Chapter 6 Common Stocks
Common stock represents equity,or an ownership
position in a corporation,It is a residual claim,in
the sense that creditors and preferred
stockholders must be paid as scheduled before
common stockholders can receive any payments.
In bankruptcy,common stockholders are in principle
entitled to any value remaining after all other
claimants have been satified.
The great advantage of the corporate form of
organization is the limited liability of its owners,
Common stocks are generally,full paid and
nonassessable”,meaning that common
stockholders may lose their initial investment,but
not more.
Chapter 6 Common Stocks
The corporate form of business organization
Sole proprietorship
A sole proprietorship is a business owned by a single
individual or one person,This is the simplest type of
business to start and is the least regulated form of
organization.
The owner of a sole proprietorship keeps all the
profits,And the owner has unlimited liability for
business debts.
There is no distinction between personal and business
income,so all business income is taxed as personal
income.
The life of this firm is limited to the owner’s life span.
Chapter 6 Common Stocks
Partnership
A partnership is similar to a proprietorship,except that
are tow or more owners(partners),That means
partnership is business formed by tow or more
individuals or entities.
There have general partnership and limited partnership
in a partnership firm.
Some conclusions of the tow forms of corporation
Unlimited liability for business debts on the part of the
owners,
Limited life of the business,
Difficulty of transferring ownership.
The ability of such business to grow can be seriously limited
by an inability to raise cash for investment.
Chapter 6 Common Stocks
Corporation
The corporation is the most important form of business
organization all over the world,That refer to a business
created as a distinct legal entity composed for one or
more individuals or entities.
The relative ease of transferring ownership,the limited
liability for business debts,and the unlimited life of the
business are the reasons why the corporate form is
superior when it comes to raising cash.
The disadvantage of corporation is,since a corporation
is a legal,person”,it must pay taxes,Money paid out to
stockholders in the form of dividends is taxed again as
income to those stockholders,this is double taxation.
Chapter 6 Common Stocks
There is an S corporation is a special type of small
corporation that is essentially taxed liked a
partnership and thus avoids double taxation,In mid-
1996,the maximum number of shareholders in an S
corporation was raised from 35 to 75.
A corporation by another name
The corporation form of organization has many
variations around the world,but the essential features
of public ownership and limited liability remain,
These firm are often called joint stock companies,public
limited companied,or limited liability
companies,depending on the specific nature of the
firm and the country of origin.
Chapter 6 Common Stocks
The corporate form
Corporate charter
A corporation exists only when it has been granted a
charter,or certificate incorporation.
Charter is a document issued by a state to a
corporation that specifies the rights and obligations
of the corporation’s stockholders,The charter is the
most important constitution of a corporation.
It may be amended with the approval of the
stockholders,perhaps by a majority or two—thirds
vote,where each share of stock generally entitles its
owner to one vote.
Chapter 6 Common Stocks
Both the initial terms of the charter and the terms of
any amendment must also be approved by the
state in which the corporation is chartered.
Stock certificates
The ownership of a firm’s stock has typically
been represented by a single certificate,with
the numbers of shares held by the particular
investor noted on it,
Shares of stock held by an investor may be
transferred to a new owner with the assistance
of either the issuing corporation or,more
commonly its designated transfer agent.
Chapter 6 Common Stocks
Transfer agent is a designated agent of a
corporation,usually a bank or other financial
institution,that administers the transfer of
shares of a corporation’s stock between old
and new owners.
Voting
Because an owner of a share of common stock
is one of the owners of a corporation,he or she
is entitled to vote on matters brought up at the
corporation’s annual meeting,and to vote for
the corporation’s directors,Any owner may
attend and vote in person,but most choose
instead to vote by proxy,
Chapter 6 Common Stocks
Proxy fight
Majority system
Cumulative system
In the context of a corporation,a method of
voting in which a stockholder is permitted to
give any one candidate for the board of
directors a maximum number of votes equal to
the number of shares owned by that
shareholder times the number of directors
being elected,
n=( )+1dsD+1
Chapter 6 Common Stocks
Where,n= minimum number of shares that must be
owned;
d= number of directors the stockholder
wants to be certain of electing;
s= number of shares outstanding
D= number of directors to be elected
In summary,the cumulative voting system gives
minority stockholders the right to have some
representation on the board of directors,provided
that the number of shares owned is sufficiently
large,
Chapter 6 Common Stocks
Takeovers
Periodically,a firm or a wealthy individual who is
convinced that the management of a corporation
is not fully exploiting its opportunities will attempt
a takeover.
This is frequently done with a tender offer being
made by a dibber to a target firm,Before this
offer is announced,some of the target firm’s
shares are usually publicly acquired by the
bidder in the open market through the use of
broker.
White knight,meaning that another firm that is
favorably inclined toward current management
will be invited to make a better offer to the
target’s stockholders.
Chapter 6 Common Stocks
Greenmail,another type of response by
management is to pay greenmail to bidder,
meaning that any shares held by the bidder will be
bought by the target firm at an above—market
price.
Repurchase offer,where the firm offers to buy
back some of its own stock.
PacMan defense,where the initial target turns
around and makes a tender offer for the initial
acquirer.
Crown jewel defense ; where the target sells its
most attractive assets to make the firm less
attractive.
Chapter 6 Common Stocks
Poison pills ; where the target gives its
shareholders certain rights that can be exercised
only in the event of a subsequent takeover and
that,once exercised,will be extremely onerous
to the acquirer,
Ownership versus control
Much has been written about the effect of the
separation of ownership and control of the
modern corporation,This separation gives rise to
what is known as a principal—agent problem,
Stockholders can be viewed as principals who
hire management to act as their agent,The
agent is to make decisions that maximize
shareholder wealth as reflected in the stock price.
