8.Equity Markets and Stock Valuation

Question 1

Introduction to Share Markets

Answer 1

• Primary markets
o Companies and governments raise capital by selling newly issued securities.
• Secondary markets
• Existing securities are traded among the market participants.
• Dealers
• Dealers buy (at bid price) and sell (at ask price) on their own account.
• The spread between bid and ask price is the dealer’s profit.
• Brokers
• Brokers act as intermediary and bring investors together.
• Brokers arrange transactions by matching buy and sell orders.

Question 2

The two main forms of shares are

Answer 2

• Common shares and

* Preferred shares

Question 3

Features of common shares

Answer 3

Voting rights
• At the annual shareholders’ meeting shareholders elect directors / supervisory board members who hire management and oversee their major decisions. Thereby shareholders control the corporation.
• “One share - one vote” principle
Proxy voting
• Grant voting authority to another party.
• Proxy fights: a battle at the directors’ election.
(Minority) shareholders try to replace management by obtaining as many proxy votes as possible.

Classes of share
o Companies often have different classes of stock.
o They often have unequal voting rights.
o The rationale is keeping control of the firm (i.e. the voting power to remain with a certain group).
o Contradicts the one share - one vote principle.
Other Rights
o Share proportionally in declared dividends.
o Share proportionally in remaining assets during liquidation / bankruptcy.
o Preemptive right – new share issue has to be offered first to existing shareholders to maintain proportional ownership if desired.

• Payment of dividends / plowback amount: management and board of directors give a recommendation. The final decision is taken at the annual shareholders’ meeting.*
• Dividends are not a liability of the firm until a dividend has been declared. Consequently, a firm cannot go bankrupt for not declaring dividends.
• Dividends and Taxes
o Dividend payments are not considered a business expense,
therefore, they are not tax-deductible.
o Dividends received by individuals have historically been taxed as ordinary income (but tax treatment varies by country).

Question 4

Features of preferred shares

Answer 4

• Preferred share has preference over common share,
o in the payment of dividends, and
o in the distribution of assets in the event of default.
o Preferred stock often promises a fixed dividend forever.
• Preferred dividends
o Dividends must be paid before any dividends can be paid to common
shareholders.
o Dividends are not a liability of the firm and preferred dividends can be deferred indefinitely (independently from net income).
o Most preferred dividends are cumulative – any missed preferred dividends have to be paid before common dividends can be paid.
• Preferred share generally does not carry voting rights.
 However, if preferred dividends are missed for some time preferred shareholders are often granted voting rights

Question 5

Share Valuation

Answer 5

If you own a share, you can receive cash in two ways
o The company pays dividends
o You sell your shares (either to another investor in the market or back to the company)
o As with bonds or any other investments, the value of the share is the present value of these expected cash flows.

Question 6

Dividend Models

Answer 6

1. Constant dividend (zero growth)
   • The firm will pay a constant dividend forever.
   • The price is computed using the perpetuity formula.
   • Example: preferred share
2. Constant dividend growth
   • The firm will increase the dividend by a constant percent every period.
3. Nonconstant growth
   • Divide the forecast into 2 periods: Dividend growth varies in the first period, but settles down to constant growth eventually.