Shares (Equity) – Characteristics

and Valuation
Valuation of Financial Assets -
Equity (Stock)
 Preferred Stock: hybrid security
• similar to bonds with fixed dividend amounts
• similar to common stock as dividends are not
required and have no fixed maturity date
 Common Stock
Preferred Stock Features
 Par Value
 The nominal or face value of a stock or bond
 Cumulative Earnings
 Any preferred dividends not paid in previous periods must
be paid before common dividends can be distributed
 Maturity
 Generally has no specific maturity date
 Priority to Assets and Earnings
 Dividends must be paid on preferred stock before they can
be paid on common stock
Preferred Stock Features
 Control of the Firm (Voting Rights)
 Almost all preferred stock is nonvoting stock
 Convertibility
 Most preferred stock may be converted to common stock
 Other Provisions
 Call provision - Gives the issuing corporation the right to call
in the preferred stock for redemption
 Sinking fund - Call for the repurchase and retirement of a
given percentage of the stock each year
 Participating - Participates with the common stock in
sharing the firm’s earnings
Common Stock Features
 Par Value
 Legally, represents a stockholder’s minimum financial
obligation in the event the corporation is liquidated
 Dividends
 The firm has no legal obligation to pay common stock
dividends
 Maturity
 Generally has no specific maturity date
 Priority to Assets and Earnings
 Dividends can be paid only after the interest on debt and
the preferred dividends are paid
Common Stock Features
 Control of the Firm (Voting Rights)
 Common stockholders have the right to elect the
firm’s directors and to vote on shareholder’s
proposals, mergers, and changes in the firm’s
charter
 Preemptive Right
 Gives stockholders the right to purchase any
additional shares of stock sold by the firm before
the shares can be offered to new investors.
Types of Common Stock

 Classified Stock
Common stock that is given a special designation,
such as Class A, Class B, etc., to meet special
needs of the company
 Founder’s Shares
A class of stock owned by the firm’s founders who
have sole voting rights
Equity Instruments in International
Markets

 American Depository Receipts

Certificates created by banks that represent
ownership in stocks of foreign countries
 Foreign Equity
Yankee stock
Euro stock
Stock Valuation Models - Terms
 Market Price
P0 = the actual market price of the stock today

Pt = the expected price at the end of Year t

P0 = the intrinsic value as seen by the investor

P1 = the price expected at the end of Year 1

Stock Valuation Models - Terms
 Expected Dividends

Dt = the dividend the investor expects to

receive at the end of Year t

D0 = most recent dividend already paid

D1 = is the next dividend expected to be paid

and it will be paid at the end of this year
Stock Valuation Models - Terms
 Growth Rate

g = the expected rate of change in

dividends per share
Stock Valuation Models - Terms
 Required Rate of Return

rS = the minimum rate of return on a

common stock that stockholders consider
acceptable given its riskiness and returns
available on other investments
Stock Valuation Models - Terms
 Dividend Yield

The expected dividend divided by the

current price of a share of stock
Stock Valuation Models - Terms
 Capital Gain Yield

the change in price (capital gain) during

a given year divided by its price at the
beginning of the year
Stock Valuation Models - Terms
 Expected Rate of Return

The rate of return on a common

stock that an individual investor
expects to receive
Stock Valuation Models - Terms
 Actual Rate of Return

= the rate of return on a common stock that

an individual investor actually receives, after
the fact; equal to the dividend yield plus the
capital gains yield.
Expected Dividends as
the Basis for Stock Values
Cash-flow Timeline

s
Expected Dividends as
the Basis for Stock Values
Valuing Stocks with Zero Growth
 Assume that dividends will remain at the same level
forever

· Since future cash flows are constant, the value of a zero

growth stock is the present value of a perpetuity:
Valuing Stocks with Constant, or Normal,
Growth
 Growth that is expected to continue into the
foreseeable future at about the same rate as
that of the economy as a whole.
Normal, or Constant, Growth
(Gordon Model)
Present Value of Dividends of a Constant
Growth Stock
Expected Rate of Return on a Constant
Growth Stock
Valuing Stocks with
Nonconstant Growth
 Nonconstant Growth: The part of the life
cycle of a firm in which its growth is either
much faster or much slower than that of the
economy as a whole.
Valuing Stocks with
Nonconstant Growth
1. Compute the value of the dividends that experience
nonconstant growth, and then find the PV of these
dividends,
2. Find the price of the stock at the end of the
nonconstant growth period, at which time it has
become a constant growth stock, and discount this
price back to the present, and
3. Add these two components to find the intrinsic value
of the stock P0.
· Assume that dividends will grow at rate g1 for N
years and grow at rate g2 thereafter.
Dividends will grow at rate g1 for N years and grow
at rate g2 thereafter

…
0 1 2

… …
N N+1
We can value this as the sum of:
 a T-year annuity growing at rate g1

 plus the discounted value of a perpetuity growing at

rate g2 that starts in year T+1
Consolidating gives:
Other Stock Valuation Models
 P/E Ratios
The higher the P/E ratio the more investors are
willing to pay for each rupee earned by the firm
P/E ratio gives an indication of a stock’s “payback
period”
Other Stock Valuation Models
 Economic Value Added Approach
Changes in Stock Prices

 Prices move opposite to changes in rates of

return
 They move in the same direction as changes
in cash flows expected from the stock in the
future