1. Chapter 6 Equities

2. Common Stock Represents ownership of a business entity with claims on earnings and dividends Can have different classes of stock where one class can be given disproportionate powers Right to vote –Proxy

3. Intrinsic Value Present value of expected net cash flows that accrues to the owner of security

4. Dividend Discount Model Process of evaluating stocks on basis of present value of their expected stream of dividends Also known as the dividend valuation model

5. Intrinsic Value of Common Stock P 0 = price of stock today d t =dividend during period t r =required rate of return H =holding period P H =price of the stock at the end of the holding period

6. Holding Period Model Is Misleading Problem with defining price of stock in terms of dividends and selling price is that this is circular argument, as it begs the question of what determines selling price. Selling price is present value of dividends to be paid forever thereafter.

7. Dividend Discount Model Because model runs to infinity, it can’t be implemented without making additional assumptions about pattern of future dividends.

8. Required Rate of Return Rate of return on an investment required by market to justify degree of risk incurred Risk-free rate plus the risk premium In equilibrium (quantity supplied equals quantity demanded), required rate of return equal to expected rate of return.

9. Value Cannot Be Based on Earnings Double counting –Earnings retained (i.e., reinvested) in firm should lead to higher earnings in future –Higher earnings are NOT additional value to investor, but simply a return on value of earnings previously invested

10. Valuation of Stocks That Don’t Pay Dividends If they will never, ever pay a dividend: –Truly worthless If they will start paying a dividend in the future: –Value today based on when they are expected to start paying dividends, and amount of payment at that time

11. Gordon (Constant) Growth Model Form of dividend discount model Used to evaluate the intrinsic value of an asset based on assumptions of constant growth rate g of cash flow or dividends and a known discount rate r, where r>g. (continued)

12. Gordon (Constant) Growth Model (continued) V o = d 1 /(r – g) = d 0 x (1 + g)/(r – g) where V 0 = intrinsic value, d 1 = next year’s dividend, g = growth rate of dividends, and r = required rate of return. d n = d n – 1 (1+g) or d n = d 0 (1 + g) n

13. Implications of Growth Model Decrease in required rate of return (that is, discount rate), will cause value of stock to be higher Increase in expected growth rate of dividends (g), will cause value of stock to be higher Increase in next year’s expected dividend (d 1 ) will cause value of stock to be higher

14. Alternative Meaning of “g” Can solve constant growth rate model for r: r = d 1 /V o + g = dividend yield plus growth rate Return to investor equals dividend yield plus expected percentage price change If discount rate = expected return, then dividend growth rate = expected percentage price change

15. Zero Growth Model Assume dividends will never change (i.e., no growth) P = d / r where P =intrinsic value of a stock whose dividends are expected to form a perpetuity d =the constant, annual dividend r = discount rate

16. Selection of Discount Rate Sufficient to compensate investor for the riskiness of dividend stream Frequently use CAPM: r i = r f +  (r m – r f )

17. Application of CAPM Risk-free rate interest rate on riskless investment, such as Treasury bill Market portfolio portfolio of all assets, but good surrogate is S&P 500

18. Market-Price Based Ratios Used to judge relative appropriateness of current stock price –Price-earnings ratio –Price-cash flow ratio Price-free cash flow ratio –Price-sales ratio –Price-earnings/growth rate ratio

19. Earnings Per Share (EPS) Net income of company, minus any preferred dividend requirements, divided by the number of outstanding common shares Provides investor or potential investor with information on stability of dividends and capital gains potential Considered one of most important indications of value of common stock

20. Price-Earnings (P/E) Ratio Share price of stock divided by its actual or anticipated earnings per share –For trailing earnings, stock price relative to most recent 12-month earnings per share Factual –For ex ante earnings, stock price relative to expected next 12-month earnings. Fantasy

21. Dividend Payout Ratio Dividends on common stock paid out as percentage of net income (after preferred dividends)

22. Growth Model & P/E Ratio Where E 0 = last year’s earnings m = the payout ratio (continued) P 0 = E 0 x m x (1 + g)/(r – g)

23. Growth Model & P/E Ratio (continued) Dividing through by last year’s earnings produces the price-to-past earnings ratio: P 0 / E 0 = m x (1 + g) / (r – g) or P 0 / [E 0 x (1+g)] = m / (r – g) P 0 / E 1 = m / (r – g)

24. Characteristics of Companies with High P/E Ratios High expected growth rate of earnings Low discount rate (less risky) Small spread between the discount rate and growth rate

25. Growth Stocks vs. Value Stocks Growth stocks synonymous with above average PE ratios Value stocks synonymous with below average PE ratios Recent evidence suggests value stocks perform better than growth stocks the majority of the time

26. Forecasting with P/E Ratio Individual stock: –Forecast earnings per share –Forecast P/E ratio –Multiply the two together Market: –Forecast earnings for index –Forecast P/E for that index –Multiply the two together

27. Other Equity Instruments Straight Preferred stock and Participating Preferred stock Rights Offering Warrants

28. Rights Issued to raise new capital Exercise Price < Market Price –Sometimes by a large margin –Hence, Intrinsic Value > 0 Short lifespan Transferable –Trade on exchanges or OTC for larger companies

29. Mechanics of Dividends Declaration date Ex-dividend date Record date Payment date

30. Dividend Patterns Many companies boast of number of years of consecutive dividend payments Dividends paid on same date of each quarter Dividend increases usually same quarter of each year

31. Non-Traditional Investments Collectables –requires a market for the asset Noncollectables –items that are unique and expensive Natural Resources –depletion allowance on some mineral rights Precious Metals –rare metallic chemical element of high, durable economic value