Chapter 8: Stock Valuation Flashcards
In practice, it is more difficult to value a share of common stock than a bond for at least _______ reasons
three (3)
3 reasons as to why it is harder to value common stock than bonds
First, not even the promised cash flows are known in advance.
Second, the life of the investment is essentially forever because common stock has no maturity.
Third, there is no way to easily observe the rate of return that the market requires
Calculating the value of a share today
P0 = (D1 + P1) / (1 + r)
P0 = Current price of stock P1 = Price in one period D1 = Cash dividend paid at the end of the period r = Required return in the market
Importantly, no matter what the stock price is, the present value is essentially _____ if we push it far enough away
zero
We have illustrated here that the price of the stock today is equal to the present value of all the future dividends. How many future dividends are there? discount them all
In principle, there can be an infinite number. This means we still can’t compute a value for the stock because we would have to forecast an infinite number of dividends and then
Assuming there will be future dividends, there are three cases to consider regarding their patterns, what are they?
(1) the dividend has a zero-growth rate,
(2) the dividend grows at a constant rate, and (3) the dividend grows at a constant rate after some length of time.
Zero Growth
Since the dividend is always the same, the stock can be viewed as an ordinary perpetuity with a cash flow equal to D every period
A share of common stock in a company with a constant dividend is much like a share of _________ stock
preferred
Zero Growth Stock Formula (equation)
P0 = D / r
D = Dividend (which is always the same, aka perpetuity)
r = Required return
Constant Growth
a
Why would the dividend grow at a constant rate?
The reason is that, for many companies steady growth in dividends is an explicit goal
Dividend aristocrats
Such companies with a policy of consistently increasing dividends every year for a specific period of time
**In Canada, the time frame to attain dividend aristocrat status is five consecutive years of dividend increases
Dividend Growth Model
A model that determines the current price of a stock as its dividend next period, divided by the discount rate, less the dividend growth rate.
We can actually use the dividend growth model to get the stock price at any point in time, not just today. In general, the price of the stock as of time t is:
(equation)
Pt = (D1 x (1 + g) / r - g) = (Dt + 1) / (r - g)
If growth rate, ‘g’, is larger than the discount rate, ‘r’
You do not get a negative stock price!
Rather, is g>r than the stock price is infinitely large
Therefore, the dividend growth model should not be used unless the growth rate is less than the discount rate (g < r)
Non-Constant Growth
The main reason to consider this is to allow for supernormal growth rates over some finite length of time
To avoid the problem of having to forecast and discount an infinite number of dividends, we assume that the dividends start growing at a constant rate sometime in the future
Critics raise two points about the dividend growth model
First, in the late 1990s, the level of the market, and especially tech stocks, was far higher than the present value of expected dividends.
Second, market prices are far more volatile than the present value of dividends
Rearranging P0 = D1 / r - g to solve for r (equation)
r - g = D1 / P0
ORRRR
r = (D1 / P0) + g
Dividend Yield
A stock’s cash dividend divided by its current price. (D1 / P0)
Capital Gains Yield
The dividend growth rate or the rate at which the value of an investment grows.
So variable ‘g’
Dividend Growth Model Calculates Total Return as
r = Dividend Yield + Capital Gains Yield
or, in Math Formate
r = (D1 / P0) + g
Reference P/E ratio / Benchmark
Pt = Benchmark P/E Ratio x EPSt
Pt = Price at a time EPS = Earning per share
“forward” P/E ratio
A P/E ratio that is based on estimated future earnings
For example, suppose you felt that Aphria’s earnings for the coming year were going to be $0.79, reflecting its growing customer base.
In this case, if the current stock price is $15.05, the forward P/E ratio is $15.05 / $ 0.79 = 19
Preferred stock
- Stock with dividend priority over common stock,
- Normally with a fixed dividend rate
- Often without voting rights, no voting options, but can
- If company is liquidated, preferred stock gets the share of the assets first over common stock (still placed behind all creditors)
- Is a form of Equity from a legal, tax and regulatory standpoint
Stated Value
Preferred shares have a stated liquidating value. The cash dividend is described in dollars per share or as a percentage of the stated value
For example, Bank of Montreal’s fixed quarterly dividend of “$0.275” translates easily into an annual dividend yield of 4.4% of the $25 stated share value.
Dividends payable on preferred stock are either ________________________
cumulative or non-cumulative
**But most are cumulative
Arrearage
A legal term for the part of a debt that is overdue after missing one or more required payments.
What does it mean is the preferred stock are cumulative?
If a company is to not pay dividends one year, than it will carry over to the next year to be paid (known as arrearage)! Therefore, there is always dividends to be paid.
