Stocks, NPV and other investment rules (Chapter 6 & 7) Flashcards
Stock ownership produces cash flows from:
▪ Dividends
▪ Capital Gains
What is the dividend growth model (DGM)?
The Dividend Growth Model (DGM) is a method used to value a company’s stock by assuming that dividends will grow at a constant rate indefinitely (a perpetuity).
How can you estimte growth rate g for the DGM?
g = Retention ratio × Return on retained earnings
Downsides with DGM
- Need to agree on r and g
▪ Can calculate implicit r and g using the DGM - What if r < g?
▪ DGM will give negative company value - What if the company don’t pay dividend?
▪ DGM will value company = 0 - What if the company provide other cash flows than dividends?
▪ Total Payout model - How about extra opportunities?
▪ NPVGO.
What is total payout valuation?
Dividends may not be a firm’s only cash payout. Recently many
firms have repurchased shares, another form of payout
Using the Dividend Growth Model, the price of a share will be
higher if considering total payout rather than just dividends.
What are growth opportunities?
Opportunities to invest in positive NPV projects.
The value of a firm can be conceptualized as the sum of the value of a firm that pays out 100% of its earnings as dividends plus the net present value of the growth opportunities (NPVGO).
What conditions must be met for a company to grow?
Two conditions must exist if a company is to grow:
* It must not pay out all of its earnings as dividends, i.e. retained earnings (or the retention rate) must be > 0; and,
* It must invest in projects with a positive NPV
What is the P/E ratio?
Interpret the P/E ratio
Historically a company has a fair price if the P/E ratio is between 10 – 17.
Below 10:
▪ The company’s earnings are thought to be in decline, and the company’s future might be in question.
▪ Or, current earnings are substantially above historical earnings (e.g. through asset sales).
Over 17:
▪ The stock is overvalued or the earnings have increased since the last earnings figure was published.
▪ Or, the stock is a growth company where earnings are expected to increase in the future.
Over 25:
▪ High expected future growth in earnings (e.g. Facebook).
▪ May be a speculative bubble.
Investment rules
What are the three growth models?
Why don’t firms with no dividends
have stock price of $0?
Such firms believe their earnings are better used to pursue growth opportunities. Investors pay a stock price that conforms to their own calculus of the NPVGO of the no-payout firm. The dividend growth model does not work in valuing this firm.
Features of common and preferred stocks
- The term common stock is usually applied to stock that has no special preference either in receiving dividends or in bankruptcy.
- Shareholders have the right to vote for the board of directors and other important issues.
- The effect of cumulative voting is to permit minority participation.
- **Straight voting **can “freeze out” minority shareholders. With straight voting, each share of stock has one vote (i.e. 10,000 shares will give you 10,000 votes).
- Proxy voting is the grant of authority by a shareholder to someone else to vote his/her shares. Proxy votes are similar to absentee ballots.
- Proxy fights occur when minority owners are trying to get enough votes to obtain seats on the Board or affect other important issues that are coming up for the vote.
- Classes of stock: Different classes of stock can have different rights. Owners may want to issue a nonvoting class of stock if they want to make sure that they maintain control of the firm.
- Other rights
- Share proportionally in declared dividends
- Share proportionally in remaining assets during liquidation
- Preemptive right – first shot at new stock issue to maintain proportional ownership if desired
Preferred stock differs from common stock because it has preference over common stock in the payment of dividends and in the distribution of corporation assets in the event of liquidation.
Features of preferred stock:
Dividends:
- Stated dividend must be paid before dividends can be paid to common stockholders.
- Dividends are not a liability of the firm, and preferred dividends can be deferred indefinitely.
- Most preferred dividends are cumulative – any missed preferred dividends have to be paid before common dividends can be paid.
Preferred stock generally does not carry voting rights.
Preferred stock versus debt:
There are a lot of features of preferred stock that are similar to debt. In fact, many new issues have sinking funds that effectively convert what was a perpetual security into an equity security with a definite maturity. However, for tax purposes, preferred stock is equity, and dividends are not a tax deductible expense, unless they meet specific characteristics as discussed in the text.
Dealers vs. brokers
Dealer: maintains an inventory and stands ready to trade at quoted bid (price at which they will buy) and ask (price at which they will sell) prices. Make their profit from the difference between the bid and ask prices, called the bid-ask spread. The smaller the spread, the more competition and the more liquid the stock. The move to decimalization allows for a smaller bid-ask spread (“Used car dealer”).
**Broker: ** a broker matches buyers and sellers. They perform the search function for a fee (commission). They do not hold an inventory of securities (“Real estate agent”).
NPV
Minimum acceptance:
NPV > 0
Ranking criteria:
Highest NPV
Reinvestment assumption: The NPV rule assumes that all cash flows can be reinvested at the discount rate.
Must estimate cash flows, discount rate and initial investment
