Stock Valuation Corporate Finance | CMA Exam | CPA Exam BEC |

These lectures covers stock valuation including zero growth model, non-constant growth model, constant growth model, components of required rate of return,  price earnings ratio.

Common Stock Valuation: Zero Growth Model | Corporate Finance

Constant Growth Model for Stocks | Corporate Finance

Nonconstant Growth Model for Stocks | Corporate Finance

Components of the Required Rate of Return | Corporate Finance

Stock Valuation using Multiple | Price Earning Ratio | Corporate Finance

A share of common stock is more difficult to value in practice than a bond for at least three reasons. First, with common stock, not even the promised cash flows are known in advance. Second, the life of the investment is essentially forever because common stock has no maturity. Third, there is no way to easily observe the rate of return that the market requires. Nonetheless, as we will see, there are cases in which we can come up with the present value of the future cash flows for a share of stock and thus determine its value.
Zero Growth
The case of zero growth is one we’ve already seen. A share of common stock in a company with a constant dividend is much like a share of preferred stock.

 

COMMON STOCK FEATURES

The term common stock means different things to different people, but it is usually applied to stock that has no special preference either in receiving dividends or in bankruptcy.

Shareholder Rights

The conceptual structure of the corporation assumes that shareholders elect directors who, in turn, hire managers to carry out their directives. Shareholders, therefore, control the corporation through the right to elect the directors. Generally, only shareholders have this right.

Directors are elected each year at an annual meeting. Although there are exceptions (discussed next), the general idea is “one share, one vote” (not one shareholder, one vote). Corporate democracy is thus very different from our political democracy. With corporate democracy, the “golden rule” prevails absolutely.3

Directors are elected at an annual shareholders’ meeting by a vote of the holders of a majority of shares who are present and entitled to vote. However, the exact mechanism for electing directors differs across companies. The most important difference is whether shares must be voted cumulatively or voted straight.

To illustrate the two different voting procedures, imagine that a corporation has two shareholders: Smith with 20 shares and Jones with 80 shares. Both want to be a director. Jones does not want Smith, however. We assume there are a total of four directors to be elected.

The effect of cumulative voting is to permit minority participation.4 If cumulative voting is permitted, the total number of votes that each shareholder may cast is determined first. This is usually calculated as the number of shares (owned or controlled) multiplied by the number of directors to be elected.

With cumulative voting, the directors are elected all at once. In our example, this means that the top four vote getters will be the new directors. A shareholder can distribute votes however he or she wishes.

Will Smith get a seat on the board? If we ignore the possibility of a five-way tie, then the answer is yes. Smith will cast 20 × 4 = 80 votes, and Jones will cast 80 × 4 = 320 votes. If Smith gives all his votes to himself, he is assured of a directorship. The reason is that Jones can’t divide 320 votes among four candidates in such a way as to give all of them more than 80 votes, so Smith will finish fourth at worst.

In general, if there are N directors up for election, then 1/(N + 1) percent of the stock plus one share will guarantee you a seat. In our current example, this is 1/(4 + 1) = 20%. So the more seats that are up for election at one time, the easier (and cheaper) it is to win one.

With straight voting, the directors are elected one at a time. Each time, Smith can cast 20 votes and Jones can cast 80. As a consequence, Jones will elect all of the candidates. The only way to guarantee a seat is to own 50 percent plus one share. This also guarantees that you will win every seat, so it’s really all or nothing.

COMMON STOCK FEATURES

The term common stock means different things to different people, but it is usually applied to stock that has no special preference either in receiving dividends or in bankruptcy.

Shareholder Rights

The conceptual structure of the corporation assumes that shareholders elect directors who, in turn, hire managers to carry out their directives. Shareholders, therefore, control the corporation through the right to elect the directors. Generally, only shareholders have this right.

Directors are elected each year at an annual meeting. Although there are exceptions (discussed next), the general idea is “one share, one vote” (not one shareholder, one vote). Corporate democracy is thus very different from our political democracy. With corporate democracy, the “golden rule” prevails absolutely.

Directors are elected at an annual shareholders’ meeting by a vote of the holders of a majority of shares who are present and entitled to vote. However, the exact mechanism for electing directors differs across companies. The most important difference is whether shares must be voted cumulatively or voted straight.

To illustrate the two different voting procedures, imagine that a corporation has two shareholders: Smith with 20 shares and Jones with 80 shares. Both want to be a director. Jones does not want Smith, however. We assume there are a total of four directors to be elected.

The effect of cumulative voting is to permit minority participation.4 If cumulative voting is permitted, the total number of votes that each shareholder may cast is determined first. This is usually calculated as the number of shares (owned or controlled) multiplied by the number of directors to be elected.

With cumulative voting, the directors are elected all at once. In our example, this means that the top four vote getters will be the new directors. A shareholder can distribute votes however he or she wishes.

Will Smith get a seat on the board? If we ignore the possibility of a five-way tie, then the answer is yes. Smith will cast 20 × 4 = 80 votes, and Jones will cast 80 × 4 = 320 votes. If Smith gives all his votes to himself, he is assured of a directorship. The reason is that Jones can’t divide 320 votes among four candidates in such a way as to give all of them more than 80 votes, so Smith will finish fourth at worst.

