Midterm 2 Part V Flashcards by Laura Cooper

What is another name for stock valuation?

Equity valuation

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Equity

Represents ownership in a firm, when you buy a share of a company’s stock.
You have rights as a part owner.

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Residual claim

Stockholders have a claim to any leftover earnings of a company (after they pay for operations and their creditors)

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True or False: Shareholders have claim to residual earnings in proportion to the percentage of shares they own.

True

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True or False: Stockholders still have claim to residual earnings after liquidation.

True

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A right that common stock shareholders have is the right to vote on company management and policy.

True

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Equity often is a big part of individual investment portfolios.

True

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Reasons to understand stock valuation:

Equity is a large portion of an individual’s investment portfolio
You may be approached at some point to buy stock on behalf of someone else
Many compensation packages include stock options
The stock market is one way capitalism functions.

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Where does price discovery happen?

The stock market

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What are the two types of stock?

Common and preferred

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Which type of stock is viewed as a hybrid security?

Preferred stock

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Which type of stock is a variable return security?

Common stock

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What is the main difference between common and preferred stock?

The preferred stock has a stated dividend, meaning the managers of the firm intend to pay dividends per stock share, but if they don’t, there’s not legal recourse.

Typically, the dividend IS paid.

Common stock has no guarantee that they will receive dividends.

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What is a broader term for equity? (not stock)

Variable-return securities

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True or False: The income from variable-return securities (such as common stock) is variable.

True. Duh.

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What is the opposite of fixed income (bonds)?

Stock (variable-returns)

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What factors impact dividends paid to common stockholders?

Business cycle, how well management runs company, national and world economies.

The return to stockholders varies as the fortunes of a company rise and fall.

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True or False: Common stock holders can vote in company matters.

True

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What is the big issue that many shareholders vote on?

The election of the company Board of Directors. These people hire the management team, which influences dividends.

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Corporate governance

The structure, rules, and regulations of a company.

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When does a common stock shareholder get paid?

After everybody else. Sometimes that means they get nothing.

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True or False: Stock has a maturity/expiration date.

False

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How do shareholders get rid of their shares?

They sell on the market or back to the company.

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Capturing the upside

Potentially making thousands of percentages of return because the earnings from shares are unlimited (as opposed to bonds with a set rate)

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Hybrid security

It has elements similar to equity and others like debt (bonds).

True or False: Preferred stock has a maturity date.

False

In what ways is preferred stock like bonds/debts?

The dividends are fixed, regardless of how the company performs (like coupon payments).

Why is it bad for a company to stop paying dividends to preferred shareholders?

Because then they also can't pay anything to common shareholders. This would result in a lot of people refusing to invest in the company.

Dividends in Arrears

Dividends cannot be paid to common stockholders until preferred holders have been paid.

True or False: Preferred stock is cumulative, meaning that if a company skips a payment of their dividends, they are still required to pay that amount in the future.

True

Which types of firms issue preferred stocks?

1. Mature firms with regular dividend programs (utilities, steady and predictable) 2. Start up ventures

Fixed annual dividend percentage equation

Percentage x $pershare = annual dividend

True or False: Preferred stock can vote and participate in company affairs.

FALSE

What is the order of payout of residual earnings?

1. Debt holders 2. Preferred stockholders 3. Common stockholders

Two main ways to increase company value:

1. Increase future cash flows (either by increasing sales or lowering expenses). 2. Decrease the cost of capital.

Intrinsic value of an asset

Equals the present value of the stream of expected cash flows discounted at an appropriate rate of return.

True or False: A good company equals a good investment

False

Should you invest in preferred stock as an individual? Why or why not.

NO. It's only "preferred" for corporate owners or the very VERY wealthy. It's set as "preferred" to avoid double taxation on the corporate level, and doesn't benefit you as an individual at all. You're better off buying bonds than preferred stock.

Which of the following securities represents ownership in the firm?

Common and preferred stock

Which of the following statements is correct regarding preferred stock and the common stock?

Both preferred and common stocks do not have fixed maturities like bonds.

Which of the following statements correctly defines the difference between preferred stock and common stock?

Preferred shareholders have more of a claim to dividends than common stockholders Preferred shareholders do not have the voting rights that common stockholders have Common shareholders have more exposure to variable share prices than preferred shareholders

Which one of the following does NOT describe common stock? It normally has voting and participating rights. It has no maturity. It has the lowest priority to claim the asset in case of bankruptcy. It has fixed dividends.

