1. CHAPTER 7 Stocks and Their Valuation
Outline
Features of Common Stock
Different approaches for valuing common stocks
Preferred stock

2. Features of Common Stock
Represents ownership
Right to elect directors
Directors appoint managers
Voting rights: One vote per stock
Can transfer voting rights to another person by a proxy.
Proxy is a document giving one person the authority to act for another
Preemptive Right: The provision that gives common stockholders the right to purchase on a pro rata basis new issues of common stocks.

3. Types of Common Stocks
Most companies have only one form of common stock.
There are some companies who classify their stocks into Class A and Class B to differentiate between the difference in special rights of each type of stocks. These are called Classified Stocks.
Founders’ Shares are stocks owned by firm’s founders that has sole voting rights but restricted dividends for specified number of years.

4. Stock Price VS Intrinsic Value
Stock Price - Current Market Price
Intrinsic Value - “True” value based on it’s ability to generate cash now and in the future.
“Stock Price = Intrinsic Value” when market is at equilibrium.
Consistent equilibrium leads to efficient market
Inefficient markets have “overvalued” and “undervalued” stocks.

5. Different approaches for valuing common stock
Discounted Dividend model
Zero Growth Dividend model
Constant Growth Dividend model
Variable or Non-Constant Growth Dividend model
Corporate valuation model
FCF valuation model

6. Discounted Dividend Model
Two types of cash flows are expected from Common Stocks:
The portion of the profit that investors receive periodically while he or she holds the stock. This constitutes the Dividend gain/yield.
The price received when the stock is sold. This constitutes the Capital gain/yield.
CAPM gives us the rate of the expected capital gain.

7. Dividend growth model
Value of a stock is the present value of the future dividends expected to be generated by the stock.
Assuming the stock will be held till eternity, so there is no Capital gain.

8. Zero Growth Stock
A common stock whose future dividends are not expected to grow at all. G=0.
So, D1= D2=…..= Dt
Dividends behave like perpetuity

9. Constant growth stock
A stock whose dividends are expected to grow forever at a constant rate or same rate, g.
D1 = D0 (1+g)1
D2 = D0 (1+g)2
Dt = D0 (1+g)t
If g is constant, the dividend growth formula converges to Gordon Model:

10. Constant Growth Model Rs = required rate of return
At market equilibrium required return is equal expected return.
Thus when market is at equilibrium stock price grows at the same rate the dividend grows

11. Dividend VS Growth Dividends are paid out of profit
Growth in dividend depends on growth in profit.
But if dividend grows retained earnings reduces.
Without reinvestment of earnings growth in profit is not possible.
Thus higher the percentage of retained earnings the higher the profit growth.
In the long run Dividends become constant, i.e. g=0.

12. Required Conditions for Constant Growth Model
Rate of return should be greater than growth rate. rs > g.
Otherwise the stock price will have a negative value, which is meaningless.
Growth rate has to be constant throughout. g0 = g1 = g∞

13. Variable or Non-Constant Growth Stock
Supernormal (Nonconstant) Growth: The part of the firm’s life cycle in which it grows much faster than the economy as a whole.
Terminal (Horizon) Date: The date when the growth rate becomes constant.
Horizon (Terminal) Value: The value at the horizon date of all dividends expected thereafter.

14. Non-Constant Growth Stocks
The stock’s intrinsic value today is the present value of the dividends during the nonconstant growth period plus present value of horizon value.

15. Corporate Valuation Model
A valuation model used as an alternative to the discounted dividend model to determine a firm’s value, especially one with no history of dividends, or the value of a division of a larger firm.
This model first calculates the firm’s expected free cash flows, then finds their present values to determine the firm’s value.

16. Preferred Stock
Preferred stocks are a hybrid of common stock and bonds.
Like interest of bonds, the dividends of preferred stocks are also fixed periodic payments.
Thus they behave like perpetuity.

17. Vp = D / kp $50 = $5 / kp kp = $5 / $50 = 0.10 = 10%
If a preferred stock with an annual dividend of $5 sells for $50, what is the preferred stock’s expected return?
Vp = D / kp
$50 = $5 / kp
kp = $5 / $50
= 0.10 = 10%