDAQ Not a physical exchange, but a computer- based quotation system Large portion of technology stocks