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Module 2: Financial Securities

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:

o callable provision, which allows preferred stock to be called at the issuer's

request and retired, like a bond

o 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).