Chapter 6 Common Stocks
No problem would exist if stockholders could
monitor the managers costlessly,but the monitor
is not costless,
Stockholder’s equity
Par value
Book value
Reserved and treasury stock
Classified stock
Cash dividends
Payments made in cash to stockholders are termed
dividends,These are typically declared quarterly by
the board of directors and paid to the stockholders
Chapter 6 Common Stocks
of record at a date specified by the board,known as
the date of record,
Stock dividends and stock splits
Occasionally,the board of directors decides to forgo
a cash dividend and,pays” a stock dividend
instead,
A stock split is similar to a stock dividend in that the
stockholder owns more shares afterward.
With a stock split,all the old shares are destroyed
and new ones are issued with a new par value,
Afterwards the number of new shares outstanding
is usually larger than the previous number of old
shares by 25% or more.
Chapter 6 Common Stocks
Reverse stock split is a form of stock
split whereby the number of shares is
reduced and the par value per share is
increased.
Chapter 6 Common Stocks
Ex—distribution dates
Similar to the payment of cash dividends,the
corporation specifies three dates associated with
either stock dividends or stock splits,a
declaration date,a date of record and a payment
date,
However,there is now an ex—distribution date
instead of an ex—dividend date,That refers to
the date on which ownership of stock is
determined for purposes of paying stock
dividends or issuing new shares due to stock
splits,Owners purchasing shares before the
ex—distribution date receive the new shares in
question,
Chapter 6 Common Stocks
Owners purchasing shares on or after ex—
distribution date are not entitled to the new
shares.
Reasons for stock dividends and splits
Nothing of importance would appear to be
changed,as such actions do not increase
revenues or reduce expenses,All that happens
is that there is a change in the size of the units
in which ownership may be bought and sold,
Moreover,because the process involves
administrative effort,and costs something to
execute,one wonders why it is done.
Chapter 6 Common Stocks
It is sometimes argued that stockholders respond
positively to,tangible” evidence of the growth of
their corporation,
Another view holds that splits and stock dividends,
by decreasing the price per share,may bring the
stock’s price into a more desirable trading range
and hence increase the total value of the amount
outstanding.
For each split,the stock’s,abnormal” return was
determined by relating monthly returns on the
stock to the corresponding returns in the stock
market.
This abnormal returns were averaged across firms
Chapter 6 Common Stocks
for each month relative to the firm’s split and then
cumulated across time.
The evidence also suggests that rather than decreasing
transaction costs,stock splits actually increased them,
A study of presplit and postsplit behavior showed that
after splits,trading volume rose less than
proportionately,and both commission costs and bid—
ask spreads,expressed as a percentage of value,
increased hardly reactions that are favorable to
stockholders,
Another study of stock splits and stock dividends
uncovered an apparent market efficiency.
Chapter 6 Common Stocks
Preemptive rights
Preemptive right means that when new shares
are to be sold,the current stockholders must be
given the right of first refusal in regard to the
purchase of the new shares.
Usually,the new shares will be priced below the
current market price of the stock,making such
right valuable,The stockholder can exercise the
right by purchasing allotted amount of new shares,
thereby maintaining proportional ownership in the
firm,but at the cost of providing additional capital.
Alternatively,the rights can be sold to someone
else,
Chapter 6 Common Stocks
For example,a firm want to raise $10,000,000 for new
project by sell new shares,The current market price
of the firm’s shares is $60 per share,a rights offering
may be used,where the subscription price is set at
$50 per share,Thereby,200,000 new shares are to
be sold.
Assuming the firm has 4,000,000 shares outstanding,
this means that the owner of one share will receive
the right to buy 1/20 of a new share,That someone
must be owned 20shares in order to be able to buy
one new share.
The rights are valuable because their owner can buy
stock at $50 a share when the market price is
significantly higher,
Chapter 6 Common Stocks
The preemptive rights owner can either use the rights or
sell the rights to someone else,But what is a fair price
for the right?
R = C0 – (RN+S)
Where,C0 =,rights—on” market price of stock
R = value of a right
N = number of rights needed to buy one share
S = subscription price
R= C0 - SN+1
Chapter 6 Common Stocks
Type of common stock
Blue chip stock
Growth stock
Cyclical stock
Defensive stock
Speculative stock
Performance stock
Chapter 6 Common Stocks
Stock quotations
Open price
Close price
High price
Low price
Insider trading
Insiders and insider trading
Narrowly,Insiders refers to the traders such as
stockholders,officers,or director of a corporation
who owns a,significant” proportion of a
corporation’s stocks,
Chapter 6 Common Stocks
More broadly defined anyone who has access to
information that is both,materially” related to the
value of a corporation’s securities and
unavailable to the general public,
In most country,it is illegal for any one to enter into
security transaction if he or she has taken
advantage of material,inside” information (that is,
substantive nonpublic information) about the
corporation that is unavailable to other people
involved in the transactions,
Ex ante and ex post value
In the opinion of well—informed investors,securities
with different attributes will have different expected
returns.
Chapter 6 Common Stocks
Thus the focus of these is on future or ex ante
(before the fact) expected returns,However,only
historical or ex post (after the fact) actual returns,
To bridge this gap,investors have used the
average historical return of a security as an
estimate of its expected returns.
Growth versus value
Stocks are often divided into growth stocks and
value stocks,
Book—value—to—market—value ratio
Chapter 6 Common Stocks
Growth stock refers to a kinds of stocks that has
experienced or is expected to experience rapidly
increasing earnings per share,and is often
characterized as having low earnings—to—price
and book—value—to—market—value ratio.
Value stock,typically refers to a stock that has
experienced relatively poor past price
performance,or whose issuing company has
experienced relatively poor past earnings results,
it is often characterized as having high earnings—
to—price and book—value—to—market—value
ratio.
Chapter 6 Common Stocks
The book value of the firm’s common stock is
determined by using the most recent
balance sheet data and calculating the total value of
stockholder’s equity,
The market capitalization of the firm’s common
stock is determined by taking the most recent
market price for the firm’s common stock and
multiplying it by the number of shares outstanding,
The book value of stockholder’s equity is divided by
the market capitalization to arrive at the BV/MV
ratio,
Relatively low value of this ratio characterize
growth stocks,and relatively high value
characterize value stock.
