Equity Markets and
Stock Valuation
Chapter 7
Common Stock Valuation
 Cash flows from owning a share of stock
come in the form of future dividends (vs.
coupon pmts on a bond)
 P0 = D1 / (1 + R)1 + D2 / (1 + R)2 + . . .
Common Stock Valuation
 In Certain special cases it’s possible to calculate
the present value of all the future dividends to
determine the value for the stock
 Table 7.1, Pg 190
 Constant $ Dividend
– Zero Growth
 Steady Dividend Growth
– Dividend grows at a steady rate
– Known as the Dividend Growth Model
 Required Return
 Dividend Yield
Common Stock Valuation
Constant $ Dividend - Zero Growth
P0 = D/R
 Example: Not in Book
 Suppose Smith, Inc. has just issued a dividend of
$2.90 per share. Subsequent dividends will
remain at $2.90 indefinitely. Returns on the stock
of firms like Smith, Inc. are currently running
15%. What is the value of one share of stock?
 P0 = $2.90 / .15
 P0 = $19.33
Common Stock Valuation
Steady Dividend Growth
P0 = D1 / (R – g)
 Example: Problem 4, Page 203
 Motorheadache Corporation will pay a $4.00 per
share dividend next year. The company pledges to
increase its dividend by 4% per year indefinitely.
If you require a 13 percent return on your
investment, how much will you pay for the
company’s stock today?
 P0 = 4.00 / (.13 - .04)
 P0 = 4.00 / .09
 P0 = 44.44
Common Stock Valuation
Required Return
R = D1/P0 + g
 Where: D1/ P0 = is the dividend yield
 And: g = the capital gains yield
– The same as the growth rate in dividends for the steady growth
case
 Example: Problem 2, Page 203
 The next dividend payment by BJG, Inc., will be $2 per
share. The dividends are anticipated to maintain a 6
percent growth rate, forever. If BJG stock currently sells
for $35.00 per share, what is the required return?
 R = 2 / 35 + .06
 R = .0571 + .06
 R = .1171 or 11.71%
– Also work Problem 8, Page 203
Common Stock Valuation
Required Return
R = D1/P0 + g
 Example: Not in Book
 The current price of XYZ stock is $50.00
Dividends are expected to grow at 7% indefinitely
and the most recent dividend was $1. What is the
required rate of return on XYZ stock?
 R = (1 x 1.07) / 50 + .07
 R = 1.07 / 50 + .07
 R = .0214 + .07
 R = .091 or 9.1%
Common Stock Valuation
Dividend Yield = D1/P0
 Example: Not in Book
 Wilson Corporation Stock pays a constant
dividend of $2.50 forever and currently sells for
$20.00. What is the required rate of return.
 Remember: Required Return R = D1/P0 + g
– Where: D1/ P0 = is the dividend yield
 Here we are excluding the g rate
 R = D1/P0
 R = $2.50 / 20
 R = .1250 or 12.50%
Common Stock Features
Shareholder Rights
 Shareholders
– Hold Common Stock: Equity w/o priority for
dividends or in bankruptcy
 Directors
– Elected by a vote at the annual shareholders’
meeting
– Hire Management
Common Stock Features
Shareholder Rights
 Straight Voting: A procedure in which a
shareholder may cast all votes for each
member of the board of directors.
 Cumulative Voting: A procedure in which
a shareholder may cast all votes for one
member of the board of directors.
Common Stock Features
Shareholder Rights – Straight Voting
50 percent plus one share = control
 Straight Voting:
 Directors are elected one at a time
 # of Votes a Shareholder may cast:
• # of shares (owned or controlled)
 Shareholders may cast all votes for each
member of the board of directors
• If Smith has 20 votes and Jones has 80 votes, Jones
will be able to elect all the directors
• 50 percent plus one share = control
 Can “freeze out” minority shareholders
Common Stock Features
Shareholder Rights – Cumulative Voting
 Cumulative Voting:
 Directors are elected all at once
 # of Votes a Shareholder may cast is:
• # of shares (owned or controlled) x # of directors to be elect
• 20 shares x 4 directors = 80 votes
 Shareholders can distribute votes as they wish
 The shareholder may cast all votes for one member of the
board of directors
 Permits minority participation
 Mandatory in some states
Common Stock Features
Shareholder Rights – Cumulative Voting
1 / (N + 1) % of stock plus one share
 In general:
1 / (N + 1) % of stock plus one share
where N = the number of directors up for election
Will guarantee a seat
 Example: If four directors are up for
election, what % of the shares (plus one
share), will guarantee election?
– 1 /( 4 +1)
– 1 / 5 = .20 or 20%
Common Stock Features
Shareholder Rights
 Example: Problem 9, Page 203
 After successfully completing your corporate finance
class, you feel the next challenge ahead is to serve on
the board of directors of Huckaba Enterprises.
Unfortunately, you will be the only individual voting for
you.
