1 Stocks and Their Valuation Bondholders are creditors Stockholders are owners. They have residual...
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Transcript of 1 Stocks and Their Valuation Bondholders are creditors Stockholders are owners. They have residual...
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Stocks and Their Valuation Bondholders are creditorsStockholders are owners. They have residual claim.
Stockholders have ownership and control rightsShareholders of a corporation use their control rights
through voting: Stockholders elect directors Directors elect & monitor management Management’s goal: Maximize the stock price
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Shareholder Rights voting: straight
cumulative
With both voting systems, a shareholder receives a total number of votes that equals the number of directors to be elected times the number of shares owned.
With straight voting, a shareholder may give any one candidate, as a maximum, only a number of votes equal to the number of shares owned.
With cumulative voting, a shareholder may give all the votes he/she holds to a single candidate.
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Example
A corporation has two shareholders. Smith with 25 shares and John
with 75 shares. John does not want Smith to be a director. Assume
four directors will be elected.
John nominates four candidates, Smith nominates himself
Straight voting: John can elect all four directors
Cumulative voting: Smith has 4*25=100 votes John has 4*75=300 votesSmith will be elected a director
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Cumulative Voting
Minimum number of shares that must be owned in cumulative voting to be able to win d positions on the board
n: minimum number of shares that must be ownedd: number of directors the stockholder wants to be certain of electings: number of shares outstandingD: number of directors to be elected
Continuing with the above example what is the minimum number of shares Smith should own to be elected
Smith 21 and John 79 is enoughSmith 20 and John 80 is not enough
(a tie)
21114
100*1
n= 11
*
Dsd
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internal control
Ownership and Control are separated when we have diverse
ownership
Consider 2 scenarios: An individual who is the single owner of a firm A corporation in which none of the owners have more
than 1% ownership
In the latter scenario who has the control of the firm
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internal control
Small shareholders are not very likely to attend shareholders’ meetings
Instead they can transfer their voting rights to another person with a proxy
If the current management collects those proxies, it can elect the board members.
A board elected by the management can hardly have authority on it.
This way, the monitoring of management by board may not be possible.
proxy fight by shareholders is difficult
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external control mechanism
If the incumbent management team is inefficient
if internal control mechanism fails to remove the management team
then we must rely on external control mechanism i.e. the market for corporate control
Takeover by another firm friendlyhostile
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Shareholder rights other than voting
dividends preemptive right stock split
preemptive rightThe right of a company's existing common shareholders to
have the first chance to purchase shares in a company's future
stock issuance.
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New stock issuance
New stock issuance can be a bonus or a rights issue
Bonus issueFirm issues free shares
Rights issueFirm issues new shares. Cash flows into the firm.
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Price adjustment
Price adjustment following the issuance of new stock:
Where SB and SR show the amounts of bonus and rights issues (in %),PR denotes the price at which the right will be used and Div shows the amount of cash dividend to be paid to “old”
shares
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Example
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Types of Common Stock
Some companies may have classified stock. In other words, there
can be more than one type of stock.
These will differ regarding: dividends and voting power
Most common: founders’ sharesSuperior voting rights, inferior dividend
rights
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Types of Stock Market Transactions
Based on number of stockholders, we can classify firms as: Closely held corporation Publicly owned corporation
Stocks of small publicly owned corporations are not listed, trade in OTC
We have previously defined Secondary market: trading of existing shares among investors Primary market: sale of new stock by publicly owned corporations
IPO market: stock of a closely held corporation is sold to public for the first time
Economically it is important to distinguish: Does company raise capital from public offering Does a large shareholder sell his/her stake to the public
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Valuation: dividend growth model
Value of a stock is the present value of the future dividends expected to be generated by the stock.
Even if you hold stock for only two periods the above equation is valid
This equation is not usable in practice, there are unknowns Some simplifying assumption that fits the observed pattern is
necessary.
ks is required return
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Valuation: dividend growth model
zero growth constant growth nonconstant growth
zero growth: Dt= Dt-1 t
constant growth: Dt= Dt-1(1+gt) gt=constant t
zero growth
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constant growth PV of future dividends under constant dividend growth rate assumption is:
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What happens if g > ks?
If g > ks, the constant growth formula leads to a negative stock price, which does not make sense.
The constant growth model can only be used if: ks > g g is expected to be constant forever
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Expected rate of return
Total return from investing in stocks is the sum of Dividend yield Capital gains yield
zero growth:
Capital gains is zero
constant growth:
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Nonconstant growth
To make the method useful in practice
Story 1: Profitable firm Growing market: high growth for a while Saturated market: constant lower level of growth afterwards
Story 2: Troubled firm. A plan to increase operating efficiency.Losses will continue for
a while Positive or zero growth thereafter
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Example
g1, g2, g3 non constant growth
g4=g5=gt t>3 constant growth
use D0 and g1, g2, g3, g4 to find D1-D4
use D4 to find
use D1-D3 and P3 to find P0
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Valuation free cash flow method
What if the firm is not paying dividends. How to determine the intrinsic value of its stock?
Especially young, fast growing firms may prefer not to pay any dividends so that they use all their earnings to finance growth.
In that case, one can forecast the free cash flows (FCF) the firm will generate in the next N years.
Free cash flow is the amount of cash flow remaining after a company makes asset investments necessary to support operations. In other words, it is cash flow available for distribution to investors. After N years, one can assume constant growth of FCF. The present value found will be the value of total firm. After subtracting the market value of debt, the remaining figure will be the value of equity.
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Valuation Firm multiples method
Analysts often use the following multiples to value stocks.
P / E P / CF P / Sales
EXAMPLE: Based on comparable firms, estimate the appropriate P/E. Multiply this by expected earnings to back out an estimate of the stock price.
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What is market equilibrium?
In equilibrium, stock prices are stable and there is no general tendency for people to buy versus to sell.
In equilibrium, expected returns must equal required returns.
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Market equilibrium
Expected returns are obtained by estimating dividends and expected capital gains.
Required returns are obtained by estimating risk and applying the CAPM.
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How is market equilibrium established?
If expected return exceeds required return … The current price (P0) is “too low” and offers
a bargain. Buy orders will be greater than sell orders. P0 will be bid up until expected return
equals required return
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Factors that affect stock price
Required return (ks) could change Changing inflation could cause kRF to change Market risk premium or exposure to market risk (β)
could change
Growth rate (g) could change Due to economic (market) conditions Due to firm conditions
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What is the Efficient Market Hypothesis (EMH)?
Securities are normally in equilibrium and are “fairly priced.”
Investors cannot “beat the market” except through good luck or better information.
Levels of market efficiency Weak-form efficiency Semistrong-form efficiency Strong-form efficiency
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Weak-form efficiency
Can’t profit by looking at past trends. A recent decline is no reason to think stocks will go up (or down) in the future.
Evidence supports weak-form EMH, but “technical analysis” is still used.
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Semistrong-form efficiency
All publicly available information is reflected in stock prices, so it doesn’t pay to over analyze annual reports looking for undervalued stocks.
Largely true, but superior analysts can still profit by finding and using new information
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Strong-form efficiency
All information, even inside information, is embedded in stock prices.
Not true--insiders can gain by trading on the basis of insider information, but that’s illegal.
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Is the stock market efficient?
Empirical studies have been conducted to test the three forms of efficiency. Most of which suggest the stock market was:
Highly efficient in the weak form. Reasonably efficient in the semistrong form. Not efficient in the strong form. Insiders could and
did make abnormal (and sometimes illegal) profits.
Behavioral finance – incorporates elements of psychology to better understand how individuals and markets respond to different situations.