Transcript No Slide Title

Chapter
7
Common Stock:
Characteristics, Valuation,
and Issuance
Copyright ©2003 South-Western/Thomson Learning
Introduction
• This chapter describes the
characteristics of common stock.
• It discusses the process for selling
securities and the role of the
investment banker.
• It develops the valuation models for
common stock.
Common Stock
• Common stock (C/S) is the permanent
long-term financing of a firm.
• Common Stock (C/S) represents the true
residual ownership of a firm.
• Stockholders elect the board of directors.
Stock Quotations
• Table 7.1 shows selected stock
quotations for stocks traded on the New
York Stock Exchange.
TABLE 7.1 Selected Stock Quotations from the New York Stock
Exchange
YTD
%
CHG
-15.8
52 Weeks
Hi
Lo
49.88
32.64
Stock
SYM
DIV
YLD
%
PE
Vol
100s
Last
NET
CHG
DuPont
DuPont
DuPont
DD
pfA
pfB
1.40
3.50
4.50
3.4
5.8
5.9
40
25369
40.70
60
76.25
+0.09
-0.05
Stock Quotations
• Beginning at the left-hand side, the second
and third columns show the stock’s price
range during the previous 52 weeks. For
example, the per-share price of E. I. DuPont
de Nemours & Company common stock
ranged between $32.64 and $49.88.
• The column immediately to the right of the
stock name shows the ticker symbol used to
identify this stock on the exchange’s ticker
tape, DD for DuPont.
Stock Quotations
• The next column shows the current annual
dividend rate; for example, the DuPont
Company’s current annual dividend rate is
$1.40 per share of common stock. Dividends
are normally paid in four quarterly installments
throughout the year.
• The next column shows the dividend yield
(percentage). For DuPont the figure is 3.4
(calculated as the annual dividend divided by
the closing price, or $1.40/$40.70 = 3.4%).
Stock Quotations
• The price-to-earnings or P/E ratio (the closing
price divided by the sum of the latest four
quarters of earnings per share) is shown next.
The P/E ratio (40) indicates how much
investors are willing to pay for $1 of current
earnings from the firm. Similarly, the P/E ratio
will tend to be higher the more rapid the
expected growth rate in future earnings.
• The next figure is the sales volume in
hundreds of shares; on this day, 2,536,900
shares of DuPont common stock were traded.
Stock Quotations
• The next column lists the last or closing prices
for the day.
• The final column shows the net change in
price per share for the day, or the difference
between this day’s last price and the last price
on the previous business day (or the last day
on which a trade took place). For the day, the
common stock of DuPont gained 9 cents per
share.
Stock Quotations
• When a company has preferred stock
outstanding that is also traded on the New
York exchange, the different classes of
preferred stocks are listed in a separate table.
• As can be seen in Table 7.1, DuPont has two
preferred stock issues (pfA and pfB that pay
$3.50 and $4.50 per share respectively).
Unlike common stock dividends, the preferred
stock dividend rate normally will not change
over the time the issue is outstanding.
Balance Sheet Accounts Associated
With C/S
• Stockholders’ equity include both preferred
stock (if any exists) and common stock. The
total equity attributable to the common stock of
a company is equal to the total stockholders’
equity less the preferred stock.
• In other words, the sum of the common stock
account, contributed capital in excess of par
value account, and retained earnings account
equals the total common stockholders’ equity.
• Book value Total common stockholders’ equity
per share =
# of shares outstanding
Rights of Common Stockholders
• Dividend rights
Stock holders have the right to share
equally on a per-share basis in any
distribution of corporate earnings in the
form of dividends.
Rights of Common Stockholders
• Asset rights
In the event of a liquidation, stockholders
have the right to assets that remain after
the obligations to the government
(taxes), employees, and debt holders
have been satisfied.
Rights of Common Stockholders
• Preemptive rights
Stockholders may have the right to share
proportionately in any new stock sold.
• Voting rights
Stockholders have the right to vote on
stockholder matters, such as the
selection of the board of directors.
Voting for the Board of Directors
• Majority voting
– It requires more than 50 percent of the
votes to elect a director.
– With majority voting, it is possible that a
group of stockholders with a minority
viewpoint will have not representation on
the board.
Voting for the Board of Directors
• Cumulative voting
– Each share of stock represents as many
votes as there are directors to be elected.
– For example, if a firm is electing seven
directors, a particular holder of 100 shares
would have 700 votes and could cast all of
them for one candidate, thereby increasing
that candidate’s chances for being elected
to the board.
– Shareholders may concentrate votes on a
few candidates.
Voting for the Board of Directors
• Proxy
– Shareholders can sign over their voting
rights to someone else.
– Normally, a stockholders can expect to
receive a single proxy statement from the
firm’s management requesting that
stockholders follow management’s
recommendations. In the rather unlikely
event that another group of stockholders
sends out its own proxy statement, a proxy
fight is said to occur.
Voting for the Board of Directors
– Proxy fights are most common when a
company is performing poorly or is in the
midst of a takeover attempt.
Features of C/S
• C/S classes
• Stock splits
• Reverse stock splits
• Stock dividends
• Stock repurchases
Features of C/S: Common Stock
Classes
• Occasionally, a firm may decide to create
more than one class of common stock. The
reason for this may be that the firm wishes to
