CH8 Flashcards
What does common stock represent?
Ownership in a company with voting rights and claim to future earnings.
Who has control in a corporation?
Shareholders → Elect board of Directors → Appoint Managers.
What is the principal-agent problem?
Managers may act in their own interest instead of maximizing shareholder value.
What is a proxy fight?
A battle where an outside group tries to take control by getting shareholders’ votes.
What are dual-class shares?
Some stocks have more voting power (super-voting) or none at all (restricted voting).
What is the preemptive right?
The right to buy new shares before outsiders to prevent dilution.
What is preferred stock?
A hybrid security that pays fixed dividends but lacks voting rights.
Why do some firms use dual-class shares?
To allow founders or insiders to retain control over the company.
What are the main stock types?
Common stock: Voting, dividends vary. Preferred stock: No voting, fixed dividends.
Why might investors prefer growth stocks?
High potential price increase, reinvested earnings, minimal dividends.
What determines a stock’s intrinsic value?
The present value of expected future cash flows (dividends, price appreciation).
What does the Dividend Discount Model (DDM) assume?
That stock price = present value of future dividends.
What’s the intrinsic value formula for constant growth stocks? DDM
P0 = D1 / (rs - g)
What happens if the growth rate (g) is greater than required return (r_s)? On the DDM formula
The DDM breaks down (infinite stock price).
What is the relationship between stock price and required return?
Higher rs → Lower stock price, and vice versa.
What is the Free Cash Flow (FCF) method used for?
Valuing firms that do not pay dividends by estimating total firm value.
What is the formula for firm value using FCF?
V = ∑ (FCFt / (1+WACC)^t)
How do we find stock price from firm value?
Stock Price = (Firm Value - Debt) ÷ Shares Outstanding
What is Market Multiple Valuation?
Comparing stock value using industry averages (P/E, EV/EBITDA, etc.).
What’s a major weakness of market multiple valuation?
Hard to find perfect comparable firms, as ratios can vary widely.
What is a dividend yield?
Dividend Yield = D1 / P0 (How much dividend income a stock pays relative to price).
What is a capital gains yield?
Capital Gains Yield = (P1 - P0) / P0 (Stock price increase percentage).
What is total expected return?
Total Return = Dividend Yield + Capital Gains Yield
What happens to stock price if dividends increase?
Stock price rises, assuming all else stays constant.
What type of stock pays little to no dividends?
Growth stocks (e.g., Amazon, Tesla).
What’s the key difference between common and preferred stock?
Common stock: Voting rights, dividends vary. Preferred stock: No voting, fixed dividends.
What is the formula for preferred stock valuation?
P0 = D / r (Like a perpetuity).
Why are preferred stocks considered “hybrids”?
Like bonds: Fixed payments. Like stocks: No maturity date.
Can a company delay preferred stock dividends?
Yes, but they must be paid before common stock dividends.
Do preferred stocks get voting rights?
No, unless specified in special cases.
What does the Efficient Market Hypothesis (EMH) state?
Stock prices instantly reflect all available information.
What are the three forms of EMH?
Weak: Past prices don’t predict future. Semi-strong: All public info is priced in. Strong: Even insider info is priced in.
What does EMH say about “beating the market”?
It’s impossible without insider information.
What type of investing does EMH support?
Index funds & passive investing (because active trading doesn’t work long-term).
Why do some investors reject EMH?
Markets can be irrational (bubbles, crashes).
A stock just paid a $2 dividend, expects 5% growth, and has a required return of 10%. What is its price?
P0 = 2.10 / (0.10 - 0.05) = 42
A stock’s P/E ratio is 20 and its EPS is $3. What is its stock price?
P = P/E × EPS = 20 × 3 = 60
What happens to the stock price if required return rises?
Stock price drops, as higher returns make it less attractive.
A stock has a total expected return of 12%, dividend yield of 4%. What is the capital gains yield?
8% (Total return = Dividend Yield + Capital Gains Yield → 12% - 4%)
What is the value of a preferred stock that pays a $5 dividend and has a required return of 8%?
P0 = 5 / 0.08 = 62.50
Why are index funds popular?
They track the market without needing to “beat” it.
How does the market react to new public information?
Prices adjust instantly (Semi-Strong EMH).
What kind of stocks do risk-averse investors prefer?
Dividend stocks (stable returns, lower risk).
What kind of stocks do risk-tolerant investors prefer?
Growth stocks (higher risk, higher return).
What does a high P/E ratio indicate?
Investors expect strong future growth.
What is a stock buyback?
A company repurchases its own shares, reducing supply & increasing price.
What causes stock price bubbles?
Irrational speculation and overconfidence.
What does it mean when a stock is “undervalued”?
Its intrinsic value > market price → Buy signal!
What does it mean when a stock is “overvalued”?
Its intrinsic value < market price → Sell signal!
Why are high-growth companies often unprofitable?
They reinvest earnings instead of paying dividends.
for the firm value formula, the free cashflow that you put on top is it year 0? or year1?
year 1. if we are given the current free cashflow then we need to grow it to the next period and then use the growing perpetuity formula
