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 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 Markets NYSE, 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

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 Year’s 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/ ( ) = $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

22 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