Chapter 8

A share of common stock is more difficult to value in practice than a bond for at least three reasons.
1. not even the promised cash flows are known in advance.
2. the life of the investment is essentially forever because common stock has no maturity.
3. there is no way to easily observe the rate of return that the market requires.
Calculating the return
(Sale price / purchase price) - 1

More generally, let P0 be the current price of the stock, and assign P1 to be the price in one period. If D1 is
the cash dividend paid at the end of the period, then:
where R is the required return in the market on this investment.

The current price of the stock can be written as the present value of the dividends beginning in one period
and extending out forever:

We have illustrated here that the price of the stock today is equal to the present value of all of the future dividends.

Simplifying assumptions about the pattern of future dividends. The three cases we consider are the following: (1)
The dividend has a zero growth rate, (2) the dividend grows at a constant rate, and (3) the dividend grows at a
constant rate after some length of time.

1. Zero growth rate: Because the dividend is always the same, the stock can be viewed as an ordinary
perpetuity with a cash flow equal to D every period. The per-share value is thus given by:
where R is the required return.

2. Constant growth: growing perpetuity. we know that the dividend t periods into the future, Dt, is
given by:
where g = growth rate and D0 = the dividend just paid
As long as the growth rate, g, is less than the discount rate, r, the present value of this series of cash
flows can be written simply as:
Dividend growth model

The price of stock at time t:

First find the dividend then calculate the stock price.
Growth rate must be less than discount rate.

3. Nonconstant growth: the growth rate cannot exceed the required return indefinitely, but it certainly could
do so for some number of years.
To see what the stock is worth today, we first find out what it will be worth once dividends are paid. We can
then calculate the present value of that future price to get todays price.

The first dividend will be paid in five years, and the dividend will grow steadily from then
on. Using the dividend growth model, we can say that the price in four years will be:

If the stock will be worth $5 in four years, then we can get the current value by
discounting this price back four years at 20 percent:

The stock is therefore worth $2.41 today.

If dividends are not zero the first few years To calculate this present value, we first have to compute the present value of the stock price three
years down the road, just as we did before. We then have to add in the present value of the
dividends that will be paid between now and then. So, the price in three years is:

We can now calculate the total value of the stock as the present value of the first three dividends
plus the present value of the price at Time 3, P3:

The value of the stock today is thus $43.88.

4. Two-stage growth:

Calculate stock price t years from now

Then plug the result into the two-stage formula

Required return - Earlier, we calculated P0 as:

If we rearrange this to solve for R, we get:

This tells us that the total return, R, has two components.

D1/P0, is called the dividend yield, it is conceptually similar to the current yield on a bond.
Growth rate, g. We know that the dividend growth rate is also the rate at which the stock price grows. Thus, this
growth rate can be interpreted as the capital gains yieldthat is, the rate at which the value of the investment
grows.

The dividend growth model calculates total return as:

Capital gains yield(or capital gains yield)

Stock valuation using multiples When companies dont pay dividends.

A common approach is to make use of the PE ratio (stock price/EPS), which we defined in Chapter 3 as the ratio
of a stocks price per share to its earnings per share (EPS) over the previous year.

A PE ratio that is based on estimated future earnings is called a forward PE ratio.

Notice that your benchmark PE of 20 applies to earnings over the previous year.
If earnings over the coming year turn out to be $2.50, then the stock price one year from today should be 20
$2.50 = $50. Forecast prices such as this one are often called target prices.
-

When companies dont pay dividends and are not yet profitable.
Use the pricesales ratio Price per share/sales per share
As with PE ratios, pricesales ratios vary depending on company age and industry.
Typical values are in the .82.0 range, but they can be much higher for younger, faster-growing
companies.

8.2
Shareholder rights

Cumulative voting directors elected all at once

In general, if there are N directors up for election, then 1/(N + 1) percent of the stock plus one share will
guarantee you a seat.

Straight voting directors elected one at a time.

Staggered boards - called classified boards because directors are placed into different classes with terms that
expire at different times.

Two basic effects

1. makes it more difficult for a minority to elect a director because there are fewer directors to be
elected at one time.
2. makes takeover attempts less likely to be successful because it makes it more difficult to vote in
a majority of new directors.
Staggering provides institutional memorythat is, continuity on the board of directors. This may be
important for corporations with significant long-range plans and projects.
8.3
Stock Markets
primary market - , or new issue, market, shares of stock are first brought to the market and sold to
investors.
secondary market - existing shares are traded among investors.
A dealer maintains an inventory and stands ready to buy and sell at any time.
Bid price the price a dealer is willing to pay.
Ask price the price at which the dealer will sell.
Spread the difference between the bid and asked price, dealer profits.

A broker brings buyers and sellers together but does not maintain an inventory. Arranges transactions
between investors, matching investors wishing to buy securities with investors wishing to sell securities.

There are three different types of license holders

Designated market makers (DMMs) - maintains a two-sided market, meaning that the DMM
continually posts and updates bid and ask prices. By doing so, the DMM ensures that there is
always a buyer or seller available, thereby promoting market liquidity.
Floor brokers - execute trades for customers, with an emphasis on getting the best price
possible. The interaction between floor brokers and DMMs is the key to nonelectronic trading on
the NYSE.
Supplemental liquidity providers (SLPs) - investment firms that agree to be active participants
in stocks assigned to them. Their job is to regularly make a one-sided market (i.e., offering to
either buy or sell). SLPs do not operate on the floor of the stock exchange.
Order flow - means the flow of customer orders to buy and sell stocks.

There are two key differences between the NYSE and NASDAQ:
1. NASDAQ is a computer network and has no physical location where trading takes place.
2. NASDAQ has a multiple market maker system rather than a DMM system.

A securities market largely characterized by dealers who buy and sell securities for their own inventories is
called an over-the-counter (OTC) market.

Many people still refer to NASDAQ as an OTC market.

NASDAQ has three levels of information access.

Level 1 is designed to provide a timely, accurate source of price quotations. These prices are
freely available over the Internet.
Level 2 allows users to view price quotes from all NASDAQ market makers. In particular, this
level allows access to inside quotes. Inside quotes are the highest bid quotes and the lowest
asked quotes for a NASDAQ-listed security. Level 2 is now available on the Web, sometimes for
a small fee.
Level 3 is for the use of market makers only. This access level allows NASDAQ dealers to enter
or change their price quote information.

NASDAQ is actually made up of three separate markets:

the NASDAQ Global Select Market - larger and more actively traded securities, lists about 1,200
companies
the NASDAQ Global Market - somewhat smaller in size, and NASDAQ lists about 1,450 of these.
the NASDAQ Capital Market - smallest companies listed, about 650 are currently listed.

electronic communications networks (ECNs) - ECNs act to increase liquidity and competition.
Notice that the yield is just the reported dividend divided by the stock price: $1.24/$111.79 = .011, or 1.1%.