raise additional equity capital by selling a
portion of the existing owners’ stock while
maintaining control of the firm. This can be
accomplished by creating a separate class of
nonvoting stock.
• Typically, so-called Class A common stock is
nonvoting, whereas Class B has voting rights;
normally, the classes are otherwise equal.
Features of C/S: Stock Splits
• If management feels that the firm’s common
stock should sell at a lower price to attract
more purchasers, it can effect a stock split.
• Many investors believe stock splits are an
indication of good financial health. The mere
splitting of a stock, however, should not be
taken in and of itself as evidence that the
stock will necessarily perform well in the
future.
• From an accounting standpoint, when a stock
is split, its par value is changed accordingly.
No changes occur in the firm’s account
balance or capital structure.
Features of C/S: Reverse Stock
Splits
• Reverse stock splits are stock splits in which
the number of shares is decreased. They are
used to bring low-priced shares up to more
desirable trading levels.
• Many investors feel reverse stock splits
indicate poor corporate health. For this
reason, such splits are relatively uncommon.
Features of C/S: Stock Dividends
• A stock dividend is a dividend to stockholders
that consists of additional shares of stock
instead of cash.
• From an accounting (but not a cash flow)
standpoint, stock dividends involve a transfer
from the retained earnings account to the
common stock and additional paid in capital
accounts.
Features of C/S: Stock Repurchases
• From time to time, companies repurchase
some of their own shares (known as treasury
stock).
• A company may have a number of reasons for
repurchasing its own stock as follows:
– Disposition of excess cash
– Financial restructuring
– Future corporate needs
– Reduction of takeover risk
Features of C/S: Stock Repurchases
• Disposition of excess cash.
The company may want to dispose of excess
cash that it has accumulated from operations
or the sale of assets.
• Financial restructuring.
By issuing debt and using the proceeds to
repurchase its common stock, the firm can
alter its capital structure to gain the benefits of
increased financial leverage.
Features of C/S: Stock Repurchases
• Future corporate needs.
Stock can be repurchased for use in future
acquisitions of other companies, stock option
plans for executives, conversion of convertible
securities, and the exercise of warrants.
• Reduction of takeover risk.
Share repurchases can be used to increase
the price of a firm’s stock and reduce a firm’s
cash balance (or increase its debt proportion
in the capital structure) and thereby reduce
returns to investors who might be considering
an acquisition of the firm.
C/S Advantages and Disadvantages
• Advantages
– Flexible
– Reduced financial leverage
– Lower the firm’s weighted (average) cost of
capital
• Disadvantages
– Diluted EPS
– Expensive: high issuance costs associated
with common stock sold to the public
Investment Banking
• Long-range financial planning
• Timing of security issues
• Purchase of securities
• Marketing of securities
• Arrangement of private loans and leases
• Negotiation of mergers
How Are Securities Sold?
• Public cash offering
– Selling securities through investment
bankers to the public
– IPO’s Web site: http://www.ipo.com/
• Private or direct placement
– Placing a security issue with one or more
large investors
How Are Securities Sold?
• Rights offering
– Selling common stock to existing
stockholders
• Standby underwriting
– Investment banker purchases shares not
sold to rights holder.
Public Cash Offering
• Normally, when a corporation wishes to
issue new securities and sell them to the
public, it makes an arrangement with an
investment banker whereby the
investment banker agrees to purchase
the entire issue at a set price. This is
called a firm commitment underwriting.
The investment banker then resells the
issue to the public at a higher price.
Public Cash Offering
• A negotiated underwriting is simply an
arrangement between the issuing
company and its investment bankers.
Most large industrial corporations turn to
investment bankers with whom they
have had on going relationships.
Public Cash Offering
• In competitive bidding, the firm sells the
securities to the underwriter (usually a
group) that bids the highest price.
• Normally, a group of underwriters, called
a purchasing syndicate, agrees to
underwrite the issue in order to spread
the risk.
Public Cash Offering
• An important part of the negotiations
between the issuing firm and the
investment banker is the determination
of the security’s selling price.
• It is in the best interests of both the
issuing firm and the underwriter to have
the security “fair priced.”
Public Cash Offering
• If the security is underpriced, the issuing
firm will not raise the amount of capital it
could have, and the underwriter may
lose a customer.
• If the security is overpriced, the
underwriter may have difficulty selling
the issue, and investors who discover
that they paid too much may choose not
to purchase the next issue offered by
either the corporation or the underwriter.
Public Cash Offering
• Occasionally, with smaller company
issues, the investment banker agrees to
help market the issue on a “best efforts”
basis rather than underwriting it.
• Under this type of arrangement, the
investment banker has no further
obligation to the issuing company if
some of the securities cannot be sold.
Public Cash Offering
• The investment banker functions as a
dealer in an underwriting situation and
as a broker in a best-efforts situation.
• In a best-efforts offering, the investment
banker does not assume the risk that the
securities will not be sold at a favorable
