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Chapter 9 Stock ValuationLearning Objectives1. 2.

List and describe the four types of secondary markets. Explain why many financial analysts treat preferred stock as a special type of bond rather than as a true equity security.

3. Describe how the general dividend-valuation model values a share of stock. 4. Discuss the assumptions that are necessary to make the general dividend-valuation model easier to use, and be able to use the model to compute the value of a firms stock.5.

Explain why g must be less than R in the constant-growth dividend model.

6. Explain how valuing a preferred stock with a stated maturity differs from valuing a preferred stock with no maturity date, and be able to calculate the price of a share of preferred stock under both conditions.

I.9.1

Chapter OutlineThe Market for Stocks Equity securities are certificates of ownership of a corporation. Households dominate the holdings of equity securities, owning more than 36 percent of outstanding corporate equities. A. Secondary Markets

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In secondary markets, outstanding shares of stock are bought and sold

among investors. An active secondary market enables firms to sell their new debt or equity

issues at a lower funding cost than firms selling similar securities that have no secondary market. B. Secondary Markets and Their Efficiency In the United States, most secondary market transactions are conducted on

one of the many stock exchanges. In terms of total volume of activity and total capitalization of the

firms listed, the NYSE is the largest in the world and NASDAQ is the second largest. In terms of the number of companies listed and shares traded on a

daily basis, NASDAQ is larger than the NYSE. Firms listed on the NYSE tend to be, on average, larger in size and

their shares trade more frequently than firms whose securities trade on NASDAQ. There are four types of secondary markets, and each type differs according

to the amount of price information available to investors, which in turn, affects the efficiency of the market. 1. Direct Search The secondary markets farthest from our ideal of complete price information are those in which buyer and seller must seek each other out directly.

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It is too costly to perform a thorough search among all possible partners done to locate the best price.

Securities that sell in direct search markets are usually bought and sold so infrequently that no third party, such as a broker or dealer, finds it profitable to serve the market.

The sales of common stock of small private companies and private placement transactions are good examples of direct search markets.

2.

Broker Brokers bring buyers and sellers together to earn a fee, called a commission. Brokers extensive contacts provide them with a pool of price information that individual investors could not economically duplicate themselves.

By charging a commission fee less than the cost of direct search, brokers give investors an incentive to make use of the information by hiring them as brokers.

3.

Dealer Market efficiency is improved if there is someone in the marketplace to provide continuous bidding (selling or buying) for the security.

Dealers provide this service by holding inventories of securities, which they own, then buying and selling from the inventory to earn a profit.

Dealers earn their profits from the spread on the securities they tradethe difference between their bid price (the price at which they buy) and their offer price (the price at which they sell).

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The advantage of a dealer over a brokered market is that brokers cannot guarantee that an order will be executed promptly, while dealers can because they have an inventory of securities.

A dealer market eliminates the need for a time-consuming search for a fair deal by buying and selling immediately from the dealers inventory of securities.

NASDAQ is the best-known example of a dealer market. Electronic communications network (ECN) systems provide additional price information to investors and increase marketability and competition, which should improve NASDAQ efficiency.

4.

Auction In an auction market, buyers and sellers confront each other directly and bargain over price.

The New York Stock Exchange is the best-known example of an auction market.

In the NYSE the auction for a security takes place at a specific location on the floor of the exchange, called a post.

The auctioneer in this case is the specialist who is designated by the exchange to represent orders placed by public customers.

C.

Reading the Stock Market Listings The Wall Street Journal, the New York Times, and other newspapers in

large metropolitan areas provide stock listings for the major stock exchanges, such as the NYSE and the relevant regional exchanges.

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Exhibit 9.1 shows a section of the listing in the Wall Street Journal for the

NYSE. D.

Types of Equity Securities The two types of equity securities are common stock and preferred stock. Common stock represents the basic ownership claim in a corporation. One of the rights of the owners is to vote on all important matters

that affect the life of the company, such as electing the board of directors or voting on a proposed merger or acquisition. Owners of common stock are not guaranteed any dividend

payments and have the lowest-priority claim on the firms assets in the event of bankruptcy. Legally, common stockholders enjoy limited liability. Common stocks are perpetuities in the sense that they have no

maturity. Preferred stock also represents ownership interest in the corporation, but

preferred stock receives preferential treatment over common stock in certain matters. If a preferred dividend payment is not paid due to the firms

financial condition, the firm is not in default technically. However, the market reacts as if the failure to make the dividend payment is a default and punishes the stock accordingly.

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Preferred stock owners are given priority treatment over common

stock with respect to dividends payments and the claims against the firms assets in the event of bankruptcy or liquidation. Dividends payments are paid with after-tax dollars subject to

taxation. Even though preferred stock is equity, the owners have no voting

privileges. Preferred stocks are legally classified as perpetuities because they

have no maturity. However, most preferred stocks are not true perpetuities because the shares contain a call provision and the share contract often requires management to retire a certain percent of the stock annually until the entire issue is retired. E. Preferred Stock: Debt or Equity? Legally, preferred stock is equity. Like the dividends on common stock, preferred stock dividends are

taxable. A strong case can be made that preferred stock is really a special type of

bond. First, regular preferred stock confers no voting powers. Second, preferred stockholders receive a fixed dividend, regardless

of the firms earnings, and if the firm is liquidated, they receive a stated value (usually par) and not the residual value.

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Third, preferred stocks often have credit ratings that are similar

to those issued to bonds. stock. Finally, most preferred stock issues today are not true perpetuities. Fourth, preferred stock is sometimes convertible into common

Increasingly, preferred stock issues have the sinking fund feature, which require mandatory annual retirement schedules.

9.2

Common Stock Valuation Valuation of common and preferred stock is done by using the same basic methodology that was discussed for bond valuations in Chapter 6. Applying the valuation procedure to common stocks is more difficult than applying it to bonds for various reasons. First, in contrast to coupon payments on bonds, the size and timing of the dividend cash flows are less certain. Second, common stocks are true perpetuities in that they have no final maturity date. Finally, unlike the rate of return, or yield, on bonds, the rate of return on common stock is not directly observable. A.

A One-Period Model A one-period model provides an estimate of the market price. The value of an asset is the present value of its future cash flowsthe

future dividend and the end-of-period stock price.

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B.

A Two-Period Model This model can be viewed as two one-period models strung together. A Perpetuity Model

C.

A series of one-period stock pricing models is strung together to arrive at a

stock perpetuity model.

Though theoretically sound, this model is not practical to apply because

the number of dividends could be infinite. D.

The General Dividend Valuation Model Equation 9.1 is a general expression for the value of a share of stock. It

says that the price of a share of stock is the present value of all expected future dividends. The formula does not assume any specific pattern for future cash

dividends, such as a constant-growth rate. It does not make any assumption about when the share of stock is

going to be sold in the future. Finally, the model says that to compute a stocks current value, we

need to forecast an infinite number of dividends. Equation 9.1 implies that the underlying value of a share of stock is

determined by the markets expectations of future cash flows that the firm can generate. In efficient markets, stock prices change constantly as new information

becomes available and is discounted into the firms market price