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Valuation and Characteristics of Stocks

In this section, we continue to use the previously developed concept of security valuation and apply it to the second of the two principal securities—equities. Specifically, we will address the characteristics and valuation of the two primary equities, preferred stock and common stock. We begin by discussing the definition, characteristics, and valuation of preferred stock and conclude by examining the definition, characteristics, and valuation of common stock.

The Characteristics and Valuation of Preferred Stock

Many consider preferred stock to be a hybrid security with characteristics of both common stock and bonds. Preferred stock is similar to common stock in that it has no fixed repayment date, and the firm is not obligated to pay dividends. Preferred stock is similar to bonds in that the periodic payment amount is fixed. Preferred stock is normally issued by established, publicly traded firms to raise capital without diluting the current investors' common stock ownership. Because of the flexibility of terms, preferred stock is also frequently used in the initial private financing of startup companies.

Preferred Stock Characteristics

The following is a list of the significant characteristics of preferred stock as compared to the other two securities, common stock and bonds.

· Preferred stock does not provide the preferred stockholder a claim to ownership or voting rights in the firm.

· Preferred stock does entitle the stockholder to priority over the common stockholders in claims on the firm's assets in the event of bankruptcy.

· Preferred stockholders receive periodic dividends instead of interest, however, unlike with bond interest, failure to pay the dividends is not a cause for bankruptcy.

· Multiple classes of preferred stock can be issued with each class having different characteristics.

· Preferred stock normally carries a cumulative feature that requires that all past unpaid preferred stock dividends must be paid in full before any common stock dividends can be issued.

· Preferred stock may contain other varied protective and incentive provisions that are designed to protect the investor's investment.

· Preferred stock may contain a provision that allows it to be converted to a predetermined number of shares of common stock (convertible preferred).

· Most preferred stocks are perpetuities (nonmaturing), however, retirement features are frequently included. Two common retirement features are:

· callable provision, which allows preferred stock to be called at the issuer's request and retired, like a bond

· sinking fund provision, which requires the firm periodically to repurchase and retire a set amount of the preferred stock

Preferred Stock Valuation

According to the general valuation theory, the value of preferred stock is equal to the sum of all the cash flows generated from the investment, discounted by the investor's required rate of return. Because the only cash flow generated from preferred stock is the dividend payment, the value of a preferred stock equals the present value of all the future preferred stock dividends. Because a preferred stock is normally nonmaturing, and the dividends are expected to be paid in equal amounts each year in perpetuity, the value of the preferred stock can be determined simply by dividing the annual dividend by the required rate of return:

Vps = annual dividend/required rate of return 

Vps = D/kps

where:

Vps = value of the preferred stock D    = annual dividend kps  = required rate of return

The Characteristics and Valuation of Common Stock

Common stock is the unique security that provides the investor a part ownership of a corporation. It has no maturity date and entitles the common stockholder to common stock dividends and a share in any appreciation of the firm's stock value. On the downside, in the event of bankruptcy and liquidation, the common stockholders have last claim on the assets of the firm, after all creditors, bondholders, and preferred stockholders. Corporations issue common stock to raise long-term capital without incurring the disadvantages of legal obligations to pay interest, principal, or dividends.

Common Stock Characteristics

The following is a list of the significant characteristics of common stock as related to the other two securities, preferred stock and bonds.

1. Common stockholders have the right to the residual income and assets of the corporation after all bondholders, other debts, and preferred stockholders have been paid.

2. Common stockholders have the right to elect the corporation's board of directors.

3. Common stockholders' personal liability as owners of the corporation is limited to the amount of their investment in the company (their original common stock investment amount).

4. The issuance of additional new shares of common stock can dilute the percent of ownership of the current common stockholders.

Common Stock Valuation

According to the general valuation theory, the value of common stock is equal to the sum of all the cash flows generated from the investment, discounted by the investors' required rate of return. Because the only cash flow generated from common stock until sold is the dividend payment, the value of a common stock equals the present value of all the future preferred stock dividends. 

In general, a common stockholder also receives a return on her or his common stock in one of two ways:

1. an increase in market value, which is caused by a higher stock price—normally because of higher actual or expected generated earnings, or

2. by common stock dividends, which are expected to increase with higher corporate earnings

To calculate the value of a common stock (Vcs), we must discount all future expected dividends (D1, D2, D2, …Dn) to the present at the stockholders' required rate of return, kcs. Now because the amount of the annual dividends is not fixed and is typically expected to increase with higher corporate earnings, we require a new assumption for the future dividend amount. One simplified assumption, which would apply to many growing companies, is to assume that the dividend amount is increasing by a constant growth rate each year. With this assumption, we can determine the common stock value as follows:

Vcs = D1/(kcs – g) + D2/(kcs – g) + D3(kcs – g)  + --- + Dn/(kcs – g)

The above common stock cash stream can be shown algebraically to reduce to the following equation when g, the annual growth rate is a constant:

Vcs = D1/(kcs – g) 

Interpreting the above formula, we see the common stock value is equal to the next expected dividend in year 1 (D1)(divided by the net of the required rate of return (kcs), minus the growth rate (g).

This formula can also be written to use the last issued (previous, dividend) D, and the annual growth rate g:

Vcs = D(1 + g)/(Kcs – g) 

where:

D1     = D(1 + g) = the next expected dividend D0       = last or most recent dividend  g        = annual growth rate Vcc   = value of common stock

Carefully note the relationship between the last issued (previous) dividend (Do) and the next (expected) dividend D1 = D(1 + g). 

Chapter 7 “Stock Valuation” from Finance by Boundless is used under the terms of the Creative Commons Attribution-ShareAlike 3.0 Unported license. © 2014, boundless.com.

Chapter 8 “Introduction to Risk and Return” from Finance by Boundless is used under the terms of the Creative Commons Attribution-ShareAlike 3.0 Unported license. © 2014, boundless.com.

Must be APA format, answer post thoroughly, must have at least one verifiable, legitimate reference if needed Due Saturday @ 8:00 PM June 22, 2019. 24 hours from now.

Response #1

Miller - Post 1

Your assignment is to identify three market value ratios and explain what they mean or what they show/reveal about a company.

The following are market value rations:  Book value per share, dividend yield, Earnings per share, Market value per share, and Price/earnings ratio.

 1.   Book value per share --is calculated as the aggregate amount of stockholders’ equity and divided by the number of shares outstanding. This measure can be used as a benchmark to determine if the market value per share is higher or lower, which can also be used as the basis for decisions to buy or sell shares.

2.  Dividend Yield – is calculated as the total dividends paid per year, divided by the market price of the stock. This will give you the return on investment to investors if they bought shares at the current market price.

3.  Earnings per share –is calculated as the reported earnings of the business, divided by the total number of shares outstanding. This measurement does not reflect market price of a company’s shares, but can be used by investors to derive the price they think the shares are worth.

4.  Market value share – is calculated as the total market value of the business, divided by the total number of shares outstanding. This number shows the value that the market currently assigns to each  share of a company’s stock.

5.  Price/earning ratio –is calculated as the current market price of a share, divided by the reported earnings per share. The resulting multiple is used to evaluate whether the shares are over or under priced in comparison to the same ratio results for competing companies.

Bragg, S. (2017), Market Value ratios, AccountingTools, retrieved from: