Module VIII: Stock Basics and Dividend Discount Models

Foundations of Corporate Capital and Common Stock

  • The Firm as an Entity: A firm is defined as an entity that raises capital from investors to acquire assets.

  • Primary Capital Sources: Capital is primarily raised through two types of securities:     * Bonds: Debt instruments providing fixed payments.     * Common Stock: Equity instruments providing residual ownership.

  • Hybrid Securities: Additional capital can be raised via hybrids, such as:     * Preferred Stock.     * Convertibles.     * Warrants.

  • Terminology Note: In this context, the term "stock" refers exclusively to Common Stock, as hybrid securities are omitted from the scope of this discussion.

Characteristics and Classification of Common Stock

  • Investor Benefits and Rights:     * Residual Ownership: Stockholders are owners of the firm but are paid last, after all other obligations (e.g., debt) are met.     * Voting Rights: Stockholders possess voting power to elect the board of directors and influence company control.     * Limited Liability: The maximum loss an investor can incur is limited to their initial investment, similar to bondholders.     * Perpetual Payments: Dividends are paid until perpetuity; common stock has no fixed maturity date.     * Liquidity: Stocks are liquid securities that are easy to buy and sell with relatively low transaction costs, providing an easy exit strategy.

  • Share Classes: Some firms issue multiple classes of common stock (e.g., Class A and Class B).     * Dividend Equality: Usually, different classes receive the same dividends per share.     * Voting Power: The primary difference lies in voting rights. Multiple classes often allow a small group (such as founders or a family) to maintain control over a publicly traded company.     * Case Study: Ford Motor Company:         * Class A: Common investors own approximately 2,800,000,0002,800,000,000 regular shares.         * Class B: The Ford family owns approximately 70,000,00070,000,000 shares.         * Disproportional Control: Each Class B share has significantly more voting rights than a Class A share. Consequently, the Ford family controls 40%40\% of the voting power despite owning less than 2.5%2.5\% of the total shares.

Comparative Risk and Historical Returns

  • Risk Profile: Stocks are considered riskier than bonds.     * Payment Priority: Bondholders are paid first. The probability of stockholders receiving nothing is higher than for bondholders.     * Upside Potential: While the danger is higher, stocks offer the opportunity for significantly higher returns if the firm performs well.     * Security Hierarchy: Stocks are riskier than both bonds and preferred stock.

  • Historical Performance: Over the past 5050 years, stocks have outpaced debt instruments:     * Average Stock Returns: 11%11\%     * Average High-Grade Corporate Bond Returns: 6%6\%

The Firm Life Cycle and Dividend Growth Profiles

  • Theoretical Basis: Stock prices depend on the dividends they pay. A firm's growth in dividends is heavily influenced by its position in its life cycle.

  • Category 1: Mature Companies: Stable firms in stable industries.     * Market Dynamics: They possess stable market shares. Sales growth is primarily driven by population growth (approx. 2–3%2\text{--}3\%) and inflation (approx. 2–3%2\text{--}3\%), leading to total sales growth rates between 4% and 6%4\% \text{ and } 6\%.     * Financial Stability: Capital expenditures, working capital, and operating costs remain stable as a percentage of sales. Consequently, Earnings Per Share (EPS) grows at the same constant rate as sales.     * Payout Policy: Mature firms maintain stable payout ratios. Because the percentage of net income paid out or retained is fixed, Dividends Per Share (Div) grow at the same rate as EPS and Sales.

  • Category 2: Non-Mature Companies: These fall into three sub-types:     * New Companies: Extremely risky in the short term. If they survive, they enter rapid growth. They typically pay no dividends and are often acquisition targets.     * Growth Companies: These exhibit rapid but variable sales growth, often because they are in a new industry or capturing market share. They pay low or no dividends because earnings are retained for reinvestment. Dividend growth is not constant and does not equal earnings growth unless the payout ratio is fixed.     * Dying Companies: Firms in financial trouble that often reduce dividends. They eventually fail or reinvent themselves as growth/mature entities.

  • Life Cycle Convergence: In the long run, surviving non-mature firms are expected to mature, transitioning to a state where earnings and dividends grow at the same constant rate.

