Global Portion Investment PDF

# Chapter 1: Asset Classes and Securities ## Learning Objectives Upon completion of this chapter, students will be able to: - Describe the characteristics of common stock - Explain the purpose of an Initial Public Offering (IPO) - Explain dividends - Calculate the dividend payout ratio - Explain ke...

# Chapter 1: Asset Classes and Securities ## Learning Objectives Upon completion of this chapter, students will be able to: - Describe the characteristics of common stock - Explain the purpose of an Initial Public Offering (IPO) - Explain dividends - Calculate the dividend payout ratio - Explain key dates associated with stock dividend payouts - Calculate stock splits and reverse stock splits - Explain why a company would use a stock split or reverse stock split - Calculate the intrinsic value of a dividend-paying stock using the dividend discount model - Describe alternative valuation methods for stocks that do not pay a dividend - Describe the characteristics of a bond - Identify the types of bonds issued by various entities - Calculate a bond's current price/value - Describe the characteristics of preferred stock - Calculate the inherent value of preferred stock using the zero-growth model - Describe the advantages and disadvantaged of owning real estate - Calculate the value of income-producing real estate using the net income method - Identify strategies used to employ call and put options - Explain structured products - Explain how futures contracts are used to hedge a long or short position - Explain alternative investments ## Introduction Which is best-stocks, bonds, commodities, real estate, or something else? At one time or another, most people have heard a supposed guru expounding on the value of investing in a particular asset type. The financial advisor's objective is to know enough about various asset types to be able to incorporate them appropriately into clients' portfolios in a way that best meets clients' goals, risk profiles, and other criteria. The opportunities available to investors are plentiful and varied. The many types of financial instruments can be categorized into groups with shared traits called asset classes. Assets that offer a fixed return, such as bonds, are in the fixed income asset class. Assets that represent ownership in an underlying company are in the equity asset class. Assets that create more income or growth opportunities from an underlying asset are in the derivatives asset class. In this chapter, we're going to review several of the main asset classes: equity, fixed income, real assets (primarily real estate), commodities, derivative securities, structured products (market-linked), and alternatives. ## To deploy an asset, one must first purchase it. How and when you purchase the asset can have an impact on how successful it is within a client's portfolio. Eventually assets must be liquidated, and their disposal can affect taxes as well as the ending value received for the asset. We will explore each area in this chapter, starting with a discussion of the characteristics of equities/common stock holdings. ## Equity/Common Stock ### Capitalization of a Business At some point in their development, most businesses find themselves in need of additional capital. Normal operations, expansion and growth, and maintaining adequate cash flow are reasons why an organization might need additional money. Many businesses receive initial financing by the business owner, who may have ready assets to use. Sometimes, family and friends help with the funding. Depending on the circumstances, the owner may also take out personal loans (or use credit cards) to fund operations. Personal funds or loans are not normally enough in the long term for the business, especially if the company is growing. An owner who wants the business to continue growing eventually faces a funding need. One of the most frequently used methods to raise capital for a growing business is to issue stock. Stock acts as permanent capital because, unlike bonds, it has no maturity. Therefore, it exists for as long as the company is in business. Companies generally issue stock in one of two forms: common or preferred (preferred stock is discussed in more detail later in this unit). Stocks represent ownership of a company (i.e., equity). Common stock represents basic company ownership. Common stockholders generally have voting rights, along with rights to any discretionary dividends paid or increases in the stock's value. When most people talk about stock ownership, they are generally referring to common stock. ### Rights Ownership of common stock confers ownership in the company. In addition to holding equity, common stockholders (normally) have certain legal rights, including dividends, voting, and preemptive rights (i.e., the right to purchase new stock issue before others). Dividends consist of a portion of the company's profits that are distributed to shareholders. Shareholders have the right to receive declared dividends in proportion to the number of shares of stock they own. Most common stock comes with voting rights. Shareholders have the right to elect members to the board of directors and to vote on corporate policy at the annual meeting, the issuance of additional securities, stock splits, and any other substantial changes in the