Computing the Price of Common Stock

Maturity and the volatility of bond returns

1. Only bond whose return = yield is one with maturity = holding period

2. For bonds with maturity > holding period, i ↑ P ↓ implying capital loss

3. Longer is maturity, greater is price change associated with interest rate change

4. Longer is maturity, more return changes with change in interest rate

5. Bond with high initial interest rate can still have negative return if i ↑

Reinvestment risk

1. For a given YTM and a given non-zero coupon rate, the longer the maturity, the more the bond’s total dollar return depends on reinvestment income to realize the YTM at time of purchase (i.e., the larger the reinvestment risk)

2. For a coupon paying bond, for a given maturity and a given YTM, the higher the coupon rate, the more dependent the bond’s total dollar return will be on the reinvestment of the coupon payments in order to produce the YTM at time of purchase

Limited liability – personal assets and obligations of shareholders are not the assets and obligations of corporation, shareholders are not responsible for lawsuits against the firm

Transferable shares – conduct of business unaffected by owner changes and it allows the corporation to have unlimited life, allows for contestability in management and makes it easy to monitor managerial performance

Investor ownership – control rights allow to vote in the election of board members and to approve major transactions, cash flow rights assume the rights to receive the firm’s net earnings

Stocks

I. What does a stock represent?

1. Stockholders have claim on all assets

2. Right to vote for directors and on certain issues

II. How does it earn a return?

1. Price of the stock rises over time

2. Dividends paid to the stockholder

III. Two types: common stock, preferred stock

1. Common stock – security that pays an uncertain cash flow

a) Right to vote for the board in proportion to share holdings

b) Receive dividends

Preferred stock

a) Receive a fixed dividend

b) Do not usually vote

Preferred Stocks

1. Preference over common stock in cash rights:

· in the payments of dividends

· in the assets in case of bankruptcy

2. No voting rights, unless no dividends 6 quarters in a row (1 year in Russia)

Dividends

1. Payments to shareholders from firm

· Usually cash

· Usually paid quarterly

2. Firm sets amounts

3. Dividends paid after all other obligations are met

4. Amount can be zero

5. Dividend timing

a) Key date: Ex-dividend date

· Purchase before: get dividend

· Purchase after: no dividend

Computing the Price of Common Stock

1. How do we value common stock?

In theory, no different from valuing debt securities: determine the future cash flows and

discount them to the present at an appropriate discount rate

2. Four ways to do it:

· The One-Period Valuation Model

· The Generalized Dividend Valuation Model

· The Gordon Growth Model

· Price Earnings Valuation Method

Stock return

1. Expected Return - the percentage yield that an investor forecasts from a specific investment over a set period of time (sometimes called the market capitalization rate)

2. Two parts to a Stock Return = (capital gain) + (dividend yield)

Дата добавления: 2015-11-14