STOCK
Contents:
A) PREFERRED STOCK
1. Definition of Preferred Stock
2. Preferred Stock Valuation
3. Preferred Stockholder’s Expected Rate of Return
B) COMMON STOCK
1. Definition of Common Stock
2. Characteristics of Common Stock
3. Common Stock Valuation
4. Common Stockholder’s Expected Rate of Return
Preferred Stock
Hybrid security -- Characteristics of both
common stock and bonds
Common stock characteristics:
No fixed maturity date
Failure to pay dividends does not bring on
bankruptcy
Dividends are not deductible
Bond Characteristics:
Dividends are limited or fixed either as a
percentage of par value or specific dollar
amount
Features of Preferred Stocks
Multiple series of preferred stock
Preferred stock’s claim on assets and income
Cumulative dividends
Protective provisions
Convertibility
Retirement Features
4
Multiple Series
If a company desires, it can issue more than
one series of preferred stock, and each series
can have different characteristics.
Convertible
Protective provisions
5
Claim on Assets and Income
Preferred stock has priority over common
stock with regard to claim on assets in the
case of bankruptcy.
Honored before common stockholders, but
after bonds.
Must pay dividends to preferred
stockholders before it pays common
stockholder dividends.
6
Cumulative Dividends
Cumulative features require that all past,
unpaid preferred stock dividends be paid
before any common stock dividends are
declared.
7
Protective Provisions
Protective provisions generally allow for
voting rights in the event of nonpayment of
dividends, or they restrict the payment of
common stock dividends if sinking-funds
payments are not met or if the firm is in
financial difficulty.
8
Convertibility
Convertible preferred stock can, at the
discretion of the holder, be converted into a
predetermined number of shares of common
stock.
Almost one-third of preferred issued today is
convertible preferred.
Reduces the cost of the preferred stock to
the issue
9
Retirement Features
Although preferred stock has no set maturity
associated with it, issuing firms generally
provide for some method of retiring the
stock.
10
Callable Preferred
A call provision entitles a company to repurchase
its preferred stock (or bonds) from their holders at
stated prices over a given time period.
Call feature usually involves an initial premium of
10% above par value
Premium declines over time
Allows the issuing firm to plan for the retirement
of its preferred stock at predetermined prices.
11
Sinking-Fund Provision
Sinking-fund provision requires the firm to
set aside an amount of money periodically
for the retirement of its preferred stock.
Money used to purchase the preferred stock
in the open market or to call the stock,
whichever method is cheaper.
12
Valuing Preferred Stock
The value of a preferred stock is the present
value of all future dividends.
Calculate the value of preferred stock:
= Annual dividend / required rate of return
13
Valuing Preferred Stock
Vps= annual dividend =D
required rate of return kps
Example: Xerox’s Series C preferred stock
pays an annual dividend of $6.25 and the
investors required rate of return is 5%.
Vps= D = $6.25 = $125.00
kps 0.05
14
EXERCISE
..
Calculate the value of a preferred stock that pays a
dividend of $6 per share and your required rate of
return is 12%
What is the value of a preferred stock where the
dividend rate is 14% on a $100 par value? The
appropriate discount rate for a stock of this risk
level is 12%
Expected Rate of Return of Preferred Stock
(kps )
The preferred stockholder’s expected
rate of return ;
Where D : annual
kps = D / P0 dividend
P0 : Market Price
Info!!
When the expected rate of return is greater than the
required rate of return, you should buy the stock
BUY when kps > kps
EXAMPLE :
If you know the preferred stock price is $40, and
the preferred dividend is $4.125.
a)What is your expected rate of return?
b)If your require 11% return, given the current
price should you buy more stock?
Solution:
a) kps = $4.125 / $40 = 0.103 @ 10.3%
b) I shouldn’t buy the stock because the expected
return is lower than the required return.
(10.3% < 11% )
EXERCISE..
1) Calculate the expected return of preferred stocks
that :
a) Pay dividend $1.95 per share & currently sold for
$42.16
b) Currently sold for $38.50 per share and pay dividend
of $3.25 per share.
2) RBC’s preferred stock, which currently sells for
$75.80 per share and pays dividends of $5.50 per
share
• What is your expected rate of return?
• If you require rate of return is 7%, should you buy the
stock?