Chapter 6 Common Stocks
Earnings—to—price ratio
First,the accounting value of the firm’s
earnings per share is determined by using the
most recent income statement and dividing he
firm’s earnings after taxes by the number of
shares outstanding,
Second,the market price of the firm’s common
stock is determined by taking the most recent
price at which the firm’s common stock was
traded,
The earnings per share figure is divided by the
market price of the stock to arrive at the E/P
ratio.
Chapter 6 Common Stocks
The low value of this ratio characterize
growth value stocks,and relatively high value
characterize value stock.
Size
Although firm’s size is not generally used as
a criterion for distinguishing growth from
value stocks,it is often used to sort stocks,
Many investment professional think of stocks
in terms of tow dimensions as follows:
Hence stocks could be classified as growth
or value using the BV/MV ratio and as large or
small using their size,The result is that each
stock could be located in a sector diagram
like the one shown,
Chapter 6 Common Stocks
Size
Large
It can be seen that there is a clear inverse
relationship between size and average
return,That is,stocks of small firm tend to
have higher return than stock of larger firm.
Ratio
Low
Growth
High
Value
Small
Chapter 6 Common Stocks
Seasonality in stock returns
January effect
That is a important empirical regularity whereby
stock returns appear to be higher in January
than in other months of the year.
The reason of this effect should be the
periodically consume value of special Days and
other reasons such as taxes exemption,
Day—of—the—week effect
It is also be called the week end effect,refers to
an empirical regularity whereby stock returns
appear to be lower on Monday s than on other
days of the week.
Holiday effect
Chapter 6 Common Stocks
Ex—distribution price
Ex—distribution price refers to the
stock’s price after corporate addition
offered,
If Pc represent ex—distribution price,PC-
1represent the close price before ex—
distribution date,Pp represent the
subscription price,Rp represent rate of
additional,Rs represent the rate of stock
dividends,e represent the amount of
cash dividends,then,
Chapter 6 Common Stocks
1,The corporate has the stock dividends,then,the
price of ex—distribution will be：
PC=PC-1/（ 1+ RS ）
2,If the corporate offer addition stock the price will be：
PC =（ PC-1 + PP × RP ） /（ 1+ RP ）
3,additional offer and stock dividends payed at the
same time,the price of ex-distribution will be：
PC =（ PC-1 + PP × RP ） /（ 1+ RS + RP ）
Chapter 6 Common Stocks
4,additional offer and cash dividends payed at
the same time the price of ex—distribution
will be：
PC =（ PC-1 － e ＋ PP × RP ） /（ 1+ RP ）
例如：某公司发布分配计划，除权日前一天的股票收盘价为 18元，（ 1）公司实行送股，送股率为 10送 5；（ 2）公司配股，配股率为 10配
3，配股价为 6元；（ 3）公司宣布每股分派现金股息 0.5元；试用上述方法，计算不同情况下的股票除权价。
（ 12； 15.23； 11； 14.85）
Chapter 7 The Valuation of
Common Stocks
Capitalization of income method of
valuation
Capitalization of income method of valuation is
an approach to valuing financial asset,It is
based on the concept that the,true” or
“intrinsic”value of a financial asset is equal to
the discounted value of future cash flows
generated by the asset.
Because these flows are expected in the future,
they are adjusted by a discount rate to reflect
not only the time value of money but also the
riskiness of the cash flows,
Chapter 7 The Valuation of
Common Stocks
Where Ct denotes the expected cash flow
associated with the asset at time t and k is the
appropriate discount rate for cash flows of this
degree of risk,
Net present value
The NPV is equal to the difference between its
intrinsic value and cost(or principle).
V= + + +…=∑C1 C2 C3
(1+k)1 (1+k)2 (1+k)3 (1+k)t
Ct
Chapter 7 The Valuation of
Common Stocks
Internal rate of return
That is the discount rate that equates the sum
of the present value of future cash flows
expected to be received from particular
investment to the cost of that investment.
That is to say the discount rate that make the
NPV equal to Zero of the project.
Application to common stocks
Because the cash flows associated with an
investment in any particular common stock are
the dividends that are expected to be paid
throughout the future on the shares purchased,
Chapter 7 The Valuation of
Common Stocks
the models suggested by this method of value
are often known as dividend discount models,
There is a complication using that equation to
determine the intrinsic value of a share of
common stock,In particular,in order to use
this equation the investor must forecast all
future dividends,But the stock dose not
have a fixed lifetime.
On the other hand,the dividends from a firm
should be growth with a specified rate,that is
Dt = Dt-1 (1+gt)
Chapter 7 The Valuation of
Common Stocks
The zero—growth model
Net present value
V=D1 / k
Internal rate of return
IRR = D1 /P
The constant—growth model
We can assume that dividends will growth from
period to period at the same rate forever,and is
therefore known as the constant growth model.
Chapter 7 The Valuation of
Common Stocks
D0,D1 =D0(1+g),D2 =D1(1+g),D2 =D0(1+g)2
then in general the Dt =Dt-1(1+g) = D0(1+g)t
Net present value
V=D0 [(1+g)/(k-g)] then V= D1 /(k-g)
Internal rate of return
K=D0 (1+g)/P +g,then K=D1/P+g
Relationship to the zero—growth model
Chapter 7 The Valuation of
Common Stocks
The multiple—growth model
The multiple—growth model is the more general
DDM for valuing common stock.
The focus is on a time in the future(denoted by
T) after which dividends are expected to grow at
a constant ate g,Although the investor is still
concerned with forecasting dividends,these
dividends do not need to have any specific
pattern until this time,after which they will be
assumed to have the specific pattern of
constant growth.
Chapter 7 The Valuation of
Common Stocks
The dividends up until T(D1,D2,D3,… DT) will be
forecast individually by the investor,Thereafter
dividends are assumed to growth by a constant
rate g that the investor must also forecast,
meaning that:
DT+1 = DT(1+g)
DT+2 = DT+1(1+g)= DT(1+g)2
DT+3 = DT+2(1+g)= DT(1+g)3
Net present value
The present value of forecast stream of
dividends must be determined when we want
to determined the value of the stock with the
multiple— growth model.
