Learning Activities
Learning Objective Readings
Module Review Questions 4–7 Calculate one or more stock
performance measurement indexes for given portfolio returns and risk.
41–43
4–8 Specify relationships among various indicators of security returns.
44–49
4–9 Evaluate the risk-adjusted performances of alternative investment securities or portfolios to recommend the most
appropriate selection for a given client situation.
50–53
Exam Formula Sheet
PLEASE NOTE: You do not need to memorize these formulas for the exam. An exact copy of this formula sheet will be provided to you when you log on to take your IP exam. Also, the formula sheet for the CFP Certification Examination will be different from this exam formula sheet. Prior to taking the exam, please check with the CFP Board regarding their current exam formula sheet.
Chapter 1: Dividends on Stock
Reading this chapter will enable you to:
4–1 Analyze the impact of different types of cash and stock distributions on shareholders and on the company.
Importance of Dividends
uring the investment market of the mid-1990s, many investors tended to minimize the relevance of dividends. One of the reasons they did this was the fact that dividends took a back seat to capital appreciation during the bull market run of the decade. Another reason was that many corporations reduced their dividend payout rate, which led to the lowest historical dividend yield on stocks in the 20th century.
In spite of this trend, dividends play an important role in both theory and practice in the investment area. Historically, dividends have accounted for approximately 40% of the total return on securities (Dow Jones & Company website, 2006).
One of the EMH anomalies mentioned in Module 3 is that stocks with high dividend rates often have historically outperformed stocks with low dividend rates. For example, the “Dogs of the Dow” investment strategy uses the 10 Dow Industrial Average stocks with the highest dividend yields to form a portfolio.
Dividends play an important role in the valuation of stocks, as you will see in the next chapter. The dividend discount model is the key element used by many professional investment managers in determining stock valuation. Famed Omaha investor Warren Buffett uses the model in his valuation computations.
D
Dividend Basics
The focus of most investment analysis is earnings per share. A company’s earnings, and especially its earnings surprises, drive the performance of the company’s stock.
Many companies, especially the large, mature companies typically found in the major stock market indexes such as the S&P 500 average, pay a portion of their earnings per share to shareholders in the form of dividends. Unlike interest payments on a company’s bonds, a company does not have a legal requirement to pay dividends. The company’s board of directors determines if a dividend should be paid. As a practical matter, once established, boards tend to be reluctant to cut or eliminate dividend payments to stockholders, but will do so if slumping business conditions make that prudent. Dividends on both preferred stock and common stock normally are paid quarterly so a company that, say, pays $1.00 per share annually would pay $0.25 per share every three months.
Preferred stockholders receive a fixed annual dividend amount per share. Some preferred stock have a feature called “cumulative” which means if a dividend is missed, all such dividends must be made up before common stockholders receive their dividends.
Common stockholders receive a dividend only after the preferred stockholders receive their dividends. Since common shareholders are entitled to a claim on the residual earnings after bondholders and preferred stockholders are paid,
hopefully their dividends will increase over time as the company’s earnings increase, a major attraction to owning common stock. Some dividend-paying companies aim to pay a common stock dividend that is a set percentage of earnings.
For example, assume that a company’s earnings per share is $2.00 and that the company has decided that it likes to pay approximately 30% of its earnings as a dividend. In this example, the company would pay 30% of $2.00, or $.60, per share to common stockholders. This percentage is called the dividend payout
Special Dividend
Sometimes a company will pay a special dividend beyond their regular dividend if they have had especially strong earnings in a year. Usually this is due to a buildup of corporate cash, with the board deciding this is an appropriate way to share the company’s success with the common stockholders.
For example, on October 24, 2012, Wynn Resorts Ltd. declared a cash dividend of $8 a share, which included the usual $0.50 quarterly dividend and $7.50 per share of a special dividend. This dividend was payable November 20 of that year to shareholders on record as of November 7.
Key Dividend Distribution Dates
Many dates are associated with dividends. On the declaration date, the board of directors of the corporation declares that a dividend will be paid and identifies the key dates. On the distribution date, the dividend is actually paid to
shareholders. These dates are easy to remember.
The dates that students have difficulty with are the ex-dividend date and the record date. The record date is the date that the corporation closes its books and identifies who the shareholders are. Anyone who is a shareholder on the record date is entitled to receive the dividend.
Securities laws require that all trades be cleared (settled) in three business days.
That is, anyone who receives a confirmation that a trade has been executed will not actually be the owner of record until three business days later, when all financial aspects of the trade are settled. Therefore, anyone who buys a security three business days before the record date will be a registered shareholder on the record date.
An investor who buys a security two business days before the record date will have his or her trade cleared one day after the record date and will not be entitled
who receives confirmation that a trade has been executed two business days before the record date will not receive the dividend that is to be paid on the next distribution date.
Example. Cash Cow Inc. is going to pay out a dividend with a distribution date of September 10 to shareholders who were on the corporation’s books as shareholders on the record date of August 10. Assuming that August 10 was a Monday, two business days before that date was Thursday, August 6. Therefore, August 6 will be the ex-dividend date because trades executed on August 6 would not be cleared until three business days thereafter, on August 11, which was one day after the record date. Note that if you buy on Wednesday, August 5th, your trade will settle on August 10th—in time for the dividend.
