WFU Law School
Law & Valuation
4.3 Stock Valuation Basics

4.3.1 Characteristics of Common Stock

Stock rights

Common stock represents a bundle of rights and powers. They include:

  • the right to receive dividend payments typically from earnings -- if authorized by the board of directors
  • the power to sell the stock (liquidity rights) and realize capital gains on public trading markets or in private transactions-- if there are willing buyers
  • the right to receive consideration in a merger or other fundamental transaction -- if approved by the board and the shareholders
  • the right to vote to elect directors and to approve fundamental transactions (mergers, sale of assets, amendments to articles, dissolutions)
  • the right to receive a proportionate distribution of assets on corporate liquidation -- if the board and shareholders approve a dissolution

Shareholders are often said to have a residual claim to the income and assets of the business. Financially, they stand last in line behind corporate creditors, such as bondholders, short-term lenders, banks, trade creditors. When a company is unable to pay its debts, and the company is forced into bankruptcy, shareholders receive nothing.

There are other kinds of ownership interests. For example, preferred stock has a prior and often fixed claim to dividends and distributions, but typically lacks the power to elect directors or vote on fundamental corporate transactions. Often seen as a hybrid between debt and common stock, preferred has characteristics of both. Similar to debt, preferred stock offers a fixed dividend, but usually no voting rights unless the company stops paying dividends. Similar to equity, preferred has no maturity and the firm does not go bankrupt if it cannot pay dividends.

It is possible to have non-voting stock, which has all the financial rights of common stock, but lacks the power to choose directors or veto corporate transactions.

Uncertain returns

As you can see, the returns on common stock are uncertain. The company might not have earnings with which to pay dividends. The board might not declare dividends, but instead reinvest earnings in the company. There may not be a market into which to sell stock. The market might, because of structural or informational flaws, not value stock effinciently. The board might approve a merger that imposes a price that does not reflect the stock's future return potential. The board might approve a dissolution and liquidation of the company's assets at a price that does not reflect the company's ongoing business value.

Value based on dividends

Professional stock valuators focus on cash dividends. Why is this? Some companies do not pay dividends, and most companies pay less in dividends than has been earned. In addition, many shareholders realize returns when they sell the stock (capital gains) or receive a higher price in a fundamental corporate transaction, such as a merger.

In the end, stock has value because of the possibility of cash returns:

  • Earnings. Even if current earnings are retained and reinvested, the reinvested earnings should produce future earnings that eventually will be paid as dividends.
  • Capital gains. If a shareholder sells stock on the market, it is because the buyer values the potential for future returns - that is, dividends.
  • Merger. If a company is acquired in a merger, and its shareholders paid for their stock, the acquirer values the company's potential for creating returns - dividends.

For this reason, professional stock valuators say that only dividends are relevant. But stock markets are more realistic about human nature. Market traders know, for example, that stock prices in mergers often involve more than the acquirer's valuation of future dividends. Sometimes the acquirer's managers have big egos and just want to run a bigger business! The selling shareholders know this and will demand a higher merger price.

[The role of dividend policy Brudney & Bratton Casebook 550-570; Supplement 97-103].

Stock nomenclature

Class A vs. Class B common. Although there are no standard definitions for lettered classes of stock. Class A generally has inferior voting rights to Class B

Publicly owned vs. closely held common. Publicly-owned stocks have many owners, who trade on stock exchanges and other public markets. Closely held stocks have few owners, without a trading market. (Some very big companies can be closely-held, such as Wlamart until about 10 years ago.) Publicly owned stock can be readily sold, and the company can issue new shares. The drawbacks of publicly owned stock include costly registration and reporting requirements and the possibilty for hostile takeovers.

Company size. Stocks are often categorized by size, specifically by the issuer's market capitalization or the number of shares outstanding times the share price.

Less than $500 million
Small caps
$500 million to $2 billion
$2 billion to $10 billion
Large caps
$10 billion to $100 billion
Mega caps
More than $100 billion

Styles of stock. Stocks are also categorized by their style:

Company is expanding at above average rate; Cisco of the late 1990s was a growth stock.
Stock whose price is seen as below its true worth
Rise and fall with the economy; steel companies are good examples

Stock sectors. Often referred to depending on the sector of the underlying business. The following are S&P's 10 sectors and examples of each:

Consumer Discretionary GM, Home Depot, Walt Disney
Consumer Staples Pepsico, RJR, Sara Lee
Energy Exxon/Mobil, Noble Drilling, Halliburton
Financials Wachovia, Bank of America, Goldman Sachs
Health Care Merck, Pfizer, Aetna
Industrials Boeing, UPS, Delta
Information Technology Microsoft, Yahoo, Intel
Materials Alcoa, International Paper, U.S. Steel
Telecommunications AT&T, Bellsouth, Verizon
Utilities Duke Energy, Southern Co., Calpine

Importance of dividends

Not only have dividends contributed almost half of the stock market's long-run total return, but also they have provided investors with a remarkably reliable stream of income. In fact, a good case can be made that stocks are a better source of income than bonds. (More>>)

Marriage of common and junk

... they are generically called "income trusts" in Canada and Income Deposit Securities, or IDS, in the U.S. All work on essentially the same concept. They typically stitch together a share of company equity with a company's junk-rated bonds, making them saleable in one "unit," much like a real-estate investment trust.

Instead of trading on a company's growth prospects, IDS units are valued on the consistency of their cash flows. Those cash flows are nearly all paid to shareholders in the form of quarterly dividends and bond interest payments. Banks expect that IDS issuers will pay annual yields of 8% to 11%, which they are hoping will attract investors still hungry for dividends in the wake of last year's dividend-tax rollbacks. (More>>)

"Payout Policy in the 21st Century"

BY: ALON BRAV - Duke University, Fuqua School of Business / JOHN ROBERT GRAHAM - Duke University / CAMPBELL R. HARVEY - Duke University, Fuqua School of Business National Bureau of Economic Research (NBER) / RONI MICHAELY - Cornell University, Samuel Curtis Johnson Graduate School of Management

Document: Available from the SSRN Electronic Paper Collection: SSRN 358582

Date: February 2003

We survey 384 CFOs and Treasurers, and conduct in-depth interviews with an additional two dozen, to determine the key factors that drive dividend and share repurchase policies. Consistent with Lintner (1956), we find that managers are very reluctant to cut dividends, that dividends are smoothed through time, and that dividend increases are tied to long-run sustainable earnings but much less so than in the past. Managers are less enthusiastic than in the past about increasing dividends and see repurchases as an alternative. Paying out in the form of repurchases is viewed by managers as more flexible than using dividends, permitting a better opportunity to optimize investment. Managers like to repurchase shares when they feel their stock is undervalued and in an effort to affect EPS. Dividend increases and the level of share repurchases are generally paid out of residual cash flow, after investment and liquidity needs are met.

Financial executives believe that retail investors have a strong preference for dividends, in spite of their tax disadvantage relative to repurchases. In contrast, they believe that institutional investors as a class have no strong preference between dividends and repurchases. In general, management views provide at most moderate support for agency and clientele hypotheses of payout policy; and even less support for the signaling stories. Tax considerations play only a secondary role. By highlighting where the theory and practice of corporate payout policy are consistent and where they are not, we attempt to shed new light on important unresolved issues related to payout policy in the 21st century.

4.3 Stock Valuation Basics

©2003 Professor Alan R. Palmiter

This page was last updated on: April 13, 2004