company. Each share of stock normally confers one vote for the shareholder. Shareholders may cast votes either in statutory or cumulative voting. Statutory voting entitles the shareholder to cast one vote per share of stock for each position on the board of directors. Cumulative voting has one difference from statutory voting. Under a cumulative voting system, shareholders can cast their votes in any way they want. For example, assume there are five positions open on the board. A shareholder with 150 shares has 750 total votes (150 shares times each of the five positions). Under the statutory system, the shareholder could give a maximum of 150 votes for each candidate. Under a cumulative system, that same shareholder could cast all 750 votes for one candidate. The cumulative system allows minority shareholders to have a greater potential impact in elections. Sometimes a company will have different classes of shares, such as A and B shares, and greater voting rights link to shares of one of those classes, even to the point where one class has voting rights and the other class does not. A proxy is a written power of attorney authorizing someone to vote on behalf of, and on the instructions of, a shareholder. This would be used when the shareholders will not be attending an annual meeting. Companies usually send proxy forms to shareholders prior to a given meeting and shareholders use them for voting during that meeting. Preemptive rights come into play when a stockholder tries to maintain a certain percentage ownership of a company. Preemptive rights give stockholders the right to purchase enough of any newly issued shares of stock to maintain their ownership percentage. Stockholders get the right to purchase the shares before they're offered to the public. Not all shares of common stock come with preemptive rights. Where they exist, shareholders receive a subscription warrant indicating how many shares they are entitled to buy prior to the new issue. The subscription price (the price at which shareholders can purchase the new stock) often is lower than the market value at the time of the offering. ### Other Rights Owners of common stock have other rights, including the right to receive annual reports and know about the other stockholders. Owning common stock does not normally convey the right to make a detailed inspection of all the corporation's account books. Shareholders have limited liability. As such, they are protected from having to pay off all the debts of a corporation; they are liable only up to the amount of money invested in the company. ### Initial Public Offering (IPO) Stock ownership is usually categorized as either public or private. Publicly owned stocks are traded on the various stock exchanges or the over-the-counter (OTC) market, which is a network of dealers trading electronically. A limited number of individuals (sometimes family members) usually own privately held corporations, which do not trade stock on any stock exchange. Closely held companies are those that have at least a majority of their shares held by one individual or family. When small businesses choose to issue additional shares of stock, they often become publicly held corporations through an initial public offering (IPO). Once issued, the stock from companies with IPOs typically trades in the over-the-counter market because the companies are so young that they do not yet meet the requirements for listing on one of the exchanges. When a company is ready to raise capital through a security offering (e.g., IPO), it will approach an investment bank to underwrite the offering. As the underwriter, the investment bank agrees to either sell the security to the public to meet demand (returning unsold shares to the company) or buy all company shares issued to sell them itself. When the investment bank is simply facilitating the sale to the public, it's called a best efforts commitment. When the investment bank buys all shares to resell them, it's called firm commitment underwriting. In addition to investment banks, an IPO uses the services of other entities, such as accounting and law firms, collectively referred to as the selling syndicate. As part of the stock-issuing process, the company will need to develop and deliver offer documentation, including a prospectus. These are legal documents that provide important details about the business and the stock offering. The initial prospectus will identify the size of the offering (how many shares of stock), the offering price, and if it refers to a mutual fund, details about the fund's objectives, investment strategies, fees, expenses, fund management, and risks. The prospectus will also identify the investment bank(s), names of the company's principals, the company's financial information, etc. The offer documents usually need to be registered with the securities authority in that territory (such as the Securities Exchange Commission in the US, or the Brazilian Securities Commission (CVM)). These offer documents must be provided to all who express interest in the company's stock before a purchase is made. Purchasing stock through an IPO usually involves a large amount of risk. The company is often small and/or unknown. It has not had enough time to prove its viability. This may mean large losses for investors (especially considering that some