ACST101 Lecture Notes - Lecture 7: Dividend Discount Model, Common Stock, Preferred Stock

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ACST101 LECTURE 12/4/18

WK7; SHARES

THE MARKET FOR SHARES

Primary and Secondary Markets

Primary Market

- Where new security is created and sold for the first time

- From issuer (such as companies) to investors

- In an initial public offering (IPO), a company’s shares are listed on a stock exchange

for the first time, the issue of new shares is a primary market transaction

Secondary Market

- Where owners of outstanding security can resell from current investors to new

investors

Equity securities are a company’s certificates of ownership

Secondary Markets

- Outstanding shares of a company are bought and sold among investors

- Types;

1. Direct Search Markets (buyer and seller actively search for each other)

2. Broker Markets

3. Dealer Markets

4. Auction Markets

Broker

Brokers bring buyers and sellers together to earn a fee, called a commission

Dealer

Dealers make markets for assets (like car dealers) and provide greater liquidity by holding

inventories of securities, which they own, then buying (bid) and selling (ask) from inventory

to earn profit based on the price difference (spread). NASDAQ is an example.

Auction

In an auction market, buyers and sellers confront each other directly and bargain over a

price. The ASX originally operated as an ‘open out-cry’ market. In NYSE, auction for a

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

Exchange vs Over the Counter (OTC) markets

Exchange

- NYSE; ASE is electronic exchange

- Central trading location

- Only members (brokers) can use the exchange

Over the Counter Markets

- No central trading location

- Transactions are done over telephone or electronic trading platforms

Public and Private

- Public financial markets where securities are traded on an exchange

- Private sale of a security directly to an investor

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TYPES OF EQUITY SECURITIES

Ordinary Shares

- Ordinary shares represent a basic ownership claim in a company

- One of the owner’s rights is to vote on all important matters that affect life of

company, such as vote to elect board of directors, capital budget, or proposed

merger or acquisition

- Owners of ordinary shares are not guaranteed any dividend payments; have lowest

priority claim on company’s assets in event of insolvency. They have residual claim

on assets after paying out all creditors (debtholders) and preference shareholders

- Legally, ordinary shareholders enjoy limited liability

Preference Shares

- Preference shares also represent ownership interest in company, but gets

preferential treatment over ordinary shares in certain matters

- Preference share dividend payments are company’s fixed obligations, similar to

interest payments on corporate bonds

- Dividend payments are paid with after-tax dollars subject to taxation

- Preference share owners are given priority over ordinary share owners in event of

insolvency or liquidation

- Owners have no voting privileges

DIVIDENDS

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Document Summary

Where new security is created and sold for the first time. In an initial public offering (ipo), a company"s shares are listed on a stock exchange for the first time, the issue of new shares is a primary market transaction. Where owners of outstanding security can resell from current investors to new investors. Equity securities are a company"s certificates of ownership. Outstanding shares of a company are bought and sold among investors. Types: direct search markets (buyer and seller actively search for each other, broker markets, dealer markets, auction markets. Brokers bring buyers and sellers together to earn a fee, called a commission. Dealers make markets for assets (like car dealers) and provide greater liquidity by holding inventories of securities, which they own, then buying (bid) and selling (ask) from inventory to earn profit based on the price difference (spread). In an auction market, buyers and sellers confront each other directly and bargain over a price.

Related Questions

Question 1

Financial investments are made in efficient markets. The existence of these markets suggests that:

	a.	Investors cannot earn superior returns.
	b.	Investors cannot expect to outperform the market consistently.
	c.	Security prices are random.
	d.	Bearing additional risk will not increase return.

2 points

Question 2

A new issue of corporate securities sold to the general public must be:

	a.	Registered with the SEC.
	b.	Initially sold through brokers.
	c.	Offered initially to existing stockholders.

2 points

Question 3

Money market mutual funds invest in which of the following?

Commercial paper.

Repurchase agreements.

Corporate bonds.

	a.	1 and 2.
	b.	1 and 3.
	c.	2 and 3.
	d.	All of the choices are correct.

3 points

Question 4

FDIC insures:

	a.	U.S. Treasury bills.
	b.	Money market mutual funds.
	c.	Saving accounts.
	d.	Repurchase agreements.

3 points

Question 5

Which of the following does not have default risk?

	a.	Money market mutual funds.
	b.	Commercial paper.
	c.	Negotiable certificates of deposit.
	d.	U.S. Treasury bills.

