Chapter 7

Valuation and Characteristics

of Stock

Aim
1.
2.
3.
4.
5

Identify the basic characteristics and

features of ferret stock.
Value preferred stock
Identify the characteristics and features
of common stock
Value common stock
Calculate a stocks expected rate of
return

Terms
Preferred Stock
Common Stock
The Stock Holders
Expected Rate of
Return
Call provision
Convertible Preferred
Stock
Cumulative Feature

Cumulative Voting
Expected Rate of Return
Internal Growth
Limited Liability
Majority Voting
Multiple-holding Period
Preemptive Right
Protective Provisions
Proxy
Proxy Fight
Sink-fund Provision
Valuation Model

Preferred stock
Hybrid security
1. No fixed maturity date.
2. Nonpayment of dividends leads no
bankruptcy.
3. Taxable
4. Limited in amount.

Multiple classes
More than one series or class
Each different characteristics. 13
Priority status regarding assets in bankruptcy.

No residual earning
Par: $25
Dividend rate: 7.56%
Dividend $1.89

Cumulative feature
Past unpaid be paid before common stock
dividends declared.
No dividend enforcement.

Claims on assets and incomes

Priority over common stock.
Bonds > preferred stock
Preferred stock safer > common stock
Common stock.

Protective provisions
Restrict the payment of common stock.
Voting right in case of nonpayment.
(six quarterly dividends in arreas.
Sinking funds

Convertibility
At discretion( predetermined
shares.
1/3 convertibility feature.
Reduced the cost of common stock.

Retirement feature
Take advantage of falling interest rates.
Call provision: repurchase at stated price.
Initial premium above the par 10%.
Sinking fund provision: set a maturity date.

OBJECTIVE 1 Preferred stock

Multiple classes of preferred stock

Preferred stocks claim on assets and incomes
Cumulative dividends
Protective provisions
Convertibility
Multiple classes
Claim on assets and incomes

52 WEEK
HI

LO

YLD

STOCK

SYM

GenElec

GE

VOL

NET

DIV % PE 100s

HI

2.08 2.0 24 28140

GenGrowProp GGP 1.72 5.5 14

dd

GenHost

GH

GenHouse

GHW 0.32 3.1 dd

GenlnstrCp GIC

LO CLOSE CHG

1498

439

dd

65
7091

GenMills

GIS 2.00 2.9 24

5591

GenMotor

GM 2.00f 3.5 10

29880

Cumulative feature
Protective provisions
Convertibility
Retirement Features
Callable Preferred
Sinking-Fund Provisions

dividend in year1
1
(1 required rate of return )

V ps

dividend in year 2
(1 required rate of return ) 2

dividend in inf inity

(1 required rate of return )

D1
(1 k ps )1

V ps

t 1

D2
(1 k ps ) 2

Dt
(1 k ps )t

D
(1 k ps )

VPS

annual dividend
required rate of return

V ps

D
k ps

$3.64
0.0728

D
k ps

$50

Axiom
Axiom 1: The Risk-Return Trade-off
We Won't Take on Additional
Risk Unless We Expect to Be
Compensated with additional Return.
Axiom 2: The Time Value of MoneyA Dollar
Received Today is Worth More Than
A Dollar Received in the Future.
Axiom 3: CashNot Profitsis King.

OBJECTIVE 3 COMMON STOCK

Common stock is certificate that indicates
ownership in the corporation.
Features or Characteristic of Common Stock

Claim on income
Claim on Assets
Voting Rights
Preemptive Rights
Limited Liability

OBJECTIVE 4 Valuing Common Stock

g= ROE * r

g = the growth rate of future earnings and the

growth in the common stockholders investment in the firm

ROE = the return on equity (net

income/common book value)
r = the company's percentage of profits retained, called
the profit-retention rate6

g=16%*0.25=4%

Claim on income
1. Residual income: to shareholders
nothing if after bondholders
2. Reinvestment : earning power (capital
gains)
3. Limitless return
4. Nothing

Voting
Voting directors of board
Voting for the charter changes
Proxy fight when takeover
Majority vote
Cumulative vote: minority shareholders.

Cumulative vote
Outstanding: 1 000
Majority control:749
Minority control : 251
Election of board of directors?

formula
NE= O x D/TN + 1
NE: number of shares needed to elect a certain number of
directors.
O = total number of shares of common stock
outstanding.
D = number of directors desired.
TN = total number of directors to be elected.

D= 1,2 and 3
(1000 x 1)/(3 + 1 + 1 = 251
(1000 x 2)/(3 + 1 + 1 = 501
(1000 x 3)/(3 + 1 + 1 = 751

Preemptive right
Preemptive right: entitles the common
shareholder to maintain a proportionate
share of ownership in the firm when issuing
new stocks.
Dilution of ownership

Limited liability
Liability limited in case of bankruptch to
investment.
Help raising the funds or debt.

Common Stock ValuationSingle Holding Period

Vcs present value of dividend in one yeay( D1 )

present value of market price in one yeay( P1 )

D1
(1 k cs )

(1Pk1cs )

at the beginning of this year.

Dividend:$1.64,
market price:projected $22.
required rate of return:18%
Value ?
Vcs = $1.64/(1+0.18) +$22/(1+0.18)
=$1.39+$18.64
=$20.03

multiple-holding-period valuation model

Vcs

D1
(1 K CS )1

D2
(1 k cs ) 2

common stock value

Vcs

D1
k cs g

Dn
(1 k cs ) n

(1 k cs )

dividend in year1
required rate of return growth rate

 Dividend: $2
growth rate: 10%
Required rate of return: 15%

D1=D0(1+g)=$2(1+0.10)=$2.20
Vcs=D1/(kcs-g)
=$2.20/(0.15-0.10)=$44

OBJECTICVE 5 The Stockholders Expected Rate

of Return

Vcs

annual dividend
required rate of return

k ps

annual dividend
market price

D
k cs

D
Pps

annual dividend
market price

K1ps=D/Pps
=$3.64/$50=7.28%

D
Pps

The Common Stockholder's Expected Rate of

Return

value

dividend in year1
(1 required rate of return )1

dividend in year 2

1 required rate of return ) 2

dividend in year inf inity

1 required rate of return )

Vcs

D1

D2

(1 k cs )

Vcs (1 k
t 1

(1 k

cs )

D1
k cs g

(1 k

)
cs

Dt
t
)
cs

common stock value

Vcs

dividend in year1
required rate of return growth rate

k cs ( ) g
D1
Vcs

k cs ( ) g
D1
Vcs

 kcs = $2.20 / $44 + 10% =15%

Quiz
Why would a preferred stockholder want
the stock to have a cumulative dividend
feature and protective provisions?