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Stocks, Stock Valuation and Stock Market Equilibrium
(Chapter 8)
Legal Rights and Privileges of Common Shareholders
Common shareholders have the right to elect the board of directors: o Shareholders usually receive one vote for each share they own. o They can vote in person at the annual general meeting or they can vote by proxy. o A proxy allows a shareholder to transfer their votes to another party. o In some cases, proxies are solicited by dissatisfied shareholders who then stage a proxy fight in order to replace the board of directors. Some shares, usually only in private companies (i.e. whose shares are not listed on a stock exchange) have preemptive rights. o They give shareholders the right to participate, on a pro rata basis, in any new issue of shares.
Types of Common Shares Sometimes a company will have two types of “common shares” which each type being entitled to a different number of votes. o For example Rogers Communications has Class A common shares that are entitled to 50 votes each and Class B non-voting common shares that have no votes per share. o The Rogers family owns 97.5% of the Class A shares and 9.9% of the Class B shares, giving it voting control of the company while owning only 29.2% of all common shares. o The B shares recently traded at $56. (1) and the A shares at $58. (1)
. Should there be a bigger price difference? o Note that the average daily volume over the last 3 months was only 976 shares for the Class A shares vs. 1,600,324 shares for the Class B shares. 1. As at August 4 2022
Americas NASDAQ Realtime * NYSE Realtime * Toronto Stock Exchange 15 Europe Euronext Paris Realtime Deutsche Börse Frankfurt Stock Exchange Realtime Borsa Istanbul 15 London Stock Exchange Realtime Moscow Exchange Realtime Tel Aviv Stock Exchange 20 Asia Bombay Stock Exchange Limited Realtime Hong Kong Stock Exchange 15 Korea Stock Exchange 20 National Stock Exchange of India Realtime Singapore Exchange Realtime Shanghai Stock Exchange 1 Shenzhen Stock Exchange Realtime Taiwan Stock Exchange Realtime Tokyo Stock Exchange 20 *Real-time price data represents trades which execute on the NASDAQ and NYSE exchanges. Volume information, as well as price data for trades that don’t execute on those exchanges, are consolidated and delayed by 15 minutes. Quote Delays (mins) from Selected Stock Exchanges (Google Finance)
Common Stock Valuation
Common shares are valued like any other financial asset: a stock’s value is equal to the present value of its future cash flows. However, unlike bonds, the cash flows and the discount rate for stocks are both highly uncertain. o Many firms pay dividends but a corporation is under no legal obligation to pay anything to its stock holders. o The term of the investment is open-ended as common stock has no maturity date. o It is more difficult to observe the market rate of return required by common stock investors. Nonetheless, we can make some simplifying assumptions about the patterns of common stock cash flows and required rates of return to estimate a value. The potential cash flows that a stock investor may receive are: o Cash dividends during the period that the investor holds the stock. o Cash proceeds from the sale of the stock at some future price at the end of the holding period.
Example 1- Zero Growth
Under this scenario, we assume that the dividend per share will remain at a constant dollar amount to infinity (i.e. D 0 = D 1 = D 2 etc).The stock can be viewed as a perpetuity.
P
0
D
0
r
s 2
Example 2 - Constant Growth
In many cases, the market expectation is that the dividends will grow at a constant rate over the long term. In that case, the stock is a growing perpetuity whose value is equal to
P
o
D
0
×( 1 + g )
r
s
-g
or
P
0
D
1
r
s
-g
This equation is often referred to as the Gordon Model.
Assuming that growth remains at a constant rate of 3%, determine what the price of the stock will be now and at the end of year seven.
P 0 ¿^
$ 2 x ( 1 +0.03)
0.12−0.03 =^
P 7 =
$ 2 x ( 1 +0.03 ) 8
Notice that we always use the dividend one year from the point in time for which we are calculating the stock price e.g. the dividend in year 8 for the price in year 7. This approach to valuation can be used for companies with a long (10+ years) history of regular growth in dividends such as Canadian banks or utilities.
For constant growth stocks we find that: o The expected stock price grows at a rate equal to g o The expected dividend yield does not change. o The expected capital gain per year (the capital gains yield) is equal to g. o The expected total return = the expected dividend yield + the expected capital gains
Valuing Stocks That Have a Non-Constant Growth Rate Some firms, such has technology companies, have a very high initial growth rate (a “supernormal” rate) followed by constant long-term growth. We can modify the constant growth model to fit these cases by splitting our analysis into two parts: o The supernormal or high growth phase. o The constant growth phase. We call the point at which growth becomes normal as the terminal or the horizon date. The following formula allows us to calculate the expected stock price when we have non-constant growth:
Example 4
Assume that Do = $1.00, rs = 0.12 and that the following growth rates are expected: Year 1 20% Year 3 15% Year 2 30% Year 4 to infinity 3%
D1 = 1.00 x 1.20 = $1.20 D2 = 1.20 x 1.30 = $1.
D3 = 1.56 x 1.15 x 1.15 = $1.79 D4 = 1.79 x 1.03 = $1.
P3 = $1.84 / (0.12 – 0.03) = $20.
Supernormal Normal
Using the CF keys CF0 = 0 CO1 = 1.20 CO2 = 1.56 CO3 = $1.79 + 20.44 = 22. NPV I = 12 NPV CPT NPV = $18.
Example 5
Ornette Ltd. has EBITDA of $53 million and debt of $127 million. The EBITDA multiple of similar firms is 5.5. Ornette has 8 million common shares outstanding. Estimate Ornette’s value per share. EV = $53 x 5.5 = $291.5 million Equity = $291.5 - $127 = $164.5 million Per share = $164.5 / 8.0 = $20.
Preferred Stock
Preferred stock is classified as part of equity on the balance sheet but it is quite different from common stock: o It ranks ahead of common stock in terms of dividends: no common dividends can be paid unless the preferred dividends have been paid. o Preferred stock, in public companies, usually has no voting rights. o In the event of bankruptcy preferred stock ranks ahead of common, by the amount of its par value, but ranks behind all debt. o Preferred stock typically pays a fixed dividend: the dividend does not grow as the firm grows.
We can also compare preferred stock to debt: o Non-payment of preferred dividends, unlike non-payment of interest, cannot result in bankruptcy. o Like all dividends, and unlike interest, preferred dividends are not tax- deductible by the corporation. o However, the Income Tax Act provides for a lower effective rate for dividend income vs. interest income received by investors. o Like common stock, and unlike debt, preferred stock does not have a maturity date. Preferred stock occupies a position between debt and common equity. It is less risky than the common stock, but riskier than the bonds, for a given company. Preferred stock can be valued as a perpetuity with the perpetual cash flow equal to the dividend. The discount rate will be based on the rate for preferred stock issued by companies of similar risk. Therefore: V ps = D ps r ps
o Market equilibrium means: Expected return = required return o Which is the same as saying : Market price = intrinsic value
