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Valuation and Characteristics of Common Stocks

Valuation and Characteristics of Common Stocks. Financial Management B 642. Outline. What are stocks? Types of Stocks Preferred Stock Common Stock Characteristics of Preferred Stocks Characteristics of Common Stocks How to value a Preferred Stock? How to value a Common Stock?.

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Valuation and Characteristics of Common Stocks

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  1. Valuation and Characteristics of Common Stocks Financial Management B 642

  2. Outline • What are stocks? • Types of Stocks • Preferred Stock • Common Stock • Characteristics of Preferred Stocks • Characteristics of Common Stocks • How to value a Preferred Stock? • How to value a Common Stock?

  3. What is a Stock? • Stocks represent ownership capital • Stockholders are part owners of the company

  4. Types of Stocks • Preferred Stocks • A stock that enjoys preference over common stockholders in terms of payment of dividend and in terms of distribution of assets in case of liquidation of the firm • A hybrid security • Has features of both common stock and a bond • Pays a fixed rate of dividend each year (like coupon on a bond) and • Has infinite life (like common stock) • Non payment of dividend does not bring bankruptcy • Dividends cannot be deducted from firm’s income for tax purposes • Cumulative Dividend

  5. How to value preferred stock? • Present value of anticipated/expected cash flows when discounted at the required rate of return by the preferred stockholders • What cash flows are anticipated by preferred stockholders? • Dollar amount of dividend every year for an infinite time period • Value of Preferred Stock = PV of anticipated dividend discounted at the required rate of return • Examples

  6. Common Stocks • Common Stock • Common stockholders are the true owners of the company • Entitled to dividend if and when declared by the board of directors • Entitled to vote at the annual general meetings of the firm • They have the last claim on the assets of the firm after paying off creditors and bond holders and preferred stockholders • They are also residual owners

  7. How to value common stock? • PV of expected cash flows for common stockholders when discounted at the required rate of return for the common stockholders • What cash flows are expected by common stockholders? • An unequal stream of dividends for each year • Value of Common Stock = PV of dividends for common stock holders • Simplifying Assumptions to Value Common Stock • Zero Growth Model • Constant Growth Model

  8. Zero Growth Model • If we assume that dividend for common stockholder will be the same every year • DIV1 = DIV2 =DIV3=……=DIV • Under zero growth model, stockholders anticipate to receive the same amount of dividend per year forever • Thus, we have a perpetuity of dividends • Price of Stock will equal the present value of this perpetuity • Examples

  9. Constant Growth Model • If we assume that dividends grow at a constant rate of ‘g’ per year forever DPS1 P0 = --------- r - g

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