2 points

Question 6

The spread is the:

	a.	Difference between the bid and ask prices.
	b.	Commission charged by the broker.
	c.	Difference between the purchase and sale prices.
	d.	Difference between the commissions charged by full-service and discount brokers.

3 points

Question 7

Securities regulations protect investors by:

	a.	Requiring disclosures of information by firms.
	b.	Stopping investors from buying overpriced stock.
	c.	Reducing competition among brokers.
	d.	Establishing commission schedules.

3 points

Question 8

If a stock is bought on margin:

	a.	The full amount of the cost of the investment is borrowed.
	b.	The commissions on the investment are increased.
	c.	The cost of the investment is reduced.
	d.	The interest on the borrowed funds is set by the SEC.

3 points

Question 9

Sarbanes-Oxley, the latest important securities law:

	a.	Reduces potential conflicts between securities analysts and investment bankers.
	b.	Legalizes the sale of securities by investment brokers.
	c.	Requires corporate boards of directors to own stock.
	d.	Mandates that security analysts file their recommendations with the SEC.

2 points

Question 10

Which of the following are true about the present value of a dollar?

It increases as the interest rate increases.

It decreases as the interest rate increases.

It increases as the time period increases.

It decreases as the time period increases.

	a.	1 and 3.
	b.	1 and 4.
	c.	2 and 3.
	d.	2 and 4.

3 points

Question 11

Time value concepts may not be used to determine:

	a.	The present value of an annuity.
	b.	The margin required on a stock purchase.
	c.	The future value of $100 deposited in a bank.
	d.	The present value of a lump sum.

2 points

Question 12

What is the marginal tax rate?

	a.	The tax rate paid on investment gains from items purchased on margin.
	b.	The tax rate paid on an additional dollar of taxable income.
	c.	The margin required on a stock purchase.
	d.	The present value of a lump sum.

2 points

Question 13

Examples of capital gains include sales of which of the following?

IRA accounts.

Stocks sold for a profit.

Real estate sold for a profit.

	a.	1 and 2.
	b.	1 and 3.
	c.	2 and 3.
	d.	All of these choices.

3 points

Question 14

With a Roth IRA, the individual:

	a.	May deduct annual contributions.
	b.	Earns tax-free income.
	c.	Defers taxes.
	d.	Avoids estate taxes.

2 points

Question 15

Sources of unsystematic risk include which of the following?

A firms financing decisions.

A firms operations.

Fluctuating market prices.

	a.	1 and 2.
	b.	1 and 3.
	c.	2 and 3.
	d.	All of these choices.

2 points

Question 16

For diversification to reduce risk:

	a.	The returns on the individual securities should be highly correlated.
	b.	The prices of the stocks should be stable.
	c.	The returns on the individual securities should be negatively correlated.
	d.	One firm should offer dividends and the other should offer capital gains.

2 points

Question 17

Which of the following are true about beta coefficients?

They are a measure of systematic risk.

They relate the return on an individual security to the return on the market.

They measure the variability of an assets return.

	a.	1 and 2.
	b.	1 and 3.
	c.	2 and 3.
	d.	All of these choices.

3 points

Question 18

Which of the following does an efficient portfolio do?

Maximizes risk for a given return.

Minimizes risk for a given return.

Maximizes return for a given level of risk.

Minimizes return for a given level of risk.

	a.	1 and 3.
	b.	1 and 4.
	c.	2 and 3.
	d.	2 and 4.

3 points

Question 19

The security market line does not:

	a.	Indicate the relationship between risk and return.
	b.	Relate the market return and beta to a stock's return.
	c.	Identify the optimal portfolio for the investor.
	d.	Use beta coefficients as a measure of risk.

3 points

Question 20

Mutual funds ____ realized capital gains and income (for example, dividends received):

	a.	Retain.
	b.	Reinvest.
	c.	Distribute.
	d.	Distribute or reinvest.

2 points

Question 21

An index fund limits its portfolio to:

	a.	High quality securities.
	b.	Stocks that respond to changes in the consumer price index.
	c.	Stocks included in an aggregate measure of stock prices.
	d.	Stocks of firms in a particular industry.

2 points

Question 22

Mutual funds with beta coefficients greater than 1.0:

	a.	Have outperformed the market.
	b.	Have underperformed the market.
	c.	Have more systematic risk than the market.
	d.	Have less systematic risk than the market.

