CONTEMPORARY FINANCIAL MANAGEMENT

Chapter 6:

Common Shares: Characteristics and Valuation

INTRODUCTION

This chapter describes: the characteristics of common shares common share valuation models

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COMMON SHARES Common shares are evidence of ownership.

Common shareholders own the firm.

Common shares are a form of long-term financing for a firm.

Common shares are often called a residual security as their value represents whatever assets are left after all prior claims against the assets have been settled.

Common shareholders elect the Board of Directors.

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BALANCE SHEET ACCOUNTS Par Value of Common Shares (can ignore for all practical

purposes)

Contributed Capital in Excess of Par Additional paid in capital Capital surplus

Retained earnings

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BOOK VALUE PER SHARE

The book value of a company’s assets attributable to each share of common stock

Example: ZBC Corporation reports a common share account balance of $10M and a retained earnings of $5M with 100M shares outstanding. The book value per share is $0.15. 5

Common Shares + Retained EarningsNumber of Shares Outstanding

COMMON SHAREHOLDER RIGHTS

Right to vote at shareholder meetings.

Right to share in the profits of an organization (paid either as a dividend or as reinvested profits).

Right to share in the residual assets of an organization after all other stakeholder (i.e. governments, creditors, employees) claims are satisfied.

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VOTING FOR THE BOARD OF DIRECTORS

Majority voting Each share carries one vote Requires more than 50% of the votes to elect a Director

Cumulative voting Each share carries as many votes as there are Directors to be

elected Shareholders may cast all votes for one candidate

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VOTING BY PROXY

Shareholders may elect to assign their voting rights to someone else.

Management actively solicits proxies.

A dissent shareholder group may attempt to solicit proxies to wrest control away from management.

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COMMON SHARE FEATURES

Certificate of ownership

Classes Voting vs. non-voting

Amount shareholder invests in common shares is the maximum capital at risk (shares are said to be “fully paid and non-assessable”).

Common shares are marketable securities that can be transferred from one investor to another.

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COMMON SHARE FEATURES

Advantages Flexible Reduces financial risk

Disadvantages Dilute Earnings Per Share Most expensive form of financing

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COMMON SHARE TRANSACTIONS

Cash Dividend Firm pays a portion of retained earnings in cash to

shareholders based upon number of shares owned (i.e. $0.60/share)

Stock Dividend Funds transferred from retained earnings to the common

share account. Shareholders receive certificate for additional shares.

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COMMON SHARE TRANSACTIONS

Stock Split Firm increases the number of shares outstanding by issuing a

specific number of new shares for every old shares outstanding

Example: stock splits 3 for 1.

Reverse Stock Split Firm decreases the number of shares outstanding by

consolidating a specific number of old shares into one share. Example: stock reverse split of 1 for 3

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COMMON SHARE TRANSACTIONS Stock Repurchases

Disposition of excess cash Repurchased shares are often cancelled Earnings power of remaining shares is increased Financial restructuring Future corporate needs (stock option plans) Reduction of takeover risk

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VALUATION OF COMMON SHARES

Cash flows attributable to a common stock accrue from:

Dividend stream (while owning the stock) Sale price (the future dividends that would have been

received from sale date to perpetuity)

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The market value of a common stock is equal to the present value of its

expected future cash flows!

DIVIDEND VALUATION MODELS

Zero growth model

Constant growth model

Nonconstant growth model

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DIVIDEND VALUATION MODELS Zero Growth Model

The cash flow (dividend) is expected to remain the same over time. Identical to model applied to preferred shares

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10

e

DP =

kD = Dividend at time period 1k = Required Rate of Return

ZERO GROWTH: EXAMPLE

Firm ABC currently pays a dividend of $1.00 per share. This is expected to remain the same into the foreseeable future. If shareholders require a return of 20% to hold the stock, what is each share worth in the market?

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=

=

10

e

D 1.00P =

k 0.20

$5.00

DIVIDEND VALUATION MODELS Constant Growth Model

The cash flow (dividend) is expected to increase at a constant rate over time

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10

e

DP =

k - g

D1 = Dividend in Next Period [D1 = D0 x (1+g)]k = Required Rate of Returng = constant growth rate

CONSTANT GROWTH: EXAMPLE

Yesterday, Tinkerbell Corporation paid a dividend of $1.00 per share. The dividend is expected to grow at a rate of 5% per year for the foreseeable future. If the shareholders require a 15% return to hold Tinkerbell shares, what is each share worth in the market?

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( )

( )

+=

= =−

010

e e

D 1 gDP =

k - g k - g

1.00 1.05$10.50

0.15 0.05

DIVIDEND VALUATION MODELS

Nonconstant Growth Model

Many firms grow rapidly for period of time. However, eventually, growth slows to a long-run sustainable constant rate

To deal with the nonconstant growth example, we simply present value all dividends back to time period zero

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NONCONSTANT GROWTH: EXAMPLE

Tiny Toys Inc. is a new firm that is expected to grow at a 20% rate for 3 years. From then on, growth is expected to be 10% per year. The firm paid a dividend of $1.00 yesterday. The dividend is expected to grow at the same rate as the firm’s growth rate. If the shareholders require a 15% return to hold the common stock, what is each share worth in the market?

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NONCONSTANT GROWTH: SOLUTION

Draw a time line showing the expected cash flows. Each dividend must be calculated, using the growth rate for the period.

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0 4321

∞$1.00 $1.20 $1.44 $1.73 $1.90

20% 20% 20% 10%

NONCONSTANT GROWTH: SOLUTION

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( )( )

1 0D = D 1+g

= 1.00 1.20

= $1.20

( )( )

3 2D = D 1+g

= 1.44 1.20

= $1.73

( )( )

2 1D = D 1+g

= 1.20 1.20

= $1.44

( )( )

4 3D = D 1+g

= 1.73 1.20

= $1.90

NONCONSTANT GROWTH: SOLUTION

( ) ( ) ( )

( ) ( ) ( )( ) ( )

÷ ÷ ÷ ÷= + + + ÷ ÷−

= + + +

=

31 2 40 2 3 3

e ee e e

2 3 3

DD D D 1P = + + +

1+K K -g1+K 1+K 1+K

1.20 1.44 1.73 1.90 11.15 0.15 0.101.15 1.15 1.15

1.0435 1.0888 1.1375 38 .6575

$28.25

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NONCONSTANT GROWTH: HELPFUL HINTS

Draw a timeline

Calculate each dividend on the timeline

During the period of nonconstant growth, present value dividends back to time zero

Once growth has stabilized: Calculate the present value of all dividends from that point

forward out to infinity. Calculated value must be brought back to time zero. Example: Dividend4, multiply by:

25( ) ÷ ÷

3

e

1

1+K

SOURCES OF GROWTH RATE FORECASTS

Value Line Investment Survey www.valueline.com

Thompson Financial/First Call www.tfn.com

Zacks Earnings Estimates www.zacks.com

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MAJOR POINTS

Common shares are a form of long-term financing for a firm.

The value of a common share is equal to the present value of its future cash flows.

The value of a common share is determined using: Zero growth model (preferred shares) Constant growth model (blue chip stocks) Nonconstant growth model (growth stocks)

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