chapter06 common shares characteristics and valuation
TRANSCRIPT
CONTEMPORARY FINANCIAL MANAGEMENT
Chapter 6:
Common Shares: Characteristics and Valuation
INTRODUCTION
This chapter describes: the characteristics of common shares common share valuation models
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COMMON SHARES Common shares are evidence of ownership.
Common shareholders own the firm.
Common shares are a form of long-term financing for a firm.
Common shares are often called a residual security as their value represents whatever assets are left after all prior claims against the assets have been settled.
Common shareholders elect the Board of Directors.
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BALANCE SHEET ACCOUNTS Par Value of Common Shares (can ignore for all practical
purposes)
Contributed Capital in Excess of Par Additional paid in capital Capital surplus
Retained earnings
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BOOK VALUE PER SHARE
The book value of a company’s assets attributable to each share of common stock
Example: ZBC Corporation reports a common share account balance of $10M and a retained earnings of $5M with 100M shares outstanding. The book value per share is $0.15. 5
Common Shares + Retained EarningsNumber of Shares Outstanding
COMMON SHAREHOLDER RIGHTS
Right to vote at shareholder meetings.
Right to share in the profits of an organization (paid either as a dividend or as reinvested profits).
Right to share in the residual assets of an organization after all other stakeholder (i.e. governments, creditors, employees) claims are satisfied.
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VOTING FOR THE BOARD OF DIRECTORS
Majority voting Each share carries one vote Requires more than 50% of the votes to elect a Director
Cumulative voting Each share carries as many votes as there are Directors to be
elected Shareholders may cast all votes for one candidate
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VOTING BY PROXY
Shareholders may elect to assign their voting rights to someone else.
Management actively solicits proxies.
A dissent shareholder group may attempt to solicit proxies to wrest control away from management.
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COMMON SHARE FEATURES
Certificate of ownership
Classes Voting vs. non-voting
Amount shareholder invests in common shares is the maximum capital at risk (shares are said to be “fully paid and non-assessable”).
Common shares are marketable securities that can be transferred from one investor to another.
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COMMON SHARE FEATURES
Advantages Flexible Reduces financial risk
Disadvantages Dilute Earnings Per Share Most expensive form of financing
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COMMON SHARE TRANSACTIONS
Cash Dividend Firm pays a portion of retained earnings in cash to
shareholders based upon number of shares owned (i.e. $0.60/share)
Stock Dividend Funds transferred from retained earnings to the common
share account. Shareholders receive certificate for additional shares.
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COMMON SHARE TRANSACTIONS
Stock Split Firm increases the number of shares outstanding by issuing a
specific number of new shares for every old shares outstanding
Example: stock splits 3 for 1.
Reverse Stock Split Firm decreases the number of shares outstanding by
consolidating a specific number of old shares into one share. Example: stock reverse split of 1 for 3
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COMMON SHARE TRANSACTIONS Stock Repurchases
Disposition of excess cash Repurchased shares are often cancelled Earnings power of remaining shares is increased Financial restructuring Future corporate needs (stock option plans) Reduction of takeover risk
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VALUATION OF COMMON SHARES
Cash flows attributable to a common stock accrue from:
Dividend stream (while owning the stock) Sale price (the future dividends that would have been
received from sale date to perpetuity)
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The market value of a common stock is equal to the present value of its
expected future cash flows!
DIVIDEND VALUATION MODELS
Zero growth model
Constant growth model
Nonconstant growth model
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DIVIDEND VALUATION MODELS Zero Growth Model
The cash flow (dividend) is expected to remain the same over time. Identical to model applied to preferred shares
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e
DP =
kD = Dividend at time period 1k = Required Rate of Return
ZERO GROWTH: EXAMPLE
Firm ABC currently pays a dividend of $1.00 per share. This is expected to remain the same into the foreseeable future. If shareholders require a return of 20% to hold the stock, what is each share worth in the market?
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=
=
10
e
D 1.00P =
k 0.20
$5.00
DIVIDEND VALUATION MODELS Constant Growth Model
The cash flow (dividend) is expected to increase at a constant rate over time
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10
e
DP =
k - g
D1 = Dividend in Next Period [D1 = D0 x (1+g)]k = Required Rate of Returng = constant growth rate
CONSTANT GROWTH: EXAMPLE
Yesterday, Tinkerbell Corporation paid a dividend of $1.00 per share. The dividend is expected to grow at a rate of 5% per year for the foreseeable future. If the shareholders require a 15% return to hold Tinkerbell shares, what is each share worth in the market?
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( )
( )
+=
= =−
010
e e
D 1 gDP =
k - g k - g
1.00 1.05$10.50
0.15 0.05
DIVIDEND VALUATION MODELS
Nonconstant Growth Model
Many firms grow rapidly for period of time. However, eventually, growth slows to a long-run sustainable constant rate
To deal with the nonconstant growth example, we simply present value all dividends back to time period zero
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NONCONSTANT GROWTH: EXAMPLE
Tiny Toys Inc. is a new firm that is expected to grow at a 20% rate for 3 years. From then on, growth is expected to be 10% per year. The firm paid a dividend of $1.00 yesterday. The dividend is expected to grow at the same rate as the firm’s growth rate. If the shareholders require a 15% return to hold the common stock, what is each share worth in the market?
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NONCONSTANT GROWTH: SOLUTION
Draw a time line showing the expected cash flows. Each dividend must be calculated, using the growth rate for the period.
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0 4321
∞$1.00 $1.20 $1.44 $1.73 $1.90
20% 20% 20% 10%
NONCONSTANT GROWTH: SOLUTION
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( )( )
1 0D = D 1+g
= 1.00 1.20
= $1.20
( )( )
3 2D = D 1+g
= 1.44 1.20
= $1.73
( )( )
2 1D = D 1+g
= 1.20 1.20
= $1.44
( )( )
4 3D = D 1+g
= 1.73 1.20
= $1.90
NONCONSTANT GROWTH: SOLUTION
( ) ( ) ( )
( ) ( ) ( )( ) ( )
÷ ÷ ÷ ÷= + + + ÷ ÷−
= + + +
=
31 2 40 2 3 3
e ee e e
2 3 3
DD D D 1P = + + +
1+K K -g1+K 1+K 1+K
1.20 1.44 1.73 1.90 11.15 0.15 0.101.15 1.15 1.15
1.0435 1.0888 1.1375 38 .6575
$28.25
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NONCONSTANT GROWTH: HELPFUL HINTS
Draw a timeline
Calculate each dividend on the timeline
During the period of nonconstant growth, present value dividends back to time zero
Once growth has stabilized: Calculate the present value of all dividends from that point
forward out to infinity. Calculated value must be brought back to time zero. Example: Dividend4, multiply by:
25( ) ÷ ÷
3
e
1
1+K
SOURCES OF GROWTH RATE FORECASTS
Value Line Investment Survey www.valueline.com
Thompson Financial/First Call www.tfn.com
Zacks Earnings Estimates www.zacks.com
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MAJOR POINTS
Common shares are a form of long-term financing for a firm.
The value of a common share is equal to the present value of its future cash flows.
The value of a common share is determined using: Zero growth model (preferred shares) Constant growth model (blue chip stocks) Nonconstant growth model (growth stocks)
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