3 points

Question 23

Which of the following will tend to cause a stock's price to fall?

The firms beta declines.

The firms beta increases.

The risk-free rate declines.

The risk-free rate increases.

	a.	1 and 3.
	b.	1 and 4.
	c.	2 and 3.
	d.	2 and 4.

2 points

Question 24

The use of P/E ratios to select stocks suggests that:

	a.	High P/E stocks should be purchased.
	b.	Low P/E ratio stocks are overvalued.
	c.	A stock should be purchased if it is selling near its historic low P/E.
	d.	A stock should be purchased if it is selling near its historic high P/E.

2 points

Question 25

What does the efficient market hypothesis require?

Financial markets to be competitive.

Prices to adjust rapidly.

Prices of undervalued securities to fall.

	a.	1 and 2.
	b.	1 and 3.
	c.	2 and 3.
	d.	All of these choices.

3 points

Question 26

Which of the following does the strong form of the efficient market hypothesis suggest?

Inside information will not lead to superior investment results.

Inside information will lead to superior investment results.

Studying financial statements will not lead to superior investment results.

Studying financial statements will lead to superior investment results.

	a.	1 and 3.
	b.	1 and 4.
	c.	2 and 3.
	d.	2 and 4.

3 points

Question 27

Which of the following is the least broad-based measure of stock prices?

	a.	NASDAQ market index.
	b.	Dow Jones industrial average.
	c.	S&P 500 stock index.
	d.	AMEX market value index.

3 points

Question 28

What is dollar-cost averaging?

	a.	Periodically buying a round lot of stock.
	b.	Periodically investing a specified dollar amount in a stock.
	c.	A means to increase the average cost basis.
	d.	A means to ensure a positive return.

2 points

Question 29

Stock dividends cause:

	a.	The price of a share of stock to rise.
	b.	The price of a share of stock to fall.
	c.	The value of the firm to rise.
	d.	The value of the firm to fall.

2 points

Question 30

Which of the following occurs when a stock has a two-for-one split?

	a.	The price of the stock doubles.
	b.	The firm's assets increase.
	c.	The firm's liabilities decrease.
	d.	The par value of the stock is reduced.

3 points

Question 31

Dividend reinvestment plans offer which of the following advantages?

Deferment of federal income taxes.

A convenient means to accumulate shares.

Dollar-cost averaging.

	a.	1 and 2.
	b.	1 and 3.
	c.	2 and 3.
	d.	2.

3 points

Question 32

When the Federal Reserve seeks to expand the money supply, it:

	a.	Sells securities.
	b.	Buy securities.
	c.	Runs a deficit.
	d.	Runs a surplus.

2 points

Question 33

The sum of cash, currency, and demand deposits is:

	a.	M1.
	b.	M2.
	c.	M3.
	d.	M4.

3 points

Question 34

If the Federal Reserve lowers the target federal funds rate:

	a.	The discount rate rises.
	b.	Liquidity in the banking system is increased.
	c.	Security prices fall.
	d.	Required reserves are also decreased.

3 points

Question 35

The anticipation of inflation suggests that the investor should:

	a.	Buy bonds.
	b.	Anticipate higher interest rates.
	c.	Avoid real estate investments.
	d.	Sell stocks of gold companies.

3 points

Question 36

The current ratio is unaffected by:

	a.	Using cash to pay a dividend.
	b.	The collection of an account receivable.
	c.	Selling inventory for a profit.
	d.	Selling bonds and using the funds to finance inventory.

2 points

Question 37

Which of the following are true as the debt ratio increases?

Fewer assets are debt financed.

More assets are debt financed.

The ratio of debt equity increases.

The ratio of debt equity decreases.

	a.	1 and 3.
	b.	1 and 4.
	c.	2 and 3.
	d.	2 and 4.

2 points

Question 38

The technical approach suggests that future stock prices are forecasted by:

	a.	Past stock rates.
	b.	Financial ratios.
	c.	Accounting statements.
	d.	Monetary policy.

2 points

Question 39

The Dogs of the Dow strategy:

	a.	Forecasts the direction of the Dow Jones averages.
	b.	Suggests buying the Dow stocks with the highest dividend yields.
	c.	Outperforms the S&P 500.
	d.	Suggests buying the lowest-priced Dow stocks.