IPOs have initially high prices), or it may mean large profits when things work out as hoped. ## Buying and Selling Securities Most individuals purchase investment products either directly (such as a direct purchase from a mutual fund company) or through the securities markets. Investments can be tangible (like gold bars, or a rental property) or intangible (like stocks, bonds, bank deposits, and mutual funds). Intangible investments are also called securities, There are four types of securities markets, although individuals are typically only involved with the first two. Let's look at the four markets in which securities trade. ### Primary Market The primary market is where all initial public offerings (or IPOs) occur. These are stocks and bonds that are being offered to the public for the first time. When buying in this market, the investor is buying the security directly from the issuer. ### Secondary Market The secondary market is where investors trade existing securities. In these transactions, the seller of the securities, rather than the issuing company, receives the proceeds. Transactions in this market normally happen through one of the stock exchanges. Most developed territories have at least one stock exchange, and individuals from one territory can trade on exchanges from other territories as well. Broad movements in stock prices can be followed by watching the various stock market indexes, each of which is related to a given exchange. A sampling of market indexes includes: - ASX 200 (XJO)-Australia - Bovespa (BVSP)-Brazil - Toronto Exchange (TSX)-Canada - S&P 500-U.S. - FTSE 100 (UKX)-U.K. - CAC 40 (CAC)-France - DAX (DAX)-Germany - Hang Seng (HSI)-Hong Kong - NZX 50 (NZ50)-New Zealand - Nikkei 225 (NKY)-Japan - Shanghai A Share (SHASHR)-China - KRX 100 (KRX100)-South Korea ### Third Market The third market is used by institutional investors and broker-dealers who are not exchange members, to trade large blocks of exchange-listed securities outside of exchanges, known as the "OTC" or "over-the-counter" market. The over-the-counter, futures, commodities, currency, and other markets have additional indexes. There are too many to list, but below are a few examples: - The Intercontinental Exchange (ICE) lists indexes for agriculture, credit, currency, energy, futures, and several additional areas. - The Nasdaq Composite Index represents over 4,000 stocks traded over-the-counter on the Nasdaq Stock Market, many of which are mid-cap and small-cap stocks in the technology industry. - The Eurex deals with futures contracts throughout Europe. - NYSE Euronext is a global exchange trading futures, options, bonds, and all types of global equities. ### Fourth Market The fourth market is also for institutional investors. Here, institutions buy and sell securities directly with one another through private computer networks. INSTINET (Institutional Networks Corporation), owned by Nomura Holdings in Tokyo, is an example of one of these networks. When investors purchase securities in the secondary market, they do so by placing an order. Orders typically represent 100 shares of stock, commonly referred to as a "round lot," with each security having two prices quoted: a bid price and an ask price. This is because the secondary market operates as an auction between investors. The bid price indicates the maximum price a buyer is willing to pay for a security, and the ask price is the minimum price a seller is willing to receive for a security. The difference between the bid and ask prices is referred to as the "spread." ## Types of Orders Sometimes, investors want to place specific parameters around the purchase and sale of a security (also called a position). They may want to purchase only when a security hits a certain price or sell when the security reaches a profitable price. These parameters determine the type of order the investor wants a financial advisor or broker to place. There are five types of orders we're going to review. ### 1) Market Orders A market order is a request to immediately buy or sell a position at its current price in the market. Market orders are executed at the best available price at the time the order is placed, which is not guaranteed. ### 2) Limit Orders A limit order is an order to purchase or sell a security at a specific price, which sets either the maximum amount an investor is willing to pay for a purchase, or the minimum amount an investor is willing to accept for a sale. The order will not be executed unless the specified price (or better) is reached. ### 3) Stop Order A stop order (or stop-loss order) is an order to buy or sell a security once a price is reached, that becomes a market order once triggered. A sell stop order would be placed below the current price of the stock (to defensively sell if the stock falls to a certain price) and a buy stop order would be placed above the current price (to buy if a stock price rises to a certain point). **Example:** An investor owns a stock that is currently trading at $50 per share that they originally purchased for $30. They are concerned that the price may decline, and while they don't want to sell their shares right now, they do want to protect at least some of their profit. The investor could enter a sell stop order at $40, and the order would not be executed unless the stock's price