Features of Common Stock Features of Preferred Stock the Stock Markets

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Features of Common Stock Valuation of Securities: Stocks • Voting rights (Cumulative vs. Straight) • Proxy voting Econ 422: Investment, Capital & Finance • Classes of stock University of Washington • Other rights Eric Zivot – Share proportionally in declared dividends Fall 2007 – Share proportionally in remaining assets during January 31, 2007 liquidation – Preemptive right – first shot at new stock issue

E. Zivot 2006 E. Zivot 2006 R.W. Parks/L.F. Davis 2004 to maintain proportionalR.W. Parks/L.F. Davis 2004 ownership if desired

Features of Preferred Stock The Stock Markets • Dealers vs. Brokers • Dividends • New York Stock Exchange (NYSE) – Stated dividend must be paid before dividends can be paid to common stockholders. – Largest stock market in the world – Dividends are not a liability of the firm, and –Members preferred dividends can be deferred • Own seats on the exchange indefinitely. • Commission brokers – Most preferred dividends are cumulative – any • Specialists missed preferred dividends have to be paid • Floor brokers before common dividends can be paid. • Floor traders • Preferred stock generally does not carry – Operations E. Zivot 2006 – Floor activity E. Zivot 2006 voting rights. R.W. Parks/L.F. Davis 2004 R.W. Parks/L.F. Davis 2004

1 NASDAQ Stock Market Reporting

52 WEEKS YLD VOL NET • Not a physical exchange – computer-based HI LO STOCK SYMDIV % PE 100s CLOSECHG quotation system 25.72 18.12 Gap Inc GPS 0.18 0.8 18 39961 21.35 … Gap pays a • Multiple market makers dividend of 18 Gap has cents/share. Gap ended trading at • Electronic Communications Networks been as high $21.35, which is as $25.72 in unchanged from yesterday. • Three levels of information the last year. Given the current price, the dividend – Level 1 – median quotes, registered yield is .8%. representatives 3,996,100 shares traded – Level 2 – view quotes, brokers & dealers Gap has been as Given the current hands in the last day’s low as $18.12 in trading. – Level 3 – view and update quotes, dealers only price, the PE ratio is the last year. 18 times earnings. E. Zivot 2006 E. Zivot 2006 • Large portion of technologyR.W. Parks/L.F. Davis 2004 stocks R.W. Parks/L.F. Davis 2004

Valuing Stock Cash Flow • Valuing a firm’s equity involves the same ideas introduced for valuing a firm’s debt instruments A stock’s cash flow consists of: • Stream of dividend payments received during ownership of stock • To value a firm’s stock • The sale price for the stock upon deciding to sell 1. Determine the expected cash flows 2. Calculate the present value of the cash Note: flows • The dividend stream may continue indefinitely • The dividend stream may be finite • Valuing stock, however, is more complicated • The dividend stream may change over time than valuing bonds because the cash flows are • There may be no dividend stream not contractually specified or fixed. E. Zivot 2006 E. Zivot 2006 R.W. Parks/L.F. Davis 2004 R.W. Parks/L.F. Davis 2004

2 Valuation of Stocks Valuation of Stocks Let’s calculate the rate of return for holding a stock r = [P1- P0]/P0 + D1/P0 for one Rewrite in terms of P : period (holding period return). Define: 0

P = D /(1+r) + P /(1+r) P0 = today’s price of the stock 0 1 1

P1 = next year’s price Today’s price equals the present value of next D1 = next year’s dividend year’s dividend plus the present value of next year’s price. HPR = r = [P1 + D1 - P0]/P0 = [P1- P0]/P0 +

E. Zivot 2006 E. Zivot 2006 D1/P0 R.W. Parks/L.F. Davis 2004 R.W. Parks/L.F. Davis 2004

Example Valuation of Stocks continued P0 = D1/(1+r) + P1/(1+r) • P0 = 100, P1 = 110, D1 = 5. Solve for r: Similarly, we can write next year’s price as a 110− 100 5 r =+ function of the dividend in year 2 and the year 2 100 100 price of the stock: =+=0.10 0.05 0.15 P1 = D2/(1+r) + P2/(1+r) Given r, P , and D = 5 now solve for P 1 1 0 Substituting for P1: 5 110 P =+=100 P0 = D1/(1+r) + [D2/(1+r) + P2/(1+r)]/(1+r) 0 2 2 1.15 1.15 P0 = D1/(1+r) + D2/(1+r) + P2/(1+r)