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Stocks And Their Valuation
Fundamentals of Financial Management
CBAFin123
Legal Rights and Privileges
of Common Stockholders
• A corporation’s common stockholders are the
owners of the corporation, and as such, they
have certain rights and privileges.
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Control of the Firm
• A firm’s common stockholders have the right to
elect its directors, who in turn elect the officers
who manage the business. In a small firm, usually
the major stockholder is also the president and
chair of the board of directors.
• In large, publicly owned firms, the managers
typically have some stock, but their personal
holdings are generally insufficient to give them
voting control. Thus, the management of most
publicly owned firms can be removed by the
stockholders if the management team is not
effective.
Control of the Firm
• Proxy. A document giving one person the authority
to act for another, typically the power to vote
shares of common stock.
• Proxy Fight. An attempt by a person or group to
gain control of a firm by getting its stockholders to
grant that person or group the authority to vote its
shares to replace the current management.
• Takeover. An action whereby a person or group
succeeds in ousting a firm’s management and
taking control of the company.
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The Preemptive Right
• A provision in the corporate charter or bylaws
that gives common stockholders the right to
purchase, on a pro rata basis, new issues of
common stock (or convertible securities).
• Common stockholders often have the right,
called the preemptive right, to purchase on a
pro rata basis any additional shares sold by the
firm.
The Pre-emptive Right
• The purpose of the preemptive right is twofold.
First, it prevents the management of a
corporation from issuing a large number of
additional shares and purchasing those shares
itself. Management could use this tactic to
seize control of the corporation and frustrate
the will of the current stockholders.
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The Pre-emptive Right
• The second, and far more important, reason for
the preemptive right is to protect stockholders
from a dilution of value. For example, suppose
1,000 shares of common stock, each with a
price of $100, were outstanding, making the
total market value of the firm $100,000. If an
additional 1,000 shares were sold at $50 a
share, or for $50,000, this would raise the
firm’s total market value to $150,000.
The Pre-emptive Right
• When the new total market value is divided by
the 2,000 total shares now outstanding, a value
of $75 a share is obtained. The old
stockholders would thus lose $25 per share,
and the new stockholders would have an
instant profit of $25 per share. Thus, selling
common stock at a price below the market
value would dilute a firm’s price and transfer
wealth from its present stockholders to those
who were allowed to purchase the new shares.
The preemptive right prevents this.
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Types of Common Stock
• Classified Stock. Common stock that is given
a special designation such as Class A or Class
B to meet special needs of the company.
• Founders’ Shares. Stock owned by the firm’s
founders that enables them to maintain control
over the company without having to own a
majority of stock.
Types
TypesofofCommon
CommonStock
Stock
• The use of classified stock enables the
company’s founders to maintain control over
the company without having to own a majority
of the common stock. For this reason, Class B
stock of this type is sometimes called founders’
shares.
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Stock
StockPrice
Priceversus
versusIntrinsic
IntrinsicValue
Value
• Stock price is simply the current market price, and it is
easily observed for publicly traded companies.
• By contrast, intrinsic value, which represents the “true”
value of the company’s stock, cannot be directly
observed and must instead be estimated.
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Why Do Investors And Companies
Care About Intrinsic Value?
• When investing in common stocks, one’s goal
is to purchase stocks that are undervalued
(i.e., the price is below the stock’s intrinsic
value) and avoid stocks that are overvalued.
Why Do Investors And Companies
Care About Intrinsic Value?
• Two basic models are used to estimate intrinsic
values: the discounted dividend model and the
corporate valuation model.
• The dividend model focuses on dividends,
while the corporate model goes beyond
dividends and focuses on sales, costs, and
free cash flows.
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The Discounted Dividend Model
• The value of a share of common stock
depends on the cash flows it is expected to
provide, and those flows consist of two
elements: (1) the dividends the investor
receives each year while he or she holds the
stock and (2) the price received when the stock
is sold. The final price includes the original
price paid plus an expected capital gain.
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The Discounted Dividend Model
• Growth Rate, g. The expected rate of growth in
dividends per share.
• Required Rate of Return, rs. The minimum rate of
return on a common stock that a stockholder considers
acceptable.
• Expected Rate of Return, ȓs. The rate of return on a
common stock that a stockholder expects to receive in
the future.
• Actual (Realized) Rate of Return, r-bars. The rate of
return on a common stock actually received by
stockholders in some past period.
The
TheDiscounted
DiscountedDividend
DividendModel
Model
• Dividend Yield. The expected dividend divided
by the current price of a share of stock.
• Capital Gains Yield. The capital gain during a
given year divided by the beginning price.
• Expected Total Return. The sum of the
expected dividend yield and the expected
capital gains yield.
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Expected Dividends As The Basis
For Stock Values
• Stock prices are likewise determined as the
present value of a stream of cash flows, and
the basic stock valuation equation is similar to
the one for bonds. What are the cash flows that
a corporation will provide to its stockholders?