In general, if there are N directors up for election, then 1/(N + 1) percent of the stock plus one share will guarantee you a seat. In our current example, this is 1/(4 + 1) = 20%. So the more seats that are up for election at one time, the easier (and cheaper) it is to win one.

With straight voting, the directors are elected one at a time. Each time, Smith can cast 20 votes and Jones can cast 80. As a consequence, Jones will elect all of the candidates. The only way to guarantee a seat is to own 50 percent plus one share. This also guarantees that you will win every seat, so it’s really all or nothing.

There are many other cases of corporations with different classes of stock. For example, at one time, General Motors had its “GM Classic” shares (the original) and two additional classes, Class E (“GME”) and Class H (“GMH”). These classes were created to help pay for two large acquisitions, Electronic Data Systems and Hughes Aircraft. Another good example is Google, the Web search company, which only recently became publicly owned. Google has two classes of common stock, A and B. The Class A shares are held by the public, and each share has one vote. The Class B shares are held by company insiders, and each Class B share has 10 votes. Then, in 2014, the company had a stock split of its Class B shares, creating Class C shares, which have no vote at all. As a result, Google’s founders and managers control the company.

Historically, the New York Stock Exchange did not allow companies to create classes of publicly traded common stock with unequal voting rights. Exceptions (like Ford) appear to have been made. In addition, many non-NYSE companies have dual classes of common stock.

A primary reason for creating dual or multiple classes of stock has to do with control of the firm. If such stock exists, management of a firm can raise equity capital by issuing nonvoting or limited-voting stock while maintaining control.

The subject of unequal voting rights is controversial in the United States, and the idea of one share, one vote has a strong following and a long history. Interestingly, however, shares with unequal voting rights are quite common in the United Kingdom and elsewhere around the world.

Other Rights

The value of a share of common stock in a corporation is directly related to the general rights of shareholders. In addition to the right to vote for directors, shareholders usually have the following rights:

  1. The right to share proportionally in dividends paid.

  2. The right to share proportionally in assets remaining after liabilities have been paid in a liquidation.

  3. The right to vote on stockholder matters of great importance, such as a merger. Voting is usually done at the annual meeting or a special meeting.

In addition, stockholders sometimes have the right to share proportionally in any new stock sold. This is called the preemptive right.

Essentially, a preemptive right means that a company that wishes to sell stock must first offer it to the existing stockholders before offering it to the general public. The purpose is to give stockholders the opportunity to protect their proportionate ownership in the corporation.

Dividends

A distinctive feature of corporations is that they have shares of stock on which they are authorized by law to pay dividends to their shareholders. Dividends paid to shareholders represent a return on the capital directly or indirectly contributed to the corporation by the shareholders. The payment of dividends is at the discretion of the board of directors.

Some important characteristics of dividends include the following:

    1. Unless a dividend is declared by the board of directors of a corporation, it is not a liability of the corporation. A corporation cannot default on an undeclared dividend. As a consequence, corporations cannot become bankrupt because of nonpayment of dividends. The amount of the dividend and even whether it is paid are decisions based on the business judgment of the board of directors.

  1. The payment of dividends by the corporation is not a business expense. Dividends are not deductible for corporate tax purposes. In short, dividends are paid out of the corporation’s aftertax profits.

  2. Dividends received by individual shareholders are taxable. In 2014, the tax rate was 15 to 20 percent, but this favorable rate may change. However, corporations that own stock in other corporations are permitted to exclude 70 percent of the dividend amounts they receive and are taxed on only the remaining 30 percent.

    PREFERRED STOCK FEATURES

    Preferred stock differs from common stock because it has preference over common stock in the payment of dividends and in the distribution of corporation assets in the event of liquidation. Preference means only that the holders of the preferred shares must receive a dividend (in the case of an ongoing firm) before holders of common shares are entitled to anything.

    Preferred stock is a form of equity from a legal and tax standpoint. It is important to note, however, that holders of preferred stock sometimes have no voting privileges.

    Stated Value

    Preferred shares have a stated liquidating value, usually $100 per share. The cash dividend is described in terms of dollars per share. For example, General Motors “$5 preferred” easily translates into a dividend yield of 5 percent of stated value.

    Cumulative and Noncumulative Dividends

    A preferred dividend is not like interest on a bond. The board of directors may decide not to pay the dividends on preferred shares, and their decision may have nothing to do with the current net income of the corporation.

    Dividends payable on preferred stock are either cumulative or noncumulative;most are cumulative. If preferred dividends are cumulative and are not paid in a particular year, they will be carried forward as an arrearage. Usually, both the accumulated (past) preferred dividends and the current preferred dividends must be paid before the common share-holders can receive anything.

    Unpaid preferred dividends are not debts of the firm. Directors elected by the common shareholders can defer preferred dividends indefinitely. However, in such cases, common shareholders must also forgo dividends. In addition, holders of preferred shares are often granted voting and other rights if preferred dividends have not been paid for some time. For example, at one point, USAir had failed to pay dividends on one of its preferred stock issues for six quarters. As a consequence, the holders of the shares were allowed to nominate two people to represent their interests on the airline’s board. Because preferred stockholders receive no interest on the accumulated dividends, some have argued that firms have an incentive to delay paying preferred dividends; but, as we have seen, this may mean sharing control with preferred stockholders.