bba (finance), mba (banking), du

1Ayesha Saimoon www.studyandjobs24.com

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Lecture TopicsDefinition of Stocks, Types of Stocks: Common Stock Versus Preferred stocks, valuations of stocks, Constant and Non-Constant Growth Models. Numerical ExamplesThe Stock Markets and EMH: Stock Exchanges, SEC of Bangladesh and OTC market, The Primary markets: New issues, IPO, Investment banker, Underwriting, Syndicate, Private placement, Secondary market, Listing, and Efficient market Hypothesis.


Stock: What is it?• An instrument that signifies an ownership

position (called equity) in a corporation, and represents a claim on its proportional share in the corporation's assets and profits.

• Ownership in the company is determined by the number of shares a person owns divided by the total number of shares outstanding.

• For example, if a company has 1000 shares of stock outstanding and a person owns 50 of them, then he/she owns 5% of the company.

http://www.investorwords.com/4725/stock.html




Types of Stocks• Common Stocks• Preferred stocks• Blue chip stocks• …………………………So many!!

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When is a stock sale an initial public offering (IPO)?

• A firm “goes public” through an IPO when the stock is first offered to the public.

• Prior to an IPO, shares are typically owned by the firm’s managers, key employees, and, in many situations, venture capital providers.


Common StockA Common Stock is a part of ownership of

a corporation.It is a security that represents the ultimate ownership and risk position in a corporation.

Example: If a company issues 10 shares of stock, each share Represent 10% of the ownership of the company.


Common Stocks characteristics1. Right to vote2. The stockholders have the residual ownership3. Residual claim on income and assets:

The holder has a claim to the profits of the business (through dividends). In the event of failure, the holder has a claim to the residual value of the assets after claims of all other entitled parties are met.

4. Limited Liability: A legal concept which protects shareholders whose liability to meet a company’s debts is limited to any amount unpaid on the shares they hold

5. Right to control: Common stockholders control the operation and the participate in the management.


Preferred Stock

A special form of stock having a fixed periodic dividend that must be paid prior to payment of any common stock dividends.

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Characteristics of Preferred Stock• Dividends: Owners of preferred stock receive

payment of dividends before the owners of common stock.

• Convertibility: Often, preferred stock can be changed or converted into common stock.

• Callability: Company can contact the owners of preferred stock and force them to sell it back to the company for either cash or common stock.

• Bankruptcy: Priority to take…• Less Volatility: Preferred stock generally does not

move up or down as fast as common stock. This means it is less volatile.


01.What are the differences between Common

stock and preferred stock?02.Are there any similarities

between preferred stock and Debt (i.e. Bond or bank loan)?


Types of Stock Dividends

• Cash dividends • Stock dividend• Property dividends


What is a stock Market?The system in which communication networks, financial institutions and relevant rules and regulations are established and activated in order to facilitate smooth flow of funds and corresponding financial instruments/assets.

The building or place where stocks are bought and sold is known as stock market or Stock Exchange.


Functions of a Stock market/Exchanges1. The first function is to provide companies with a way of

issuing shares to people who want to invest in the company.

2. Provide its members with the premises, systems and mechanisms which furnish them with clear information on the purchase and sales bids of the securities, the impartial execution of the respective instructions and the efficient settlement of their operations.

3. Promote the trading of securities, carrying out the necessary activities and offering the appropriate services for such purposes to ensure permanent growth of the market.

4. Offer information to the general public regarding stockbrokerage houses, stock brokers and market transactions.


Functions of stock Exchange….5. Register, in accordance with the legal provisions and

regulations, the stock and securities to be traded and the respective operations.

6. Divulge and keep the general public up to date on the information concerning stock values, and the financial situation and other circumstances of the equity issuers.

7. Supervise that its members or their representatives act in accordance with the accepted commercial ethics, and the respective legal dispositions, regulations and statutes.

8. Publish information on the Stock Market and any other information related to stockbroking activities.


Functions of stock exchange….9. Certify the value of the securities traded on the

Exchange.10. Investigate new facilities or products which may be

offered to either current investors or potential investors and equity issuers,

11. Establish and implement other complementary and compatible services.

12. Carry out all other acts necessary to comply with the objectives of the Exchange.

13. Create subsidiaries for those purposes established by the General Members Assembly; and others as indicated by legal dispositions and these statutes.


Types of Stock Markets/Exchange

1. Physical location stock exchanges (Organized Market)

2. Electronic dealer-based markets (OTC Market)


Characteristics of a Good Stock market/ Exchanges?


Stock Markets In Bangladesh

• DSE• CSE


• Stock Valuation is more difficult than Bond Valuation because stocks do not have a finite maturity and the future cash flows, i.e., dividends, are not specified. Therefore, the techniques used for stock valuation must make some assumptions regarding the structure of the dividends.


Stock Valuation Model

1. Zero dividend growth model: The zero dividend growth model assumes that the stock will pay the same dividend each year, year after year.

2. Constant Growth Model: The constant dividend growth model assumes that the stock will pay dividends that grow at a constant rate each year, year after year.

3. Non-Constant Growth Model: The non-constant (variable) dividend growth model assumes that the stock will pay dividends that grow at one rate during one period, and at another rate in another year or thereafter.


Constant Growth Model Equation

Where:P0 = the stock price at time 0/ Current price of the stock/ present value of the stock/ Selling price of the stock D0 = the current dividend, (recently paid dividend)

D1 = the next dividend (i.e., at time 1), g = the growth rate in dividends, and Ks = the required return on the stock, and g < Ks.

gk

Dgkg1D

Ps

1

s

00

NB: Some books use r instead of Ks.