price.
Private Placements
• Many industrial companies choose to
directly, or privately, place debt or
preferred stock issues with one or more
institutional investors instead of having
them underwritten and sold to the public.
• In these cases, investment bankers who
act on behalf of the issuing company
receive a “finder’s fee” for finding a
buyer and negotiating the terms of the
agreement.
Private Placements: Advantage
• They can save on flotation costs by
eliminating underwriting costs.
• They can avoid the time delays
associated with the preparation of
registration statements and with the
waiting period.
• They can offer greater flexibility in the
writing of the terms of the contract
(called the indenture) between the
borrower and the lender.
Private Placements: Disadvantage
• As a very general rule, interest rates for
private placements are about one-eighth
of a percentage point higher than they
are for debt and preferred issues sold
through underwriters.
Rights Offerings
• Firm may sell their common stock
directly to their existing stockholders
through the issuance of rights, which
entitle the stockholders to purchase new
shares of the firm’s stock at a
subscription price below the market
price.
Rights Offerings
• Rights offerings also are called
privileged subscriptions.
• Each stockholder receives one right for
each share owned.
Standby Underwritings
• In an arrangement called a standby
underwriting, the investment banker
agrees to purchase—at the subscription
price—any shares that are not sold to
rights holders. The investment banker
then resells the shares.
• In a standby underwriting, the
investment banker bears risk and is
compensated by an underwriting fee.
Direct Issuance Costs
• An investment banker who agrees to
underwrite a security issue assumes a
certain amount of risk, and, in turn,
requires compensation in the form of an
underwriting discount or underwriting
spread, computed as follows:
Underwriting spread
= Selling price to public – Proceeds to
company
Direct Issuance Costs
• It is difficult to compare underwriting
spreads for negotiated and competitive
offerings because rarely are two
offerings brought to market at the same
time that differ only in the ways in which
they are underwritten.
Direct Issuance Costs
• Other direct costs of security offerings
include legal and accounting fees, taxes,
the cost of registration with the
Securities and Exchange Commission
(SEC), and printing costs.
• Generally, direct issuance costs are
higher for common stock than for
preferred stock issues, and direct
issuance costs of preferred stock are
higher than those of debt issues.
Direct Issuance Costs
• One reason for this is the amount of risk
of each type of issue involves. Common
stocks usually involve more risk for
underwriters than preferred stock, and
preferred stock involves more risk for
underwriters than debt.
Direct Issuance Costs
• Another reason is that investment
bankers usually incur greater marketing
expenses for common stock than for
preferred stock or debt issues. Common
stock is customarily sold to a large
number of individual investors, whereas
debt securities are frequently purchased
by a much smaller number of institutional
investors.
Direct Issuance Costs
• Low-quality debt issues tend to have
higher percentage direct issuance costs
than high-quality issues because
underwriters bear more risk with lowquality issues and therefore require
greater compensation.
Direct Issuance Costs
• Direct issuance costs tend to be a higher
percentage of small issues, all other
things being equal, because
underwriters have various fixed
expenses that are incurred regardless of
the issue’s size.
Other Issuance Costs
• The cost of management time in
preparing the offering.
• The cost of underpricing a new (initial)
equity offering below the correct market
value: Underpricing occurs because of
the uncertainty associated with the value
of initial public offering (IPO) and a
desire to ensure that the offering is a
success.
Other Issuance Costs
• The cost of stock price declines for stock
offering by firms whose shares are
already outstanding—so-called
seasoned offerings. The announcement
of new stock issues by a firm whose
shares are already outstanding causes a
price decline averaging about 3% for the
outstanding shares.
Other Issuance Costs
• The cost of other incentives provided to
the investment banker, including the
overallotment or “Green Shoe” option.
This option, often contained in
underwriting contracts, gives the
investment bankers the right to buy up to
15% more new shares than the initial
offering amount at a price equal to the
offering price.
Other Issuance Costs
• The green shoe option is designed to
allow investment bankers to handle
oversubscriptions. This option normally
lasts for 30 days.
Registration Requirements
• SEC (Securities and Exchange
Commission) act of 1933 & SEC
exchange act of 1934
• Any interstate security issue over $1.5
million and having a maturity greater
than 270 days is required to register
issue with the SEC.
• Provide all buyers of the new security
with a final copy of the prospectus
• Shelf registration
• Check NYSE regulations
Global Equity Markets
• Multinational firms can take advantage of
institutional differences from one country
to another.
• Stock markets in United States, Japan,
London, and Paris
• Nearly 24-hour per day trading of C/S
• Provide investors with opportunities to
buy and sell shares any time they wish
• Global name and product recognition
Valuation of C/S
• Capitalized value of the stock’s expected
stream of cash flow during holding
period
Dividends
Not constant
Expected to grow over time
Capital gain or loss
Uncertain
Valuation of C/S
• One-Period Dividend Valuation Model:
D1
P1
P0 