3 points

Question 40

Behavioral finance combines aspects from which two fields in an attempt to identify human traits that affect investment decisions?

	a.	Accounting and finance.
	b.	Finance and psychology.
	c.	Physics and finance.
	d.	Finance and marketing.

ceruleanelephant209

Alex Dale is a portfolio manager at ADIA Investment Company inEurope. Alex would like to buy 50,000 shares of alpha stock whichis a new IPO that was previously offered at Â£30, but unfortunatelyhe couldnât get any shares of it. Now, he is still interested inthese shares, but not at a price that is greater than Â£45. JillJones works for The Global Brokerage House, which providesexecution services for ADIA. In his conversation with Alex, Jillhas suggested that a market order is most suitable for the trade.Alex is also interested in using a market order to sell a largeblock of Gamma shares. However, he is worried that if he instructeda selling using a market order the price would decline and he loseson the value of the deal. Jill argued that this should not be aproblem as automated order driven trading systems provide specialarrangements for small trades (which are often market orders) aswell as for block trades. Alex is also interested in reducing thecost of selling of his Christian Dior shares, Jill suggested thathe should use European electronic crossing network to sell some ofhis shares. She told Alex that these networks are cheap, preserveanonymity and allows for 6 crossing opportunities of trades perday. They also allow participants to place some restrictions suchas price and minimum fill. All orders submitted to the network isgood for day which is means that any unfulfilled part of an orderis automatically resubmitted to subsequent crossing sessions duringthe day. Following Jillâs advice, Alex has submitted his 150,000 CDshares to be sold in the European crossing network with a minimumfill of 125,000. The following orders are on the network for theshares of CD at the time of the first crossing session of the day.The most recent trading price of CD at the Paris Bourse is â¬ 37. ï·A order: a market order to buy 100,000 shares ï· B order: a marketorder to sell 50,000 shares ï· C: an order to buy 20,000 shares at â¬36 In the next crossing session new orders are submitted. The mostrecent trading price of CD at the Paris Bourse is â¬ 38. ï· D order:a market order to buy 150,000 shares ï· E order: A market order tosell 50,000 In her speech to buy side clients Jill has made thefollowing statements about electronic communication and crossingnetworks (ECNs): Statement 1: Electronic communication networks areorder driven systems, in which the limit order book plays the acentral role Statement 2: Electronic crossing networks anonymouslymatch buy and sell orders by a pool of participants, generallyinstitutional investors and broker dealers Statement 3: In an ECN,a trade takes place only during a crossing session time and only ifthere are offsetting orders entered by other participants.

Task: 1. For buying alpha shares, should Alex place a marketorder or a limit order? What would be the advantage anddisadvantage of each type of order, given his purpose? (2 Marks) 2.In selling a large block of Gamma shares explain Jillâs argumentthat automated order driven trading systems must provide specialarrangements for small and large trades? (1 Mark) 3. In the firstcrossing session discuss what trades would take place on thecrossing network and what orders remain unfilled? (2 Marks) 4. Inthe second crossing session discuss what trades would take place onthe crossing network and what orders remain unfilled? (2 Marks) 5.Which of Jillâs statement about electronic communication andcrossing networks (ECNs) is true? Justify your answers. (1 Mark) 6.Indicate how you would assess the quality of financial markets? (2Marks)

rubyswan468

International Research Journal of Applied Finance ISSN 2229 â 6891

Vol. VI Issue â 8 August, 2015 Case Study Series

A Stock Valuation Case: An Application of the âMethod of Comparablesâ for Macyâs Shares

Halil D. Kaya* ,Julia S. Kwok

Abstract

The primary focus of this case is the application of the âMethod of Comparablesâ in the estimation of the value of a security. An investment decision will be made based on the comparison of the selling price and the estimated value. A security will be good for purchase if the estimated value is higher than the market price. This method utilizes basic financial ratios that are commonly provided by financial web sites. First, using Yahoo Finance website, the pricing, sales, book value of equity and shares outstanding data are collected for both the target firm and the competitor firms. Then, the pricing multiples (i.e. price earnings ratio, price to sales ratio and price to book ratio) of the competitors are calculated. After that, those multiples along with the target firmâs earnings, sales, book value and shares outstanding data are used to estimate target firmâs share value. The case also examines the impact of treating ânegativesâ in the data. Students will learn that replacing negative earnings with zeros tend to induce less bias in target firmâs value estimation than excluding the ânegativeâ data altogether.

Introduction

March 14, 2015 was a sunny day. Mary took advantage of the nice weather to have lunch at the Mall. On her way back to work, she walked by Susanâs investment office. Susan was Maryâs college roommate. They both liked shopping together to find new fashionable clothes. Looking at her watch, Mary realized she had half an hour to spend. She thought she would drop by and say hello to Susan.

The Performance of Macyâs

âHi, Susan, how are you?â How is your business?â said Mary. Susan was a recent finance graduate. Susan replied, âI am doing fine. Thank you. After so many years, the market is still recovering from the mortgage crisis; many investors have been buying back stocks that they have sold during the crisis. What are you up to?â âI want to start my investment in securities, too. I have a couple thousand dollars, would Macyâs be a good stock to invest in now? That was our favorite store to shop among all of the department stores,â Mary exclaimed. She added, âAlso, I read from Motleyâs Foolâs article on Macyâs today about its earnings per share growth for the last 16 quartersâ (Zahid Waheed, 2014).

In response to Maryâs questions, Susan checked the monthly adjusted returns of Macyâs in Yahoo Finance. She found that, since March 2010, Macyâs stock price had an average annual increase of 23.5% over the last 5 years. The stock rose from $19.98 to $57.38. Susan then told Mary that Macyâs was indeed a growing stock. She added that its success could be attributed to the omni-channel integration, e-commerce and magic selling strategies which allowed merging of sales channels, online shopping and better customer care. Since investment strategy 101 is to buy low, and sell high, given Macyâs stock price had been going up, Susan was not sure whether Macyâs was currently overvalued or undervalued by the market.

The Method of Comparables

Susan remembered her class lecture on the two types of valuation of stocks, namely absolute and relative evaluation. The absolute evaluation focuses on finding the intrinsic value of the security based on fundamentals. That involves more complicated models of discounting cash flows from dividends, operations and residual income.

On the other hand, relative evaluation is quick and easy to use. It assumes two similar securities should sell for one price in an efficient market, i.e. âLaw of One Price.â So an analyst can estimate its stock price by multiplying target companyâs specific earnings, sales and equity value data by the earning, sales and equity âper shareâ financial multiples of its competitors.

Since Mary was not familiarized with financial models, Susan decided to use the easy-toperform-and-analyze âComparables Methodâ to estimate the relative value of Macyâs stock.

The Financial Data

Dillards, JC Penney and Nordstrom were selected as competitors of Macyâs as they were all in retail department store business. Susan would need some financial data regarding these companies. She went to SECâs (i.e. Securities and Exchange Commission) website and downloaded these companiesâ most recent balance sheet and income statement data. Out of those statements, she knew that she would need the EPS (i.e. earnings per share), the sales number, the number of outstanding shares, and the book value of equity. She also knew that she would need the current share price for each company. After some work, she had found all the necessary information to run the analysis. Below were the data that she had gathered:

All data are in US$ except for the number of outstanding shares. The share price as of March 15, 2014 is shown in the first column. The âEarnings per shareâ is shown in the second column. The third column reports the book value of equity. The last column shows the number of outstanding shares.

Firm	P ($)	EPS ($)	Sales ($)	BV of equity ($)	# of shares
Macy's	58.58	3.93	27,931 mil.	6,249 mil.	378.3 mil.
Dillard's	90.61	7.10	6,532 mil.	1,992 mil.	45.6 mil.
JC Penney	8.71	-5.57	11,859 mil.	3,087 mil.	249.3 mil.
Nordstrom	61.33	3.77	12,166 mil.	2,080 mil.	194.5 mil.

The Decision

Susan thinks that the following steps would be necessary to perform the analysis:

1.Based on the data above, calculate Sales per share, BV of equity/share values of all firms. Note that EPS is directly given.

2.Calculate P/E, P/Sales, and P/B for all of Macyâs competitors based on the data obtained.

3.Find the average of the P/E, P/Sales, and P/B multiples for the three competitors.

4.Multiply those averages calculated in step 3 with Macyâs EPS, Sales per share, and BV of equity/share values, respectively to get three value estimates for Macyâs shares.

5.The average of the three estimates would then be Susanâs best estimate of Macyâs value per share.

answer # 1-5 please

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ACST101 Lecture Notes - Lecture 7: Dividend Discount Model, Common Stock, Preferred Stock

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