FIN 3400 — Finance for Non-Financial Managers · MDC Kendall · Fall 2026
Module 2 — Exam: Nov 1 (200 pts)
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Equity: Ownership, Not Loans
Businesses need capital to start up, expand, and enter new markets. Chapter 7 covered how firms borrow money through bonds. This chapter explores the other side: equity financing — selling ownership stakes to investors.
Why Investors Buy Stock
Unlike bondholders, stockholders have no promised payments. No coupon, no maturity date, no guarantee of getting your money back. So why would anyone buy stock? Because ownership comes with upside potential — dividends and price appreciation that can far exceed bond returns. Over the long run, stocks have historically returned about 12.8% annually, compared to 6% for bonds.
The tradeoff: stocks are riskier. Prices fluctuate daily, companies can go bankrupt, and dividends can be cut. But investors accept that risk because the market rewards it.
Discussion starter: Would you rather own a bond that pays you 5% guaranteed, or stock in a company that might return 15% — or might lose 40%? Your answer depends on your time horizon, risk tolerance, and financial goals. There's no universally "right" answer.
Common Stock: The Residual Claim
Common stock represents ownership in a corporation. As a shareholder, you're a part owner — but your claim is residual, meaning you get whatever's left after everyone else is paid.
The Order of Claims in Bankruptcy
First: Employees, tax authorities, lawyers
Next: Secured creditors (mortgage bondholders)
Then: Unsecured creditors (debenture holders)
Then: Preferred stockholders
Last: Common stockholders — whatever remains (often nothing)
Being last in line is risky, but it also means unlimited upside. Bondholders can never earn more than their promised yield. Stockholders can see their investment double, triple, or more if the company thrives.
What Drives Stock Value?
Company profitability — earnings and cash flow
Growth prospects — can the company expand revenue and margins?
Market interest rates — higher rates make future cash flows worth less
Overall market conditions — bull and bear markets affect all stocks
Stock Exchanges and Markets
Stock exchanges provide liquidity — the ability to buy and sell quickly at a known price. Without liquidity, stock investing would be far less attractive. Imagine owning shares but having no way to sell them!
Major U.S. Exchanges
NYSE (New York Stock Exchange)
Largest equities marketplace in the world
Home to 2,300+ companies
Physical trading floor with designated market makers
Home to most large, established blue-chip companies
Nasdaq
Second-largest equities marketplace
Fully electronic — no physical trading floor
Uses dealers (market makers) who set bid/ask prices
Known for technology companies (Apple, Microsoft, Google)
Stock Market Indexes
Indexes track the performance of groups of stocks, giving us a pulse on the overall market:
Dow Jones Industrial Average (DJIA) — 30 large, industry-leading firms; price-weighted
S&P 500 — 500 large companies; market-cap weighted (broader than the Dow)
Nasdaq Composite — all stocks listed on Nasdaq; tech-heavy
Why index design matters: The Dow has only 30 stocks and is price-weighted, so a high-priced stock like UnitedHealth moves the index more than a low-priced one — regardless of company size. The S&P 500 is market-cap weighted, so Apple's movement matters far more than a small company's. Always know how an index is constructed before interpreting its movement.
How Stock Trading Works
When you place a trade, you enter a world of bid prices, ask prices, and order types. Understanding these mechanics makes you a smarter investor.
Bid and Ask Prices
Bid Price
Highest price a market maker will pay
The price at which you sell
Ask Price
Lowest price a market maker will accept
The price at which you buy
The spread between bid and ask is the market maker's profit and your hidden cost. On highly liquid stocks, the spread might be a penny. On less-traded stocks, it can be much wider.
Order Types
Market order — execute immediately at the current price. Fast, but you have no control over the exact price. A buy market order fills at the ask; a sell fills at the bid.
Limit order — execute only at a specified price or better. A buy limit at $50 fills only if the ask drops to $50 or below. You control the price, but the order may never execute.
Real-world tip: Market orders guarantee execution but not price. Limit orders guarantee price but not execution. For a stock you must own immediately, use a market order. For a price you're unwilling to exceed, use a limit order. Most experienced investors use limit orders for larger trades to avoid surprises.
Basic Stock Valuation
Stock valuation is fundamentally about finding the present value of future cash flows — just like bonds. But there's a crucial difference: stock cash flows are uncertain. You don't know what future dividends will be, and you don't know what price you'll sell at.
The One-Period Model
If you plan to hold a stock for one year, its value today is:
P₀ = (D₁ + P₁) / (1 + i)
Where D₁ = expected dividend in one year, P₁ = expected selling price, and i = required return.
Extending to Multiple Periods
For a two-year holding period:
P₀ = D₁/(1+i) + (D₂ + P₂)/(1+i)²
Using a longer horizon reduces some uncertainty — but not all, because you still must estimate the final selling price. And what if you hold indefinitely?
The fundamental insight: If you extend this to an infinite holding period, the selling price term disappears. The stock's value becomes simply the present value of all future dividends forever. This is the theoretical foundation of the dividend discount model — every stock's value ultimately comes from the cash it returns to shareholders.
The Dividend Discount Model
The dividend discount model (DDM) says a stock's value equals the present value of all expected future dividends. In theory, you'd need to estimate an infinite number of future dividend payments. In practice, we make simplifying assumptions.