Usually both the cumulated (past) preferred dividends plus the current preferred dividends must be paid before the common shareholders can receive anything.
Directors elected by the common shareholders can defer preferred dividends indefinitely. However, in such cases:
1) Common shareholders must also forgo dividends.
2) Holders of preferred shares are often granted voting and other rights if preferred dividends have not been paid for some time.
Do preferred dividends receive interest?
No, this may be why some delay paying preferred dividends
Are preferred stocks callable?
are often callable by the issuer and the holder often has the right to sell the preferred stock back to the issuer at a set price
Are preferred stocks convertible?
Sometimes they are convertible into common stocks
The price of a share can be derived using the Zero Growth Formula, exmaple
Therefore if given stock information:
P0 = D / r
AKA divide the dividend by the Yield and the stock price is calculated
CARP
cumulative, adjustable-rate preferred stock
This is basically a preferred stock with adjustable dividends (aka dividends set to two-third of the bank’s average Canadian Prime Rate)
Tax loophole
Encourages corporations that are lightly taxed or not taxable due to losses or tax shelters to issue preferred stock
Why would a company use a tax loophole?
They can issue preferred stock and enjoy lower financing costs because preferred dividends are significantly lower than interest payments
Fully taxed firms reasons for issuing preferred stock
First, firms issuing preferred stock can avoid the threat of bankruptcy that might otherwise exist if debt were relied on. Unpaid preferred dividends are not debts of a corporation, and preferred shareholders cannot force a corporation into bankruptcy because of unpaid dividends.
A second reason for issuing preferred stock concerns control of the firm. Since preferred shareholders often cannot vote, preferred stock may be a means of raising equity without surrendering control.
Common Stock
Equity without priority for dividends or in bankruptcy
aka no special preference either in dividends or bankruptcy
Who does the board of directors hire?
The managers to run the company
How many votes does each shareholder get?
One share = one vote
10 shares = 10 votes
Are firms legally required to follow recommended best practices from the Dey Report published in 1994?
Canadian firms are legally required to disclose whether or not they wish to comply with a recommendation of best practices put forth in the Dey Report published in 1994, but they are not legally mandated to follow the recommendations
Proxy contest
is essentially a fight for shareholder votes between parties attempting to control the corporation
“Say on pay” policies
give their shareholders a voice in determining executive pay packages through an advisory and non-binding vote on executive compensation
Canadian Business Corporations Act:
1) The right to share proportionally in dividends paid.
2) The right to share proportionally in assets remaining after liabilities have been paid in a liquidation.
3) The right to vote on shareholder matters of great importance, such as a merger, usually done at the annual meeting or a special meeting.
* 4) Preemptive right - only sometimes applicable
Preemptive right
Means that a company wishing to sell stock must first offer it to the existing shareholders before offering it to the general public. The purpose is to give a shareholder the opportunity to protect his or her proportionate ownership in the corporation.
So if Sally owns 20% of a company, she will want to continue to have that percentage if new shares are issues
Dividends definition
Dividend definition
Return on capital of corporation paid by company to shareholders in either cash or stock; payments made out of a firm’s earnings to its owners, either in cash or stock.
When must dividends be paid?
As for common stock, there is no set answer.
It is at the discretion of the board of directors
Some important characteristics of dividends include the following:
1) Unless a dividend is declared by the board of directors of a corporation, it is not a liability of the corporation. A corporation cannot default on an undeclared dividend. As a consequence, corporations cannot become bankrupt because of nonpayment of dividends. The amount of the dividend, and even whether it is paid at all, are decisions based on the business judgment of the board of directors.
2) The payment of dividends by the corporation is not a business expense. Dividends are not deductible for corporate tax purposes. In short, dividends are paid out of after-tax profits of the corporation.
3) Dividends received by individual shareholders are partially sheltered by a dividend tax credit. Corporations that own stock in other corporations are permitted to exclude 100% of the dividend amounts they receive from taxable Canadian corporations. The purpose of this provision is to avoid the double taxation of dividends.
Do dividends differ from voting shares to non-voting shares?
Non-voting shares must receive dividends no lower than dividends on voting shares
Therefore, they can be higher than voting shares, but never lower
Coattail provision
- Primary reason as to why duel classes of stock are created
- If a takeover bid of the company was to come in (As in they would purchase the entire company and all the shares), non-voting shares would be left out of this decision.
