Chapter 20 and 4 Stock and Stock Valuation

Chapter 20 and 4 Stock and Stock Valuation

Common Stock and Its Features Common Stock – Securities that represent the ultimate ownership (and risk) position in a corporation. Basic Terms Authorized Shares Issued Shares Outstanding Shares Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1 -2

Types of Common Stock Value A. • • Par Value – The face value. It is merely a recorded figure in the corporate charter and is of little economic consequence. Stock should never be issued below par value as shareholders would be legally liable for any discount from par if the firm is liquidated. Common stock that is authorized without par value (no-par stock) is carried on the books at the original market price or at some assigned (or stated) value. The difference between the issuing price and the par or stated value is additional paid-in capital Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1 -3

Example of Value Fun. Fin. Man, Inc. Common stock ($1 par value; value 100, 000 shares issued and outstanding) $ 100, 000 Additional paid-in capital 400, 000 Retained earnings 650, 000 Total shareholders’ equity $1, 150, 000 The par value of Fun. Fin. Man, Inc. , is $1 per share This value is not likely to change over time from normal day-today operations. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1 -4

Types of Common Stock Value B. Book Value (per share) – Shareholders’ equity (as listed on the balance sheet) divided by the number of shares outstanding. C. Liquidating Value (per share) – The value per share if the firm’s assets are sold separately from the operating organization. • This value may be less (or greater) than book value. Rarely are the two values identical. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1 -5

Example of Book Value (per share) Fun. Fin. Man, Inc. Common stock ($1 par value; 100, 000 shares issued and outstanding) $ 100, 000 Additional paid-in capital 400, 000 Retained earnings 650, 000 Total shareholders’ equity $1, 150, 000 The book value (per share) of Fun. Fin. Man, Inc. , is determined by dividing total shareholders’ equity ($1, 150, 000) by the shares outstanding (100, 000), 100, 000 which yields a book value of $11. 50 per share This value is not likely to change over time from normal day-to-day operations. 1 -6 Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Types of Common Stock Value D. Market Value (per share) – The current price at which the stock is currently trading. • • This value is usually greater than book value (per share), but can occasionally be less than book value (per share) for firms that have been, are or expected to be in financial difficulties. Rarely are the two values identical. Market value (per share) may be difficult to obtain from thinly traded securities. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1 -7

Types of Common Stock Value D. Market Value (per share) – continued. • Typically, the shares of new companies are traded in the over-the-counter (OTC) market, where dealers maintain an inventory of the stock to provide additional liquidity. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1 -8

Rights of Common Shareholders • • • Right to Income – entitled to share in the earnings of the company only if cash dividends are paid (via approval by the board of directors). Right to Purchase New Shares (Maybe) – the corporate charter of state statute may provide current shareholders with a preemptive right, which requires that these shareholders be first offered any new issue of common stock or an issue that can be converted into common stock. Voting Rights – because the shareholders are owners of the firm, they are entitled to elect the board of directors. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1 -9

Voting Rights • Shareholders are generally geographically widely dispersed. • Two methods of voting: (1) in person or (2) by proxy Proxy – A legal document giving one person(s) authority to act for another. • SEC regulates the solicitation of proxies and requires companies to disseminate information to their shareholders through proxy mailings or via the Internet effective July 2007. • Most shareholders, if satisfied with company performance, sign proxies in behalf of management. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1 -10

Proxy Contest • Occurs usually when disagreement between management and an outside or minority party • Non-management group will register its proxy statement with the SEC and will often send an alternative proxy request to shareholders • Management, due to corporate resources and organization, is generally favored to win • e. Proxies are expected to provide a more costeffective mechanism for non-management groups to communicate with shareholders and possibly reduce the management advantage. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1 -11

Voting Procedures The board of directors are elected under either: • Plurality voting – a method of electing corporate directors, where each common share held carries one vote for each director position that is open; the highest vote count wins the open director position. Does not consider “withheld” or “against” votes. • Cumulative voting – a method of electing corporate directors, where each common share held carries as many votes as there are directors to be elected and each shareholder may accumulate these votes and cast them in any fashion for one or more particular directors. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1 -12

Voting Procedures A growing election method: • Majority or Modified Plurality voting – a method of electing corporate directors, where each common share held carries one vote for each director position that is open; a majority of all votes cast must be received to be elected. • • • Common in Europe and gaining popularity due to advocacy groups in the United States Must receive a majority of “for” plus “against” plus “withheld” votes cast Approximately two-thirds of S&P 500 have adopted by Nov 2007 versus only 16% in Feb 2006 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1 -13

