If you buy a share of stock, 2 ways you can receive cash
- company pays dividends
- you sell your shares (either to another investor in the market or back to the company)
Intrinsic value of stock
Present value of expected future cash flows from a stock - it indicates the “fair” price of a stock
What is the price of the stock
Just the PV of all expected future dividends
3 different ways companies pay dividends
- Constant dividend - pays constant dividend forever, price is computed as perpetuity formula.
- Constant dividend growth - will increase dividend by constant percent every period, price is computed as growing perpetuity.
- Supernormal (abnormal) growth - dividend growth is not consistent initially, but settles down to constant growth eventually
Zero-Growth Stock
If dividends are expected at regular intervals forever, like preferred stock, valued as a perpetuity.
How do we value a stock with uneven growth first, then constant growth
- forecast high-growth dividends individually
- find stock price at start of constant growth phase
- discount everything back to today
Common Stock Shareholders Rights
- voting right to vote for BoD, board hires management
- share proportionally in declared dividends
- share proportionally in remaining assets during liquidation
- preemptive right (first shot at new stock issue)
Why create different classes of stock
To create unequal voting rights
- voting vs non-voting shares
- control of firm
- coattail provision (non-voting rights can be turned into voting shares to stop a hostile take over)
Dividend Characteristics
- come from net income
- not a liability of the firm until declared by the board
- cannot go bankrupt for not declaring dividends
- individuals receive dividend tax credit
Preferred Stock Features
- preference over common SHs in dividend payment
- most have stated dividend, must be paid before common dividends
- not a liability of the firm, and can be deferred indefinitely
- most are cumulative - any missed preferred dividends have to be paid before common dividends can be paid
- don’t usually carry voting rights
Payout ratio
Fraction of earnings a company pays out in dividends
NPVGO
Net PV of growth opportunities
- the NPV of a firm’s future investments
Book value of equity
Net worth of firm according to balance sheet.
Total assets - total liabilities
Liquidation value
Net proceeds that would be realized by selling the firm’s assets and paying off its creditors.
Why is valuing common stock more difficult than valuing bonds
- cash flows (dividends) are not guaranteed, and don’t know amount
- stock has no maturity (infinite life)
- required return (r) is not directly observable
Why would firms issue preferred stock instead of debt
- avoid bankruptcy risk
- raise equity without giving up control
What determines the P/E ratio
P/E increases when
- r is lower
- NPVGO are higher
High P/E = market expects strong growth
Major differences between bond and stock valuation
Bonds - fixed cash flows, fixed maturity
Stocks - uncertain dividends, infinite life
