Finance Exam Study Guide

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Earnings Per Share: level of earnings of each share of stock, not necessarily what will be paid as dividends. Used to compare financial performance of companies

- The portion of earnings the company makes in a year allocated to each share

Earnings per share (EPS) = net income / # of common stock shares outstanding

Market- to Book (MTB) or price-to-book ratio: a measure of the firm’s value, typically ranging from 1 to 2.5

MTB Ratio = stock price per share / book value per share

Common Stock: full risks of ownership, usually given voting rights, usually pays variable dividends but no guarantee

Preferred Stock: usually constant dividends, usually a perpetuity, usually gives no voting right unless dividends are “passed”

→Two groups of investors, not all companies have preferred stock but those we do and invest in it have constant dividends. Dual class system – super (5 votes) / inferior (1 vote)

Valuing Preferred Stock: preferred stock is a perpetuity

Value of preferred stock = dividend per period / required period return = D/r = Vp = Pp

P0= D1 quarterly / r quarterly price of dividend/price or PV = required return on preferred stock

Payoff from common stock: a share represents partial ownership and entitles the owner to residual cash flows. The cash payoffs:

- Dividends are typically paid quarterly by firms

- Capital Gains (or losses) accrue when the stock is sold

Holding Stock for one period: supposed you… buy a share of IBM today, collect the dividend paid at the end of one period, and sell the share, what would you pay for the share? HPR= holding period return

P0 = D1/(1+rs) + P1 / /(1+rs) where Po = price for share today, D1= dividend amount, P1= price expected to sell at, rs= required return

rs= D1/ P0 + P1 - P0 / P0 Return for stock can be broken up into two parts

Dividend Yield = D1/ P0 dividend amount/price

Expected Capital gain/Loss (%) = P1 - P0 / P0 what you sell it for – what you bought it for / what you bought it for

Holding Stock for N Periods: supposed you… buy a share of IBM today, collect the dividend paid at the each of each N periods, and sell the share, what would you pay for the share?

P0 = [SUM [Dt / (1+ rs)^t ]] + [Pn / (1+ rs)^N] t= number period for that time and N = total # of periods

Values are inversely related to required return

Stocks can have value, even without dividends, which would mean all returns are in capital gains

When dividends are taxed at higher rates than capital gains:

- Dividends becomes less attractive

- Capital gains become more attractive

- Individuals prefer stocks that will give a larger portion of their returns in capital gains

The Constant ‘Gordon’ Growth Model: expected dividends grow at a constant rate g, the stock becomes a perpetuity

Where D1 = first future dividend PMT Its value is given by the growth perpetuity formula: P0 = D1/ (rs – g)

Expected dividend growth rates and stock prices are positively related

Higher dividend growth rate, higher prices but higher discount rate (i), lower price

g = ROE return on equity x required return “retains __% of its total earnings” → required return

- Shows what kind of firms will have greater payout ratios

- If always reinvesting in projects, firm will grow and be more profitable and have bigger future dividends

How do we account for growth? The retention ratio is defined as the fraction of the earnings not paid out as dividends kept within the company for future investing, measured as a percentage

THEN

- Retained earnings = (retention ratio) x earnings (kept within the company for future investments)

- Dividends = (1-retention ratio) x earnings

Retention Ratio = retained earnings / total earnings

Dividends = (1 – retention ratio) x total earnings

(1 – retention ratio) = dividend payout ratio, what % of total earnings is paid out as dividends

Retention ratio + dividend ratio = 1

Stocks give an infinite stream of expected future dividends:

- If expected future dividends are constant, then the standard perpetuity formula can be used

- If expected future dividends grow at a constant rate, then the growth perpetuity formula can be used

Investors only care about future payoffs:

- Past dividends do not matter to investors

- They should not enter your pricing formula but may tell you info about the magnitude of future dividends

Stock price includes the present value of FUTURE dividends, not including the dividend that was “just paid out” or “currently pays a $1.5 dividend” → D0

Dividend yield = D1/P0 P0 = D1/r-g (r-g) = D1/P0 = dividend yield