Chapter 7 Stocks (equity)

Characteristics and Valuation

After reading this chapter, you should be
able to answer the following questions:
What is Equity? What are some of the
features/characteristics of equity?
What factors affect stock prices?
In general, how are stock price determined?
How are stock returns (yields) determined?
What approaches (techniques) do investors use to value
stocks?
Basic Types of Stock
Preferred Stock
Common Stock
Preferred Stock Features
Par Value: the nominal or face value of a stock or bond.
The par value is important for two reasons:
i. it establishes the amount due to the preferred
stockholders in the event of liquidation, and
ii. the preferred dividend generally is stated as a
percentage of the par value.
Dividends: generally fixed, like debt; based on par value
Cumulative Dividends: preferred dividends not paid in
previous periods must be paid before common dividends
can be distributed.
Preferred Stock Features
Maturity: no specific maturity date
Priority to Assets and Earnings: Preferred stockholders have priority
over common stockholders with regard to earnings and assets.
Control of the Firm (Voting Rights):preferred stockholders neither
elect the members of the board of directors nor vote on corporate
issues.
Convertibility: can be converted to common stock.
Other Provisions
i. Call provision: A call provision gives the issuing corporation the right
to call in the preferred stock for redemption.
ii. Sinking fund: a fund used to retire a given amount of the stock each
year.
iii. Participating: shares earnings with common stockholders.
Common Stock Features
Par Value: stockholder’s minimum financial obligation
Dividends: no obligation, contractual or implied, to pay
common stock dividends.
Maturity: no specific maturity date.
Priority to Assets and Earnings: receive distributions last
Control of the Firm (Voting Rights): vote on board of
directors, stockholder proposals, etc.
Preemptive Right: right to buy new issues.
Types of Common Stock
Classified stock: special designation, such as Class A,
Class B, and so forth, to meet special needs of the
company.
Founders’ shares: Stock owned by the firm’s founders
that has sole voting rights but generally pays out only
restricted dividends for a specified number of years
Equity Instruments in International
Markets
American depository receipts (ADRs): ‘‘Certificates’’
created by organizations such as banks that represent
ownership in stocks of foreign companies that are held in
trust by a bank located in the country in which the stock
is traded.
Foreign Equity (Stock):
Euro stock : traded in countries other than the ‘‘home’’
country of the company, not including the United State
Yankee stock: issued by foreign companies and traded in
the United States.
Stock Valuation- Dividend Discount
Model (DDM)
Stock value= present value of dividends that the company
is expected to pay during its life.
If the stock never pays a dividend-whether a regular
dividend or a liquidating dividend-then its value is $0
Stock Valuation Terms

=Dividend that the stockholder expects to receive at the

end of Year t .
P₀=Vs=Actual market price (value) of the stock today.
=Expected price of the stock at the end of each Year t
g=Expected price of the stock at the end of each Year t
rs= Minimum acceptable, or required, rate of return on
the stock, considering both its riskiness and the returns
available on other investments.
Stock Valuation Terms

Expected dividend yield on the stock during the coming

year.
=Expected capital gains yield on the stock during the
coming year
s= Expected rate of return, which is the return that an
investor who buys the stock expects to receive.
=Actual, or realized, after-the-fact rate of return.
Valuing Stock with Zero Growth
zero growth stock A common stock whose future dividends
are not expected to grow at all; that is, g = 0; and D = =
=…..=
Valuing Stocks with Constant, or Normal,
Growth
-Also called the Gordon model, it is used to find the value of
a stock that is expected to experience constant growth.

P₀
Expected Rate of Return on a Constant
Growth Stock
Valuing Stocks with Nonconstant Growth

nonconstant growth The part of the life cycle of a firm in

which its growth either is much faster or is much slower
than that of the economy as a whole.
FIGURE 7-2 Illustrative Dividend Growth
Rates
Valuing Stocks with Nonconstant Growth
Step 1. We compute the value of the dividends that are affected by nonconstant
growth, and then find the present value of these dividends.
Step 2. We find the price of the stock at the end of the nonconstant growth
period, at which point it becomes a constant growth stock.

Step 3. We add these two present value components to find the intrinsic value of
the stock .
Valuing Stocks with Nonconstant Growth

rs =Stockholders’ required rate of return.

nsuper = Number of years of supernormal growth;
gsuper =Rate of growth in both earnings and dividends
during the supernormal growth period;
gnorm = Rate of normal (constant) growth after the
supernormal period;
D₀ = Last dividend paid by the company;
Valuing Stocks with Nonconstant Growth
Valuing Stocks with Nonconstant Growth
compute the value of our stock as
Valuing Stocks with Nonconstant Grow
Valuing Stocks with Nonconstant Grow
Valuing Stocks with Nonconstant Grow
Valuing Stocks with Nonconstant Grow
Evaluating Stocks Using the Economic
Value Added Approach
An analytical method that seeks to evaluate the earnings generated by
a firm to determine whether they are sufficient to compensate the
suppliers of funds— both the bondholders and the stockholders.
Evaluating Stocks Using the Economic
Value Added Approach
Evaluating Stocks Using the Economic
Value Added Approach
THANKS