Principal Finance 235 (2024) PDF

235 (2024)  Learning outcomes PART1 Stock and Stock Valuation Find out about the Basic Characteristics of Common Stock. Explain the Primary Market and...

235 (2024)  Learning outcomes PART1 Stock and Stock Valuation Find out about the Basic Characteristics of Common Stock. Explain the Primary Market and the Secondary Market. Explain Bull Market and Bear Market. Characteristics of Common Stock Provides holders Unlike bonds, no with an maturity date Major financing Holders have opportunity to (considered vehicle for ownership in the share in the future permanent financing) corporations company. and variable periodic cash flows of the issuer. income. 7-3 Ownership Share in the residual profits of the company. Claim to all its assets and cash flow once the creditors, employees, suppliers, and taxes are paid off. Voting rights – Participate in the management of the company – Elect the board of directors which selects the management team that runs the company’s day-to-day operations.  Claim on Assets and Cash Flow (Residual Claim) In case of liquidation… Shareholders have a claim on the residual assets and cash flow of the company. Known as “residual” rights. Back to the balance sheet… Assets reflect the “value of the company” Liabilities reflect the non owner claims to the assets. Owners get the remaining value of the assets. Owner’s Equity = Assets - Liabilities  Vote (Voice in Management) Standard voting rights: Typically, one vote per share provided to shareholders to vote in board elections and other key changes to the charter and bylaws. Can be altered by issuing several classes of stock. – Non-voting stock: which is usually for a temporary period of time. – Super voting rights: which provide the holders with multiple votes per share, increasing their influence and control over the company. Proxies transfer voting rights to another party  No Maturity Date No promised date when investment is returned. Purchasing of shares means you hold ownership rights until you sell the shares or the firm goes bankrupt There is no return of your original purchase price (principal) of the stock by the company Infinite life, i.e. no maturity date Principal (par value plus paid in excess) is permanently retained by the company Exception, repurchase of stock by company (Treasury Stock) Therefore, considered to be permanent financing. Dividends and Their Tax Effect Companies pay cash dividends periodically (usually every quarter) to their shareholders out of income generated by the operations.  Unlike coupon interest paid on bonds, dividends cannot be treated as a tax- deductible expense by the company. For the recipient, however, dividends are considered to be taxable income  Treasury Stock Non-dividend paying, non-voting shares being held by the issuing firm right from the time they were first issued ( OR ) Shares that have been repurchased by the issuing firm in the market. Why no voting rights for Treasury Stock? Why no dividend payments to Treasury Stock?  7-11  Privileges that allow current shareholders to buy a fixed percentage of all future issues before they are offered to the general public.  Enables current common stockholders to maintain their proportional ownership in the company. Preemptive Rights  Example Current shareholder owns 10% of the outstanding shares of the company… Company issues new shares… Current owner faces dilution if unable to purchase 10% of the new issue, so must be offered 10% of issue before open to the public Stock Markets Stocks are traded in two types of markets  Primary or “first sale” market Market where issuing firm is involved. Initial public offering (IPO). Secondary or “after-sale” market: Forum where common stock can be traded among investors themselves. Provides liquidity and variety. In the United States, 3 well-known secondary stock markets: NYSE AMEX NASDAQ Stock Markets Stocks are traded in two types of markets Bull Markets and Bear Markets Bull market: is the condition of a financial market in which prices are rising or are expected to rise. Bear market: is when a market experiences prolonged price declines.  Learning outcomes PART 2 Stock and Stock Valuation Find out about the two basic methods of valuing the stocks. Analyzing the stocks using dividend discount model. How do we select a share to buy? Two basic methods: Fundamental analysis Estimate the value of a company from things like the accounts…then buy if this value is above the market price Technical analysis: Look at the trend in share price…this indicates buying & selling pressure Fundamental analysis Two main ways to value companies: Discount models: Dividend discount model Residual income model Free cash flow model Ratios: E.g. Price earnings (PE) ratio Discount models What is the ‘value’ of something? Generally, it is the amount we can receive for that item. For shares we receive dividends each year and then a final amount when we sell. Discount models But! The dividends are received over several years. Money today is worth more than money in the future because we can earn interest on it. Future value = Present value * (1 + r) Present value = Future value / (1+r).  Dividend discount model (DDM) A stock will pay three annual dividends of $200 per year, the appropriate risk-adjusted discount rate, k, is 8% What is the value of the stock today? D1 D2 D3 V0    1  k  1  k  1  k 3 2 $200 $200 $200 V0    $515.42 1  0.08 1  0.08 1  0.08 2 3  DDM with constant growth Gordon Growth Model (GGM)  DDM with constant growth Gordon Growth Model (GGM) Assume Company X paid a dividend of $1.80 per share this year. The company expects dividends to grow in perpetuity at 5 percent per year, and the company's cost of equity capital is 7%. D1 = D0 x (1 + g) = $1.80 x (1 + 5%) = $1.89 Next, using the GGM, Company X's price per share is found to be D(1) / (k - g) = $1.89 / ( 7% - 5%) = $94.50.  Two stage DDM It is unlikely that growth will be the same in every year, we can split growth into 2 stages; initial super-growth and final constant growth  Two stage DDM Example MEGA PLC has been growing at a phenomenal rate of 30% per year You believe that this rate will last for only three more years Then, you think the rate will drop to 10% per year Total dividends just paid were £5 million The discount rate is 20% What is the total value of Mega PLC?  Two stage DDM Example First, calculate the total dividends for the “super growth’’ period: Yea Dividend: £ Millions r 1 5*1.3 = 6.5 2 6.5*1.3 = 8.45 3 8.45*1.3 = 10.985  Two stage DDM Example Initial super – growth period D1 D2 D3 V0    1  k  1  k  1  k 3 2 £6.50 £8.45 £10.985 V0    1  0.20  1  0.20  1  0.20 3 2 £5.42  £5.87  £6.36  Final constant growth period Using the long run growth rate, g, the value of all the shares at Time 3 can be calculated as: V3 = [D3 x (1 + g)] / (k – g) V3 = [£10.985 x 1.10] /(0.20 – 0.10) = £120.835 £120.835 V0  £69.93 1  0.203  Two stage DDM ~ example The total value of the company TODAY is therefore: £5.42 + £5.87 + £6.36 + £69.93 = £87.58 M If there are say 20 million shares in issue, the value of one share is: 87.58 / 20 = £4.38 If share price below £4.38 we buy share  Useful Internet Sites http://www.youtube.com/watch?v=2O4PdCgvsa Q Good introduction to dividend discount model (DDM) http://www.youtube.com/watch?v=LHTdmosp4Js Explains DDM with growth http://www.youtube.com/watch?v=FBuUchkJT9A Shows you how to do this in Excel Stock Valuation (Cont.) Company valuation Residual income model Free cash flow model Valuation ratios Technical analysis Residual income model Some companies do not pay dividends …….so how do we value them? We simply substitute profits for dividends using the clean surplus relationship. This is called the residual income model. Clean surplus relationship: Earnings per share minus dividends per share is equal to the change in book value per share during the year. Residual income model Information needed: Earnings per share at time 0, EPS0 Book value per share at time 0, B0 Earnings growth rate, g Discount rate, k EPS1  B0 g V0  k g Residual income model Company X has the following accounts data: Dividend, DIV = 0 Earnings per share, EPS0 = £1.20 Balance sheet, B0 = £5.886 EPS  B g Growth, g = 0.09 V0  1 0 Cost of capital, k = 0.13 k g Valuation = (1.2*1.09 – 5.886*0.09) / (0.13 – 0.09) This is a valuation of £19.46 per share.  Some companies do not make profits…..so how do we value them? We substitute cash flow for dividends Free cash flow Free cash flow (FCF) = Net profit after tax + valuation depreciation – capital expenditure There are different ways to measure free cash flow, this is the most common way  FCF is the total cash-flow generated from assets, therefore FCF values all assets Assets = Equity + Debt Free cash flow The value of all assets less the market value of valuation debt gives the value of equity The discount rate used here is the cost of capital for both equity and debt i.e. weighted average cost of capital (WACC)  Company Z has the following information: Profit after tax, ¥25m Depreciation, ¥10m Free cash flow Capital expenditure, ¥3 valuation Growth, g = 0.03 Cost of capital, k = 0.13 Free cash flow = 25 +10 – 3 = 32  FCF0 1  g  FCF1 V0   (Important g  k) k g k g Free cash flow Valuation of all assets ( i.e. equity plus debt) is: valuation 32*(1+ 0.03) / (0.13 – 0.03) = 329.6 If debt has a market value of ¥100m, the value of equity is ¥229.6m  Many investors use simple ratios of value when they compare different companies. The three most common are: Dividend yield (DY ratio): Dividend per year / price of share This gives a rate of return on your investment Price earnings ratio (PE ratio): Valuation ratios Price of share / earnings per share Shows how many years it will take to repay your investment in the share Price to book ratio (PB ratio): Price of share / book value of one share Shows the market price of the net assets compared to the cost of their purchase Technical analysis Share prices depend on supply and demand, this in turn depends on investor optimism or pessimism. Technical analysis looks at the trend of share prices to assess investor mood and hence predict the future direction of share prices. FAMA (1965) Efficient market hypothesis (EMH): Assess efficiency by information. Either weak, semi-strong or strong form efficient Efficiency means: Price = Value 3 Forms of market efficiency MALKIEL (1973) Cannot ‘beat the market’ so invest passively not actively, track the market using an ETF Malkiel set up Vanguard Group with John Bogle