1  ke 1  ke
• Multiple-Period Dividend Valuation
Model:
Dn
Pn
D1
D2
P0 

 ... 

1
2
n
n
(1  ke ) (1  ke )
(1  ke ) (1  ke )
Valuation of C/S: Example
• If Ohio Engineering Company common stock
is expected to pay a $1.00 dividend and sell
for $27.50 at the end of one period, what is the
value of this stock to an investor who requires
a 14 percent rate of return?
• P0 = $1.00(PVIF0.14, 1) + $27.50(PVIF0.14, 1)
= $1.00(0.877) + $27.50(0.877)
= $24.99
Valuation of C/S: Example
• Assume that the investor’s required rate of
return is 14%. Dividends from the stock are
expected to be $1 in the first year, $1 in the
second year, $1 in the third year, $1.25 in the
fourth year, and $1.25 in the fifth year. The
expected selling price of the stock at the end
of five year is $41. What is the value of this
stock to the investor today (t = 0)?
Valuation of C/S: Example
• P0 = $1(PVIF0.14, 1) + $1(PVIF0.14, 2) +
$1(PVIF0.14, 3) + $1.25(PVIF0.14, 4) +
$1.25(PVIF0.14, 5) + $41(PVIF0.14, 5)
= $1(0.877) + $1(0.769) + $1(0.675)
+ $1.25(0.592) + $1.25(0.519) +
$41(0.519)
= $24.99
Valuation of C/S
• A General Dividend Valuation Model:


Dt
Dt
P0  
 Pn  
t
t n
(1

k
)
(1

k
)
t 1
t  n 1
e
e
• The value of a firm’s common stock to the
investor is equal to the discounted present
value of the expected future dividend
stream.
• Note that the general dividend valuation
model treats the stream of dividends as a
perpetuity having no finite termination date.
Valuation of C/S
• As stated in Chapter 1, the primary goal
of firms should be the maximization of
shareholder wealth. The general
dividend valuation model indicates that
shareholder wealth, as measured by
the value of the firm’s common stock, P0,
is a function of the expected stream of
future dividend payments and the
investor’s required rate of return.
Valuation of C/S
• Thus, when making financial decisions
that are consistent with the goal of
maximizing shareholder wealth,
management should be concerned with
how these decisions affect both the
expected future dividend stream and the
discount rate that investors apply to the
dividend stream. See Figure 7.3.
Applications of the General
Dividend Valuation Model
• Zero growth
–g=0
• Constant growth dividend
– ke > g
– D1 = D0(1 + g)1 => Dt = D0(1 + g)t
• Nonconstant growth dividend
• Figure 7.4.
Zero Growth
• If a firm’s future dividend payments are
expected to remain constant forever, the
Dt in the general dividend valuation
model can be replaced by a constant
value D to yield the following:

