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Stocks and Their Valuation Bondholders are creditorsStockholders are owners. They have residual claim.

Stockholders have ownership and control rightsShareholders of a corporation use their control rights

through voting: Stockholders elect directors Directors elect & monitor management Management’s goal: Maximize the stock price

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Shareholder Rights voting: straight

cumulative

With both voting systems, a shareholder receives a total number of votes that equals the number of directors to be elected times the number of shares owned.

With straight voting, a shareholder may give any one candidate, as a maximum, only a number of votes equal to the number of shares owned.

With cumulative voting, a shareholder may give all the votes he/she holds to a single candidate.

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Example

A corporation has two shareholders. Smith with 25 shares and John

with 75 shares. John does not want Smith to be a director. Assume

four directors will be elected.

John nominates four candidates, Smith nominates himself

Straight voting: John can elect all four directors

Cumulative voting: Smith has 4*25=100 votes John has 4*75=300 votesSmith will be elected a director

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Cumulative Voting

Minimum number of shares that must be owned in cumulative voting to be able to win d positions on the board

n: minimum number of shares that must be ownedd: number of directors the stockholder wants to be certain of electings: number of shares outstandingD: number of directors to be elected

Continuing with the above example what is the minimum number of shares Smith should own to be elected

Smith 21 and John 79 is enoughSmith 20 and John 80 is not enough

(a tie)

21114

100*1

n= 11

*

Dsd

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internal control

Ownership and Control are separated when we have diverse

ownership

Consider 2 scenarios: An individual who is the single owner of a firm A corporation in which none of the owners have more

than 1% ownership

In the latter scenario who has the control of the firm

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internal control

Small shareholders are not very likely to attend shareholders’ meetings

Instead they can transfer their voting rights to another person with a proxy

If the current management collects those proxies, it can elect the board members.

A board elected by the management can hardly have authority on it.

This way, the monitoring of management by board may not be possible.

proxy fight by shareholders is difficult

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external control mechanism

If the incumbent management team is inefficient

if internal control mechanism fails to remove the management team

then we must rely on external control mechanism i.e. the market for corporate control

Takeover by another firm friendlyhostile

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Shareholder rights other than voting

dividends preemptive right stock split

preemptive rightThe right of a company's existing common shareholders to

have the first chance to purchase shares in a company's future

stock issuance.

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New stock issuance

New stock issuance can be a bonus or a rights issue

Bonus issueFirm issues free shares

Rights issueFirm issues new shares. Cash flows into the firm.

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Price adjustment

Price adjustment following the issuance of new stock:

Where SB and SR show the amounts of bonus and rights issues (in %),PR denotes the price at which the right will be used and Div shows the amount of cash dividend to be paid to “old”

shares

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Example

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Types of Common Stock

Some companies may have classified stock. In other words, there

can be more than one type of stock.

These will differ regarding: dividends and voting power

Most common: founders’ sharesSuperior voting rights, inferior dividend

rights

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Types of Stock Market Transactions

Based on number of stockholders, we can classify firms as: Closely held corporation Publicly owned corporation

Stocks of small publicly owned corporations are not listed, trade in OTC

We have previously defined Secondary market: trading of existing shares among investors Primary market: sale of new stock by publicly owned corporations

IPO market: stock of a closely held corporation is sold to public for the first time

Economically it is important to distinguish: Does company raise capital from public offering Does a large shareholder sell his/her stake to the public

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Valuation: dividend growth model

Value of a stock is the present value of the future dividends expected to be generated by the stock.

Even if you hold stock for only two periods the above equation is valid

This equation is not usable in practice, there are unknowns Some simplifying assumption that fits the observed pattern is

necessary.

ks is required return

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Valuation: dividend growth model

zero growth constant growth nonconstant growth

zero growth: Dt= Dt-1 t

constant growth: Dt= Dt-1(1+gt) gt=constant t

zero growth

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constant growth PV of future dividends under constant dividend growth rate assumption is:

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What happens if g > ks?

If g > ks, the constant growth formula leads to a negative stock price, which does not make sense.

The constant growth model can only be used if: ks > g g is expected to be constant forever

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Expected rate of return

Total return from investing in stocks is the sum of Dividend yield Capital gains yield

zero growth:

Capital gains is zero

constant growth:

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Nonconstant growth

To make the method useful in practice

Story 1: Profitable firm Growing market: high growth for a while Saturated market: constant lower level of growth afterwards

Story 2: Troubled firm. A plan to increase operating efficiency.Losses will continue for

a while Positive or zero growth thereafter

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Example

g1, g2, g3 non constant growth

g4=g5=gt t>3 constant growth

use D0 and g1, g2, g3, g4 to find D1-D4

use D4 to find

use D1-D3 and P3 to find P0

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Valuation free cash flow method

What if the firm is not paying dividends. How to determine the intrinsic value of its stock?

Especially young, fast growing firms may prefer not to pay any dividends so that they use all their earnings to finance growth.

In that case, one can forecast the free cash flows (FCF) the firm will generate in the next N years.

Free cash flow is the amount of cash flow remaining after a company makes asset investments necessary to support operations. In other words, it is cash flow available for distribution to investors. After N years, one can assume constant growth of FCF. The present value found will be the value of total firm. After subtracting the market value of debt, the remaining figure will be the value of equity.

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Valuation Firm multiples method

Analysts often use the following multiples to value stocks.

P / E P / CF P / Sales

EXAMPLE: Based on comparable firms, estimate the appropriate P/E. Multiply this by expected earnings to back out an estimate of the stock price.

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What is market equilibrium?

In equilibrium, stock prices are stable and there is no general tendency for people to buy versus to sell.

In equilibrium, expected returns must equal required returns.

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Market equilibrium

Expected returns are obtained by estimating dividends and expected capital gains.

Required returns are obtained by estimating risk and applying the CAPM.

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How is market equilibrium established?

If expected return exceeds required return … The current price (P0) is “too low” and offers

a bargain. Buy orders will be greater than sell orders. P0 will be bid up until expected return

equals required return

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Factors that affect stock price

Required return (ks) could change Changing inflation could cause kRF to change Market risk premium or exposure to market risk (β)

could change

Growth rate (g) could change Due to economic (market) conditions Due to firm conditions

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What is the Efficient Market Hypothesis (EMH)?

Securities are normally in equilibrium and are “fairly priced.”

Investors cannot “beat the market” except through good luck or better information.

Levels of market efficiency Weak-form efficiency Semistrong-form efficiency Strong-form efficiency

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Weak-form efficiency

Can’t profit by looking at past trends. A recent decline is no reason to think stocks will go up (or down) in the future.

Evidence supports weak-form EMH, but “technical analysis” is still used.

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Semistrong-form efficiency

All publicly available information is reflected in stock prices, so it doesn’t pay to over analyze annual reports looking for undervalued stocks.

Largely true, but superior analysts can still profit by finding and using new information

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Strong-form efficiency

All information, even inside information, is embedded in stock prices.

Not true--insiders can gain by trading on the basis of insider information, but that’s illegal.

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Is the stock market efficient?

Empirical studies have been conducted to test the three forms of efficiency. Most of which suggest the stock market was:

Highly efficient in the weak form. Reasonably efficient in the semistrong form. Not efficient in the strong form. Insiders could and

did make abnormal (and sometimes illegal) profits.

Behavioral finance – incorporates elements of psychology to better understand how individuals and markets respond to different situations.