The Constant-Growth Model (Gordon Growth Model)
If we assume dividends grow at a constant rate forever, the infinite series simplifies to a single elegant formula:
P₀ = D₁ / (i − g)
Where D₁ = next year's dividend, i = required return, and g = constant growth rate.
Example: Coca-Cola
Coca-Cola paid $1.84 per share in dividends in 2023. If we project dividends growing at 5.49% and investors require a 9% return:
With Coca-Cola's actual price around $59.54, the model suggests the stock is fairly valued — the small difference reflects differing growth or risk assumptions among investors.
How much comes from growth? If Coca-Cola's dividend never grew (g = 0), the stock would be worth $1.84 / 0.09 = $20.44. Since the actual value is much higher, over 65% of Coca-Cola's stock value comes from expected dividend growth. Growth expectations are the engine of stock valuation.
Preferred Stock: The Hybrid
Preferred stock is a hybrid security — it has features of both debt and equity. Like debt, it pays a fixed dividend. Like equity, it represents ownership (with no maturity date).
Key Characteristics
Priority: Preferred dividends must be paid before any common dividends
Fixed dividend: Usually stated as a percentage of par (typically $100)
No voting rights in most cases
Tax advantage: Corporations receiving preferred dividends from other companies get significant tax deductions — which is why most preferred stock is owned by institutions, not individuals
Valuing Preferred Stock
Because preferred dividends are constant (zero growth), we use the constant-growth model with g = 0:
P₀ = D / i
It's simply a perpetuity — the present value of a fixed payment continuing forever.
Example
Coca-Cola preferred stock paying $1.84 annually, with investors requiring 9%:
P₀ = $1.84 / 0.09 = $20.44
Compare this to the common stock value of $55.27 — the difference is entirely due to growth expectations. Preferred stock has no growth upside, which is why it trades at a much lower price.
Variable-Growth Valuation
The constant-growth model is elegant, but real companies don't grow at one rate forever. A startup might grow 30% for five years, then settle into 5% long-term growth. The variable-growth model handles this in two stages:
Two-Stage Approach
Stage 1: Estimate and discount each dividend during the high-growth period (years 1 through n)
Stage 2: Use the constant-growth model to find the stock's terminal value at year n, then discount it back to today
P₀ = Σ Dₜ/(1+i)ᵗ + [Dₙ₊₁/(i−g₂)] / (1+i)ⁿ
When to Use Variable Growth
Temporarily struggling companies — currently low or no dividends, but recovery expected
High-growth companies — rapid growth now, but will mature and slow down
Moderately high-growth companies — growth exceeds the sustainable rate temporarily
Important constraint: The constant-growth model breaks down when g > i (you get a negative price, which is nonsensical). The variable-growth model solves this by assuming growth eventually drops below the required return. This is why we can't value Amazon or Tesla with a simple Gordon Growth model — their current growth rates are too high.
The P/E Ratio: Relative Valuation
Instead of computing a stock's fundamental value from cash flows, the P/E ratio approach compares a stock's price to its earnings. It's a relative valuation tool — is this stock expensive or cheap compared to similar companies?
Two Types of P/E
Trailing P/E = Current Price / Past 4 quarters of EPS
Forward P/E = Current Price / Expected next 4 quarters of EPS
Estimating Future Price with P/E
If you expect a company to earn $5 per share next year and similar companies trade at an average P/E of 15:
Market expects high growth — or stock is overvalued
Low P/E
Market expects low growth — or stock is undervalued
Zero P/E
Company is losing money (no earnings to divide by)
Historical P/E ratios — S&P 500 vs. Coca-Cola vs. McDonald's
Caution: P/E ratios vary enormously across industries. A tech company with a P/E of 40 might be fairly valued if it's growing rapidly, while a utility with the same P/E would be wildly overpriced. Always compare P/E to industry peers, not to the broad market.
Expected Return from Stocks
If a stock is fairly priced, the discount rate used in the constant-growth model tells us the expected return investors anticipate. We can rearrange the Gordon Growth formula:
i = (D₁ / P₀) + g
This splits expected return into two components:
Dividend yield (D₁/P₀) — the income portion, like a bond's current yield
Capital gains yield (g) — the expected price appreciation from growth
Example
If a stock pays $2 in dividends next year, trades at $50, and grows dividends at 5%:
Dividend yield: $2 / $50 = 4%
Capital gains yield: 5%
Expected return: 4% + 5% = 9%
Compare to bonds: A bond's return comes from coupon income and price changes. A stock's return comes from dividends and price changes. The structure is identical — the difference is certainty. Bond cash flows are contractual; stock cash flows are expectations. That uncertainty is why stocks must offer higher expected returns.
Key Takeaways
Common stock = ownership with residual claim — unlimited upside, highest risk
Stock value = PV of all future dividends — theoretically, forever
Constant-growth model: P₀ = D₁ / (i − g) — simple but powerful
Preferred stock is a perpetuity: P₀ = D / i (no growth)
Variable-growth model handles companies with changing growth rates in two stages
P/E ratio enables relative valuation — compare to peers, not to unrelated industries
Expected return = dividend yield + capital gains yield
Next up: Chapter 9 — Characterizing Risk and Return. Now that we can value stocks and bonds, we need to understand how to measure and compare their risk. The risk-return relationship is the foundation of all investment decisions.
Further Learning Resources
Explore these to deepen your understanding of this chapter's topics: