Introduction to Stock Ownership and Valuation Models

Practice flashcards reviewing stock ownership rights, comparison with bonds, dividend mechanics, the Capital Asset Pricing Model (CAPM), and the Dividend Discount Model (DDM).

What does owning a share of stock represent?

It represents partial ownership in a company, granting the right to a proportionate share of profits and voting rights on company issues.

How many votes does a shareholder receive for each share of common stock owned?

A shareholder receives one vote per share owned.

What type of corporate role do shareholders typically vote to hire?

Shareholders vote on hiring positions such as directors to oversee the company and represent shareholders.

What is a major financial risk of owning common stock if a company fails?

An investor can lose a portion or the entirety of their investment, and stockholders only have a claim to assets after bondholders are paid.

In the event of company failure, what claim do bondholders have that stockholders do not?

Bondholders have a direct claim on company assets listed on the balance sheet, such as equipment, real estate, and patents.

What are dividends?

Cash payments distributed to shareholders, typically paid out of the company's profits.

What are the two ways an investor makes money from owning stocks?

By collecting dividend payments and through an increase in the stock price.

How frequently do most dividend-paying companies distribute their dividends?

Most companies pay dividends quarterly (such as in April, July, October, and January), though some pay monthly.

What does the acronym CAPM stand for?

Capital Asset Pricing Model.

What is the primary purpose of the Capital Asset Pricing Model (CAPM)?

To evaluate whether an investor's required return is reasonable based on the risk involved.

What are the three components that determine the required return in CAPM?

The risk-free rate, beta ($\beta$), and the market risk premium.

What does a beta ($\beta$) of $1.0$ represent in the market?

It represents the average risk level of all stocks in the market.

What does a stock beta of $1.2$ indicate about its risk?

It indicates that the stock is $20\%$ riskier than the overall market.

What does a stock beta of $0.8$ indicate about its risk?

It indicates that the stock is approximately $20\%$ less risky than the overall market.

How does an increase in a stock's beta affect the investor's required return?

As beta goes up, the required return also goes up because taking more risk requires higher compensation.

What is the market risk premium?

The risk incurred from investing in the market at all rather than doing nothing or staying risk-free.

In dividend valuation notation, what is the difference between $D_0$ and $D_1$?

$D_0$ is the dividend received today, whereas $D_1$ is the dividend expected to be paid one year from now.

What formula calculates next year's dividend ($D_1$) from current dividend ($D_0$) and growth rate ($g$)?

$$D_1 = D_0 \times (1 + g)$$

What is the formula for the Dividend Discount Model (constant growth)?

$\text{Value} = \frac{D_1}{r - g}$, where $D_1$ is next year's dividend, $r$ is required return, and $g$ is the constant growth rate.

If $D_0 = \$3$, $g = 0.04$, and $r = 0.10$, what is the intrinsic value of the stock using the Dividend Discount Model?

$\$52$, calculated as \frac{\3 \times 1.04}{0.10 - 0.04} = \frac{\3.12}{0.06} = \$52.