  • Stock Concept IV: Dividends for mature firms grow at a constant rate (Growth Rate of Div=Growth Rate of EPS\text{Growth Rate of Div} = \text{Growth Rate of EPS}). Non-mature firms feature zero or variable dividend growth until they reach maturity.

The Dividend Discount Model (DDM) for Mature Firms

  • Pricing Logic: The maximum price an investor will pay is the Present Value (PV) of future cash flows (dividends and the expected terminal selling price).

  • Discount Rate: Expected dividends are discounted at the required rate of return (rr), which is determined using the Capital Asset Pricing Model (CAPM). This differs from bonds, which are discounted at the Yield to Maturity (YTM).

  • Stock Concept V: The purchase price equals the PV of dividends received during the holding period plus the PV of the selling price at year NN.     * Basic Formula: P0=Div1(1+r)+Div2(1+r)2+⋯+DivN+PN(1+r)NP_0 = \frac{Div_1}{(1+r)} + \frac{Div_2}{(1+r)^2} + \dots + \frac{Div_N + P_N}{(1+r)^N}

  • Stock Concept VI: The Dividend Discount Model posits that the price of common stock is the PV of all future dividends per share till perpetuity.     * Perpetual Holding Logic: The price at which you sell a stock compensates you for the dividends paid after you sell it. Therefore, the holding period of a specific investor does not change the stock price.

  • Mature Firm Pricing Formula: For mature firms, dividends are treated as a growing perpetuity.     * P0=Div1r−gP_0 = \frac{Div_1}{r - g}     * Where Div1Div_1 is the dividend expected in the next period, rr is the required return, and gg is the constant growth rate.

Comprehensive Example: Mature Firm Pricing (IBM)

  • Scenario Parameters:     * Expected Dividend Next Year (Div1Div_1): $1.00\$1.00     * Growth Rate (gg): 7%7\%     * Discount Rate (rr): 10%10\%

  • A) Stock Price Today:     * P0=1.000.10−0.07=$33.33P_0 = \frac{1.00}{0.10 - 0.07} = \$33.33

  • B) Stock Price One Year From Today:     * Right After Dividend Payment: The first dividend for the new purchaser is Div2=1.00×(1+0.07)=$1.07Div_2 = 1.00 \times (1 + 0.07) = \$1.07.     * P1=1.070.10−0.07=$35.67P_1 = \frac{1.07}{0.10 - 0.07} = \$35.67     * Right Before Dividend Payment: The purchaser receives the immediate $1\$1 dividend plus the remaining value of the stock (P1 after dividendP_1 \text{ after dividend}).     * P1=1.00+35.67=$36.67P_1 = 1.00 + 35.67 = \$36.67

  • C) Returns and Yields:     * Expected Return: 35.67−33.33+1.0033.33=10%\frac{35.67 - 33.33 + 1.00}{33.33} = 10\%     * Expected Capital Gains Yield: 35.67−33.3333.33=7%\frac{35.67 - 33.33}{33.33} = 7\% (Note: this equals the growth rate of dividends).     * Expected Dividend Yield: 1.0033.33=3%\frac{1.00}{33.33} = 3\%     * Formula: Required Return=Dividend Yield+Capital Gains Yield\text{Required Return} = \text{Dividend Yield} + \text{Capital Gains Yield}

Stock Price Dynamics and Market Reactions

  • Stock Concept VII: When a dividend is paid, the stock price drops exactly by the amount of the dividend payment.

  • Stock Concept VIII: In efficient markets, the expected change in stock price (capital gains) is equal to the growth rate of dividends/earnings. This is true even if growth is zero or negative.

  • Stock Concept IX: If expectations for dividends and the required rate remain unchanged, the realized return will equal the expected return.

  • Stock Concept X (Dividend News): If news reveals that future dividends will be higher than previously expected, the stock price increases, leading to realized returns being higher than expected returns (and vice versa).

  • Stock Concept XI (Risk News): If news results in an increase in the required rate of return (rr) due to higher risk, the stock price drops, and realized returns are lower than expected returns (and vice versa).