Chapter 7 The Valuation of
Common Stocks
The stream could be divided into tow parts,the
first part consists of finding the present value of
all the forecast dividends that will paid up to
and including time T,this part denoted by VT-,
The second part consists of finding the present
value of all the forecast dividends that will be
paid after time T,and involves the application of
the consist—growth model.
T
t
t
T t
k
DV
1 )1(
Chapter 7 The Valuation of
Common Stocks
The application begins by imagining that the
investor is not at time zero but is at time T,and
has not changed his forecast of dividends for
the stock,This means that the next period’s
dividend DT+1 and all those thereafter are
expected to grow at the rate g,V with constant-
growth model will
VT represents a lump sum that is just as desirable
as the stream of dividends after T.
)1(1
gk
DV TT
Chapter 7 The Valuation of
Common Stocks
Now we suggest the investor is at time zero(the
present value at t=0),the present value at time
zero for all dividends after T denoted VT+,
Because the present value equal to VT-+VT+
The value of the stock will be:
)1)((
]
)1(
1
[
1
kgk
D
k
VV
T
TTT
Chapter 7 The Valuation of
Common Stocks
Internal rate of return
T
T
t
T
t
t
TT
kgk
D
k
D
VVV
)1)(()1(
1
1
T
T
t
T
t
t
kgk
D
k
DP
*)1)(*()*1(
1
1
Chapter 7 The Valuation of
Common Stocks
Relationship to the constant—growth
model
The constant—growth model can be shown to
be a special case of the multiple—growth
model,In particular,if the time when constant
growth is assumed to begin is set equal to
aero,then
)()1)((
0
)1(
11
1
gk
D
kgk
D
V
a n d
k
D
V
T
T
T
t
T
t
t
T
Chapter 7 The Valuation of
Common Stocks
Because T=0 and (1+k)0 =1.given the multiple—
growth model the V=VT-+VT+,it can be seen that
setting T=0 resulting in V=D1/(k-g),a formula
that is equivalent to the formula for the
constant—growth model.
Tow—stage and three—stage model
Tow dividend discount models that investors
sometimes use are the tow—stage model and
the three—stage model.
The tow—stage model assumes that a constant
growth rate g1 exists only until some time T,
Chapter 7 The Valuation of
Common Stocks
when a different growth rate g2 is assumed to begin
and continue thereafter.
The three—stage model assumes that a constant
growth rate g exists only until some time T1,
when a second growth rate is assumed to begin
and last until a later time T2,when a third growth
rate is assumed to begin and last thereafter.
By letting VT+ denote the present value of all
dividends after the last growth rate has begun
and VT- the present value of all the preceding
dividends,it can be seen that these models are
just special cases of the multiple—growth model.
Chapter 7 The Valuation of
Common Stocks
In applying the capitalization of income method of
valuation to common stocks,it might seem
appropriate to assume that the stock will be
sold at some point in the future,In this case the
expected cash flows would consist of the
dividends up to that point as well as the
expected selling price,
Because dividends after the selling date would be
ignored,the use of a dividend discount model
may seem to be improper,However,as will be
shown next,this is not so.
Chapter 7 The Valuation of
Common Stocks
Valuation based on a finite holding period
The investor could not hold the stock forever,if
he or she sell the stock,then would be affect
the formula we have told about.
The intrinsic value of the stock to the investor
by discounting these tow cash flows at the
required rate of return will be:
k
P
k
D
k
PD
V
11
1
11
11
Chapter 7 The Valuation of
Common Stocks
Where the D1 and P1 are the expected dividend
and selling price at t=1.
The selling price will be based on the dividends
that are expected to be paid after the selling
date,Thus the expected selling price at t=1 is
1
2
3
4
2
3
1
2
1
)1(
.,,
)1()1()1(
t
t
t
k
D
k
D
k
D
k
D
P
Chapter 7 The Valuation of
Common Stocks
Models based on price—earnings ratio
1
4
4
3
3
2
2
1
1
1
1
)1(
...
)1()1()1()1(
)
)1(
1
(
)1(
t
t
t
k
D
k
D
k
D
k
D
k
D
k
p
k
D
V
1111
11
)/(P w h e r e
)(
EEP
P
DPP
r e t u r nE x p e c t e d
Chapter 7 The Valuation of
Common Stocks
Some security analysts expand this procedure,
estimating earnings per share and price-
earnings ratios for optimistic,most likely,and
pessimistic scenarios to produce a rudimentary
probability distribution of a security’s return.
Other security analysts determine whether a
stock is underpriced or overpriced by
comparing the stock’s actual price—earnings
ratio with its normal P/E ratio.
The earnings per share E are related to
dividends per share D by the firm’s payout ratio.
Chapter 7 The Valuation of
Common Stocks
1
3
33
2
22
1
11
...3
3
2
2
1
1
)1(
...
)1()1()1(
)1()1()1(
t
tt
t
k
Ep
k
Ep
k
Ep
k
Ep
k
D
k
D
k
D
V
Chapter 7 The Valuation of
Common Stocks
Sources of earnings growth
Assuming that no new capital is obtained
externally and no shares are repurchased,the
portion of earnings not paid to stockholders as
dividends will be used to pay for the firm’s new
investments,
If the pt denotes the payout ratio,then (1- pt ) will
be equal to the portion of earnings not paid out,
known as the retention ratio,Then the firm’s
new investment stated on per share will be
It= (1- pt ) Et
Chapter 7 The Valuation of
Common Stocks
The growth rate to earnings per share depends
on (1) the proportion of earnings and (2)the
average return on equity for the earnings that
are retained.
Then if other things being equal,a stock’s
value (and its price ) should be greater,the
greater its average return on equity for new
investments
A three-stage DDM
Making forecasts
Chapter 7 The Valuation of
Common Stocks
Estimating the intrinsic value
Implied returns
The security market line (SML)
Required returns and α
Once the required return has been determined,
the difference between the stock’s implied
return and this required return can be
calculated,If is αpositive,the stock being
undervalued,other is over value.
