This chapter has covered the basics of stocks and stock valuations. The key points include:
A stock can be valued by discounting its dividends. We mention three types of situations:
The case of zero growth of dividends.
The case of constant growth of dividends.
The case of differential growth.
An estimate of the growth rate of a stock is needed for the dividend discount model. A useful estimate of the growth rate isg = Retention ratio x Return on retained earnings
It is worthwhile to view a share of stock as the sum of its worth, if the company behaves like a cash cow (the company does no investing), and the value per share of its growth opportunities. We write the value of a share as<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/free/007353059x/335643/chap6_summary1.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (5.0K)</a>We show that, in theory, share price must be the same whether the dividend growth model or the above formula is used.
From accounting, we know that earnings are divided into two parts: dividends and retained earnings. Most firms continually retain earnings in order to create future dividends. One should not discount earnings to obtain price per share since part of earnings must be reinvested. Only dividends reach the stockholders and only they should be discounted to obtain share price.
We suggest that a firm's price-earnings ratio is a function of three factors:
The per-share amount of the firm's valuable growth opportunities.
The risk of the stock.
The type of accounting method used by the firm.
As the owner of shares of common stock in a corporation, you have various rights, including the right to vote to elect corporate directors. Voting in corporate elections can be either cumulative or straight. Most voting is actually done by proxy, and a proxy battle breaks out when competing sides try to gain enough votes to have their candidates for the board elected.
In addition to common stock, some corporations have issued preferred stock. The name stems from the fact that preferred stockholders must be paid first, before common stockholders can receive anything. Preferred stock has a fixed dividend.
The two biggest stock markets in the United States are the NYSE and the NASDAQ. We discussed the organization and operation of these two markets, and we saw how stock price information is reported in the financial press.
