Comparing Stock And Bond Investments' Cash Flows In An Essay On The Nature Of Stock As An Investment.

Ownership and Dividends in Stock Investment

Stock is the share of the stockholder in the ownership of an entity. It signifies the claim on company’s total assets and total earnings. Owning stock does not give the ownership to the stockholders rather it gives them the voting rights on certain matters that are held for discussion in the shareholder’s meetings (Gregoriou, 2009).

Further, the stockholders are entitled to the dividend on the shares they hold in the company. Dividends are the part the part of company’s earnings that is paid out to the stockholders in return to their investments in the company. Stocks are issued by the company with the objective of raising funds for its operations in order to grow and expand its business. The stockholders can also earn return from their investments in company’s stocks through the price appreciation (Cecchetti & Kharroubi, 2012). The gain on price appreciation is the capital gain and is achieved when the market price of the shares increases in comparison to the price that is being paid at the time of purchasing the company’s stock. Company’s issues stocks majorly in one of two categories: first is the common stock and second is preferred stock. Stocks are at times interchangeably called as securities since it is provides the financial security and sometimes called as equities due to the fact that stock represents the ownership in company. Common stockholders owns a part of ownership in the corporation whereas preferred stockholders enjoys the preference over the equity shares for the dividend is distribution. Moreover, there is a fixed rate of dividend in case of preference shares whereas companies generally offer fluctuating rates of dividend depending upon the level of profits of the company (Chang & Shi, 2011). Shares separates ownership with the management and thereby allowing the external parties i.e. the investors to economically participate in company as they possess voting rights in the meetings on various business matters like for the appointment of managing directors and managers of the company. This power promotes the allocation of company’s resources specially the human capital (Goyenko & Ukhov, 2009).

Normally, shareholders have one voting right available per share. With the privilege of voting rights the company’s equity stock suffers from some limitations as described further. With some exceptions, there is generally no fixed date at which the dividend is paid out to the shareholders and even there is no fixed guaranteed dividend rate. Therefore, before investing funds in the company’s stock the potential investors must consider various factors such as their return and risk expectations as higher returns involves higher risks and if the investors are not ready to bear higher risks, they must not invest in the shares yielding higher dividend rates. A company’s stock may be traded publicly in the stock markets or they may be traded privately (Baker & Wurgler, 2007).

Types of Stock

Stockholders do play an important role in the management of firm’s business as they directly or indirectly participate in company’s important business matters such a financing, management, governance, controls and other significant considerations (Fernández, 2007). Firstly, in financing the funds for the company’s operations. In return, the stockholders are given the part ownership (Guidolin & Timmermann, 2005).

Secondly, stockholders participates directly or indirectly in the company’s operations. As they are entitled to elect the board of directors of the company who supervises the chief executive officers (CEO) and also the chief financial officers (CFO). The potential investors invest their monies in the company’s which has sound performance track and beats the investor’s expectations time to time otherwise they imposes pressure on the corporations to repay their invested funds. This factor compels the company to beat the profit projections. The corporate governance practices also requires the company to maintain greater level of transparency with adequate amount of disclosures in the financial reports (Gitman et al., 2015).

Therefore, the framework of corporate governance demands the management to carry out their accounting and financial operations adequately as they are indirectly accountable to the shareholders of the company. Stockholders generally determines who actually controls the corporation. They can prevent the hostile takeovers of the company if they believe that the acquirers are not offering appropriate price. Institutional shareholders can also publicly call on management of company to take strategic decisions like mergers, amalgamation, spin offs etc. (Foerster & Sapp, 2005).

 The public corporations have to incur various regulatory costs for its stockholders such as expenses in relation to conducting the annual general meetings and payment of legal fees and other related costs (Gebhardt et al., 2005).

 Therefore it can easily be concluded that the stockholders plays vital role in the management of the company in direct or indirect manner. Although they do not participate in the internal affairs of the corporations in which they have invested their funds, but yet they have the power to influence the company’s functions.  