The implied return on the stock market
Common stock represents equity,or an ownership
position in a corporation,It is a residual claim,in
the sense that creditors and preferred
stockholders must be paid as scheduled before
common stockholders can receive any payments.
In bankruptcy,common stockholders are in principle
entitled to any value remaining after all other
claimants have been satified.
The great advantage of the corporate form of
organization is the limited liability of its owners,
Common stocks are generally,full paid and
nonassessable”,meaning that common
stockholders may lose their initial investment,but
not more.
Chapter 6 Common Stocks
The corporate form of business organization
Sole proprietorship
A sole proprietorship is a business owned by a single
individual or one person,This is the simplest type of
business to start and is the least regulated form of
organization.
The owner of a sole proprietorship keeps all the
profits,And the owner has unlimited liability for
business debts.
There is no distinction between personal and business
income,so all business income is taxed as personal
income.
The life of this firm is limited to the owner’s life span.
Chapter 6 Common Stocks
Partnership
A partnership is similar to a proprietorship,except that
are tow or more owners(partners),That means
partnership is business formed by tow or more
individuals or entities.
There have general partnership and limited partnership
in a partnership firm.
Some conclusions of the tow forms of corporation
Unlimited liability for business debts on the part of the
owners,
Limited life of the business,
Difficulty of transferring ownership.
The ability of such business to grow can be seriously limited
by an inability to raise cash for investment.
Chapter 6 Common Stocks
Corporation
The corporation is the most important form of business
organization all over the world,That refer to a business
created as a distinct legal entity composed for one or
more individuals or entities.
The relative ease of transferring ownership,the limited
liability for business debts,and the unlimited life of the
business are the reasons why the corporate form is
superior when it comes to raising cash.
The disadvantage of corporation is,since a corporation
is a legal,person”,it must pay taxes,Money paid out to
stockholders in the form of dividends is taxed again as
income to those stockholders,this is double taxation.
Chapter 6 Common Stocks
There is an S corporation is a special type of small
corporation that is essentially taxed liked a
partnership and thus avoids double taxation,In mid-
1996,the maximum number of shareholders in an S
corporation was raised from 35 to 75.
A corporation by another name
The corporation form of organization has many
variations around the world,but the essential features
of public ownership and limited liability remain,
These firm are often called joint stock companies,public
limited companied,or limited liability
companies,depending on the specific nature of the
firm and the country of origin.
Chapter 6 Common Stocks
The corporate form
Corporate charter
A corporation exists only when it has been granted a
charter,or certificate incorporation.
Charter is a document issued by a state to a
corporation that specifies the rights and obligations
of the corporation’s stockholders,The charter is the
most important constitution of a corporation.
It may be amended with the approval of the
stockholders,perhaps by a majority or two—thirds
vote,where each share of stock generally entitles its
owner to one vote.
Chapter 6 Common Stocks
Both the initial terms of the charter and the terms of
any amendment must also be approved by the
state in which the corporation is chartered.
Stock certificates
The ownership of a firm’s stock has typically
been represented by a single certificate,with
the numbers of shares held by the particular
investor noted on it,
Shares of stock held by an investor may be
transferred to a new owner with the assistance
of either the issuing corporation or,more
commonly its designated transfer agent.
Chapter 6 Common Stocks
Transfer agent is a designated agent of a
corporation,usually a bank or other financial
institution,that administers the transfer of
shares of a corporation’s stock between old
and new owners.
Voting
Because an owner of a share of common stock
is one of the owners of a corporation,he or she
is entitled to vote on matters brought up at the
corporation’s annual meeting,and to vote for
the corporation’s directors,Any owner may
attend and vote in person,but most choose
instead to vote by proxy,
Chapter 6 Common Stocks
Proxy fight
Majority system
Cumulative system
In the context of a corporation,a method of
voting in which a stockholder is permitted to
give any one candidate for the board of
directors a maximum number of votes equal to
the number of shares owned by that
shareholder times the number of directors
being elected,
n=( )+1dsD+1
Chapter 6 Common Stocks
Where,n= minimum number of shares that must be
owned;
d= number of directors the stockholder
wants to be certain of electing;
s= number of shares outstanding
D= number of directors to be elected
In summary,the cumulative voting system gives
minority stockholders the right to have some
representation on the board of directors,provided
that the number of shares owned is sufficiently
large,
Chapter 6 Common Stocks
Takeovers
Periodically,a firm or a wealthy individual who is
convinced that the management of a corporation
is not fully exploiting its opportunities will attempt
a takeover.
This is frequently done with a tender offer being
made by a dibber to a target firm,Before this
offer is announced,some of the target firm’s
shares are usually publicly acquired by the
bidder in the open market through the use of
broker.
White knight,meaning that another firm that is
favorably inclined toward current management
will be invited to make a better offer to the
target’s stockholders.
Chapter 6 Common Stocks
Greenmail,another type of response by
management is to pay greenmail to bidder,
meaning that any shares held by the bidder will be
bought by the target firm at an above—market
price.
Repurchase offer,where the firm offers to buy
back some of its own stock.
PacMan defense,where the initial target turns
around and makes a tender offer for the initial
acquirer.
Crown jewel defense ; where the target sells its
most attractive assets to make the firm less
attractive.
Chapter 6 Common Stocks
Poison pills ; where the target gives its
shareholders certain rights that can be exercised
only in the event of a subsequent takeover and
that,once exercised,will be extremely onerous
to the acquirer,
Ownership versus control
Much has been written about the effect of the
separation of ownership and control of the
modern corporation,This separation gives rise to
what is known as a principal—agent problem,
Stockholders can be viewed as principals who
hire management to act as their agent,The
agent is to make decisions that maximize
shareholder wealth as reflected in the stock price.
Chapter 6 Common Stocks
No problem would exist if stockholders could
monitor the managers costlessly,but the monitor
is not costless,
Stockholder’s equity
Par value
Book value
Reserved and treasury stock
Classified stock
Cash dividends
Payments made in cash to stockholders are termed
dividends,These are typically declared quarterly by
the board of directors and paid to the stockholders
Chapter 6 Common Stocks
of record at a date specified by the board,known as
the date of record,
Stock dividends and stock splits
Occasionally,the board of directors decides to forgo
a cash dividend and,pays” a stock dividend
instead,
A stock split is similar to a stock dividend in that the
stockholder owns more shares afterward.
