STOCK

COMMON STOCK
- Common stockholders are the owners of the firm.
- They elect the firm’s board of directors, who in turn appoint the firm’ s top
management team.

Claim on Assets
◦ In case of liquidation, common stockholders have residual claim on assets.
◦ However, bankrupt firms rarely have enough assets to satisfy the claims of
bondholders.

STOCK MARKET
Primary market: Market for the sale of new securities by corporations. The
corporation receives money from sale of its securities only in the primary market.

Secondary Market: Market in which already issued securities are traded by

investors.

Ex: Shannon sells 100 shares of Google stock from her portfolio for $500 per
share to help pay for her son Domenic’s college education. How much does
Google receive from the sale of its shares? Does this transaction occur on the
primary or secondary market?

THE BASIC VALUATION MODEL

CASH FLOWS TO STOCKHOLDERS

If you buy a share of stock, you can receive cash in two ways
◦ The company pays dividends (dividend yield)
◦ You sell your shares, either to another investor in the market or back to the
company (capital gain)
-> Price of stock is PV of these expected cash flow

THE DIVIDEND DISCOUNT MODEL (DDM)

Basic valuation model: Stock value is the present value of all expected future
cash flows:
1. Dividend
2. Price investors expected to receive when selling the stocks

DDM assumes that the price of any stock is equal to the present value of
the expected future dividends it will pay.

There are 3 versions of DDM:

◦ Zero growth
◦ Constant growth
◦ Non-constant growth

1. ZERO GROWTH DIVIDEND (thường gặp khi đề cho preferred stock):

firm pays a constant dividend indefinitely
D1=D2=D3=....=D=constant
- Stock can be viewed as an perpetuity

rE: required rate of return/ expected rate of return

 Ex: Paradise Prototyping Co. 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 of stock if the required return is 20%?

*PREFERRED STOCK
- In general, size of preferred stock dividend is fixed
- Preferred stockholders receive the same fixed dividend regardless of how well
the firm does
- In the event of bankruptcy, preferred stockholders have priority over common
stock. -> Debt (Bonds & bank loans) > PS>CS
- Firm must pay dividends on preferred stock prior to paying dividend on common
stock
=> Preferred stocks are less risky than common stocks but more risky than bonds.

2. CONSTANT GROWTH DIVIDEND (Gordon growth model)

If dividends grow at a constant rate forever, you can value stock as a Growing
Perpetuity

where D0 = dividend just paid

Dt = dividend at time t periods into the future
g = dividend growth rate

Ex: D1 = D0x(1+g)
D2 =D1x(1+g)=D0x(1+g)^2

Ex: 1. Suppose Big D, Inc., just paid a dividend of $0.5 per share. It is expected to
increase its dividend by 2% per year. If the market requires a return of 15% on assets of
this risk, how much should the stock be selling for?
2. Suppose TB Pirates, Inc., is expected to pay a $2 dividend in one year. If the dividend
is expected to grow at 5% per year and the required return is 20%, what is the price?

ESTIMATING GROWTH RATE (g)

A firm can do one of two things with its earnings:

◦ It can pay them out to investors.
◦ It can retain and reinvest them.

Retention growth model

◦ Payout ratio : Fraction of earnings paid out as dividend (phần trăm trả cổ tức)
◦ Plowback ratio (retention rate) : Fraction of earnings retained and reinvested in the
firm (phần trăm tái đầu tư)

3. NON-CONSTANT GROWTH DIVIDENDS (nhiều growth rate)

Ex: Estimate the current value of Morris Industries' common stock, P0

Assume:
◦ The most recent annual dividend payment of Morris Industries was $2 per share.
◦ Investors expect that these dividends will increase at an 30% annual rate over the next
3 years.
◦ After three years, dividend growth will level out at 6%.
◦ The firm's required return, r , is 13%
Ex2:
Suppose a firm is expected to increase dividends by 20% next year and by 15% the
following year. After that, dividends will increase at a rate of 5% per year indefinitely. If
the last dividend was $1 and the required return is 20%, what is the price of the stock?
Ex3: The Highfield Co.’s dividend is expected to grow at 20% for the next 5 years. After
that, the growth is expected to be 4% forever. If the required return is 10%, what’s the
value of the stock? The dividend just paid was $2

COMPONENTS OF THE REQUIRED RETURN

We can use DDM to find the required return
Ex: Suppose a firm’s stock is selling for $10.50. It just paid a $1 dividend, and dividends
are expected to grow at 5% per year. What is the required return? What is the dividend
yield? What is the capital gains yield?

REVISION EXERCISES

1. Fletcher Company’s current stock price is $36, its last dividend was
$2.40, and its required rate of return is 12%. If dividends are expected to
grow at a constant rate, g, in the future, and if required return is expected
to remain at 12% , what is Fletcher’s expected stock price 5 years from
now?
2. Snyder Computers Inc. is experiencing rapid growth. Earnings and dividends
are expected to grow at a rate of 15% during the next 2 years, 13% the following
year, and at a constant rate of 6% during Year 4 and thereafter. Its last dividend
was $1.15, and its required rate of return is 12%. a. Calculate the value of the
stock today. b. Calculate the expected price of the stock in year 1 and 2.