For a constant growth stock,

D D gD D gD D gt t

t

1 01

2 02

111

gk

Dgkg1D

Ps

1

s

00

If g is constant, then:


What happens if g > ks?

• If ks< g, get negative stock price, which is nonsense.

• We can’t use model unless (1) g ks and (2) g is expected to be constant forever. Because g must be a long-term growth rate, it cannot be ks.

.k requires s1

0 ggk

DPs


Constant Growth Model: Example • Suppose Big D, Inc. just paid a dividend

of $.50. It is expected to increase its dividend by 2% per year. If the market requires a return of 15% on assets of this risk, how much should the stock be selling for?

$3.92

.02)(0.150.02)0.50(1

gs

k1

D

0P

Here, Do = $.50G = 2% Ks = 15% D1 = ?Po = ?


Practice 01(a). Calculate the stock’s market value if D0 = 2.00, ks = 13% and g = 6%.

Constant growth model:

gk

DgkgDP

ss

100

1

= = = $30.29.0.13 - 0.06

$2.12 $2.120.07


Practice 01(b). What is the stock’s market value one year from now, P1?

• D1 will have been paid, so expected dividends are D2, D3, D4 and so on. Thus,

07024722

21

..$gk

DPs

$32.10.


Practice 01(c). Find the expected dividend yield and capital gains yield during the first year.

Dividend yield = D1

P0

Capital Gains Yield = P1 - P0

P0

Dividend yield = = = 7.0%.$2.12$30.29

D1

P0

CG Yield = =P1 - P0

P0

$32.10 - $30.29$30.29

= 6.0%.


Practice 01(d): Find the total return during the first year.

Total return = Dividend yield + Capital gains yield.

Total return = 7% + 6% = 13%.Total return = 13% = ks.

For constant growth stock: Capital gains yield = 6% = g.


Rearrange model to rate of return form:

.k to s gPD

gkDPs

0

110

Then, ks = $2.12/$30.29 + 0.06= 0.07 + 0.06 = 13%.


What would P0 be if g = 0?

The dividend stream would be a perpetuity.

2.00 2.002.00

0 1 2 3ks=13%

P0 = = = $15.38.PMTk

$2.000.13


Solve It!Ewald Company’s current stock price is $36, and its last dividend was $2.40. In view of Ewald’s strong financial position and its consequent low risk, its required rate of return is only 12 percent. If dividends are expected to grow at a constant rate, g, in the future, and if ks is expected to remain at 12%, what is Ewald’s expected stock price five years from now?


Result

• g = 5%• P5 =$45.95

0

10sk01sk

01sk

to 10

PgD

PD

gand

gPD

gskD

P


Gordon Model: PracticeUse the constant-growth model (Gordon model) to find the value of each firm shown in the following table:

Firm D1 g KsA $ 1.20 8% 13%B $ 4.00 5% 15%C $ 0.65 10% 14%D $ 6.00 8% 9%E $ 2.25 8% 20%

a. $24b. $40.00e. $18.75


Practice Problem: 02• Perry Motors’ common stock currently pays an annual

dividends of $1.80 per share. The required return on the common stock is 12%. Estimate the value of the common stock under each of the following assumptions about the dividend.

1. Dividends are expected to grow at an annual rate of 0% to infinity.

2. Dividends are expected to grow at a constant annual rate of 5% to infinity.

3. Dividends are expected to grow at an annual rate of 5% for each of the next 3 years, followed by a constant annual rate of 4% in years to infinity.

1. $ 152. D1 = $1.89, Po = $273. $23.97


Nonconstant Growth Stock Valuation

where P0 = the stock price at time 0, Dt = the expected dividend at time t, T = the number of years of nonconstant growth, gc=the long-term constant growth rate in dividends,

andr = the required return on the stock, and gc < r.

tr1cgr1TDT

1t tr)(1TD

0P


Nonconstant Growth Stock Valuation Example

• The current dividend on a stock is $2 per share and investors require a rate of return of 12%. Dividends are expected to grow at a rate of 20% per year over the next three years and then at a rate of 5% per year from that point on. Find the price of the stock.


Solutions


EMH• The efficient market hypothesis states that at any

given time, security prices fully reflect all available information.

• Efficient Market: An efficient market is defined as a market where there are large numbers of rational, profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants.


Forms of Efficient Markets


EMH forms Descriptions1. The Weak Form asserts that all past market

prices and data are fully reflected in securities prices. In other words, technical analysis is of no use.

2. The Semi-strong Form asserts that all publicly available information is fully reflected in securities prices. In other words, fundamental analysis is of no use.

3. The Strong Form Asserts that all information is fully reflected in securities prices. In other words, even insider information is of no use.


Stock Index?• A stock market index is a number that

indicates the relative level of prices or value of securities in a market on a particular day compared with a base-day figure, which is usually 100 or 1000.

Constructing an Index:Value of Portfolio Index

Day 1(Base day)

Tk. 20,000 1000

Day 2 Tk. 30,000 1500


Calculations

Day 2’s index = (Day 2’s portfolio value/Base day’s portfolio value)X Base

Day’s index = (Tk. 30,000/Tk. 20, 000)X1000

= 1500


Practice:

Besley & Brigham GitmanChapter 07. ST-5, ST-4, 7-3, 7-4, 7-5, 7-6

ST 7-1, Problems: 7-6, 7-9, 7-107-11, 7-15

bba (finance), mba (banking), du

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