Bonds and stocks are the most common types of investments in the corporate bodies used by the potential investors. Both the investment options provides the returns to the investors either in terms of interests and dividends respectively. There are also other forms of returns from these investments. Each option has its own advantages and limitations in terms of returns and risks. The investors evaluates these options critically on the basis of their priorities and expectations from the investments. Bonds are the means of investments in which potential investor loans money to some corporate bodies or the governmental institutions who requires fund for a defined term (Beber & Brandt, 2008). It allows the investors to hold a part of company’s long term debt. The investors invests their monies in the companies to earn return on their investments in the form of interest. The interest that the companies provides to the bondholders can either be on a variable rate or a fixed rate. The cash flows in relation to both bonds and stock constitutes a series of inflows in smaller amounts followed by a larger amount in the form of end payment (Guiso et al., 2008).

Role of Shareholders in the Management of Business

 This similarity between the cash flows that arises out of bond and stock investments is just superficial and Investing in bonds will entail cash flows from two events. First, the interest that is paid every year till the repayment of bonds. Second, the par value at which the bonds were purchased by the investors, paid at maturity. Sometimes, the bonds are also redeemed at premium which also becomes the part of cash flows at the time when bonds are due to mature (Gabaix et al., 2006).

The interest payment provides the investors a schedule of constant income during the life of their investments in the bonds. Along with the fixed income bonds also offers the final payment which is contractually guaranteed at the end. However, there remains the risk of default on part of company in repayment of it debt to the bondholders. Even when investment in bonds is riskier the potential investors opt for this option as with higher risk, the higher returns are involved in the case of bonds (Albul et al., 2015). Therefore, it can be said that the risk and return factors of bond investment are directly proportional. Investment in shares or common stock also offers two type of cash flows alike bond. One in the form of dividend declared by the firm and another in the form of capital gain in the form of price appreciation of stock at the time of selling of shares (Brown, 2015).  However, the investment in stock whether preferred or common, is quite riskier than the bonds investment as higher returns are associated with the stock. Even while prices of the bonds fluctuates quite substantially in the market, majorly bonds tends to repay the full debt amount in principal along with the interest on the maturity date (Li & Mei, 2013).

 Therefore, it can be said that there is comparatively lesser risk of loss than that of stock. Stocks are highly volatile and hence imposes risk of loss on the stockholders particularly in the short terms. The return on investment in the stock is although not guaranteed but both the types of return have growth potential in future (Kogan & Papanikolaou, 2013).

 The distinct feature of debt investments i.e. the bonds is that it offers guaranteed payments but with least or no possibility of return (Andersson et al., 2008). Bonds lacks the effective return potential of stocks for long term but still these are more preferred over the stocks by the investors to whom income is the priority. Sometimes, the potential investors invests their funds in both the means of investments in order to provide for the risk diversification and to dig out the privileges of both the investment options. Stocks are trade either publicly in the stock markets through recognized stock exchanges or sometimes privately. Whereas, bonds are generally traded on the debt or bond markets. The funds raised from equity stock financing are considered as internal flow of finance as the stockholders are the integral part of organization (Abreu & Mendes, 2010). However, funds raised from debt or bond financing is considered as the cash flows from the external sources of finance. The future cash flows stemming from holding of stocks are analysed on the basis of dividend yield rates, cost of capital calculated using the Gordon’s model, earnings yields, the income per share etc. whereas the cash flows from holding of funds are analysed on the basis of bond durations, current yield, nominal yield etc. (Koijen & Nieuwerburgh, 2011).  

Comparisons of Cash Flows in Stock and Bonds Investments

Reasons why growth rate models are considered as practical and convenient ways of valuing the stocks:

Stock valuation is undertaken for the purpose of determining the intrinsic value of the underlying stock so to enable the investors to take informed decisions regarding the investments or potential investments in the concerned company. As investors are the external parties that do not participate in the internal functioning of the company they are required to get the true picture of company’s performance (Ohlson & Gao, 2006).

