FINE2005 Financial Management
Lecture 5
Stocks
1
Reference
Essentials of Corporate Finance: Ross, Westerfield and
Jordan. 11th Edition
Chapter 7 (pg. 210 – 225) Chapter 10 (pg. 342 – 345)
2
Stk
Overview
XerovityX0
①
• Features of Common Stock I
preferred
combion
• Common Stock Valuation
• Price Earning Ratio (PE Ratio)
• Features of Preferred Stock
3
Overview
• Stock Quotations
• The Efficient Markets Hypothesis
4
Cash Flows Associated with a Stock
0 1 2 3 ………
Dividend1 Dividend2 Dividend3
5
Common Stock
Common stock refers to equity without priority for dividends or bankruptcy.
-
Bankruptcy
-
BIh
-
Preferred Sh
-common S/h
Features of Common Stock
• Voting Rights
- Shareholders have the right to vote for the board of directors and other
important issues.
↓
- A proxy is a grant of authority by a shareholder allowing another
individual to vote that holder’s shares. with
proxy
• Classes of stock
- Classes of stocks can be created with different voting rights.
7
$200 / 000 (Stks)
Features of Common Stock
• Shareholders have limited liability.
last one
• Shareholders have residual claim against a firm’s assets.
- The claim of the shareholder comes after the claims of the bondholder and
preferred stockholder.
8
Features of Common Stock
• Other Rights
A
- Share proportionally in declared dividends.
- Share proportionally in remaining assets during liquidation after
liabilities have been paid.
E
- Preemptive right – right to participate proportionally in any new
stock sold.
offer new stks => need to in 22 old sus first
.
9
Dividends to Shareholders
• Dividends are not a liability of the firm until a dividend has been declared
by the Board.
• Consequently, a firm cannot go bankrupt for not declaring dividends.
• Dividend payments are not considered a business expense; therefore, they
are not tax deductible.
•EStock dividend is a dividend paid by issuing additional shares of a firm
that is proportional to the shareholder’s shareholding.
10
Po PVC (DJU to
expect receive)
=
Common Stock Valuation
0 1 2 3 ………
Dividend1 Dividend2 Dividend3
The value of a share of stock can be determine by the present value of the
future cash flows from the stock.
We consider the following three cases:
1. Zero Growth
2. Constant Growth
3. Nonconstant Growth
11
Common Stock Valuation – Zero Growth
Assumption: The dividend has zero growth rate
If dividends are expected at regular intervals forever, then this is a
perpetuity and the present value of expected future dividends can be found
using the perpetuity formula
𝐷
𝑃0 = Discount Rate
𝑅 >
RequiredReturn
-
= .
where D is the constant dividend and R is the required return.
Risk R
zero-Growth
Po PV
=
(Di , Da D3 Du ....
,
, ,
12
-
·
11
a En "as
Common Stock Valuation – Zero Growth
Suppose the Paradise Prototyping Company has a policy of paying a $10
per share dividend every year. If this policy is to be continued indefinitely,
what is the value of a share if the required return is 20 percent?
- -
$50
13
Common Stock Valuation – Zero Growth
0 1 2 3 ………
𝑃0 10 10 10
𝐷 10
𝑃0 = = = $50
𝑅 0.2
14
Common Stock Valuation – Constant Growth
Assumption: The dividend has constant growth rate (g).
𝐷0 (1 + 𝑔) 𝐷1
𝑃0 = =
𝑅−𝑔 𝑅−𝑔
where 𝐷0 is the dividend just paid, 𝐷1 is the next dividend, R is the required
return and g is the constant growth rate.
This model is known as the dividend growth model.
Constant Growth
O G I 2 3 15
I I Di Doll + G)
=
I I I
said Next P2 D I (1 + DS D2(1 +j
I ())
=
Do
=
Po-PV (Di ,
D2 , Does ..... )
.
:g (Dir Growth Model ) .
Common Stock Valuation – Constant Growth
The next dividend for the Gordon Growth Company will be $4 per share.
Investor require a 16 percent return on companies such as Gordon.
Gordon’s dividend increases by 6 percent every year. What is the value of
① ②
&
Gordon’s stock today? What is the value in four years?
D5 41106/4 -
P7s0
=
In (D5 ,
③
-g
16
05
5 .
=
-06
0 .
16-0 .
=
50 50.
Common Stock Valuation – Constant Growth
𝐷0(1 + 𝑔) 𝐷1 4
𝑃0 = = = = $40
𝑅−𝑔 𝑅 − 𝑔 0.16 − 0.06
𝐷4 = 4(1.06)3 = $4.764
4.764(1.06)
𝑃4 = = $50.50
0.16 − 0.06
17
Common Stock Valuation – Constant Growth
𝑃4 = $50.50 = 40(1.06)4 = 𝑃0(1 + 𝑔)4
The dividend growth model makes the implicit assumption that the stock
price will grow at the same constant rate as the dividend.
ob
go
: .
R 0 16
I
= . .