dropped to $40 or below. It is important to note that with a sell stop order, $40 is the trigger price but not necessarily the price that will be received. In a rapidly declining market, the investor may get a price lower than the trigger price. ### 4) Stop Limit A stop limit order is similar to a stop or stop-loss order, except that once triggered, the order becomes a limit order rather than a market order. **Example:** An investor owns a stock that is currently trading at $50 per share that was originally purchased for $30. The investor wants to use the same $40 stop price but does not want to sell for less than $40. In this case, a stop-limit order would be entered, and if the stock price fell to $40 a limit order would be triggered to sell the stock, but only at $40-nothing less. ### 5) Good 'til Cancelled Good-til-cancelled (GTC) orders stay open until they are either executed or cancelled. Some institutions will place a time limit on GTC orders, such as 90 days, after which time the order is automatically cancelled. ## Buying on Margin Investors in some territories are not limited to using cash to buy securities. For these investors, instead of establishing a cash account they can establish a margin account, which allows them to buy more shares of stock by borrowing money from the investment firm (this is not allowed in some jurisdictions). With a margin account, an investor deposits cash for a portion of the purchase and borrows the remaining amount from the institution holding the account. Broadly speaking, this is known as leverage the use of debt to increase potential return (or loss). Margin accounts must comply with specific regulations, which cover the extension of credit, establish the initial and maintenance margin, and define which securities may be purchased on margin (some securities are not eligible). Initial margin is the amount of cash the investor must deposit to make the purchase and maintenance margin is the percentage of equity the investor must maintain in the position. If the stock's price falls too far, a maintenance call will be issued, and the investor must immediately deposit additional cash to restore their percentage of equity to the required level. If the margin call is not met in time, the institution will liquidate the position and the investor will be responsible for any losses in addition to the borrowed funds. ## Short Sale An investor who owns shares of stock is said to be "long" the stock. Most investors hold long positions. Generally, investors go long when they expect the price of a stock to increase, hoping to sell the stock in the future for a higher price than it was purchased at. However, sometimes an investor may believe a stock will fall in value rather than increase. When this is the case, the investor may sell the stock short. When a stock is sold short, an investor borrows shares of stock, sells the shares at the current market price, and hopes to purchase the shares at a lower price in the future (to replace the borrowed shares) - just the opposite of a long position. Selling short must be done through a margin account, and requires more market acumen than simply buying a stock in a long position. Not all shares of stock are available to sell short, and the potential losses can be significant. Given that there is no theoretical limit to how high a stock's price can go, there is theoretically no limit to how much an investor can lose by short selling a stock and being wrong. **Example:** An eligible stock is currently trading at $30, and an investor believes that price is too high, and will fall soon. She calls her broker and instructs them to "sell short" 100 shares of the stock. The broker does so, and the investor receives $3,000, not counting trading costs (100 shares x $30). A month later the stock declines to $20 per share, and the investor buys 100 shares (to replace the shares originally borrowed from the broker), which costs $2,000 (100 shares x $20). The $1,000 difference is kept as a profit. Let's say, on the other hand, that instead of declining, the stock's price rose to $40. The investor originally received $3,000 by selling short. This investor must now purchase the stock (to replace to the broker) at $40 per share, or a total of $4,000-a loss of $1,000. As you can see, this can be a very risky strategy. ## Types of Return from Common Stock Common stock offers two types of return: capital appreciation (growth) and dividends (income). Some companies do not pay dividends, choosing to reinvest all net profits back into the company to fund more growth. Similarly, some companies, especially those that are mature, do not provide much growth, but do pay regular dividends. ### Capital Appreciation Most public companies want to grow. Young companies must grow or they may be forced out of business. Well-established, older companies sometimes get to the point where they don't show much real growth anymore but are nonetheless profitable and have good earnings. Public companies that grow provide opportunities for investment growth. As the company's revenue and earnings grow, the company's stock would be expected to increase in price. A company's value comprises several factors, including sales (market share), gross revenues, net earnings, tangible assets (land, buildings, equipment, etc.), patents and other