With a stock split,all the old shares are destroyed
and new ones are issued with a new par value,
Afterwards the number of new shares outstanding
is usually larger than the previous number of old
shares by 25% or more.
Chapter 6 Common Stocks
Reverse stock split is a form of stock
split whereby the number of shares is
reduced and the par value per share is
increased.
Chapter 6 Common Stocks
Ex—distribution dates
Similar to the payment of cash dividends,the
corporation specifies three dates associated with
either stock dividends or stock splits,a
declaration date,a date of record and a payment
date,
However,there is now an ex—distribution date
instead of an ex—dividend date,That refers to
the date on which ownership of stock is
determined for purposes of paying stock
dividends or issuing new shares due to stock
splits,Owners purchasing shares before the
ex—distribution date receive the new shares in
question,
Chapter 6 Common Stocks
Owners purchasing shares on or after ex—
distribution date are not entitled to the new
shares.
Reasons for stock dividends and splits
Nothing of importance would appear to be
changed,as such actions do not increase
revenues or reduce expenses,All that happens
is that there is a change in the size of the units
in which ownership may be bought and sold,
Moreover,because the process involves
administrative effort,and costs something to
execute,one wonders why it is done.
Chapter 6 Common Stocks
It is sometimes argued that stockholders respond
positively to,tangible” evidence of the growth of
their corporation,
Another view holds that splits and stock dividends,
by decreasing the price per share,may bring the
stock’s price into a more desirable trading range
and hence increase the total value of the amount
outstanding.
For each split,the stock’s,abnormal” return was
determined by relating monthly returns on the
stock to the corresponding returns in the stock
market.
This abnormal returns were averaged across firms
Chapter 6 Common Stocks
for each month relative to the firm’s split and then
cumulated across time.
The evidence also suggests that rather than decreasing
transaction costs,stock splits actually increased them,
A study of presplit and postsplit behavior showed that
after splits,trading volume rose less than
proportionately,and both commission costs and bid—
ask spreads,expressed as a percentage of value,
increased hardly reactions that are favorable to
stockholders,
Another study of stock splits and stock dividends
uncovered an apparent market efficiency.
Chapter 6 Common Stocks
Preemptive rights
Preemptive right means that when new shares
are to be sold,the current stockholders must be
given the right of first refusal in regard to the
purchase of the new shares.
Usually,the new shares will be priced below the
current market price of the stock,making such
right valuable,The stockholder can exercise the
right by purchasing allotted amount of new shares,
thereby maintaining proportional ownership in the
firm,but at the cost of providing additional capital.
Alternatively,the rights can be sold to someone
else,
Chapter 6 Common Stocks
For example,a firm want to raise $10,000,000 for new
project by sell new shares,The current market price
of the firm’s shares is $60 per share,a rights offering
may be used,where the subscription price is set at
$50 per share,Thereby,200,000 new shares are to
be sold.
Assuming the firm has 4,000,000 shares outstanding,
this means that the owner of one share will receive
the right to buy 1/20 of a new share,That someone
must be owned 20shares in order to be able to buy
one new share.
The rights are valuable because their owner can buy
stock at $50 a share when the market price is
significantly higher,
Chapter 6 Common Stocks
The preemptive rights owner can either use the rights or
sell the rights to someone else,But what is a fair price
for the right?
R = C0 – (RN+S)
Where,C0 =,rights—on” market price of stock
R = value of a right
N = number of rights needed to buy one share
S = subscription price
R= C0 - SN+1
Chapter 6 Common Stocks
Type of common stock
Blue chip stock
Growth stock
Cyclical stock
Defensive stock
Speculative stock
Performance stock
Chapter 6 Common Stocks
Stock quotations
Open price
Close price
High price
Low price
Insider trading
Insiders and insider trading
Narrowly,Insiders refers to the traders such as
stockholders,officers,or director of a corporation
who owns a,significant” proportion of a
corporation’s stocks,
Chapter 6 Common Stocks
More broadly defined anyone who has access to
information that is both,materially” related to the
value of a corporation’s securities and
unavailable to the general public,
In most country,it is illegal for any one to enter into
security transaction if he or she has taken
advantage of material,inside” information (that is,
substantive nonpublic information) about the
corporation that is unavailable to other people
involved in the transactions,
Ex ante and ex post value
In the opinion of well—informed investors,securities
with different attributes will have different expected
returns.
Chapter 6 Common Stocks
Thus the focus of these is on future or ex ante
(before the fact) expected returns,However,only
historical or ex post (after the fact) actual returns,
To bridge this gap,investors have used the
average historical return of a security as an
estimate of its expected returns.
Growth versus value
Stocks are often divided into growth stocks and
value stocks,
Book—value—to—market—value ratio
Chapter 6 Common Stocks
Growth stock refers to a kinds of stocks that has
experienced or is expected to experience rapidly
increasing earnings per share,and is often
characterized as having low earnings—to—price
and book—value—to—market—value ratio.
Value stock,typically refers to a stock that has
experienced relatively poor past price
performance,or whose issuing company has
experienced relatively poor past earnings results,
it is often characterized as having high earnings—
to—price and book—value—to—market—value
ratio.
Chapter 6 Common Stocks
The book value of the firm’s common stock is
determined by using the most recent
balance sheet data and calculating the total value of
stockholder’s equity,
The market capitalization of the firm’s common
stock is determined by taking the most recent
market price for the firm’s common stock and
multiplying it by the number of shares outstanding,
The book value of stockholder’s equity is divided by
the market capitalization to arrive at the BV/MV
ratio,
Relatively low value of this ratio characterize
growth stocks,and relatively high value
characterize value stock.