• To answer that question, think of yourself as an
investor who purchases the stock of a
company that is expected to exist indefinitely
(e.g., GE). You intend to hold it (in your family)
forever.
Expected Dividends As The Basis
For Stock Values
• In this case, all you (and your heirs) will receive
is a stream of dividends, and the value of the
stock today can be calculated as the present
value of an infinite stream of dividends:
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Constant
ConstantGrowth
GrowthStocks
Stocks
• Still, for many companies it is reasonable to
predict that dividends will grow at a constant
rate. In this case, Equation 9.1 may be
rewritten as follows:
Constant
ConstantGrowth
GrowthStocks
Stocks
• The last term of Equation 9.2 is the constant
growth, or Gordon, model, named after Myron
J. Gordon, who did much to develop and
popularize it.
• The term rs in Equation 9.2 is the required rate
of return, which is a riskless rate plus a risk
premium. However, we know that if the stock is
in equilibrium, the required rate of return must
equal the expected rate of return, which is the
expected dividend yield plus an expected
capital gains yield.
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Constant
ConstantGrowth
GrowthStocks
Stocks
• So we can solve Equation 9.2 for rs, but now
using the hat to indicate that we are dealing
with an expected rate of return:
Illustration Of A Constant Growth
Stock
• Table 9.1 presents an analysis of Keller
Medical Products' stock as performed by a
security analyst after a meeting for analysts
and other investors presided over by Keller’s
CFO. The table looks complicated, but it is
really quite straightforward.
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Illustration Of A Constant Growth
Stock
• The discounted dividend model as expressed
in Equation 9.2 shows that, other things held
constant, a higher value for D1 increases a
stock’s price. However, Equation 9.2 shows
that a higher growth rate also increases the
stock’s price. But now recognize the following:
• Dividends are paid out of earnings.
• Therefore, growth in dividends requires growth in
earnings.
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Illustration Of A Constant Growth
Stock
• Earnings growth in the long run occurs primarily
because firms retain earnings and reinvest them in
the business.
• Therefore, the higher the percentage of earnings
retained, the higher the growth rate.
Which Is Better: Current Dividends
Or Growth?
• Logically, shareholders should prefer for the
company to retain more earnings (hence pay
less current dividends) if the firm has
exceptionally good investment opportunities;
however, shareholders should prefer a high
payout if investment opportunities are poor.
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Valuing Non-constant Growth Stocks
• Supernormal (Non-constant) Growth. The
part of the firm’s life cycle in which it grows
much faster than the economy as a whole.
Valuing
ValuingNon-constant
Non-constantGrowth
GrowthStocks
Stocks
• For many companies, it is not appropriate to
assume that dividends will grow at a constant
rate. Indeed, most firms go through life cycles
where they experience different growth rates
during different parts of the cycle. In their early
years, most firms grow much faster than the
economy as a whole; then they match the
economy’s growth; and finally they grow at a
slower rate than the economy.
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Valuing
ValuingNon-constant
Non-constantGrowth
GrowthStocks
Stocks
• Horizon (Terminal) Date. The date when the
growth rate becomes constant. At this date, it is
no longer necessary to forecast the individual
dividends.
• Horizon (Continuing) Value. The value at the
horizon date of all dividends expected
thereafter.
Valuing
ValuingNon-constant
Non-constantGrowth
GrowthStocks
Stocks
• First, we assume that the dividend will grow at
a non-constant rate (generally a relatively high
rate) for N periods, after which it will grow at a
constant rate, g. N is often called the horizon,
or terminal, date. Second, we can use the
constant growth formula, Equation 9.2, to
determine what the stock’s horizon, or
continuing, value will be N periods from today:
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Valuing
ValuingNon-constant
Non-constantGrowth
GrowthStocks
Stocks
• To value non-constant growth stocks, we go
through the following three steps:
• Find the PV of each dividend during the period of
non-constant growth and sum them.
• Find the expected stock price at the end of the non-
constant growth period. At this point it has become
a constant growth stock, so it can be valued with
the constant growth model. Discount this price back
to the present.
• Add these two components to find the stock’s
intrinsic value.
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Preferred
PreferredStock
Stock
• Preferred stock is a hybrid—it is similar to a
bond in some respects and to common stock in
others. This hybrid nature becomes apparent
when we try to classify preferred stock in
relation to bonds and common stock. Like
bonds, preferred stock has a par value and a
fixed dividend that must be paid before
dividends can be paid on the common stock.
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Preferred
PreferredStock
Stock
• However, the directors can omit (or “pass”) the
preferred dividend without throwing the
company into bankruptcy. So although
preferred stock calls for a fixed payment like
bonds, skipping the payment will not lead to
bankruptcy.
References
• Brigham, Eugene F., Houston, Joel F. (2019, 2016)
Fundamentals of Financial Management 15th Edition,
Cengage
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