– If Huckaba has 100,000 shares outstanding and the
stock currently sells for $60, how much will it cost
you to buy a seat if the company uses straight
voting?
• (a) 50 percent plus one share = control
100,000 x .50 + 1 share = 50,001 x $60 =
$3,000,000
Common Stock Features
Shareholder Rights
 Example: Problem 9, Page 203 continued
– Assume that Huckaba uses cumulative voting
and there are four seats in the current election;
how much will it cost you to buy a seat now?
• 1 / (N + 1) % of stock plus one share
1 / (4 + 1) % of stock plus one share
.20 x 100,000 + 1 = 20,001 x $60 =
$1,200,000
Common Stock Features
Proxy Voting
 Shareholders can vote in person or transfer their
right to vote via Proxy
 Proxy – A grant of authority by a shareholder
allowing another individual to vote that
shareholder’s shares
– Large Corporations - convenience
 Proxies are solicited by “Existing Management”
 Proxy Fight – Outside group of shareholders
solicit proxies to replace current management
Common Stock Features
Classes of Stock
 Some firms have more than one class of common
stock
– Different acquisitions – norm
• At one time GM had its:GM Classic, Class E (GME) – EDS
acquisition, Class H (GMH) Hughes Aircraft
– Unequal voting rights – exception
• Example: Ford Class B Common Stock
–
–
–
–
Not publicly traded
Held by Ford family interests and trusts
Has about 40% of the voting power
Even though it represents les than 10% of the total number of the
shares outstanding
Common Stock Features
Other Rights
 In addition to the right to vote for directors,
shareholders usually have the following rights:
 1. The right to share proportionally in dividends
paid.
 2. The right to share proportionally in assets
remaining after liabilities have been paid in a
liquidation.
 3. The right to vote on stockholder matters of
great importance, such as a merger. Voting is
usually done at the annual meeting or a special
meeting.
Common Stock Features
Other Rights
 Shareholders sometimes have - Preemptive
Right: The right to share proportionally in
any new stock sold
– If the company wishes to sell stock it must first
offer it to the existing stockholders before
offering it to the general public.
– Gives stockholders the opportunity to protect
their proportionate ownership in the
corporation.
Common Stock Features
Dividends
 Dividends: Payments by a corporation to
shareholders, made in either cash or stock.
 Represent a return on shareholder
investment
 Issued at the discretion of the board of
directors
– Not a liability until declared
– Once dividends are declared, they are a
liability of the corporation until paid.
Common Stock Features
Dividends
 Payment of dividends by the corporation is not a
business expense.
– Not deductible for corporate tax purposes
– Paid from after-tax profits
 Dividends received by individuals are considered
ordinary income and fully taxable.
 Corporations that own stock in other corporations
are permitted to exclude 70% of the dividend
amounts they receive and are taxed only on the
remaining 30%.
Preferred Stock Features
 Preferred Stock: Stock with dividend
priority over common stock, normally with
a fixed dividend rate, sometimes without
voting rights.
Preferred Stock Features
 Form of Equity – but a lot like debt
 May carry a credit rating much like a bond
 May be callable and convertible into common
stock
 May have a related sinking fund – final maturity
 Preferred Dividends: normally pay a fixed
dividend rate
– Paid at the discretion of the Board of director
– Cumulative Preferred Dividends – Unpaid stock
dividends carried forward in arrearage until paid
• Preference over “common” stock holders
– Non-cumulative
Preferred Stock Features
 Does not have voting rights
 Preference in the distribution of corporate
assets, over common stock holders, in the
event of liquidation
 Preferred Shareholders are only entitled to
the stated value of shares in liquidation
 Preferred Dividends are not tax deductible
by the issuing corporation
The Stock Markets
 Primary Market: The market in which new
securities are originally sold to investors.
– Shares of stock are first brought to the market and sold
to investors
– Companies sell securities to raise money
 Secondary Market: The market in which
previously issued securities are traded among
investors
– Existing shares are traded among investors
The Stock Markets
Dealers and Brokers
 Dealer: An agent who buys and sells
securities from inventory
– maintains an inventory and stands ready to buy
and sell at any time
• Like a car dealer
– Bid price – price dealer is willing to pay
– Ask price – price at which a dealer will sell
– Spread – difference between the Bid and Ask
price
• Dealer Profit
The Stock Markets
Dealers and Brokers
 Broker: An agent who arranges security
transactions among investors
– brings securities buyers and sellers together, but
does not maintain an inventory
• Like a real estate broker
– Do not buy or sell securities for their own
accounts
The Stock Markets
Organization of the NYSE
 NYSE is located on Wall Street (New York)
 Largest stock market in the world
– In terms of $ volume of activity and total value of
shares listed
 Member: Owner of a “seat” on the NYSE
– Collectively the members of the exchange are its
owners
– Buy and sell securities on the exchange floor w/o
paying commissions.
