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

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

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 2

One-Period Example Suppose 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

One-Period Example What is the maximum you would be willing to pay? –Compute the PV of the expected cash flows D 1 + P R D 1 = Cash dividend at the end of one period R = Required Rate of Return P 1 = Stock price in one period

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?

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 $ both at the end of year 3. Now how much would you be willing to pay?

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?

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

Zero Growth – Constant Dividends If dividends are expected at regular intervals forever, then this is like preferred stock and is valued as a perpetuity P 0 = D 1 / R P 0 = Current stock Price D 1 = 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?

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) D 1 = D 0 X (1 + g) D 1 = Dividend in one year D 0 = Dividend just paid g = growth rate Growing perpetuity: asset that grows at a constant rate forever

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:

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?

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?

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?

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?

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

Using the Dividend Growth Model to Find R R = D 1 + g P 0 R = Required rate D 1 = Dividends at the end of one year P 0 = Current stock price g = growth rate

Required Return Has 2 components 1)Dividends yield 2)Capital gains yield 18

Dividends Yield D 1 / P 0 Expected cash dividend / Current Price 19

Capital Gains Yield Rate at which the value of the investment grows Same as dividend growth rate 20

Finding the Required Return - Example Suppose a firm’s stock is selling for $ 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?

Features of Common Stock Voting Rights vote to elect directors at annual meeting different ways to structure the vote –Cumulative –Straight

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 23

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 24

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 25

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 26

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 27

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 28

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

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

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

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 –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

Stock Market New York Stock Exchange (NYSE)New York Stock Exchange NASDAQ works-behind-the-scenes-video.htm market-makers-video.htm

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

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 37

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 38

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 39

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 40

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

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