Wednesday
A trade that will settle on the example record date of Aug.10th—in time for the dividend.
Stock Dividend
Most dividends are paid in cash. Some are paid in additional shares of a
company’s stock, called a stock dividend. (Be aware that cash dividend and stock dividend are precise terms that refer to different types of dividends. Often
investors will loosely use the term stock dividend when they actually are
referring to a cash dividend.) The payment of a stock dividend may occur when a company wants to conserve cash but does not want to alienate shareholders. It could be that a company is having financial difficulties or it may simply decide
there are better uses for its cash. In these situations, the company does not want to increase the cash dividend, so it provides a stock dividend instead.
Many stockholders perceive that their wealth has increased because they own more shares after the stock distribution. Actually, shareholder wealth is unchanged because the market price of the stock is lowered on the distribution date to reflect the fact that the overall market value of the company remains unchanged; it is now simply divided over an increased number of shares. Each shareholder’s proportionate share of ownership of the company is unchanged because each shareholder has experienced the same proportionate increase in the number of shares owned.
Example—10% stock dividend. Assume an investor originally owns 100 shares at $50 per share ($5,000 value). Immediately after a 10% stock dividend the investor would own 110 shares priced at $45.45 (still a $5,000 value).
Stock Split
A stock split is somewhat like a stock dividend, in that each shareholder owns more shares after the split than before. However, unlike a stock dividend, a stock split is not authorized in lieu of paying cash dividends.
A stock split occurs when corporate management decides to lower the market price of a stock in order to encourage more investors to purchase shares of the company. By splitting the stock, management communicates to the investment community that the company must be successful because its shares have appreciated so much that the stock must split to lower its price to a more reasonable level. It is both a psychological and a practical move for company management.
The most common stock splits are two-for-one splits or three-for-two splits. In a two-for-one split, the investor who owns 200 shares before the split will own 400
market price of the stock is $40 per share on the day before the split, it will be
$20 per share on the day of the split. Therefore, the investor’s total market value is unchanged ($8,000).
To calculate the new price per share in a stock split you would divide the original price per share by the ratio of the new stock to the old. Here are a few examples (assume a $100 original stock price in each example):
2 for 1 split $100/(2/1) = $50 3 for 2 split $100/(3/2) = $66.67 3 for 1 split $100/(3/1) = $33.33
Reverse Split
For various reasons some companies have their stock price decline to low levels.
The problem with this is twofold. First, there is a perception problem with potential shareholders. Many investors do not want to invest in “penny stocks.” A low share price does not exude success. Another problem is with analysts and brokerage firms. Many firms will not even look at a stock that is trading at less than $5 or $10 per share. A way to address this problem is a reverse split,
converting a certain number of “old” shares into one “new” share. For example, a company trading at 50 cents per share could do a 1-for-20 reverse split,
converting 20 old shares into 1 new share. An investor with 100 pre-split shares valued at $50 (100 × $0.50) would now have 5 shares valued at $50 (5 × $10). A reverse split may temporarily help the share price, but the marketplace will continue to punish the stock price if the company does not correct the issues that drove down the price in the first place!
Dividend Reinvestment Plans (DRIPs)
Mutual fund investors have become accustomed to reinvesting all dividend and capital gains distributions by converting them into additional shares of the fund.
Many individual companies also allow investors in their stocks to reinvest their cash dividend distributions by converting them into additional shares of the
Just as with mutual fund reinvestments, the reinvested dividend distributions are taxable dividend income to the investor. The investor is assumed to have
received the cash dividend and then reinvested that cash into additional shares of the company’s stock. The investor’s basis would then increase by the amount reinvested.
The first share must be purchased from a broker or directly from the company before an investor can participate in a DRIP program. Most DRIP investors have purchased their first shares from a broker; increasingly, companies that offer DRIP programs are setting up their own direct-stock-purchase programs.
Two principal advantages accrue to an individual investor who participates in a DRIP. First, the investor is able to purchase a small number of shares
periodically without having to pay a brokerage commission on each of the purchases. Since brokerage commissions on purchases of less than 100 shares are quite expensive (in proportion to the dollar value of stock purchased), this can mean significant savings, especially in the early years of a DRIP program. As the account grows, and more than 100 shares are purchased with each transaction, this savings becomes less significant.
Second, and most important, the DRIP investor must have a long-term perspective, since he or she is participating in a buy-and-hold program and is adding to his or her stock holdings using a dollar-cost-averaging approach over a long period of time. This allows an investor to build a significant position in one or more individual stocks and to increase his or her personal net worth using a disciplined investment strategy, without worrying about day-to-day gyrations in the stock’s price.
A potential disadvantage of DRIPs is that an investor is adding to his or her position in a single stock, thereby increasing unsystematic risk. This can be minimized if the investor participates in DRIP programs for stocks in a number of different industries.
introduced into the marketplace, which reduces the percentage of ownership of nonparticipating shareholders. This dilution will also impact earnings, which will be spread over an increased number of shares.