Chapter 6 Common Stocks
Earnings—to—price ratio
First,the accounting value of the firm’s
earnings per share is determined by using the
most recent income statement and dividing he
firm’s earnings after taxes by the number of
shares outstanding,
Second,the market price of the firm’s common
stock is determined by taking the most recent
price at which the firm’s common stock was
traded,
The earnings per share figure is divided by the
market price of the stock to arrive at the E/P
ratio.
Chapter 6 Common Stocks
The low value of this ratio characterize
growth value stocks,and relatively high value
characterize value stock.
Size
Although firm’s size is not generally used as
a criterion for distinguishing growth from
value stocks,it is often used to sort stocks,
Many investment professional think of stocks
in terms of tow dimensions as follows:
Hence stocks could be classified as growth
or value using the BV/MV ratio and as large or
small using their size,The result is that each
stock could be located in a sector diagram
like the one shown,
Chapter 6 Common Stocks
Size
Large
It can be seen that there is a clear inverse
relationship between size and average
return,That is,stocks of small firm tend to
have higher return than stock of larger firm.
Ratio
Low
Growth
High
Value
Small
Chapter 6 Common Stocks
Seasonality in stock returns
January effect
That is a important empirical regularity whereby
stock returns appear to be higher in January
than in other months of the year.
The reason of this effect should be the
periodically consume value of special Days and
other reasons such as taxes exemption,
Day—of—the—week effect
It is also be called the week end effect,refers to
an empirical regularity whereby stock returns
appear to be lower on Monday s than on other
days of the week.
Holiday effect
Chapter 6 Common Stocks
Ex—distribution price
Ex—distribution price refers to the
stock’s price after corporate addition
offered,
If Pc represent ex—distribution price,PC-
1represent the close price before ex—
distribution date,Pp represent the
subscription price,Rp represent rate of
additional,Rs represent the rate of stock
dividends,e represent the amount of
cash dividends,then,
Chapter 6 Common Stocks
1,The corporate has the stock dividends,then,the
price of ex—distribution will be：
PC=PC-1/（ 1+ RS ）
2,If the corporate offer addition stock the price will be：
PC =（ PC-1 + PP × RP ） /（ 1+ RP ）
3,additional offer and stock dividends payed at the
same time,the price of ex-distribution will be：
PC =（ PC-1 + PP × RP ） /（ 1+ RS + RP ）
Chapter 6 Common Stocks
4,additional offer and cash dividends payed at
the same time the price of ex—distribution
will be：
PC =（ PC-1 － e ＋ PP × RP ） /（ 1+ RP ）
例如：某公司发布分配计划，除权日前一天的股票收盘价为 18元，（ 1）公司实行送股，送股率为 10送 5；（ 2）公司配股，配股率为 10配
3，配股价为 6元；（ 3）公司宣布每股分派现金股息 0.5元；试用上述方法，计算不同情况下的股票除权价。
（ 12； 15.23； 11； 14.85）
Chapter 7 The Valuation of
Common Stocks
Capitalization of income method of
valuation
Capitalization of income method of valuation is
an approach to valuing financial asset,It is
based on the concept that the,true” or
“intrinsic”value of a financial asset is equal to
the discounted value of future cash flows
generated by the asset.
Because these flows are expected in the future,
they are adjusted by a discount rate to reflect
not only the time value of money but also the
riskiness of the cash flows,
Chapter 7 The Valuation of
Common Stocks
Where Ct denotes the expected cash flow
associated with the asset at time t and k is the
appropriate discount rate for cash flows of this
degree of risk,
Net present value
The NPV is equal to the difference between its
intrinsic value and cost(or principle).
V= + + +…=∑C1 C2 C3
(1+k)1 (1+k)2 (1+k)3 (1+k)t
Ct
Chapter 7 The Valuation of
Common Stocks
Internal rate of return
That is the discount rate that equates the sum
of the present value of future cash flows
expected to be received from particular
investment to the cost of that investment.
That is to say the discount rate that make the
NPV equal to Zero of the project.
Application to common stocks
Because the cash flows associated with an
investment in any particular common stock are
the dividends that are expected to be paid
throughout the future on the shares purchased,
Chapter 7 The Valuation of
Common Stocks
the models suggested by this method of value
are often known as dividend discount models,
There is a complication using that equation to
determine the intrinsic value of a share of
common stock,In particular,in order to use
this equation the investor must forecast all
future dividends,But the stock dose not
have a fixed lifetime.
On the other hand,the dividends from a firm
should be growth with a specified rate,that is
Dt = Dt-1 (1+gt)
Chapter 7 The Valuation of
Common Stocks
The zero—growth model
Net present value
V=D1 / k
Internal rate of return
IRR = D1 /P
The constant—growth model
We can assume that dividends will growth from
period to period at the same rate forever,and is
therefore known as the constant growth model.
Chapter 7 The Valuation of
Common Stocks
D0,D1 =D0(1+g),D2 =D1(1+g),D2 =D0(1+g)2
then in general the Dt =Dt-1(1+g) = D0(1+g)t
Net present value
V=D0 [(1+g)/(k-g)] then V= D1 /(k-g)
Internal rate of return
K=D0 (1+g)/P +g,then K=D1/P+g
Relationship to the zero—growth model
Chapter 7 The Valuation of
Common Stocks
The multiple—growth model
The multiple—growth model is the more general
DDM for valuing common stock.
The focus is on a time in the future(denoted by
T) after which dividends are expected to grow at
a constant ate g,Although the investor is still
concerned with forecasting dividends,these
dividends do not need to have any specific
pattern until this time,after which they will be
assumed to have the specific pattern of
constant growth.
Chapter 7 The Valuation of
Common Stocks
The dividends up until T(D1,D2,D3,… DT) will be
forecast individually by the investor,Thereafter
dividends are assumed to growth by a constant
rate g that the investor must also forecast,
meaning that:
DT+1 = DT(1+g)
DT+2 = DT+1(1+g)= DT(1+g)2
DT+3 = DT+2(1+g)= DT(1+g)3
Net present value
The present value of forecast stream of
dividends must be determined when we want
to determined the value of the stock with the
multiple— growth model.
