Equity Characteristics and Valuation
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What is the primary characteristic of preferred stock compared to common stock?

  • Preferred stock has voting rights.
  • Preferred stock has fixed dividend payments. (correct)
  • Preferred stock can fluctuate more in value.
  • Preferred stock is less risky than common stock.

    • Which model would be most appropriate for valuing stocks with nonconstant dividend growth?

  • Constant growth dividend model.
  • Access to historical market prices.
  • Gordon growth model.
  • Discounted cash flow model. (correct)

    • What is the main factor that influences stock prices?

  • Company's profitability. (correct)
  • Current interest rates.
  • Historical performance of stock indices.
  • Popularity of the company.

    • How can investors evaluate stocks aside from the time value of money models?

    <p>Comparative analysis of dividend yield.</p> Signup and view all the answers

    Which statement best describes common stock?

    <p>It generally offers voting rights to shareholders.</p> Signup and view all the answers

    What happens to stock prices when a company's dividends grow at a constant rate?

    <p>They increase steadily over time.</p> Signup and view all the answers

    How do stock prices generally react to changes in rates of return?

    <p>Prices decrease with higher rates of return</p> Signup and view all the answers

    In which scenario do stock prices move in the same direction?

    <p>When cash flows from the stock are expected to change</p> Signup and view all the answers

    Which of the following is NOT a feature of preferred stock?

    <p>Voting rights for shareholders.</p> Signup and view all the answers

    Which approach is typically used to estimate a stock’s value when dividends are expected to grow at nonconstant rates?

    <p>Two-stage dividend discount model.</p> Signup and view all the answers

    What is one way stocks may be evaluated besides traditional models?

    <p>Economic Value Added Approach</p> Signup and view all the answers

    What is a consequence of a decrease in expected cash flows for a stock?

    <p>The stock price may decrease</p> Signup and view all the answers

    What is prohibited regarding the distribution of the content provided?

    <p>Public sharing without permission</p> Signup and view all the answers

    What is meant by nonconstant growth in the context of valuing stocks?

    <p>Growth that fluctuates more than the economy's average.</p> Signup and view all the answers

    What is the first step in valuing stocks with nonconstant growth?

    <p>Calculate expected dividends during the nonconstant growth period.</p> Signup and view all the answers

    How is the present value of dividends computed during the nonconstant growth phase?

    <p>Using the required rate of return to discount the future dividends.</p> Signup and view all the answers

    What happens to the dividends computed during the nonconstant growth period after the last dividend?

    <p>They transition to a constant growth model.</p> Signup and view all the answers

    What is a characteristic of constant growth in a stock's valuation?

    <p>The growth rate is fixed and predictable.</p> Signup and view all the answers

    What does 'rs' represent in the context of stock valuation?

    <p>The investors’ required rate of return.</p> Signup and view all the answers

    In the context of growth stocks, what does a growth rate of g = 0 imply?

    <p>No growth in dividends is anticipated.</p> Signup and view all the answers

    What is necessary to calculate the present value of expected dividends in the nonconstant growth period?

    <p>The investors’ required rate of return.</p> Signup and view all the answers

    What is the initial step in valuing stocks with nonconstant growth?

    <p>Compute nonconstant growth dividends</p> Signup and view all the answers

    What should be calculated after computing nonconstant growth dividends?

    <p>The first constant growth dividend</p> Signup and view all the answers

    What is the purpose of calculating the PV of P̂3?

    <p>To determine the present value of future cash flows from the stock</p> Signup and view all the answers

    How is the intrinsic value of the stock ultimately found?

    <p>By summing the results of nonconstant and constant growth calculations</p> Signup and view all the answers

    What does a higher P/E ratio indicate about a stock?

    <p>Investors are willing to pay more for each dollar earned by the firm</p> Signup and view all the answers

    Which of the following factors influences the payback period indicated by the P/E ratio?

    <p>The company's earnings relative to its stock price</p> Signup and view all the answers

    Why might an investor compare the P/E ratio of different stocks?

    <p>To determine relative stock valuations</p> Signup and view all the answers

    When valuing stocks with constant growth, what should be computed during Step 2?

    <p>The first constant growth dividend</p> Signup and view all the answers

    What is a feature of preferred stock regarding dividends?

    <p>Dividends must be paid before any common stock dividends.</p> Signup and view all the answers

    How does the maturity of preferred stock compare to other securities?

    <p>Preferred stock has no specified maturity date.</p> Signup and view all the answers

    What priority do preferred dividends have in relation to debt?

    <p>Interest on debt must be paid before preferred dividends.</p> Signup and view all the answers

    Which statement best describes voting rights associated with preferred stock?

    <p>Preferred stock typically has limited or no voting rights.</p> Signup and view all the answers

    What does convertibility in preferred stock imply?

    <p>Preferred stock can be converted to common stock at the investor's option.</p> Signup and view all the answers

    What is the significance of cumulative dividends in preferred stock?