It has fixed dividends

Which one of the following does NOT describe preferred stock? Its dividends are cumulative. It has no maturity. It has the lowest priority to claim on firm assets in the case of bankruptcy. It has fixed dividends.

It has the lowest priority

An investor who buys shares of common stock becomes a part-owner of the firm.

True

What is an infinite, constant annuity?

Perpetuity

Value of preferred stock equation

Value of preferred stock = annual fixed dividend / discount rate or RRR

A preferred stock pays a dividend of $1.79 in perpetuity. If the return required by shareholders is 8%, then the price per share for this preferred stock is:

$22.38

If a preferred stock pays a constant dividend of 5% of par, which is $50, and investors require a rate of return of 9%, what is the price of this preferred stock?

$27.78

(Preferred stockholder expected return) Spaceman Corp’s preferred stock is selling at $35.29 a share and pays a $2.26 dividend. What is the expected rate of return of Spaceman’s stock?

6.4%

(Preferred stockholder expected return) You own 252 shares of Global Services’ preferred stock, which currently sell for $18.12 and pay annual dividends of $1.19 per share. If you require a 10% return, given the current price, would you be interested in selling or buying more stock?

You should sell the stock since it is overvalued by $6.22.

A preferred stock pays a dividend of $3.50 in perpetuity. If the return required by shareholders is 11%, then the price per share for this preferred stock is:

$31.82

If a preferred stock pays a constant dividend of $3.50, and investors require a rate of return of 10.5%, what is the value of this stock?

$33.33

(Preferred stock valuation) Calculate the value of a preferred stock that pays a $6.25 dividend per share and your required rate of return is 9%.

$69.44

(Preferred stock valuation) What is the value of a preferred stock where the dividend rate is 12% on a $100 par value? The appropriate discount rate is 18%.

$66.67

(Preferred stockholder expected return) You own 252 shares of Global Services’ preferred stock, which currently sell for $18.12 and pay annual dividends of $1.19 per share. What is your expected return?

6.57%

Explain the assumptions of the Single Holding Period Model

An investor buys a stock and holds it for one year before selling. During that process, the investor generates a return from 2 sources: dividends and an increase in the price of stock.

Capital gain

Money gained by selling a stock at a higher price than what you paid for it (because the price increased).

As an example, let's say that we want to buy one share of XYZ stock today. We expect the stock to pay a dividend of $5.50 at the end of the year, at which time we forecast the stock price will be $120. If we require a 15% rate of return on our investment, how much will we be willing to pay today for the stock?

$109.13

What is the major downfall of the Single Period Holding Model?

You have to know the price of the stock in one year in order to calculate it. You can forecast it, but it won't be as accurate.

Explain the assumption of the Basic Model

If we want to know the value of a share of common stock today, we have to estimate the future dividends forever, then discount them all back to the present. That's dumb.

What is another name for the Gordon Growth Model?

Constant Dividend Growth Model

What is the assumption that the Gordon model makes?

That dividends will continue to increase each year, they will not stay the same. They grow at a CONSTANT rate.

Gordon Growth Model Equation

Value of the stock at time 0 = Dividend at time 0 (1 + g) / Required rate of return - g g = constant growth rate

What percentages should g be close to?

3-6%, never higher than that. It should be close to the growth rate of the economy.

GetBig stock recently paid a $5.00 dividend. The dividend is expected to grow at 10% per year indefinitely. What would we be willing to pay for one share of this stock if our required return on GetBig stock is 15%?

$110

What is an example of when to use the Gordon Growth Model?

Real estate

cap rate

the denominator of the Gordon model (the k-g part)

Two Stage Growth model assumptions (this is NOT the Gordon model)

It estimates cash flows for two unique situations: 1. Dividends that are growing at above average rates (like Google 267%) 2. Dividends growing at the industry average rate This model allows the firm to grow at different rates at different times. It estimates both. It permits that a company can grow at above average rates for an initial period, but assumes it will not grow at that rate forever.

Two Stage Growth Model equation

Value = PV(stage 1) + PV(stage 2)

How do you calculate the PV of stage 1 in the multi stage growth model (2-stage model)?

You use TVM to find the PV of each dividend.

How do you calculate the PV of stage 2 in the multi stage growth model?

Use Gordon model

What do you plug into the Gordon model if the company doesn't pay dividends?

The FCFF in place of D1

Terminal value

The final dollar amount from a project