270 Part 3 Financial Assets
In Chapter 7, we examined bonds. We now turn to stocks, both common and pre-
ferred. Since the cash! ows provided by bonds are set by contract, it is generally easy
to predict their cash! ows. Preferred stock returns are also set by contract, which
makes them similar to bonds; and they are valued in much the same way. However,
common stock returns are not contractual—they depend on the " rm’s earnings,
which in turn depend on many random factors, making their valuation more di# -
cult. Two fairly straightforward models are used to estimate stocks’ intrinsic (or “true”)
values: (1) the discounted dividend model and (2) the corporate valuation model.
A stock should, of course, be bought if its price is less than its estimated intrinsic
value and sold if its price exceeds its intrinsic value. By the time you " nish this chap-
ter, you should be able to:• (^) Discuss the legal rights of stockholders.
• (^) Explain the distinction between a stock’s price and its intrinsic value.
• (^) Identify the two models that can be used to estimate a stock’s intrinsic value: the
discounted dividend model and the corporate model.
• (^) List the key characteristics of preferred stock and explain how to estimate the
value of preferred stock.
Stock valuation is interesting in its own right; but you also need to understand valu-
ation when you estimate the cost of capital for use in capital budgeting, which is
probably a " rm’s most important task.
9-1 LEGAL RIGHTS AND PRIVILEGES OF COMMON
STOCKHOLDERS
A corporation’s common stockholders are the owners of the corporation; and as
such, they have certain rights and privileges, as discussed in this section.
returns of the overall market. For example, in 2007, the over-
all market (as measured by the S&P 500 Index) was up
slightly (!5.49%). That same year some individual stocks
realized huge gains while others declined sharply. On the
plus side, Research in Motion was up 166%, Amazon.com
rose 135%, and Apple Computer climbed 133%. On the
down side, E*Trade Financial plummeted 84%; Circuit City,
78%; and Starbucks, 42%. This wide range in individual
stocks’ returns shows, first, that diversification is important
and, second, that when it comes to picking stocks, it is not
enough to simply pick a good company—the stock must
also be “fairly” priced.
To determine whether a stock is fairly priced, you first
need to estimate the stock’s true value, or “intrinsic value,”
a concept first discussed in Chapter 1. With this objective
in mind, in this chapter, we describe some models that
analysts have used to estimate intrinsic values. As you will
see, while it is difficult to predict stock prices, we are not
completely in the dark. Indeed, after studying this chapter,
you should have a reasonably good understanding of the
factors that influence stock prices; and with that
knowledge—plus a little luck—you should be able to
successfully navigate the market’s often-treacherous ups
and downs.
Sources: Allan Sloan, “The Incredible Shrinking Bull,” Fortune, March 17, 2008, p. 24 and Alexandra Twin, “Best and Worst Stocks of
2007,” CNNMoney.com, December 31, 2007.
Key trends in the securities
industry are listed and
explained at http://www.sifma.
org/research/statistics/
key_industry_trends.html.
P U T T I N G T H I N G S I N P E R S P E C T I V E