    <p>Cumulative dividends need to be paid before any dividends on common stock.</p> Signup and view all the answers

    What does par value represent in the context of preferred stock?

    <p>The nominal or face value of the stock or bond.</p> Signup and view all the answers

    Which of the following correctly distinguishes common stock from preferred stock?

    <p>Common stock may provide voting rights, while preferred stock usually does not.</p> Signup and view all the answers

    What is the primary basis for the valuation of stocks with expected dividends?

    <p>Expected dividends</p> Signup and view all the answers

    Which growth type is characterized by a consistent rate expected to match the overall economy?

    <p>Constant growth</p> Signup and view all the answers

    If the expected growth rate (g) for a stock is 5%, how is this expressed as a decimal?

    <p>0.05</p> Signup and view all the answers

    In the given example of a constant growth stock, what is the expected dividend (D0)?

    <p>$1.60</p> Signup and view all the answers

    What does the variable 'rs' represent in the context of stock valuation?

    <p>Required rate of return</p> Signup and view all the answers

    What is the impact of a higher required rate of return (rs) on the present value of a stock's dividends?

    <p>Decrease in present value</p> Signup and view all the answers

    If a stock's dividends are expected to maintain constant growth, what characteristic distinguishes this type of growth?

    <p>Alignment with economic performance</p> Signup and view all the answers

    What can be inferred if the growth rate for a stock is below the required rate of return?

    <p>The stock is overvalued</p> Signup and view all the answers

    Study Notes

    Equity Characteristics and Valuation

    • Equity is a type of ownership in a company
    • Preferred stock is a hybrid security, similar to bonds with fixed dividends, but dividends are not required and there is no maturity date
    • Common stock has no fixed dividend payments and no maturity date.
    • Preferred stock has priority to assets and earnings, paid after interest on debt, but before common stock dividends
    • Preferred stock is almost always nonvoting
    • Preferred stock can be convertible to common stock
    • Preferred stock can have other provisions, such as a call provision (allowing the issuing corporation to buy back the stock) or a sinking fund (requiring the repurchase of a set percentage of stock at particular times)
    • Participating preferred stock shares in the distribution of the firm's earnings with common stockholders
    • Common stock has no legal obligation to pay dividends
    • Common stock legally represents a stockholder's minimum financial obligation if the corporation is liquidated
    • Common stock gives stockholders voting rights to elect directors and vote on proposals.
    • Common stock can have preemptive rights, giving current stockholders the right to buy additional shares before they are offered to new investors
    • Classified stock has special designations (e.g., Class A, Class B) to meet specific needs
    • Founder's shares are owned by the company's founders and have sole voting rights in early years
    • American Depository Receipts (ADRs) are certificates that represent ownership in foreign stocks
    • Yankee stock is stock of a foreign company traded in the US
    • Euro stock is traded in a country other than the company's home country

    Stock Valuation Models - Terms

    • Dt = dividend expected at the end of Year t

    • Pt = expected price of the stock at the end of Year t

    • P0 = actual price of the stock at the end of Year t

    • g = expected growth rate in dividends

    • rS = required rate of return (minimum rate investors expect)

    • If the expected rate of return (rs) is greater than or equal to the required rate of return, it is a good investment; otherwise, not a good investment.

    Stock Valuation Models - Cash Flow Timeline

    • Present Value of all future dividends sums to the Intrinsic Value of the stock

    Valuing Stocks with Constant, or Normal, Growth

    • Growth is expected to continue into the foreseeable future at about the same rate as the economy
    • g = constant growth stated as a decimal

    Valuing Stocks with Constant Growth Formula

    • P0 = D1 / (rs - g)

    Special Case of Constant Growth: g = 0

    • P0 = D1 / rs

    Expected Rate of Return on a Constant Growth Stock

    • rs = D1/P0 + g

    Valuing Stocks with Nonconstant Growth

    • Nonconstant growth is when a company's growth is either much faster or slower than the economy
    • Dividends grow at a specific rate for a period of time.
    • Calculate dividend for the growth phase
    • Calculate the present value of each growth phase dividend
    • Calculate the Present Value of the constant growth portion of the dividend stream
    • Sum the present values from both phases to get intrinsic value

    Other Stock Valuation Models

    • P/E Ratio: P/E = Market Price per share of common stock / Earnings per share
    • Economic Value Added (EVA): EVA = EBIT(1-T) – [(Average cost of funds) x (Invested capital)]

    Changes in Stock Prices

    • Prices move opposite to changes in rates of return.
    • Prices move in the same direction as changes in expected cash flows from the stock in the future.

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    Stocks Valuation Models PDF

    Description

    Explore the key characteristics and valuation methods for equity, focusing on preferred and common stock. This quiz covers essential concepts such as dividend payments, voting rights, and preferential treatments of different stock types. Test your understanding of equity ownership in companies.

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