- To protect non-voting shares, the coattail effect which gives non-voting shareholders either the right to vote or to convert their shares into voting shares that can be tendered to the takeover bid
When looking at the TSX, how to read the stock
1) Company = the business dumb ass
2) Symbol = The name for the business in short
3) Volume = The number of shares that moved hands that day (not the total number of shares)
4) Close = the price at which the share closed at
Net Change = Equals how much higher or lower it closed at when comparing the day before
Cash Cow
A company with a level stream of earnings per share in perpetuity and the company pays all these earnings out to shareholders as dividends
EPS = Div
NPVGO
Net present value (per share) of the growth opportunity.
Value of a share of stock when firm acts as a cash cow (equation)
EPS / r = Div / r
Where r = discount rate on a share of stock
Stock price after firm commits to new project (equation)
(EPS / r) + NPVGO
The first term (EPS/r) is the value of the firm if it rested on its laurels; that is, if it simply distributed all earnings to the shareholders.
The second term is the additional value if the firm retains earnings to fund new projects.
Dividing by EPS Yields
Price per share / EPS = (1 / r) + (NPVGO / EPS)
The left-hand side is the formula for the price–earnings ratio.
Proxy definition
Grant of authority by shareholder allowing for another individual to vote his or her shares.
Straight voting
Procedure where a shareholder may cast all votes for each member of the board of directors.
Capital Market Efficiently - Chapter 12.6 Information
Chapter 12.6 Information
In an efficient market
Current prices fully reflect available information (price adjust quickly and correctly to new information)
-Stock prices are in equilibrium and are “fairly” priced
-Investments should generally have NPV’s = 0 (stock
price already reflects all the market information)
- If efficiency occurs, you should not be able to earn “abnormal” returns
- Do not imply that investors cannot earn a positive return in the stock market
What makes markets efficient?
- Many investors about there doing research (our brokers)
- As new information comes to market, this information is analyzed and trades are more based on this information
- Therefore, prices should reflect all available public information
- If investors stop researching stocks, then the market will not be efficient
Reaction to new informtation
Red line = price of share ticking at various time periods
- As investors conduct research, the line will change. If the line increase, aka price goes up, positive information was received
- If the red line goes down than the price goes down and bad information was received
- The market only goes to time 0 as we cannot predict the future, so we will always stay at 0 and change our line indefinitely when new information is received, assuming no more information will come
- Therefore, at time 0, sometimes the market will provide information too good so everyone buys into the share, which can make it no longer efficient, making it artificially inflated, this is an OVERREACTION
- There is either a delayed reaction or an over reaction and than a correction
Reaction to new informtation
Red line = price of share ticking at various time periods
- As investors conduct research, the line will change. If the line increase, aka price goes up, positive information was received
- If the red line goes down than the price goes down and bad information was received
- The market only goes to time 0 as we cannot predict the future, so we will always stay at 0 and change our line indefinitely when new information is received, assuming no more information will come
- Therefore, at time 0, sometimes the market will provide information too good so everyone buys into the share, which can make it no longer efficient, making it artificially inflated, this is an OVERREACTION
- There is either a delayed reaction or an over reaction and than a correction
A delayed reaction will take some extra time. So the line will gently bein to rise at a 45 degree angle
An over reaction will cause the line to shoot up, at a 90 degree angle, and then begin to low at a 45 degree reaction until the market it efficient
Efficient market hypothesis = red line
Capital market history
suggests that the market values of stocks and bonds can fluctuate widely from year to year.
Efficient capital market
Market in which security prices reflect available information.
Efficient markets hypothesis (EMH)
The hypothesis is that actual capital markets, such as the TSX, are efficient.
An advocate of EMH might argue that while inefficiencies may exist, they are insignificant and not common
When a market is efficient
- investments in an efficient market are zero-NPV investments
- investors get exactly what they pay for when they buy securities, and firms receive exactly what their stocks and bonds are worth when they sell them.
Are all markets the same?
For example, financial markets on the whole are probably much more efficient than real asset markets
Efficiency implies
that the price a firm obtains when it sells a share of its stock is a fair price in the sense that it reflects the value of that stock given the information available about it
Three forms of market efficiency (3)
1) Weak form efficient
2) Semistrong form efficient
3) Strong form efficient
Strong form efficient
- Then all information of every kind is reflected in stock prices.
- In such a market, there is no such thing as inside information
- Absolute transparency
Semistrong efficiency
Semi strong efficiency
Semi-strong efficiency
- The most controversial
- all public information is reflected in the stock price
- Controversial as a analyst who may be looking for mispriced stock is wasting their time as everything is already reflected in their public financial statements
- no matter what publicly available information mutual fund managers rely on to pick stocks, their average returns should be the same as those of the average investor in the market as a whole
Weak form efficiency
-At a minimum, the current price of a stock reflects its own past prices
-studying past prices in an attempt to identify mispriced securities is futile if the market is weak form efficient
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