  • The Impact of Inflation:     * Rising inflation increases the required rate of return (rr), which exerts downward pressure on stock prices.     * However, inflation also typically increases corporate profits and nominal expected dividends, which exerts upward pressure on stock prices.     * Distinction from Bonds: Unlike bonds (where prices drop as inflation rises because payments are fixed), the net effect of inflation on stocks is ambiguous because both the numerator (DivDiv) and denominator (rr) are affected.

Valuation of Non-Mature Firms and Terminal Value

  • Pricing Logic: The stock price is the PV of all dividends during the non-mature phase plus the PV of the dividends after the firm reaches maturity.

  • Non-Mature Firm Pricing Formula:     * P0=Div1(1+r)+Div2(1+r)2+⋯+DivN(1+r)N+1(1+r)N×(DivN+1r−g)P_0 = \frac{Div_1}{(1+r)} + \frac{Div_2}{(1+r)^2} + \dots + \frac{Div_N}{(1+r)^N} + \frac{1}{(1+r)^N} \times \left( \frac{Div_{N+1}}{r - g} \right)

  • Terminal Stock Price: This is the expected stock price at the point the firm matures (Year NN).     * Terminal Price Formula: PN=DivN+1r−gP_N = \frac{Div_{N+1}}{r - g}

  • Stock Concept XIV: In non-mature firms, the growth in stock price (capital gains) is not equal to the growth in dividends/earnings until after the firm matures. After maturity, they align.

Comprehensive Example: Non-Mature Firm Pricing (Halliford Corporation)

  • Scenario Parameters:     * Required Return (rr): 10%10\%     * Dividends Year 1 & 2: $0\$0     * Dividend Year 3: $2.34\$2.34     * Dividend Year 4: $2.64\$2.64     * Dividend Year 5: $4.75\$4.75     * Dividend Year 6: $4.98\$4.98     * Post-Year 6 Perpetual Growth (gg): 6%6\%

  • Terminal Value at Year 5: The firm matures in Year 5, so the terminal price (P5P_5) right after the year 5 dividend is based on the year 6 dividend.     * P5=4.980.10−0.05=$99.60P_5 = \frac{4.98}{0.10 - 0.05} = \$99.60 (Note: Transcript uses g=5%g = 5\% and g=6%g = 6\% interchangeably in this specific example; formula uses 0.10−0.050.10 - 0.05 to reach the implied math on slide 20).

  • Calculation of PV:     * PV=0(1.1)1+0(1.1)2+2.34(1.1)3+2.64(1.1)4+4.75(1.1)5+(4.980.1−0.05)(1.1)5PV = \frac{0}{(1.1)^1} + \frac{0}{(1.1)^2} + \frac{2.34}{(1.1)^3} + \frac{2.64}{(1.1)^4} + \frac{4.75}{(1.1)^5} + \frac{\left( \frac{4.98}{0.1 - 0.05} \right)}{(1.1)^5}     * Resulting Price Today: $68.35\$68.35

Comparative Analysis: Stocks vs. Bonds

  • Stock Concept XV: While both are financial assets valued as the PV of cash flows, they differ significantly in application.

  • Difference 1: Payments:     * Bonds: Fixed promised payments (principal and interest). Bondholders have priority. This results in lower risk, limited downside, and no participation in the upside.     * Stocks: Residual payments (dividends). Shareholders are paid last. This results in higher risk, exposure to downside, and significant upside potential.

  • Difference 2: Maturity:     * Bonds: Have a defined maturity date and a principal repayment.     * Stocks: Do not mature; they represent perpetual ownership.

Limitations and Constraints of the Dividend Discount Model

  • Forecasting Requirements: The DDM requires accurate estimates of future dividends per share and the equity required rate of return.

  • Complexity for Non-Mature Firms:     * Estimating the transition to maturity is difficult.     * Estimating future retention rates and the start date of first dividends for zero-dividend firms is speculative.     * Payout ratios often change over time, making modeling difficult.

  • Share Repurchases:     * Firms can return capital via stock buybacks instead of dividends.     * Repurchases reduce the number of outstanding shares, which changes dividends per share.     * Estimating the future dollar amount and timing of repurchases is complicated.

  • Summary Utility: The Dividend Discount Model is most appropriate for mature firms that do not repurchase shares. Despite these limitations, the model provides fundamental insights applicable to all firms, though alternative frameworks are often used for more complex scenarios.