creative properties, and goodwill (the intangible values a company has; for example, the name "BMW" has value to the company because of its reputation and name recognition, but that value is not specifically shown on its balance sheet). To some extent, a value can be assigned to each of the preceding factors. Revenue, earnings, tangible assets, and the like are easy to value. Goodwill, patents, and other less-tangible assets are more difficult to value, but they can be worth quite a bit to shareholders. The market price of a given stock should reflect the company's underlying assets and its earning power; however, this is not always the case. Often, the price of a stock reflects how the market perceives the stock. In other words, perception becomes reality, and market dynamics may cause the price of a stock to rise or fall out of proportion with the intrinsic value of the company. It is possible, therefore, to identify stocks that are "bargain priced." That is, the price of the stock is less than the value of underlying assets and its earning power. Sometimes, the market does not perceive that a given stock should be priced according to the company's assets and earnings. The value investing style looks for the stocks of these companies. Why? If a company is truly underpriced-i.e., its intrinsic value is greater than the price of the stock (market value) the stock offers the potential for increased capital appreciation. These stocks generally offer lower risk of loss as well, since the underlying assets provide a measure of safety. Of course, the reverse also can be true. The market may price a stock higher than the company or the underlying assets and earnings should merit. Stocks do get overpriced. Because a "market" is simply the sum total of all people with an interest in buying or selling something, it is prone to "crowd mentality," where many people are buying or selling just because everyone seems to be doing the same. One reason for stock market corrections and crashes is that too many people have bought stocks for too much money. Eventually, reality settles in, and stock prices fall-often to below their intrinsic values before eventually settling somewhere near what they "should" be. Whole categories of stock-often, as an example, in the technology sector-can be driven up in price, only to come crashing down at some point in the future. Recent history has provided an all-too-vivid example of what can happen when stock prices in general become overvalued. The financial crash of 2008 (and the surrounding period) also showed how quickly and deeply stock prices can fall. This is a major reason to understand the underlying value of a company's assets and earning power before purchasing its stock. We'll look at some of the ways to do that (price to sales; price to book; price to earnings; etc.) later in this chapter. ### Dividends Surplus profits that a company does not want to reinvest into its own growth typically are paid to shareholders as cash dividends. Most companies distribute dividends either annually, half yearly, or quarterly, and sometimes at additional, irregular intervals if profits are particularly good. Dividends must be declared as income (not capital gains) in the year in which they are received (regardless of whether they are reinvested). Many well-established companies have a long, consistent history of paying dividends to shareholders (many of these are the so-called "blue chip" companies). Dividends normally pay in cash (and, therefore, the term dividends implies cash dividends). Sometimes, however, a company may declare a stock dividend, where current stockholders receive additional shares. For example, if a company issues a 10% stock dividend, a shareholder who has 90 shares will receive nine additional shares from the company. This is not a windfall, however, because the stock price will decrease 10% when this occurs, so the shareholder has the same value as before the stock dividend. Stock dividends are sometimes not taxable (depending on the territory), an indication that stock dividends are not a return on capital. Instead, an accounting entry capitalizes returned earnings; that is, in the net worth portion of the company's balance sheet, a dollar amount transfers from the category "retained earnings" to "common stock" and "paid-in capital," although no actual transfer of money takes place. For example, if a stock sold at $10 per share and the par value of the stock was $1, then for each share in the stock dividend, $10 would be subtracted from retained earnings, $1 would be added to common stock, and $9 would be added to paid-in capital. An investor should not view a stock dividend as a substitute for a cash dividend because only the cash dividend is a return on capital invested. How does an investor know what kind of dividend payment a company will make? This can be determined by calculating the dividend payout ratio. ### Dividend Payout Ratio The dividend payout ratio is the amount of dividends paid to stockholders relative to the amount of the company's net income. The company will retain some of the net income to support continued growth and may pay out the remainder as a dividend. The amount that is kept by the company is called retained earnings. Investors can find the company's net income on its income statement. The payout