2
L
Po 40
=
D1 4
=
18
= 50 50.
Di = ) D2 2 D3 2 5
.
= :
.
S 11
-
I
O I
3 <
R =
0. D4 =
2 5 (1 05]
PV (Di Da Ja
Po (
.
.
g 0 05 2 625
:
.
= =
.
......
.
, ,
Common Stock Valuation – Nonconstant Growth
.
The dividend forecast for Zen Company for the next three years is as
follow: Pa PULDq D5, :
Year , Expected Dividend
1 $1.00 =
52 5 .
2 $2.00
3 $2.50
After the third year, the dividend will grow at a constant rate of 5 percent
-
-
per year. The required return is 10 percent. What is the value of the stock
Fir
today?
19
0 05.
= 52 5..
- it + = 43 . 88
Common Stock Valuation – Nonconstant Growth
𝐷3(1 + 𝑔) 2.5(1.05)
𝑃3 = = = $52.50
𝑅−𝑔 0.1 − 0.05
1 2 2.50 52.50
𝑃0 = + 2 + 3 + 3 = $43.88
1.1 1.1 1.1 1.1
20
Total Return
-
Div
-Capital
growth stocks
X gain (loss.
Income stocks -
Types of Stocks X
opportunities
• Growth stocks on growth uncertianty
wely So
more
Risk
- Stocks of firms with substantial growth opportunities.
-
-m
Ivorl
- Generally, these firms are younger and pay low dividends.
-
-
-
• Income stocks
- Stocks that provide investors with periodic income in the form of large
- -
-
dividends.
cash flow
-
-
Mone
- Generally, these are firms with limited growth opportunities.
-
21
of earning.
Per unit
Price
Price Earning Ratio (PE Ratio) plz-tic is .
• A stock’s PE ratio is the ratio of a stock’s price (P) to its earnings per share
(EPS).
• PE = P/EPS
Example: If P = $50.00 and EPS = $2.50,
then PE = $50.00/$2.50 = 20.0.
Investors are willing to pay $20 for each $1.00 of the
company’s earnings.
22
Price Earning Ratio (PE Ratio)
• A stock’s Price Earning (PE) ratio is likely a function of three factors:
1. Growth opportunities. Companies with significant growth opportunities
-
are likely to have high PE ratios.
2. Risk. Low risk stocks are likely to have high PE ratios.
-
3. Accounting practices. Accounting practices can have an impact on the
-
-
earning of a company.
growth stk -
high Pl.
10-g ,
Rish 9th -R4 .
PlZ:
Price
ps
.
R4 >
-
Pot 23
:
ice
P/ Pot >
-
PET.
s
Features of Preferred Stock
• Preferred stocks pay a fixed dividend and have priority over common
u
stocks in the payment of dividends.
-
• Preferred stockholders also have priority over common stockholders in
recouping their investment if the company fails or liquidates.
• Preferred stock generally carries no voting rights.
-
24
Features of Preferred Stock
• Preferred dividends can be cumulative or noncumulative.
- For cumulative dividends, if a dividend is not paid in a particular
year, it is carried forward and must be paid before any dividend can
be paid to common stockholders.
- For noncumulative dividends, any missed dividend will be lost
forever.
25
26
Stock Quotations ticker .
• In Hong Kong, the stock quote uses Arabic numerals.
• Bid price refers to the price of a buy order (the price a buyer is willing to
pay to buy the stock).
• Best/Current/Market bid price is the highest price a buyer is willing to pay
to buy the stock.
27
Stock Quotations
Best Ask : lowest price
of sell order
• Ask price refers to the price of a sell order (the price a seller is willing to
--
take to sell the stock).
• Best/Current/Market ask price is the lowest price a seller is willing to take
to sell the stock. of
Best Bic Highest
: Price
buy
order
Bid : Price of buy order
28
Mid-Terr
Stock Quotations
• The ask price is always higher than the bid price.
• Market spread = Best ask – Best bid
transition .
-
cust
• P/E refers to the price earnings ratio.
• The lot size refers to trading unit. The lot size of a listed security in Hong
Kong is determined by the issuer.
29
Efficient Market
• In an efficient capital market, current market prices fully reflect
available information.
and
adjust quickly correctly
St
value -M overreaction
project----delayed reaction .
30
tire .
O
!
Efficient Market
31
The Efficient Markets Hypothesis
• The efficient market hypothesis asserts that well-organized capital
markets (e.g. the NYSE) are efficient.
• Competition among investors makes a market efficient.
32
The Forms of Market Efficiency
public &
= private
• If the market is strong form efficient, then X
all information of every
kind is reflected in stock prices.
• If the market is semi-strong form efficient, then all public information
is reflected in the stock price.
• If the market is weak form efficient, a stock’s price movement in the
past is unrelated to its price movement in the future.
E -
past not related future.
33
Stil Analysis
.
Fundamental
-
chic historical Price Pattern
value of opy
by examing ↓
predict future
price movement.
economic/financial factor .
-
public info