Lesson 2: Equity

Question 1

How do you value preferred shares?

Answer 1

Perpetuity Formula

Question 2

How do you value common shares?

Answer 2

Dividend discount model (one and two stage)

Question 3

What are the stock-like features of preferred shares?

Answer 3

No maturity date, pays a dividend

Question 4

What are the bond-like features of preferred shares?

Answer 4

Fixed dividend, essentially a perpetual bond

Question 5

Do preferred shares have voting rights?

Answer 5

No

Question 6

In bankrupcty when are preferred stock paid in relation to common stock and debt?

Answer 6

Debt, then preferred stock, then common stock

Question 7

What is the simplified price formula for preferred shares?

Answer 7

Price = Div / rps
rps = requried rate of return for preferred shares

Question 8

What is a Seasoned Equity Offering?

Answer 8

The sale of additional shares after the IPO

Question 9

What are the three estimates that we need to make in a single-stage DDM?

Answer 9

1. Div1 (first future dividend an equity investor is expected to receive
2. re (required return by equity holders)
3. g (constant rate of growth in dividends in perpetuity

Question 10

How do you estimate “g”?

Answer 10

Using the firm’s sustainable growth rate as a proxy

Question 11

What is a sustainable growth rate?

Answer 11

A company’s max rate of growth that can be achieved using internally generated funds

Question 12

What does the sustainable growth rate depend on?

Answer 12

1. Return on Equity
2. Retention Ratio (1-Payout Ratio)

Question 13

What is the ROE formula?

Answer 13

Net Income / Book Value of Equity

Question 14

What does “g” represent?

Answer 14

The expected growth rate in dividends until forever

Question 15

What is the Payout Ratio?

Answer 15

Payout Ratio = Dividend per Share / Earnings per Share

Question 16

When your goal is to proxy “g” in DDM, do you want to use ROE for a specific year?

Answer 16

Do not use ROE for a specific year, but want to think more generally what is the ROE that the company can generate long-term

Question 17

What is a reasonable assumption when deciding on a ROE?

Answer 17

The company is going to generate internally a ROE that is similar to what investors providing equity capital are expecting

Therefore, if using gSust.growth as proxy for “g” assume ROE ~ re

Question 18

What DDM do we use when projected growth is not constant?

Answer 18

Two stage model

Question 19

What is a synonym for earnings per share?

Answer 19

Net Income per Share

Question 20

What is a synonym for Net Income per Share?

Answer 20

Earnings per Share

Question 21

How do you present value a price by half a year?

Answer 21

Div0 (6 months ago) is given, multiplied by g to get Div1 (6 months in future)
Perpetuity formula Div1/(re-g) will give present value at year0 (6 months ago)
PV1 / (1+re)1 present values PV1 (1 year back) to year0 (6 months ago), therefore
PV0 / (1+re)0.5 present values PV1 (0.5 year back) to year-0.5, therefore
to get to year0.5, PV0 * (1+re)0.5 we multiply to present value PV0 (0.5 years forward)
this leaves us PV0.5 (which is now)