Theory of Finance – Chapter 7 Common Stock (Common Equity ...

Theory of Finance – Chapter 7 Common Stock (Common Equity/Common Shares): Ownership shares in a publicly held corporation o If you want to share in RIM’s future, you will want to buy common stock in the firm. o Large firms sell or issue shares of stock to the public when they are in need to raise money o Shareholders share the ownership of the firm in proportion to the number of shares they hold o Benefit if the company prospers, and suffer if looses money  This happens because common stock is entitled to the firm’s residual cash flow, the remaining cash flow after employees and all other supplies, lenders, and the government taxes have been paid Primary Market: Sales of new shares by the firm (place where the sale of new stock first occurs) READING STOCK MARKET LISTINGS Two types of primary market issues: Initial Public Offering (IPO): A company that has been privately owned sells shares to the public for the first time Seasoned Equity Offering (SEO): Sale of new shares by a firm that has already been through an IPO Secondary Market: Market in which already issued securities are traded by investors Price Earnings (P/E) Ratio: Price per share divided by earnings per share Dividend Yield: Periodic cash distribution from the firm to the shareholders o Dividends represent that share of the firm’s profits which are distributed o A stock’s cash dividend divided by its current price Preferred Stock: Typically have fixed dividends that must be paid before the common shareholders receive any dividends o Takes priority over common stock in regards to dividends Retained Earnings: Profits that are retained in the firm and reinvested in its operations

MARKET VALUES, BOOK VALUES, LIQUIDATION VALUES Three methods used for valuing a company’s shares: Book Value of Equity: Net worth of the firm according to the balance sheet o It is the difference between the value of the assets and the liabilities o Records all the money that the company has raised from its shareholders plus all the earnings that have been plowed back into the firm on the shareholder’s behalf o Depends on the accounting rules the firm uses. Often unrealistic deduction for depreciation and no adjustment for inflation Liquidation Value: Net proceeds that would be realized by selling the firm’s assets and paying off its creditors o A successful company will be worth more than its liquidation value o The difference between a company’s actual value and its book or liquidation value is often referred to as going – concern value  Means that a well managed, profitable firm is worth more than the sum of the value of its assets Factors of “Going Concern Value”  Extra earning power  Intangible assets  Value of future investments Market – Value Balance: Financial statement that uses market value of assets and liabilities to evaluate the sources of the firm’s value. It contains two classes of assets: o Assets already in place, both tangible and intangible o Opportunities to invest in attractive future ventures o The amount that investors are willing to pay for the shares of the firm – depends on the earning power of today’s assets and the expected profitability of the future investments VALUING COMMON STOCK Intrinsic Value (V0): Present value of the cash flows anticipated by the investor in the stock Expected Return: The percentage yield that an investor forecasts from a specific investment over a set period of time o The return that the investor expects to receive 

The return obtained from a common stock comes in two formats: 1. Cash dividends received over a period of time 2. Capital gains or losses experienced

Expected Return = r = Div1 + P1 – P0 P0 Can be looked at as: Expected Return = Dividend Yield + Capital Gain r = D1 + P1 – P0 P0 P0 P0 = Price of stock today P1 = Price of stock in year 1 D1 = Dividend The Dividend Discount Model (DDM): Share value equals the present value of all expected future dividends o Present value of all expected dividends PLUS the expected value of the stock price at maturity o Discounted cash flow model that states that today’s stock price equals the present value of all expected future dividends

DDM can determine:  Price of bond  Dividend payment  Discount rate, r

P0 = Div1 + Div2 + DivH + PH (1+r)1 (1+r)2 (1+r)H

Note: Use DDM formula when they ask what is the price of the stock given In the case of NO growth  The company will pay out all of its earnings in the form of dividends to its shareholders  Retained earnings = 0 and plowback ratio = 0 Zero Growth Case: If the dividend paid by the corporation is not expected to change, then we treat the dividend as a perpetuity. The present value o Dividends remain constant, therefore we get a perpetuity o Where dividends = cash flow Present value of all dividends: P0 = Div1 r Constant Growth Case: If dividend paid by the stock is expected to grow at a constant rate, then the cash flows are treated like perpetual flows with a growth rate

o Dividend payments grow at a constant rate, g (same formula as a growing perpetuity  PV = C/r-g P0 = Div1 r-g Non – Constant Growth Case: Companies typically will have non – constant growth of their dividends followed by the rate settling down to a constant growth o Many companies grow at rapid or irregular rates for several years before finally settling down Calculating the price of a non – constant growth stock:  Before the growth rate settles down, we have to calculate each dividends separately  When the growth rate does settle down, we can find the future stock price using the constant growth formula  At the end, we have to calculate the PV of all the dividends and the future price of the bond Plowback Ratio: Fraction of the companies earnings that are retained by the firm (plowed back into the firm) to be used towards growth Plowback Ratio = Plowback Earnings Per Share Payout Ratio: Fraction of the earnings that are paid out in dividends to shareholders Payout Ratio = Dividends Earnings Per Share Growth Rate (g) = ROE x plowback ratio Note: If plowback is 0, growth rate will be 0 Relationship Between… Price & Growth Rate: The higher the growth rate of the company (that they can sustain), the higher the price of the stock Price & ROE: The higher the ROE for investors, the higher the growth rate, and this the higher the price Price & Plowback Ratio: The higher the plowback ratio and portion being reinvested into the company, the greater the company’s ability to grow and this, the higher the price

Price & Discount Rate: As the discount rate increases, the price of the bond decreases Present Value of Growth Opportunities (PVGO): The net present value of a firm’s future investments Sustainable Growth Rate: Steady rate at which a firm can grow: o plowback ratio x ROE Price – Earning Ratio: Stock price/EPS Technical Analysis: Attempting to identify undervalued stock by searching for patterns in past stock prices Random Walk: Secruity prices change randomly, with no predictable trends or patterns Fundamental Analysis: Attempting to find mispriced securities by analyzing fundamental information, such as accounting data and business prospects Efficient Market: Market where prices reflect all available information. No free lunches o Weak Form Efficiency: A market where prices rapidly reflect all information contained in the history of past prices and volumes o Semi – Strong Form Efficiency: A market where prices rapidly reflect all publicly available information o Strong Form Efficiency: A market where prices reflect all information that could be used to determine true value of assets Net Present Value: Determines if the project is worth more than it costs o Net = your overall gain once debts are paid off 

Managers increase shareholders wealth by accepting all projects that are worth more than they cost (have a positive NPV)

Two main things NVP tells us: 1. The value of the project (is it worth more than it costs) 2. How much will the project increase the value of the firm 

When you are looking at two mutual projects, choose the one with the higher NPV

Payback Method: Amount of time before you can payoff the investment Problems: 1. Ignores the cash flow generated after the cut off

2. Ignores the time value of money 3. Creates a bias against longer – term projects a. May ignore positive NPV projects because they are longer term