Voting Procedures Example You are a shareholder of Fun. Fin. Man, Inc. You own 100 shares and there are 9 director positions to be filled. • Under majority-rule voting: voting You may cast 100 votes (1 per share) for each of the 9 director positions open for a maximum of 100 votes per position. • Under cumulative voting: voting You may cast 900 votes (100 votes x 9 positions) for a single position or divide the votes amongst the 9 open positions in any manner you desire. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1 -14

Minimum Votes to Elect a Director – Cumulative Total number of Specific number of voting shares X directors sought Total number of directors to be elected + 1 +1 • For example, to elect 3 directors out of 9 director positions at Fun. Fin. Man, Inc. , (100, 000 voting shares outstanding) would require 30, 001 voting shares • (100, 000 shares) x (3 directors) + 1 = 30, 001 shares 10 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1 -15

Minimum Votes to Elect a Director – Cumulative • Notice that slightly over 30% of total voting shares are necessary to guarantee the election of three of the nine director positions – less than a majority. • Management can reduce the influence of minority shareholders by reducing the number of directors or staggering the election terms of directors so fewer positions are open at each vote. • Reducing the number of directors up for election from 9 to 4 would increase the votes necessary to elect 3 directors to 60, 001 shares (twice as many)! Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1 -16

Dual-Class Common Stock Dual-class Common Stock – Two classes of common stock, usually designated Class A and Class B. Class A is usually the weaker voting or nonvoting class, and Class B is usually the stronger. • This is used to retain control for founders, management, or some other specific group. • For example, 80, 000 shares of Class A at $20/share and 200, 000 shares of Class B at $2/share. Class A puts up 80% of the funds, but Class B has over 70% of the votes. • Usually Class B takes a lower claim to dividends and assets than Class A for this voting control. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1 -17

Common Stock Valuation Common stock represents a residual ownership position in the corporation. • Pro rata share of future earnings after all other obligations of the firm (if any remain). • Dividends may be paid out of the pro rata share of earnings. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1 -18

Common Stock Valuation What cash flows will a shareholder receive when owning shares of common stock? stock (1) Future dividends (2) Future sale of the common stock shares Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1 -19

Dividend Valuation Model Basic dividend valuation model accounts for the PV of all future dividends. Div 1 V= (1 + ke =S t=1 )1 + Div 2 (1 + ke Divt (1 + ke)t Copyright © 2011 Pearson Prentice Hall. All rights reserved. )2 +. . . + (1 + ke) Divt: Cash Dividend at time t k e: Equity investor’s required return 1 -20

Adjusted Dividend Valuation Model The basic dividend valuation model adjusted for the future stock sale. V= Div 1 (1 + ke n: Pricen: )1 + Div 2 (1 + ke Divn + Pricen )2 +. . . + (1 + ke)n The year in which the firm’s shares are expected to be sold. The expected share price in year n. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1 -21

Dividend Growth Pattern Assumptions The dividend valuation model requires the forecast of all future dividends. The following dividend growth rate assumptions simplify the valuation process. Constant Growth No Growth Phases Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1 -22

Constant Growth Model The constant growth model assumes that dividends will grow forever at the rate g. V= = D 0(1+g) (1 + ke D 1 (ke - g) )1 + D 0(1+g)2 (1 + ke )2 +. . . + D 0(1+g) (1 + ke) D 1: Dividend paid at time 1. g: The constant growth rate. k e: Investor’s required return. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1 -23

Constant Growth Model Example Stock CG has an expected dividend growth rate of 8%. Each share of stock just received an annual $3. 24 dividend. The appropriate discount rate is 15%. What is the value of the common stock? stock D 1 = $3. 24 ( 1 + 0. 08 ) = $3. 50 VCG = D 1 / ( ke - g ) = $3. 50 / (0. 15 - 0. 08 ) $50 Copyright © 2011 Pearson Prentice Hall. All rights reserved. = 1 -24

Zero Growth Model The zero growth model assumes that dividends will grow forever at the rate g = 0. VZG = = D 1 (1 + ke D 1 ke )1 + D 2 (1 + ke )2 +. . . + D (1 + ke) D 1: Dividend paid at time 1. k e: Investor’s required return. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1 -25