D
D
P0  

t
ke
t 1 (1  ke )
Zero Growth: Example
• Assume that the Mountainer Railroad
common stock pays an annual dividend
of $1.50 per share, which is expected to
remain constant for the foreseeable
future. What is the value of the stock to
an investor who requires a 12 percent
rate of return?
• P0 = $1.50/12%
= $12.50
Constant Growth
• If a firm’s future dividend payments per
share are expected grow at a constant
rate, g, per period forever, then the
dividend at any future time period t can
be forecast as follows: Dt = D0(1 + g)t
where D0 is the dividend in the current
period (t = 0).
Constant Growth
• Substituting for Dt in the general
dividend valuation model yields the
following:
D0 (1  g )t
D1
P0  

t
(1  ke )
ke  g
t 1

Dn 1
 Pn 
ke  g
• It is assumed that the required rate of
return, ke, is greater than the dividend
growth rate, g, in the constant growth
valuation model.
Constant Growth
• Note that in the the constant growth
valuation model, the dividend value in
the numerator is D1, that is, the dividend
expected to be received one period from
now. The model assumes that D0, the
current dividend, has just been paid and
does not enter the (forward-looking)
valuation process.
Constant Growth
• The constant growth dividend valuation
model can be used to illustrate the two
forms of returns an investor can expect
to receive from holding a common stock.
D1
D1
P0 
 ke 
g
ke  g
P0
• The investor’s required rate of return is
equal to the expected dividend yield,
D1/P0, plus the price appreciation yield,
g—the expected increase in dividends
and, ultimately, in the price of the stock.
Constant Growth: Example
• Suppose that Dividends for Eaton are
expected to be $1.76 per share next year.
According to estimates from Value Line and
I/B/E/S, earnings and dividends are expected
to grow at about 6.5 percent annually. To
determine the value of a share of this stock an
investor who requires a 12 percent rate of
return, substituting $1.76 for D1, 6.5 percent
for g, and 12 percent for ke in the constant
growth model yields the following value for a
share of Eaton’s common stock:
P0 = $1.76/(12%  6.5%) = $32.00
Constant Growth: Example
• Thus, the investor’s 12 percent required rate
of return consists of a 5.5 percent dividend
yield (D1/P0 = $1.76/$32.00) plus a growth
return of 6.5 percent annually.
Nonconstant Growth Dividend
• There is no single model or equation that
can be applied when nonconstant growth
is anticipated.
Nonconstant Growth Dividend
• In general the value of a stock that is
expected to experience a nonconstant
growth rate pattern of dividend can be
calculated as follows:
P0 = (present value of expected
dividends during period of nonconstant
growth) + (present value of expected
stock price at the end of the nonconstant
growth period)
Nonconstant Growth Dividend:
Example
• Suppose an investor expects the earnings and
common stock dividends of HILO Electronics
to grow at a rate of 12% per annum for the
next five years. Following the period of abovenormal growth, dividends are expected to
grow at the slower rate of 6% for the
foreseeable future. The firm currently pays a
dividend, D0, of $2 per share. What is the
value of HILO common stock to an investor
who requires a 15% rate of return?
Nonconstant Growth Dividend:
Example
Present Value of First 5 Years’ Dividend
Year, t
Dt = $2(1+0.12)t
PVIF0.15, t
Dt
1
$2(1+0.12)1 = $2.24
0.870
$1.95
2
$2(1+0.12)2 = $2.51
0.756
$1.90
3
$2(1+0.12)3 = $2.81
0.658
$1.85
4
$2(1+0.12)4 = $3.15
0.572
$1.80
5
$2(1+0.12)5 = $3.53
0.497
$1.75
$9.25
Nonconstant Growth Dividend:
Example
Value of Stock at End of Year 5:
D6
D6
P5 

ke  g 2 0.15  0.06
D6  D5 (1  g 2 )  $3.53(1  0.06)  $3.74
$3.74
p5 
 $41.56
0.15  0.06
Nonconstant Growth Dividend:
Example
P5
Present Value of P5 , PV(P5 ) =
(1  ke )5
$41.56

 $41.56(PVIF0.15, 5 )
5
(1  0.15)
 $41.56(0.497)  $20.66
Value of Common Stock:
P0  PV(first 5 years' dividends) + PV(P5 )
 $9.25  $20.66  $29.91
Sources of Analyst Growth Rate
Forecasts
• Value Line Investment Survey
– http://www.valueline.com/
• Institutional Brokers Estimate System
– http://www.ibes.com/
• Zacks Earnings Estimates
– http://www.zacks.com/
Valuing Small Firms
• Nature of business
• Earnings capacity
• History of business
• Book value
• Economic outlook
• Financial condition
• Dividend paying
• Majority or minority
capacity
• Industry
interest
• Voting or nonvoting
Valuation Web site: http://www.bearval.com/