B) COMMON STOCK
Common Stock
Certificate that indicates ownership in a
corporation
Common stockholders are the true owners
of the firm
20
Features of Common Stock
Claim on income
Claim on assets
Voting rights
Preemptive rights
Limited liability
21
Claim on Income
Common shareholders have the right to
residual income after bondholders and
preferred stockholders have been paid.
Can be in the form of dividends or retained
earnings.
22
Claim on Assets
Common stock has a residual claim on
assets after claims of debt holders and
preferred stockholders.
If bankruptcy occurs, claims of the common
shareholders generally go unsatisfied.
23
Voting Rights
Common shareholders are entitled to elect
the board of directors
Most often are the only security holders with
a vote
Can approve any change in the corporate
charter
24
Voting Rights
Voting for directors and charter changes occur at the
corporation’s annual meeting.
A proxy gives a designated party the temporary power of
attorney to vote for the signee at the corporation’s annual
meeting.
Proxy fights - battles between rival groups for proxy votes.
Cumulative voting - each share of stock allows the
stockholder a number of votes equal to the number of
directors being elected.
25
Preemptive Rights
Preemptive right entitles the common
shareholder to maintain a proportionate
share of ownership in the firm.
Rights - certificates issued to the
shareholders giving them an option to
purchase a stated number of new shares of
stock at a specified price during a two- to
ten-week period.
26
Limited Liability
Liability of the shareholder is limited to
the amount of their investment.
Limited liability feature aids the firm in
raising funds.
27
Present Value of Future Dividends
Growth factor
Infusion of capital
Financing, debt, common stock
Internal growth
Management retains some or all of
the firm’s profits for reinvestment
in the firm
28
Internal Growth
g= ROE x r
Where g = the growth rate of future earnings and
the growth in the common stockholder’s
investment in the firm
ROE = the return on equity
(net income/common book value)
r = the company’s percentage of
profits retained - profit retention rate
29
3. Common Stock Valuation…
equal to the PV of the expected cash flows to be
received by the stockholder.
the expected cash flows consist of 2 elements
1. the dividends expected in each year
2. the price investors expect to receive when they sell
the stock
2 types of Common Stock Valuation :
a) Single Holding Period
b) Multiple Holding Periods
i. Constant Growth
ii.Non-constant Growth
Single Holding Period
investor holding hold the stock for only 1 year.
the value of stock should equal the PV of both the
expected dividend in year 1 (D1) and the anticipated
market price of the share at year end (P1)
Present value Present value of
Vcs =
of dividend received in
one year (D1)
+ market price received in
one year (P1)
D1 P1
+
Vcs = (1 + Kcs) (1 + Kcs)
EXAMPLE :
XYZ common stock is expected to pay $5.50 in
dividends next year and the market price is
projected to be $120 by year end.If the investor’s
required rate of return is 15%, what is the
current value of the stock?
$120 : P1
$5.50 : D1
0 1
Vcs = (5.50/1.15) + (120/1.15)
= 4.783 + 104.348
= $ 109.13
EXERCISE
1)Honey common stock is expected to pay RM1.85
in dividend next year, and the market price is
projected to be RM42.50 by year end. If the
investor’s required rate of return is 11 percent,
what is the current value of the stock?
2)You intend to purchase Marigos common stock at
RM50 per share. Hold it 1 year and sell after a
dividend of RM6 is paid. How much will the stock
price have to appreciate for you to satisfy your
required rate of return of 15 percent.
Multiple Holding Period
Multiple Holding Period : for CS that has no
maturity date & is frequently held for many
years (perpetuities)
2 types ;
Constant Growth Model : where CS
dividends grow at a constant rate
every year
Non-constant Model (Supernormal
Growth) : where CS dividends grow
at non constant rate ever year.
1) Constant Growth Stock
Constant Growth Model : where CS dividends
grow at a constant rate every year
Formula :
D1 = the dividend at
the end of period 1
D1 Kcs = the required return
Vcs = kcs - g on the common stock
g = the constant, annual
dividend growth rate
Example : XYZ stock recently paid a $5.00
dividend. The dividend is expected to grow at 10%
per year. What would we be willing to pay if our
required return on XYZ stock is 15%?
$ 5.00
10% 10% 10%
0 1 2 n…
D1 = 5 (1.10) = $5.50
D1 5.50
Vcs = = = $110
kcs - g 0.15 - 0.10
EXERCISE
1)Header Bhd. paid a RM3.50 dividend last year.