Zero Growth Model Example Stock ZG has an expected growth rate of 0%. Each share of stock just received an annual $3. 24 dividend per share. The appropriate discount rate is 15%. What is the value of the common stock? stock D 1 = $3. 24 ( 1 + 0 ) = $3. 24 VZG = D 1 / ( ke - 0 ) = $3. 24 / (0. 15 - 0 ) = $21. 60 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1 -26

Growth Phases Model The growth phases model assumes that dividends for each share will grow at two or more different growth rates. n V =S t=1 D 0(1 + g 1)t (1 + ke)t Copyright © 2011 Pearson Prentice Hall. All rights reserved. + Dn(1 + g 2)t S t=n+1 (1 + ke)t 1 -27

Growth Phases Model Note that the second phase of the growth phases model assumes that dividends will grow at a constant rate g 2. We can rewrite the formula as: n V =S t=1 D 0(1 + g 1)t (1 + ke)t Copyright © 2011 Pearson Prentice Hall. All rights reserved. Dn+1 + (1 + ke)n (k – g 2) 1 e 1 -28

Growth Phases Model Example Stock GP has an expected growth rate of 16% for the first 3 years and 8% thereafter. Each share of stock just received an annual $3. 24 dividend per share. The appropriate discount rate is 15%. What is the value of the common stock under this scenario? Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1 -29

Growth Phases Model Example 0 1 2 3 4 5 6 D 1 D 2 D 3 D 4 D 5 D 6 Growth of 16% for 3 years Growth of 8% to infinity! Stock GP has two phases of growth. The first, 16%, starts at time t=0 for 3 years and is followed by 8% thereafter starting at time t=3. We should view the time line as two separate time lines in the valuation. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1 -30

Growth Phases Model Example 0 0 1 2 3 D 1 D 2 D 3 1 2 3 Growth Phase #1 plus the infinitely long Phase #2 4 5 6 D 4 D 5 D 6 Note that we can value Phase #2 using the Constant Growth Model Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1 -31

Growth Phases Model Example D 4 V 3 = k-g 0 1 2 We can use this model because dividends grow at a constant 8% rate beginning at the end of Year 3. 3 4 5 6 D 4 D 5 D 6 Note that we can now replace all dividends from year 4 to infinity with the value at time t=3, V 3! Simpler!! Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1 -32

Growth Phases Model Example 0 0 1 2 3 D 1 D 2 D 3 1 2 3 New Time Line Where V 3 D 4 V 3 = k-g Now we only need to find the first four dividends to calculate the necessary cash flows. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1 -33

Growth Phases Model Example Determine the annual dividends. D 0 = $3. 24 (this has been paid already) D 1 = D 0(1 + g 1)1 = $3. 24(1. 16)1 =$3. 76 D 2 = D 0(1 + g 1)2 = $3. 24(1. 16)2 =$4. 36 D 3 = D 0(1 + g 1)3 = $3. 24(1. 16)3 =$5. 06 D 4 = D 3(1 + g 2)1 = $5. 06(1. 08)1 =$5. 46 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1 -34

Growth Phases Model Example 0 1 2 3 3. 76 4. 36 5. 06 0 1 2 Actual Values 3 78 Where $78 = 5. 46 0. 15– 0. 08 Now we need to find the present value of the cash flows. Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1 -35

Growth Phases Model Example We determine the PV of cash flows. PV(D 1) = D 1(PVIF 15%, 1) = $3. 76 (0. 870) = $3. 27 PV(D 2) = D 2(PVIF 15%, 2) = $4. 36 (0. 756) = $3. 30 PV(D 3) = D 3(PVIF 15%, 3) = $5. 06 (0. 658) = $3. 33 P 3 = $5. 46 / (0. 15 - 0. 08) = $78 [CG Model] PV(P 3) = P 3(PVIF 15%, 3) = $78 (0. 658) = $51. 32 Copyright © 2011 Pearson Prentice Hall. All rights reserved. 1 -36

Growth Phases Model Example Finally, we calculate the intrinsic value by summing all of cash flow present values. V= $3. 27 + $3. 30 + $3. 33 + $51. 32 V = $61. 22 3 D 0(1 +0. 16)t V=S t (1 +0. 15) t=1 Copyright © 2011 Pearson Prentice Hall. All rights reserved. + 1 D 4 (1+0. 15)n (0. 15– 0. 08) 1 -37