Stock Repurchases
Sometimes a firm will repurchase some of its outstanding shares of stock as an alternative to paying dividends. This would then increase earnings per share since the earnings would now be spread over a decreased number of shares. There can be various reasons for a stock repurchase. There may be stock options that have been granted to employees for which the shares are needed. The shares may also be repurchased to ward off an unwanted takeover attempt. If the company has too much cash this can attract suitors, so by repurchasing shares the company will reduce its cash amount while reducing the number of outstanding shares, which in turn will increase earnings. This should also result in a higher stock price, making the stock a less-likely takeover candidate.
Chapter 2: Equity Valuation
Reading the first part of this chapter will enable you to:
4–2 Explain terminology related to equity investment valuation models.
Definitions
he total return a security should achieve is determined by calculating its required return. Required return is calculated by multiplying the market risk premium by the security’s beta and then adding the risk-free return.
The security’s required return, then, is a function of its beta (systematic risk).
This is the capital asset pricing model (CAPM) that we have already covered:
i f m f
i r (r r )
r = + − β
Expected return is the total return an investor can expect from a security, given its current price, the growth rate of its dividend, and the capital appreciation expected (which is assumed to be the same as the expected growth rate of its dividend). The calculation for this will be covered in more detail later in this chapter:
P g r =D1+
The intrinsic value of a security is the value of a security that is computed using a discounted cash flow approach to valuation. Dividends have been accepted by the investment community as the critical cash flow element to discount.
An important assumption in this computation is that dividends are a constant percentage of a corporation’s earnings; in other words, the payout ratio is constant. If this assumption is considered valid, then the growth rate of earnings
T
annual rate. If both dividends and earnings grow, then it can be assumed that the value of the company’s stock will also continue to grow.
The equation used to compute a company’s intrinsic value using the discounted cash flow approach is called the dividend discount model (DDM). It is also called the dividend growth model or the constant growth dividend discount model:
g r V D
= −1
The calculation for this will be covered in more detail later. Once a company’s intrinsic value is computed, then an investor will buy the stock if the current market price is equal to or below the intrinsic value; the investor will not buy, and indeed may sell, if the current market price is higher than the intrinsic value.
The two most difficult aspects of the dividend discount model computation are estimating the appropriate discount rate to be used for the computation and estimating the future growth rate of dividends.
The net discount rate used is the required return minus the dividend growth rate.
The assumption here is that the required return is the gross discount rate to be used in computing the total return of a security. However, a percentage of the required return is earned by the growth rate of the dividend; only the amount of the required return that represents growth above the dividend growth rate (i.e., capital gain) needs to be represented as the net discount rate used in the equation.
Estimating dividend growth can be frustrating. In reality, neither earnings nor dividends grow systematically and steadily. One year, earnings may grow at 24%
and dividends may grow at 15%; another year, earnings may decline and dividends may remain constant. Every investor must derive some method of smoothing out dividend growth so that a compound annual rate can be determined.
DDM Alternatives
A popular alternative to using dividends in the model is to use cash flow,
especially when a company does not pay dividends. Details of this approach will not be discussed here. Different assumptions may have to be made regarding the appropriate required return rate and the growth rate of cash flow.
A second approach to determining the intrinsic value of a stock is to use the P/E ratio. This is one of the most popular valuation methods that investors use. If a company has positive earnings but pays no dividends, then this method must be used because the dividend discount model can be used only when a company pays dividends (assuming that the cash flow model is not used).
When using the P/E ratio approach, two benchmarks are considered—the industry P/E ratio and the market P/E ratio. The ratio for the company in question is computed and compared against both of these benchmarks. If the company ratio is lower than either or both benchmarks, then the stock may be undervalued. If the company ratio is higher than either or both, then the stock may be overvalued.
A third approach is the price-to-sales ratio (PSR). Like the P/E ratio, this method can be used with any company; it is especially useful when a company pays no dividends and has no earnings. To use the ratio, net sales are divided by the number of shares outstanding to determine the sales per share. That number is then divided into the price per share to determine the PSR. In general, stocks with PSRs of less than 1.0 are undervalued; those with PSRs that are greater than 3.0 may be overvalued.
Another popular approach to valuation is the growth-adjusted P/E ratio, known as the PEG (PE/growth) ratio. The PEG ratio is calculated by dividing the P/E ratio by the earnings growth rate (EGR). The PEG ratio allows investors to compare companies with different growth expectations. In other words, in an industry where the average P/E ratio is 18, the P/E ratio of a stock with an expected earnings growth rate of 26% should be higher than the P/E ratio of a
Using the PEG ratio is more complex than using the other ratios. A general rule is that a PEG ratio of less than 1.0 may identify an undervalued company.
However, one cannot assume that a company’s P/E ratio is too low simply because the company’s PEG ratio is lower than the S&P 500 PEG ratio. For
However, one cannot assume that a company’s P/E ratio is too low simply because the company’s PEG ratio is lower than the S&P 500 PEG ratio. For