At a constant growth rate 5 percent, what is the
value of the common stock if the investors
require a 20 percent rate of return?
2)KPD Bhd. paid RM1 dividend last year.
Dividends are expected to grow at an 8 percent
annual rate for an indefinite number of years. If
your required rate of return is 11 percent, what is
the value of the stock?
2) Supernormal Growth
where g (growths) are different each year or at least there
are 2 different growths in cash flow.
Steps of calculation:
a) Find the expected future cash dividends (D1, D2,
D3…..Dn)
b) Find the price of the stock at the end of non-
constant growth period. (Pn)
c) Compute the PV of a & b to find the intrinsic value
of the stock, (P0)
EXAMPLE :
Let say a company is experiencing a supernormal
growth rate in cash dividends of 25% for each of
the next 4 years. After that, the dividend growth
rate is expected to be 5% per year forever. The
latest annual dividend, is $0.75. The required
return is 22%. How much does the company’s
stock worth?
a) Find the expected future cash dividends
(D1, D2, D3…..Dn)
FORMULA Dt : D0 (1 + g )t
D1 = 0.75 (1.25) D3 = 1.172 (1.25)
Dividend 0.75 0.938 1.172 1.465 1.831 1.923
D0 D1 D2 D3 D4 D5
Growth 25% 25% 25% 25% 5%
Years 0 1 2 3 4 5….
b) Find the price of the stock at the end of non-constant
growth period. (Pn)
P4 = D5 / kcs – g = 1.923 / 0.22 - 0.05
= $ 11.312
c) Compute the PV of a & b to find the intrinsic value of
the stock (P0)
P0 = D1/(1+ kcs) + D2 /(1+ kcs)2 + D3/(1+ kcs)3
+ D4/(1+ kcs)4 + P4/(1+ kcs)4
P0 = 0.938/(1.22) + 1.172/(1.22)2 + 1.465/(1.22)3
+ 1.831/(1.22)4 + 11.312/(1.22)4
= $ 8.93
EXERCISE
1) A company currently pays a dividend of RM2 per share. It is
estimated that the company’s dividend will grow at a rate of
20 percent per year for the next 2 years, then the dividend
will grow at a constant rate of 7 percent thereafter.
Stockholders require a return of 10 percent on WME’s stock.
Calculate the value of the stock today?
2) WME Bhd.is expected to experience a 15 percent annual
growth rate for the next 5 years. By the end of 5 years this
growth rate will reduce to 5 percent per year indefinitely.
Stockholders require a return of 12 percent on WME’s stock.
The most recent annual dividend which was paid yesterday,
was RM1.75 per share. Calculate the value of the stock
today?
4. Expected Rate of Return of Common Stock (kcs )
The common stockholder’s expected rate of return
where D : dividend in year 1
D1
kcs = ( Po
)+ g P0 : Market price
G : growth rate
Hint !!
When the expected rate of return is greater than the
required rate of return, you should buy the stock
BUY when kcs > kcs
EXAMPLE :
We know a stock will pay a $3.00 dividend at time
1, has a price of $27 and an expected growth rate
of 5%.
$3
kcs = ( $ 27 )+ 0.05 = 16.11%
exercise
1) The market price for Hobart common stock is RM43. The
price at the end of 1 year is expected to be RM48 and
dividends for next year should be RM2.84. What is the
expected rate of return?
2) The market price for Simpson’s common stock is RM44.
The price at the end of 1 year is expected to be RM47 and
dividends for next year should be RM2. What is the
expected rate of return?
3) The common stock of Zaidi Co. is selling for RM32.84.
The stock recently paid dividends of RM2.94 per share
and has a projected constant growth rate of 9.5 percent.
If you purchase the stock at the market price, what is your
expected rate of return?
exercise
3.Mike’s common stock currently sells for RM22.50 per
share. The companies anticipate a constant growth rate of
10 percent and an end-of-year dividend of RM2
• what is your expected rate of return?
• if you require a 17 percent return, should you
purchase the stock?
4. Black’s common stock currently sells for RM35 per
share. The company anticipate a constant growth rate of
15 percent and an end-of-year dividend of RM4.50
• what is your expected rate of return
• if you require a 20 percent return, what is the value of
the