ratio formula is used by some when considering whether to invest in a profitable company that pays out dividends versus a profitable company that has high growth potential. In other words, this formula takes into consideration steady income versus reinvestment for possible future earnings, assuming the company has a net income. The simple formula divides dividends by net income and looks like this: Dividend Payout Ratio = Dividends Net Income So, for example, a company that has net income of $100,000 and pays $30,000 dividends to shareholders, has a 30% dividend payout ratio: .30 = $30,000 $100,000 We will look at more stock valuation methods soon. Many investors take the dividend in cash and use it in various ways as income. Some recipients want to reinvest dividends and use them to purchase more shares of the stock. Some companies and some funds have plans that enable investors to automatically reinvest dividends. These plans are often identified as dividend reinvestment plans, or DRIPs. By agreeing to a DRIP, the investor will automatically purchase additional shares on a cost-averaging basis (i.e., the investor regularly purchases shares whether the price is up or down. with a resulting cost of all shares generally averaging down). Be cautious - if the financial advisor and client have determined a percentage of a company's shares they want to own, a DRIP plan could cause that percentage to drift upward. This is not bad if the financial advisor anticipates the change, but if not, the advisor could be surprised by the increased exposure to a stock or fund. Consider this point in your communication with the client. ### Key Dividend Dates Dividends can provide a big part of a stock's value and return. As such, it is important to know the four key dates related to dividend payments. - Declaration date when the board of directors declares a dividend - Distribution date - when the dividend is paid - Record date - when the corporation closes its books and identifies shareholders of record (i.e., those who own shares of the stock and will receive the dividend) - Ex-dividend date a few days prior to, or after, the record date (e.g., four days before in Australia, two days in the U.S., and the day after in New Zealand). Investors who purchase shares on or after the ex-dividend date do not receive the scheduled dividend. ### Stock Repurchase Sometimes, instead of issuing a dividend, companies want to use their cash to buy back outstanding shares of company stock. This is called a stock repurchase. When a company decides to do a stock repurchase, investors can decide whether they want to tender their shares. If they decide to, they will get the cash payment offered and, depending on the territory in which they live, may be expected to pay capital gains tax. This differs from a dividend, which is issued regardless of whether the investor wants it. ### Stock Splits Can the price of a stock get too high? Sometimes. Generally, when a company wants to increase its number of shareholders, but its stock price has grown too high to be appealing, its board of directors may authorize a stock split. A stock split (which must be approved by shareholders) reduces the price of each share of stock, thereby making it easier and more appealing for investors to buy shares. But because the split increases the number of shares outstanding, it does not change the total value nor does it impact the ownership interest of current shareholders. **Example:** Peta owns 100 shares of XYZ Company, which are worth $100 per share. To lower its share price and prompt more trading. XYZ authorizes a two-for-one stock split, dropping the price of each share to $50. Peta will now own 200 shares of XYZ at a price of $50 per share, thus maintaining her overall value of $10,000. Stock splits do not have to be two-for-one. A three-for-one split would create three shares of stock at $33 per share for each one of Peta's original shares. Thus, the after-split value of a shareholder's position will be the same as it was prior to the stock split. ### Reverse Splits On the other hand, sometimes a company wants to reduce the number of outstanding shares and/or increase its stock price. In this case, a company might do a reverse split. The primary purpose of increasing the market price per share is to raise it high enough to prevent it from being delisted on an exchange or on the over-the-counter market. After a reverse split, an existing stockholder will own fewer shares, at a greater price. Reverse splits are not all that common, and usually are associated with lower-quality companies that are in some difficulty. **Example:** In the case of a reverse 1-for-2 split, Peta's original position of 100 shares at $100 per share would now become 50 shares of XYZ Company stock at $200 per share (2x $100). ## Equity Valuation Methods Stocks are valued in many ways, using several metrics. Dividends can play an important part in the valuation of a stock, and perhaps the simplest valuation method using dividends is to calculate the Dividend Discount Model (DDM). You can use the DDM to value the price of a dividend-paying stock by dividing the dividend per share by the discount rate (the expected rate or return an investor requires, given the perceived risk) minus the expected dividend growth rate. Here is the simplified