Valuation of Stocks and Company Valuation Capital ...

Valuation of Stocks and Company Valuation

Capital Budgeting and Corporate Objectives

Professor Ron Kaniel

Simon School of Business University of Rocheser

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Overview

Introduction

? Stocks and stock markets ? Transactions & Orders

Valuation:

? Present Value ? Dividend growth models

Financial ratios

? Dividend yields ? P/E multiples

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Common Stock

What does it mean to own common stock?

? ownership ? residual claimants.

What rights do common shareholders have?

? vote at company meetings ? dividends ? sell their shares

What are the benefits of stock ownership?

? dividends ? capital gains

Why do firms issue stock?

? to finance investments ? to acquire other companies ? to repurchase debt

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Preferred Stock: Debt or Equity?

What does it mean to own preferred stock?

? ownership ? senior to equity, junior to debt securities in case of default

What rights do preferred shareholders have?

? usually no voting rights, except in case of default on dividend ? dividends and other distributions

What are the benefits of preferred stock ownership?

? periodic dividend rate, typically cumulative ? capital gains

Why do firms issue preferred stock?

? often because of the favorable tax treatment when held by other firms

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Transactions Involving Stocks

Buy (Long Position)

Savings motive Speculative

Sell

Liquidity needs Expect stock to decline in value

Short Sell

Sell stock without first owning it. Borrow stock from your broker with the promise to return it at some

later date. Sell the borrowed stock. Repurchase it at a later date to return it to your broker. Responsible for all dividends and other distributions while short the

stock.

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Short selling (in detail)

Why Short Sell?

Short Selling is one way of benefiting from a stock that is expected to decline in price.

? Instead of buying today and selling later, the short seller sells today and buys later.

How to Short Sell?

The short-seller (A) finds an existing owner of the shares (B) who is willing and able to lend the shares to A. Once A has negotiated a loan, A can then sell the borrowed shares to any willing buyer (C).

A posts collateral with B. In the US, the standard collateral is cash amounting to 102 per cent of the value of the shares, to be adjusted daily as their value fluctuates.

? Note though that under Federal Reserve Regulation T, in case where B is a U.S. broker/dealer A has to post an additional 50% margin (any long securities can be pledged to satisfy this requirement). Further, brokerdealers may institute higher short sale margin requirements than those imposed by self-regulatory organization rules. e.g., the NASD Rule 2520(d) and NYSE Rule 431(d).

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Short selling (in detail)

A pays B a fee. The fee can be determined by the "rebate" rate, which is the interest that B pays A for use of the cash collateral. For example, if the market rate for cash funds were 5% and the stock loan fee were 1.5% then B would rebate A only 3.5%. (Note that is it possible to have fees that exceed the cash rate, which would result in negative rebate rates).

A pays B any dividends/distributions made to the owners of the shares during the loan.

B has the right to recall the shares from A at any time. Loans are "open" and effectively rolled over each night until either B wants the shares returned or A voluntarily returns them. Given notice of recall, A has three days to return the shares. After this, A can try borrowing the shares from another lender or can "cover" the short position by purchasing the shares.

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Short selling (in detail)

Who are the Participants? The role of B (the lenders) is largely assumed by the big custody banks in the U.S. who act

as intermediaries for large institutional owners like pension funds, mutual funds etc.

Loans of shares can also be made by a broker from his own inventory, from the margin account of another customer, or shares borrowed from another broker. These shares are used to make settlement with the buying broker within three days of the short sale transaction, and the proceeds are used to secure the loan.

Another group that assume the role of B (lenders) consists of the broker-dealers (e.g. Goldman Sachs, Morgan Stanley). These broker-dealers lend from their internal supply of securities held by their market makers and proprietary trading desks, the accounts of institutional customers, and the margin accounts of individual investors. ? Note that Section 8 of the Exchange Act of 1934 prohibits brokers from lending shares held in retail cash or non-margin accounts.

The role of A (the short-sellers) is assumed by a broader group. More obvious examples include: ? Specialists and market makers (for balancing buy orders with sell orders) ? Traders of equity options, index futures, equity return swaps and convertible bonds (for hedging their positions) ? Hedge Funds (to execute "arbitrage" strategies) ? Speculators

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Short selling (in detail)

The NASDAQ reported that short interest (the number of shares that have already been sold short) around 4.35% days of average daily total share volume at July 2019.

Shorting is subject to many restrictions on the size, price, and types of stocks able to be shorted. For example, you cannot short sell penny stocks (they are non-marginable due to Regulation T) and most short sales need to be done in round lots.

Equity loans can occur for reasons other than short selling. For instance in cases where A borrows from B but then doesn't short to C, A is treated as the legal owner of the shares and is therefore entitled to the dividends distributed during the course of the loan (which, as previously mentioned, are required to be reimbursed by A to B). This might happen in cases where A values the distribution received more than the reimbursements given (for taxation reasons, for example)

In lending, B forfeits voting rights to A (to C in the case of the short sale). Alternative Uptick Rule: provides that a circuit breaker is triggered with respect

to a stock if the stock's price declines by 10% or more from prior day's closing price. At that point short selling is permitted only if its price is above the current national best bid. Once triggered, the circuit breaker remains in effect with respect to the stock for the remainder of the day and the following day.

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Types of Orders

Market Orders

? Buy or sell at the current market price

Limit Order

? Buy or sell at a specified price ? Limit by time period

Stop Orders

? Stop-loss: Sell if price falls below certain level ? Stop-buy: Buy if price rises above certain level

? Used in conjunction with short selling

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