– Seat
• Valuable asset
• Regularly bought and sold
• Well over $2 million in recent years
The Stock Markets
Organization of the NYSE
 Commission Brokers: NYSE members
who execute customer orders to buy and sell
stock transmitted to the exchange floor
– Responsible to customers to get the best
possible prices for their orders
– Usually about 500 NYSE members are
commission brokers
– NYSE Commission Brokers are typically
employees of brokerage companies such as
Merrill Lynch
The Stock Markets
Organization of the NYSE
 Specialist: an NYSE member acting as a
dealer in a small number of securities on the
exchange floor; often called a market maker
– Each security is assigned to a single specialist
– Obligated to maintain a fair, orderly market for
the securities assigned to them
– Post bid and ask prices
– Specialist’s post – a fixed place on the
exchange floor where the specialist operates
The Stock Markets
Organization of the NYSE
 Floor Brokers: NYSE members who
execute orders for commission brokers
(who are too busy to handle certain orders
themselves) on a fee basis (sometimes
called $2 brokers)
The Stock Markets
Organization of the NYSE
 In recent years, floor brokers have become less
important on the exchange floor because of the
efficient SuperDOT System: – an electronic
NYSE system allowing orders to be transmitted
directly to the specialist
– DOT stands for: Designated Order Turnaround
– Accounts for a substantial percentage of all trading on
the NYSE, particularly on smaller orders
The Stock Markets
Organization of the NYSE
 A small number of NYSE members are
Floor Traders: NYSE members who
independently trade for their own accounts
trying to anticipate price fluctuations
– Profit from buying low and selling high
– # of Floor Traders has declined in recent decade
• Suggesting that is has become increasingly difficult
to profit from short-term trading on the exchange
floor.
The Stock Markets
Organization of the NYSE
 The business of the NYSE is to attract and
process Order Flow: The flow of customer
orders to buy and sell securities.
– The customers of the NYSE are the individual
and institutional investors who place their
orders to buy and sell shares in NYSE-listed
companies.
The Stock Markets
Organization of the NYSE
 Floor Activity:
 On the floor of the exchange are a number of
stations – figure-eight shape
 Specialist’s Post: A fixed place on the exchange
floor where the specialist operates.
 Commission brokers receive telephoned
customers orders and move to the specialists’ posts
where the orders can be executed and return to
telephones to confirm order executions and
receive new customer orders.
The Stock Markets
Organization of the NYSE
 Floor Activity Con’t:
 Commission Brokers are obligated to get the best
possible price and must “work” the order.
– Look for another broker at the specialist post where
that particular stock trades, who represents a customer
that wants to buy the particular stock they’re selling.
– For a very actively traded stock, there may be many
buyers and sellers around the specialist’s post, and
most of the trading will be done directly between
brokers: called trading in the “crowd”.
– The specialist’s responsibility is to maintain order
• Functions as a referee
• Make sure that all buyers and sellers receive a fair price
The Stock Markets
Organization of the NYSE
 Floor Activity Con’t:
 If the Commission Broker is unable to quickly
find another broker in the crowd with a matching
offsetting order, he must sell to the specialist at the
posted bid price
– The specialist provides the liquidity necessary to allow
immediate order execution.
 The colored coats worn by many people on the
floor indicates the person’s job or position.
– Clerks, runners, visitors, exchange officials, etc.
The Stock Markets
NASDAQ Operations
 NASDAQ - Computer network of securities
dealers who disseminate timely security price
quotes to Nasdaq subscribers
– National Association of Securities Dealers Automated
Quotations system
– Dealers – act as market makers for securities listed on
NASDAQ and post bid and asked prices at which they
accept orders along with the number of stock shares
that they obligate themselves to trade at their quoted
prices.
– Nasdaq is a computer network and has no physical
location where trading takes place
– All trading is done through dealers (vs. NYSE
specialist system)
The Stock Markets
NASDAQ Operations
 NASDAQ requires that there be multiple market
makers for actively traded stock (vs. the NYSE
specialist system)
 Level 2 access – connects market makers with
brokers and other dealers allowing subscribers to
view price quotes from all Nasdaq market makers
 Level 2 allows access to Inside Quotes: The
highest bid quotes and the lowest ask quotes for a
security
– Necessary to get the best prices for member firm
customers.
The Stock Markets
Stock Market Reporting
 The Wall Street Journal
– Page 199
 Internet
 CNBC
 Bloomberg
Chapter 7
Suggested Homework
 Know chapter theories, concepts, and definitions
– Re-read the chapter and review the Power Point Slides
– Suggested Homework:
• The Chapter Review and Self-Test Problems: Page 201
– 7.1 (first question only) and 7.2 (first question only)
• Answers are provided in the book just after the problems
• Critical Thinking and Concepts Review: Page 202
– Review questions 1 through 11
• Answers are provided in the solutions manual
• Questions and Problems: Page 203
– 1 (first question only), 2, 4, 5, 8, 9, and 12
• Refer to the Solutions Manual to confirm your answers