Chapter 8 Stock Valuation and Market Operations

Vocabulary flashcards covering margin loans, active versus passive investing, stock valuation models including DDM and P/E ratios, and corporate governance terms like voting rights and preferred stock.

Margin Loan

A loan provided by a broker that allows an investor to buy more stock than they could with their own cash, using the purchased securities as collateral. (Ex: you have $20,000, so we will only let you borrow $20,000; using debt to buy more stock).

What can happen if the value of stock drops and it was purchased using a Margin Loan?

If the value of stock drops, the broker may issue a margin call, requiring the investor to deposit more funds or sell some securities to maintain the minimum equity requirement.

What can happen if the value of stock rises and it was purchased using a Margin Loan?

If the value of stock rises, the investor can potentially increase their profits, as well as the overall equity in their margin account, allowing for additional borrowing or investment opportunities.

What is a major risk of buying stock with a Margin Loan?

The major risk of buying stock with a Margin Loan is that if the value of the stock declines, the investor may face a margin call, requiring them to deposit more funds or sell assets to maintain the required equity in the account.

Active Stock Investing

An investment strategy where managers or individuals attempt to outperform an index or benchmark through specific stock selection and market timing.

Passive Stock Investing

An investment strategy that seeks to match the performance of a market index by holding the same securities, typically involving lower fees than active management.

What is a key difference between Active and Passive stock investing?

Active investing involves frequent buying and selling of stocks to outperform the market, while passive investing focuses on long-term strategies, typically using index funds or ETFs to mirror market performance.

-Only 23% of all active funds topped the average of their passive rivals over the 10 year period ended december 2020

What is a common argument for Passive Investing?

A common argument for passive investing is that it generally outperforms active management over the long term due to lower fees, reduced trading costs, and the difficulty many active managers have in consistently beating market indices.

What is a common argument for Active Investing?

Stock Cash Flows

The two primary components of income for a stock investor, consisting of periodic dividends and the capital gain from the final sale price.

Dividend Growth Rate

The estimated percentage rate at which a company's dividend payments are expected to increase over a specific period, often denoted as $g$.

Dividend Discount Model (DDM)

A method of valuing a stock by calculating the present value of all its expected future dividends; for constant growth, it is expressed as $P_0 = \frac{D_1}{R - g}$.

No Growth Dividend Stock

A stock that pays a constant dividend forever, valued as a perpetuity where the price is $\frac{D}{R}$.

Constant Growth Dividend Stock

A stock whose dividends are expected to grow at a steady rate ($g$) forever; it is valued using the Gordon Growth Model.

Required Rate of Return

The minimum annual percentage return an investor requires to compensate for the risk of an investment, often denoted as $R$.

Price-to-Earnings (P/E) Ratio

A valuation metric calculated as $\frac{\text{Current Share Price}}{\text{Earnings Per Share}}$, used to compare firm values or assess market expectations.

Dividend Yield

The ratio of a stock's annual dividend payment to its current market price, calculated as $\frac{D_1}{P_0}$.

Capital Gains Yield

The percentage return on an investment resulting from the increase in the stock price, calculated as $\frac{P_1 - P_0}{P_0}$.

Common Stock

A security representing equity ownership in a corporation, which usually grants the holder the right to vote on corporate matters and elect the board of directors.

Cumulative Voting

A voting system that allows a shareholder to cast all their total votes (shares owned $\times$ number of seats) for a single director candidate, designed to support minority shareholders.

Straight Voting

A voting system where a shareholder may cast a maximum of one vote per share for each director seat being filled.

Proxy

A legal document or grant of authority that allows one person to act or vote on behalf of a shareholder.

Proxy Fight

A competitive struggle between groups (such as management and outside activists) to obtain enough shareholder proxies to win a corporate vote or replace the board of directors.

Preferred Stock

A class of stock with a preference over common stock in the payment of dividends and the distribution of assets during liquidation; it often behaves like a hybrid of debt and equity.

Cumulative Preferred Stock

A type of preferred stock where any missed or 'skipped' dividends must be paid out in full before any dividends can be paid to common stockholders.

Non-Cumulative Preferred Stock

Preferred stock in which missed dividends do not accumulate; if the company does not declare a dividend, the shareholder loses the right to that payment.

Proxy Designation

The act of a shareholder assigning their voting rights to another party for a specific corporate meeting or decision.

Classes of Stock

Different types of common stock (e.g., Class A, Class B) that may have different voting rights, often used by founders to maintain control of a company while issuing equity.

stock valuation basics

-Future cash flows are unknowable (with bonds we know)
-The life of the investment is forever (with bonds it’s finite)
-The required rate of return is difficult if not impossible to calculate (with bonds it’s YTM)

How could you determine the required rate of return used in stock valuation?

rearrange growing perpetuity formula

How would you explain to an 8th grader what

the required rate of return is?

the return an investor requires on an investment

PE ratios

-if a company has zero earnings you can’t calculate a PE
-If a company has low earnings the PE will look very high
-Tech companies have historically had higher PE’s than other companies
-More traditional companies that have been around forever typically have lower PE’s

PE ratio of S&P 500 (historically)

6/17

How would you explain to an 8th grader what a PE ratio is?

multiple of earnings (the price you’re paying for a stock based on the multiple of earnings)

What are the two components of a stocks investment return?

current yield (dividend yield) and capital gain yield
-on tax return, current yield gets treated as marginal tax rate
-capital gain yield gets taxed at short term or long term gain

How can the PE ratio be used to assess if the stock market is over or under valued?

you are paying 30 times earnings for what people used to pay 16 times earnings for

common stock features

stockholder’s elect directors who hire managers who run the company; as a stockholder you get voting rights

What are two main benefits of stock

ownership?

dividend yield and capital gain yield

What is a proxy designation?

letting someone else vote for you in a stockholder meeting

How can classes of stock benefit company

founders

How is preferred stock different than common

stock?