Chapter 7: equity valuation Flashcards
Equity securities
ownership interests in an underlying entity, usually a corporation
no fixed maturity date
pay dividends from after-tax earnings, so, unlike interest payments, they do not provide the issuer with a tax-deductible expense
we have to pay higher taxes on interest or dividend income?
interest income
the most common type of equity security
the common share
the common share
represents a certificate of ownership in a corporation
true “owners” of the corporation
Common shareholders
residual claimants of the corporation
–> entitled to income remaining only after all creditors and preferred shareholders have been paid
–> in the case of liquidation of the corporation, common shareholders are entitled to the remaining assets only after all other claims have been satisfied
can exert control over the corporation through their power to vote, which allows them to elect the board of directors and to vote on major issues, such as takeovers, corporate restructuring, and so on
preferred shares
provide the owner with a claim to a fixed amount of equity that is established when the shares are first issued
have preference over common shares with respect to income and assets (in the event of liquidation)
they rarely have any voting rights
maturity date of a preferred share
Traditionally, preferred shares have no maturity date, but over the past 30 years preferred shares have increasingly been issued with a fixed maturity date
The main difference between preferred shares and bonds
the board of directors declares any dividends
–> dividends are not a legal obligation of the firm until that declaration is made
The discount rate for equities when valuing equities
risk-free rate of return plus a risk premium
k = RF + Risk premium
k = the required return on an equity security
RF = the risk-free rate of return
what yield do we use for our discount rate when valuing equities?
why?
many analysts use long-term Canada bond yields as the risk-free rate
–> besause the use of a short-term interest rate often introduces problems, since it is directly affected by the Bank of Canada’s monetary policy
The risk premium will be based on an estimate of the risk associated with the security; the higher the risk, the higher the risk premium
the dividend declaration date
he date on which the board of directors decides that the firm will pay a dividend
–> after this declaration, the company is legally obliged to pay a dividend
holder of record
person who officially owns a share or shares on a given date
–> whoever is the owner “of record” of the company’s shares on this given date, will be entitled to receive the dividend
ex-dividend date
date after which shares trade without the right of the purchaser to receive a dividend
–> usually two business days before the holder of record date
if you sell before the date, you will not receive dividend
if you sell on that date or in between the two days prior to the holder of record date, you will be entitled to dividends
why is dividend tax rate lower?
because corporations already payed taxes before issuing the dividends
special dividend
a dividend over and above a firm’s normal dividend that the BOD indicates is not likely to be repeated
dividend reinvestment plan (DRIP)
If the investor does not want to receive a dividend, many Canadian firms offer the option of using the cash dividend proceeds to buy new shares
DRIPs will buy as many shares as the cash dividend allows, with the residual deposited as cash
benefits of DRIPs 😳😳 for companies
shares are issued continuously at no cost, while they are also seen to be paying a regular dividend
foster a more ongoing relationship with investors
–>
benefits of DRIPs 😳😳 for investors
the automatic reinvestment averages their investment, since they are buying shares at a range of prices
also removes the problem of accumulating funds to reinvest
odd lots of shares
groups of shares that are purchased in odd-numbered lots instead of in multiples of 100
a stock dividend
a dividend paid in additional shares rather than cash
In terms of accounting, it is treated like a regular cash dividend
limited by the amount of retained earnings available
there is a lower-than-25-percent increase in the number of shares outstanding
investors face tax implications
one significant difference between a cash dividend plus DRIP and a stock dividend
With the cash dividend plus DRIP, the cash is distributed first, and it is up to the investors to decide whether they want to buy more shares
–> Regardless of the investors’ decisions, the firm has to have the cash to make the distribution
on the other hand, firms often do not have the cash and simply issue a stock dividend to give the investor “something”
