1. Chapter 6 – Stocks and Stock Valuation  Learning Objectives  Explain features of common stock  Understand contractual rights of ownership  Define primary and secondary markets  Explain efficient markets  Calculate stock value based on dividends  Calculate preferred stock price  Explain the shortcomings of the dividend models

2. Common Stock Features  Claim on Assets and Cash Flows (Residual Claim)  No Maturity Date  Vote (Voice in Management)  Tax Issues – Dividends Taxable  Other Issues  Authorized, Outstanding, Treasury Shares  Pre-emptive Rights

3. Stock Markets  Primary Market (First Issue of Stock)  IPO – Initial Public Offering  Requires registration with SEC  Prospectus  Due Diligence  Investment Banker (Partner)  Firm-Commitment  Best Efforts  Secondary Market (Resale of Stock or Used Stock)  Three well known secondary markets  New York Stock Exchange (NYSE)  American Stock Exchange (ASE)  National Association of Securities Dealers (NASD or NASDAQ)  Bid and Ask Prices from dealers or brokers…

4. Efficient Markets  Operational Efficiency  Speed and Accuracy of Processing an Order  Best available price  Quick Turnaround  SuperDOT and SOES  Informational Efficiency  Speed at which information is reflected in prices  Weak-Form (historical volume and prices)  Semi-Weak-Form (historical and public)  Strong-Form (all information public and private)

5. Stock Valuation  Just like a bond…the value is all future cash flows received  Final payment (when stock is sold) is the same as principal repayment  Dividends are the same as coupons

6. Dividend Pricing Models  Four Models  Two assumptions  Growth: constant (no-growth) dividend vs. dividend growing at a constant rate  Horizon: finite vs. infinite  Constant Dividend and Infinite Horizon  Priced as a perpetuity  Price = Dividend / r  r is the desired rate of return on investment

7. Dividend Pricing Models  Constant Dividend with Finite Horizon  Assumption on final payment  Dividends Only – Only annuity stream formula  Dividends and Final Sale at end of horizon – Annuity Stream and Lump Sum formula  TVM equations  Finding Stock Selling Price  New owner buys remaining dividend stream  Perpetuity for new owner?

8. Dividend Growth Models  Common practice to raise dividends each year  Example, Coca-Cola  Dividend changes range  $0.04 to $0.08  5.88% to 14.71%  Not constant…but…  Smooth out pattern for constant percentage change each year  Constant percentage change allows for a simplified pricing model

9. Dividend Growth Models  First Constant Growth Model – Infinite Horizon  Need g, the dividend growth rate  Need r, the require rate of return  Both stated on annual basis

10. Dividend Growth Models  Finding g,  Averaging annual dividend changes  g = (Last Dividend / First Dividend) 1/n  n is the number of dividend changes  Example of Johnson and Johnson, g = 13.8%  Select r, example J&J, r = 15%

11. Dividend Growth Models  Adjusted for Finite Horizon  Dividend stream for a fixed period of time but still has constant growth, g>0  Shareholder only gets a portion of infinite dividend stream  Add portion adjustment to model

12. Changing Dividend Patterns  What happens when g is not constant or the dividends are not constant?  Look for patterns inside the overall dividend stream  Series of dividends with constant dividends  Series of dividends with constant growth  Apply models within the series finding PV of the series  Add up all present value pieces for price

13. Preferred Stock  Preferred stock has stated annual dividend  Constant dividend each period  Dividend = dividend rate x par value  Preferred stock has no maturity date  Infinite horizon  No payment of par value  Fits constant dividend model with infinite horizon

14. Dividend Model Problems  Underestimates expected return for many companies  Low growth rate companies  See Exxon-Mobil and 3M  Reduction in dividends  Produces a negative growth rate  See Sears and Ford  No cash dividends to date  Can’t apply model without history of dividends  See Amazon.com

15. Homework  Problem 2 – Constant Dividend, Infinite  Problem 4 – Constant Dividend, Finite  Problem 6 – Growth in Dividends, Infinite  Problem 8 – Growth in Dividends, Finite  Problem 10 – Nonconstant pattern  Problem 12 – Preferred Stock  Problem 14 – Growth rates