formula: Stock Value (DDM) = Dividend per share Discount rate Dividend growth rate We will see the DDM restated and used in various settings as we move forward. It will be helpful to know how to determine the expected return of a stock by focusing on its dividend growth. The expected return combines the current price per share, dividend growth rate, and anticipated capital growth. You can see the similarity to the base DDM. The formula to calculate expected (total) return is: $r = \frac{D_1}{P_0} + g$ Where: - $r$ = return - $D_1$ = dividend plus anticipated growth - $P_0$ = current price - $g$ = capital growth (dividend growth rate and capital growth rate are assumed to be the same) Another valuation measures a stock's intrinsic value (i.e., discounted cash flows). Assuming dividends to be a constant percentage of corporate earnings, the equation to calculate a stock's intrinsic value (also called the dividend growth or dividend discount model) is: $V or P = \frac{D_1}{r-g}$ Where: - $V$ = Value (P = Price) - $D_1$ = dividend plus anticipated growth - $r$ = required return - $g$ = dividend growth rate Notice that the value is equal to the dividend plus annual growth, divided by return minus capital growth. To calculate intrinsic value using this model requires knowing the current dividend, its anticipated growth rate and the required return. Required return is CAPM, which we will explore in a later section. For now, we can see its equation and calculation: $r = r_f + β(r_m- г_f)$ Or sometimes $r = r_f + (r_m - r_f)β_i$ Where: - $r$ = required rate of return - $r_f$=risk-free rate - $r_m$=market rate - $β$ = beta of the portfolio If we assume dividends grow at the same estimated rate as earnings, we can determine the intrinsic value of the stock by: $V = \frac{D_0(1 + g)}{r - g}$ or $V = \frac{D_1}{r - g}$ Where: - $V$ = intrinsic value - $D_0$ = current dividend - $D_1$ = dividend plus anticipated growth - $r$ = required return - $g$ = dividend growth rate This valuation equation can help the advisor determine the appropriate price at which a stock could be bought. As an example, assume the investor's required return is 8%. Company XYZ's dividends are anticipated to grow at a 5% annual rate, and the current dividend per share is $1.50. With this information, let's calculate ABC's intrinsic value. $V = \frac{1.50 (1.05)}{.08-.05}$ $V = \frac{1.5750}{.03}$ $V = 52.50$ XYZ's intrinsic value is $52.50. What does this mean for the financial advisor thinking about investing in XYZ? If the current market price is $52.50, XYZ is selling at its intrinsic value. If the price is less, it is undervalued, and assuming it fits other criteria, is probably worth buying. If the price is more, XYZ is overvalued and, barring mitigating factors, probably should not be purchased until the price drops. To answer the client's question about XYZ's anticipated (i.e., expected) return, assuming a current price of $51.00, we can calculate as follows: $r = \frac{1.50 (1.05)}{51.00} + .05 = .0309 + .05 = .0809 or 8.09%$ The financial advisor's client can anticipate an 8.09% return from XYZ. If we change the current price to $53.00 per share, the expected return drops to 7.97%, a good example of why buying at the right price is important. If XYZ's growth rate is not constant, but changes annually, the financial advisor would need to calculate the net present value (NPV) of the cash flows. **Example 1** Using the dividend discount model, what is the intrinsic value of a dividend paying stock where the current dividend is $1.75, it is assumed to grow at 4% annually, and the required return is 10%? **Solution:** $V = \frac{D_0(1 + g)}{r - g}$ or $V = \frac{D_1}{r - g}$ $V = \frac{1.75 (1.04)}{.10-.04} = \frac{1.82}{.06} = $30.33 The intrinsic value is $30.33 ## Additional Valuation Ratios A financial advisor has several ratios to evaluate a stock's value. We will cover four: Price to sales (P/S), price to book (P/B), price to earnings (P/E) and price to earnings growth (PEG). ### Price to Sales (P/S) The price to sales ratio evaluates a stock's price by its sales per share. "Sales per share" is the company's sales divided by the number of outstanding shares. The simple P/S formula is: P/S = stock price/sales per share. Revisiting XYZ, we find that it had revenues last year of $170 billion, with total shares outstanding of one billion, making sales per share $170. A current price of $500 means XYZ's P/S is 500/170 = 2.94. As with most evaluation ratios, that number does not mean much in isolation. Let's say that the industry average P/S is 2.5. This means that XYZ is probably overvalued. An average industry P/S of 3.0 would indicate XYZ is slightly undervalued. ### Price to Book (P/B) The price to book ratio compares a stock's price to the company's book value (i.e., equity value divided by the number of outstanding shares). Value investors often prefer P/B over P/S as being a more conservative evaluation. Of concern is the fact that book value does not always measure real value, especially with companies that have lots of intellectual property that does not appear on the balance sheet. If XYZ has a book value per share of $135, and the current price is $500, the P/B ratio is 500/135 = 3.70. As with P/S, P/B must be compared to something. and if comparable P/B ratios are closer to 2.60, XYZ looks