Chapter 7 The Valuation of
Common Stocks
The stream could be divided into tow parts,the
first part consists of finding the present value of
all the forecast dividends that will paid up to
and including time T,this part denoted by VT-,
The second part consists of finding the present
value of all the forecast dividends that will be
paid after time T,and involves the application of
the consist—growth model.
T
t
t
T t
k
DV
1 )1(
Chapter 7 The Valuation of
Common Stocks
The application begins by imagining that the
investor is not at time zero but is at time T,and
has not changed his forecast of dividends for
the stock,This means that the next period’s
dividend DT+1 and all those thereafter are
expected to grow at the rate g,V with constant-
growth model will
VT represents a lump sum that is just as desirable
as the stream of dividends after T.
)1(1
gk
DV TT
Chapter 7 The Valuation of
Common Stocks
Now we suggest the investor is at time zero(the
present value at t=0),the present value at time
zero for all dividends after T denoted VT+,
Because the present value equal to VT-+VT+
The value of the stock will be:
)1)((
]
)1(
1
[
1
kgk
D
k
VV
T
TTT
Chapter 7 The Valuation of
Common Stocks
Internal rate of return
T
T
t
T
t
t
TT
kgk
D
k
D
VVV
)1)(()1(
1
1
T
T
t
T
t
t
kgk
D
k
DP
*)1)(*()*1(
1
1
Chapter 7 The Valuation of
Common Stocks
Relationship to the constant—growth
model
The constant—growth model can be shown to
be a special case of the multiple—growth
model,In particular,if the time when constant
growth is assumed to begin is set equal to
aero,then
)()1)((
0
)1(
11
1
gk
D
kgk
D
V
a n d
k
D
V
T
T
T
t
T
t
t
T
Chapter 7 The Valuation of
Common Stocks
Because T=0 and (1+k)0 =1.given the multiple—
growth model the V=VT-+VT+,it can be seen that
setting T=0 resulting in V=D1/(k-g),a formula
that is equivalent to the formula for the
constant—growth model.
Tow—stage and three—stage model
Tow dividend discount models that investors
sometimes use are the tow—stage model and
the three—stage model.
The tow—stage model assumes that a constant
growth rate g1 exists only until some time T,
Chapter 7 The Valuation of
Common Stocks
when a different growth rate g2 is assumed to begin
and continue thereafter.
The three—stage model assumes that a constant
growth rate g exists only until some time T1,
when a second growth rate is assumed to begin
and last until a later time T2,when a third growth
rate is assumed to begin and last thereafter.
By letting VT+ denote the present value of all
dividends after the last growth rate has begun
and VT- the present value of all the preceding
dividends,it can be seen that these models are
just special cases of the multiple—growth model.
Chapter 7 The Valuation of
Common Stocks
In applying the capitalization of income method of
valuation to common stocks,it might seem
appropriate to assume that the stock will be
sold at some point in the future,In this case the
expected cash flows would consist of the
dividends up to that point as well as the
expected selling price,
Because dividends after the selling date would be
ignored,the use of a dividend discount model
may seem to be improper,However,as will be
shown next,this is not so.
Chapter 7 The Valuation of
Common Stocks
Valuation based on a finite holding period
The investor could not hold the stock forever,if
he or she sell the stock,then would be affect
the formula we have told about.
The intrinsic value of the stock to the investor
by discounting these tow cash flows at the
required rate of return will be:
k
P
k
D
k
PD
V
11
1
11
11
Chapter 7 The Valuation of
Common Stocks
Where the D1 and P1 are the expected dividend
and selling price at t=1.
The selling price will be based on the dividends
that are expected to be paid after the selling
date,Thus the expected selling price at t=1 is
1
2
3
4
2
3
1
2
1
)1(
.,,
)1()1()1(
t
t
t
k
D
k
D
k
D
k
D
P
Chapter 7 The Valuation of
Common Stocks
Models based on price—earnings ratio
1
4
4
3
3
2
2
1
1
1
1
)1(
...
)1()1()1()1(
)
)1(
1
(
)1(
t
t
t
k
D
k
D
k
D
k
D
k
D
k
p
k
D
V
1111
11
)/(P w h e r e
)(
EEP
P
DPP
r e t u r nE x p e c t e d
Chapter 7 The Valuation of
Common Stocks
Some security analysts expand this procedure,
estimating earnings per share and price-
earnings ratios for optimistic,most likely,and
pessimistic scenarios to produce a rudimentary
probability distribution of a security’s return.
Other security analysts determine whether a
stock is underpriced or overpriced by
comparing the stock’s actual price—earnings
ratio with its normal P/E ratio.
The earnings per share E are related to
dividends per share D by the firm’s payout ratio.
Chapter 7 The Valuation of
Common Stocks
1
3
33
2
22
1
11
...3
3
2
2
1
1
)1(
...
)1()1()1(
)1()1()1(
t
tt
t
k
Ep
k
Ep
k
Ep
k
Ep
k
D
k
D
k
D
V
Chapter 7 The Valuation of
Common Stocks
Sources of earnings growth
Assuming that no new capital is obtained
externally and no shares are repurchased,the
portion of earnings not paid to stockholders as
dividends will be used to pay for the firm’s new
investments,
If the pt denotes the payout ratio,then (1- pt ) will
be equal to the portion of earnings not paid out,
known as the retention ratio,Then the firm’s
new investment stated on per share will be
It= (1- pt ) Et
Chapter 7 The Valuation of
Common Stocks
The growth rate to earnings per share depends
on (1) the proportion of earnings and (2)the
average return on equity for the earnings that
are retained.
Then if other things being equal,a stock’s
value (and its price ) should be greater,the
greater its average return on equity for new
investments
A three-stage DDM
Making forecasts
Chapter 7 The Valuation of
Common Stocks
Estimating the intrinsic value
Implied returns
The security market line (SML)
Required returns and α
Once the required return has been determined,
the difference between the stock’s implied
return and this required return can be
calculated,If is αpositive,the stock being
undervalued,other is over value.
The implied return on the stock market
