Stock Valuation Questions & Answers

Stock Valuation Questions & Answers Common stock (also known as common equity) shares of ownership that have no special preference either in paying dividends or in bankruptcy. What represents the major sources of financing for corporations? stocks and bonds combined What are some of the features of common stocks? - Shareholder rights - Classes of stock - Dividends The structure of the corporation assumes shareholders do what? elect directors who hire management to manage the day to day operations. Shareholders control the corporation through the right to elect directors. One share equals what In general, one share = one vote (not one shareholder, one vote). Proxy a grant of authority by a shareholder allowing another individual (usually management) to vote with his/her shares Reason for different classes Management can raise money through issuing shares that have limited voting rights while still maintaining control of the company. Different classes of stocks -Many firms have more than one class of stock. -Classes are often created with unequal voting rights. Dividends payment by a corporation to shareholders, made either in the form of cash or stock. Who has the discretion to pay dividends? Payment of dividends is at the discretion of the board of directors. Are dividends taxable? Dividends received by shareholders are considered ordinary income by the IRS and are fully taxable. Preferred stock stock with dividend priority over common stock, normally with a fixed dividend rate, sometimes without voting rights. How is preferred stock different from common stock? Preference in payment of dividends or in the distribution of corporation assets in event of liquidation. How is preferred stock different from bond? - Preferred dividend is not like interest on a bond. Directors may decide not to pay dividends over a specific period. If preferred dividends are not paid during a specific period, all past dividends must be paid before common shareholders can receive anything. - Usually no mandatory maturity date. Is preferred stock equity or debt? From a legal and tax point of view, preferred stock is considered a form of equity - preferred dividends are treated like common stock dividends. Most people on Wall Street consider preferred stock to be debt. Preferred shares often carry credit ratings and no voting rights. Debt v. Equity Debt is borrowing money (e.g., bank loans, issuing bonds, etc). The borrower is legally obligated to pay the debtholder back. Otherwise, the borrower defaults and enters into bankruptcy and subsequent legal proceedings. Equity is ownership. The shareholder buys a portion (share) of the firm and subsequent returns may be positive or negative depending on the outcome of the firm. What happens in the event of bankruptcy or liquidation? equity holders are the residual claimants - the individuals who receives the net income after all obligations are paid. That means, debtholders get paid before equity holders (and preferred stockholders over common stockholders). Closing price last reported trading price of one share of the stock; typically 52 week high and low prices are also reported in addition to the change in price from the previous day Volume number of shares that traded Dividend yield annual dividend divided by closing price; measures how much cash flow you are getting for each dollar invested in an equity position Earnings per share net income divided by shares outstanding Price/earnings ratio (multiple) price per share divided by earnings per share; attempts to measure the growth prospects of the firm; earnings used to calculate the price/earnings ratio are either - the most recently available (trailing P/E ratio) -estimated earnings over the next four quarters (forward P/E ratio) NYSE the largest stock market in the world. Trades are completed through member/brokers who own seats on the exchange and have the right to make trades. how does NYSE work? 1. Investor places an order to buy or sell shares in a NYSE company through his/her NYSE member broker. 2. Brokerage firm transmits the order to the NYSE trading floor. 3. Depending on the order details (size, etc.) the order goes to a broker's booth (for direct human interaction) or through the computer system directly to the trading post specialist in the stock. 4. If routed through the broker's booth, order is given to a floor broker who competes with other brokers at the trading post for the best price. 5. If routed directly to specialist, the order appears on the specialists screen and she makes the trade seeking the best price for the customer. 6. After trade is completed, transaction report is sent to the brokerage firms and the trade and price is displayed on the consolidated tape world wide. 7. Within three days the transaction is processed with funds placed in all individual accounts. Specialist a NYSE member acting as a dealer and market maker in a small number of securities at the exchange. They are obligated to maintain a fair orderly market in the securities assigned to them Anatomy of a trade - NASDAQ - Not a physical exchange - computer network of securities dealers. - Dealers act as market makers for NASDAQ securities. - Dealers post bid and ask prices at which they accept buy and sell orders. - Unlike NYSE, NASDAQ has a multiple market maker system rather than a specialist system. - Large portion of technology stocks. Valuing equity involves what? 1. Time Value of Money: we prefer a dollar today over tomorrow. 2.Uncertainty: we prefer a safe dollar over a risky dollar. How to value stock? DCF (discounted cash flow approach, also referred to as the present value approach) DCF the price of any given security should be equal to the value of its future cash flows which are discounted at the appropriate interest rate. In order to implement the DCF approach, what must the investor do? 1. Estimate the amount and timing of the future stream of cash flows. 2. Estimate an appropriate rate of return - this rate of return (or discount rate) is the minimum rate of return required to justify the risk associated with the uncertainty of the cash flows. You own a share of stock today. What do you receive for holding the share for one period? - Dividend - Price when you sell the stock DCF approach formula Dividend Discount Model a model that values shares of a firm according to the present value of the future dividends the firm will pay Issue/Solution w/ Dividend Discount Model - Main issue: the dividend stream is uncertain and the dividends for most firms are expected to grow over time. - To solve this problem, some assumption must be made about the expected growth rate of the dividend stream given that we know the current dividend stream. What are the two main growth assumptions are usually used in valuing stocks - The dividend stream has a zero growth rate (all future dividends are set equal to the current dividend) - known as the constant dividend or zero growth version. - The dividend stream is assumed to grow at a constant rate g, starting with the current dividend - known as the constant growth version (and the model is referred to as the DGM or Dividend Growth Model). zero growth in dividends In this special case, we have a stream of constant cash flows forever. In other words, we have a perpetuity which we know how to solve. Special case: zero growth in dividends formula D/r Special case: constant growth in dividends dividend growth model (DGM) 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 Two-stage dividend growth model The Two Stage DGM is a special case of non-constant growth where dividends grow at different constant rates over two periods. - The dividend will grow at a rate g1 for t years and then grow at a rate g2 thereafter. - We can value the first period as a growing annuity for t years. - We can value the second period as a discounted perpetuity. Multi-stage dividend growth model - We can value the first period as a growing annuity for t1 years. - We can value the second period as a discounted growing annuity for t2 years. - We can value the third period as a discounted growing annuity for t3 years. - We can value the last period as a discounted perpetuity. The case of no dividends If the corporation never pays dividends the value is zero - We expect the corporation to return cash to shareholders at some point in the future. 1. Dividend when no more growth available (cash cow). 2. Special dividends 3. Share repurchases or sale of the firm. Where today's dividend is zero or small the DGM may be inaccurate. Why? - Small dividends today results in most of the value coming from distant payouts. - The DGM is very sensitive to the growth rate and it is hard to forecast growth long into the future. - Be careful in interpreting the DGM for zero-dividend firms. multiples (comparables) valuation approach This approach is based on using a target or benchmark financial ratio to infer the price of the stock. The appropriate ratio to benchmark or target is determined by comparable firms in the market. The idea is that firms with similar ratios should sell at similar prices. In other words, when the firms are comparable, the value of one firm can be based on the value of a comparable firm.