The ideal market price of company’s share depends upon the financial performance of the company. The growth rate models primarily follows the theory that the share has its worth based on its intrinsic prices (Avadhani, 2010). It is difficult for the investors due to lack of financial literacy possessed by them to evaluate company’s worth so as to make effective utilization of their surplus funds. Hence, various growth rate models are introduced in the financial markets for the stock valuation. As other models stock valuations like price earnings valuation method, earning per share method, net assets methods of valuation does not consider the growth element of the business they are not practically reliable to be implemented by the business managers to assess the value of their stocks traded in the market (Brown, 2012).

The consideration of growth factor is indispensable for both managers and the stockholders to determine the market value of stock held by them. By far, only Gordon’s model considers the growth rates of the dividend in determination of intrinsic values of the stocks (Bodie, 2013). Professor Gordon who introduced the dividend growth rate model has prescribed two forms of this model: one is the constant growth rate model and other is the non-constant growth rate model (Kumar, 2009).

 Constant growth rate model works on the principle that the business grows at the steady rates and hence dividends also grows at the constant rate (Cecchetti & Kharroubi, 2012).

This method is easy to implement but not realistic as the assumption of constant growth in business is not reliable due to various internal and external factors that influences the company’s functioning (Chang & Shi, 2011).

 Due to this limitation the other form of growth rate model was considered by the Sir Gordon. The non-constant growth rate model operates on the theory that the growth in the business involves huge uncertainty due to the several market forces and even due to the internal factors (Ohlson & Gao, 2006).

Conclusion

 Thus the dividend also grows at different rates per year. But this model also assumes that after a particular point of time the dividend starts growing at the steady rates. As business has a perpetual nature growth rate models supports the business perpetuity. The growth rate models are used to identify the relationships between the growth rates and discounting rates used to find the present values of stock (Lacerda & Santa-Clara, 2010).

The growth rate models are used to provide the uniformity in the stock valuation methods across the financial markets. These models are standardized and hence they are universally acceptable.  As discussed above the growth rate models considers the several business issues before determining the intrinsic values of stocks that are traded in the stock markets (Lettau & Ludvigson, 2005)The assumptions that are used by the growth rate model as suggested by Professor are quite reliable and practical and hence they can be relied upon. Even those potential investors who do not have considerable amount of knowledge and expertise to deal with the stock valuation methods can easily use such models before they take any decision regarding the investment in the stocks of the company. And at the same time they can rely upon the authenticity of results delivered by these growth rate models (Zhuo-hua et al., 2015).

 Even when the stock valuation is sensitive to the changes in the discounting rates, the growth rate models still clearly demonstrates the relationship between the stock valuation and the returns from the stocks (Faulkender et al., 2012). 

A firm may enjoy the periods of its rapid growth. There can be several factors that can contribute the growth of the company such as change in the production technology, entrance to a new product or market, an innovative marketing strategy etc. However, the firm cannot assume its growth indefinitely as there exists the uncertainties and risks (Koijen & Van, 2011).

The risks can vary from competitive risk, product obsolescence risk, political or governmental regulations etc. Therefore, the companies must not be valued at a constant growth rate methods or approaches for the stock valuation (Fonseka et al., 2012).

 The stocks which experiences the fluctuating growth rate till a particular time in future are commonly known as supernormal, non-constants or erratic growth stocks (Ng et al., 2011).

 Stock valuation is the practice of determining the theoretical values of firms and firm’s stocks taking into consideration several variable factors (De Jong & Driessen, 2006).

This method is primarily used to anticipate the market prices of stocks in future so as to judge the return potential of the stock. Basically, if the stock is found to be overvalued than its actual current market price using the stock valuation methods, its value is generally assumed to be declining in future and hence the stockholders tends to sell those stocks in the market and if they are undervalued they are held or bought with the expectations of price rise. The major factor on which stock valuation relies is the expected growth rate of the firm ((Brealey et al., 2012).  Growth rate is determined considering the past growth rate of company’s sale and overall income. However, the use of merely historical rate of growth will not help the firm to determine its future growth rate for the stock valuation as firms operates in the environment that changes rapidly (Dardan et al., 2006). Rather, the historical data of trends that the company’s growth used to follow shall be used as the guideline. When the return from the stock in the form of dividends is not expected to be growing at the constant rate then the evaluation of dividend for each year must be done separately so ad to incorporate the expected rate of growth for every year (Ohlson & Juettner-Nauroth, 2005). For the purpose of stock valuation in case of different expected growth rates for every year, the multistage growth model must be used as prescribed by the Gordon’s Growth Rate Model. Gordon’s model is widely used as a reliable valuation tool (Damodaran, 2007).

This model is extremely sensitive to changes in the growth rate. Even this approach of multistage dividend growth also assumes that the eventually the dividend growth becomes constant (Brooks, 2015). 

Illustration to show how stock prices reacts to the changes in the growth rate every year:

ABC is a company whose dividends are assumed to be increased rapidly for the next few years and then grows at a constant rate. Dividend for the next year is assumed as $ 5 per share, but the dividend will grow annually by 8%, 12% and 15% and after that it will grow at a constant rate of 5% p.a. the actual current market price is assumed to be $ 100 per share. By analyzing unusual growth of dividend for each year separately, the fair (ideal) market value of shares can be determined.

Now,

D₁ = $ 5

Cost of capital, k = 10% (assumed)

Growth rates of dividend

Year 1 = 8%

Year 2 = 12%

Year 3= 15%

After 3 years = 5% steadily for indefinite period.

With the use of estimated dividend growth rates, actual dividends that will be paid in the respective years will be calculated as follows:

D₁ = $ 5

D₂= $ 5.40        (Calculated as 5*1.08)

D₃= $ 6.05       (Calculated as 5.40*1.12)

D₄= $ 6.96       (Calculated as 6.05*1.15)

Now, the present values will be calculated for each year’s dividend under the different growth rates.

Year 1 = $ 5.00/ (1.10) = $ 4.55

Year 2 = $ 5.40/ (1.10)² = $ 6.54

Year 3 = $ 6.05/ (1.10)³ = $ 8.06

Year 4 = $ 5.96/ (1.10)⁴ = $ 8.73

Now, the present value at the end of 5^th year will be calculated for dividend that will grow at the stable rate for indefinite term from 5^th

D5 = $ 7.31     (Calculated as 6.96*1.05)

Using the Gordon’s Growth Model i.e.

P_O=   D₅

        K - G   

      = $ 7.31/ (.10-.05)

      = $ 146.20

Present Value =

Year 4 = $ 146/ (1.10)⁴ = $ 213.76

Now, to arrive at the intrinsic value per share, all the present values calculated above will be clubbed together.

$ 4.55+ $ 6.54+ $ 8.06+$ 8.73+ $ 213.76

$241.64

Now the ideal or intrinsic value of share i.e. $ 241.64, will be compared with the actual current market price i.e. $ 100. Since the stock is undervalued in the market, it will be sold by the investors. 

From the above illustration it can be demonstrated that there can be more than two growth rates for the different years. This mean that the dividend can grow with the fluctuating rates for each year till the maturity of shares. But ultimately there will be a constant rate at which dividend income will grow for the indefinite terms.

The two things that have to be true for the last rate are explained further. First the last rate must be the constant rate as the non-constant growth method of stock valuation assumes that the dividends will grow at the constant rate. Second, the growth rate must not be more that the required rate of return because if it exceeds the required rate i.e. K_e it will result in negative market price of the shares.  

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