Common Shares | Corporate Finance | Part 2 | Section B | Episode 14 | CMA USA

Welcome back to CMA USA exam coach, your dedicated study companion on the journey to CMA success. In our last episode, we explored preference shares, their characteristics, advantages, and how they differ from other forms of equity. We saw how preference shareholders enjoy priority and dividend payments and liquidation, but often lack voting rights and control over company decisions. In this episode, we shift our focus to common shares, which represent the most basic and widely issued form of ownership in a corporation. Common shares are what people usually refer to when they talk about stocks or equity investments in a company. Let's break down what common shares really are and why they're so important in corporate finance. When a company issues common shares, it is essentially giving individuals the opportunity to buy a stake in its business. By purchasing these shares, investors become part owners of the company, and with that ownership comes both privileges and risks. One of the key privileges of owning common shares is the right to vote. Common shareholders usually have the right to participate in major corporate decisions, such as electing the board of directors or approving mergers and acquisitions. This voting power gives them a real influence over the company's direction, especially in firms where shareholder decisions play a vital role in shaping future strategy. Another important feature of common shares is the potential to earn dividends. When a company earns profits, it may choose to distribute a portion of those profits to its shareholders in the form of dividends. However, unlike preference shareholders, who often receive a fixed dividend, common shareholders do not have any guarantee. The company is not obligated to pay dividends on common shares, and whether or not they are paid, and how much, depends entirely on the company's performance and the decisions made by its board of directors. Common shareholders also enjoy what is known as limited liability. This means that if the company faces financial difficulties or even bankruptcy, the personal assets of the shareholders are protected. They can only lose the amount they invested in purchasing the shares, nothing more. This limited liability is one of the major reasons investors feel comfortable putting their money into equity markets. But ownership also comes with risk, and one such risk is the residual claim feature. This means that, in the event of liquidation, common shareholders are the last to be paid. After all debts have been settled and preferred shareholders have received their dues, only then do common shareholders get any remaining assets, if there's anything left at all. This is why common shares are considered riskier than bonds or preferred stock, but at the same time they offer a higher potential return, especially when the company grows and becomes more profitable. Another advantage of common shares is their transferability. In most cases, these shares are freely traded on stock exchanges. This means that investors can easily buy and sell their shares, providing flexibility and liquidity that's not always available with other forms of investment. So to sum it all up, common shares give investors true ownership in a company. They offer voting rights, potential dividends, limited liability, and the chance to benefit from future growth. But they also come with risks, especially in terms of dividend uncertainty and being last in line during liquidation. Understanding these features is essential, not just for the CMA exam, but also for making smart investment and financing decisions in the real world. Now, let's take a step further and understand how common shares differ from preferred shares, a very important area for your CMA USA exam and for real world financial analysis. While both common and preferred shares represent ownership in a company, they are not created equal. In fact, they serve different roles in the capital structure and offer different rights and benefits to the shareholders. Let's start with voting rights. Common shareholders typically have voting power, which gives them the right to vote on major corporate matters, including electing the board of directors. Preferred shareholders, on the other hand, usually do not have voting rights. This means they don't have a say in how the company is governed or managed. They are more like silent investors who focus on stable returns rather than corporate control. Next, let's talk about dividends. Preferred shareholders are given priority when it comes to receiving dividends. Their dividends are often fixed, and in many cases, they are guaranteed before any dividends are paid to common shareholders. Common shareholders, in contrast, receive dividends only if the company has sufficient profits and the board decides to declare them. There is no guarantee at all, and in some years, they may receive nothing. Another key difference lies in the priority of claims during liquidation. If a company goes bankrupt and its assets are being distributed, preferred shareholders are paid before common shareholders. In fact, common shareholders are last in line. They receive whatever is left after all creditors and preferred shareholders have been paid. This makes common shares riskier, but it also opens the door to higher returns when the company performs well. From an income perspective, preferred shares function almost like fixed income instruments. They offer predictable, steady dividends and are often favored by investors seeking consistent income with lower risk. Common shares, on the other hand, are more volatile. Their value can fluctuate significantly based on market conditions, company performance, and investor sentiment. But this also means that common shares have greater potential for capital appreciation over the long term. So, to sum up, preferred shares offer greater stability, fixed dividends, and liquidation preference, but little to no control over the company. Common shares offer ownership, voting rights, and the potential for higher returns, but with greater risk and uncertainty. We understood the key differences between common and preferred shares. Now, let's explore how to determine the selling price or value of common shares. One of the biggest challenges in valuing common shares is that their dividends can vary. Unlike preferred shares, which usually pay a fixed dividend, common share dividends depend entirely on the company's earnings and decisions made by the board. In fact, for many companies, these dividends are not only variable, they may actually grow over time. Now, why do dividends grow for common shareholders? The reason is rooted in the nature of business growth. As a company expands, increases its revenue, improves its profitability, and generates higher cash flows, it often has more resources available to reward its shareholders. If management chooses to share a portion of that growing profit, dividends increase. Also, companies with a strong track record may increase dividends regularly to signal financial health and build investor confidence. This growth in dividends makes common shares more attractive and valuable over the long term. With that in mind, let's now look at the two common cases used to calculate the price of common shares based on expected dividends. The first case is when dividends are constant, meaning the company pays the same dividend every year with no expected increase. This is similar to how we treat preferred shares. In this situation, we use the dividend discount model for a perpetuity. The formula is simple. Selling price equals dividend per share divided by the required rate of return. That is, P equals D divided by R. For example, if a company pays a dividend of $2 per share each year and the required rate of return is 10%, then the price of the share is 2 divided by 0.1, which equals $20. This model works well for stable, mature companies that are not expecting major growth. The second case, and the more common one, is when dividends are expected to grow at a constant rate every year. This is known as the Gordon growth model, and it's more suitable for dynamic companies that regularly increase their dividend payouts. The formula here is slightly adjusted to reflect that growth. Selling price equals dividend per share next year divided by the difference between the required rate of return and the growth rate of dividends. That is, P equals D1 divided by R minus G. Here, D1 is the expected dividend next year, R is the required rate of return, and G is the annual growth rate of the dividend. So for example, if a company is expected to pay $3 next year, the required return is 12%, and dividends are expected to grow at 5% per year. The price of the share would be 3 divided by 0.12 minus 0.05, or 3 divided by 0.07, which equals approximately $42.86. This model helps us estimate a fair price for common shares when the company has consistent, predictable growth in dividends over time. So far, we've covered how to determine the value of common shares based on dividend expectations, both when dividends are constant and when they grow. But what about when a company issues new common shares for the very first time? Well, in that case, the approach is completely different. When a company raises capital by offering new common shares, such as during an initial public offering or IPO, we don't rely on dividend-based valuation models. Why? Because most newly issued shares don't even pay dividends in the early years. So we can't use formulas like dividend divided by required rate of return, or D1 over R minus G. Instead, the selling price of new issue common shares is determined through a process led by investment banks and underwriters. Let's break that down. When a company decides to go public or raise additional equity, it typically works with an investment bank. The underwriters analyze the company's financials, look at its future growth potential, compare it with similar companies in the industry, and assess overall market sentiment. Based on all of these factors, the underwriters propose a price range. This is known as the indicative price range, and it's shared with potential institutional investors to gauge demand. After receiving feedback from the market and conducting a process called book building, the final issue price is set. This becomes the official selling price of the new common shares. Now, this price has nothing to do with dividends. It is based more on factors like projected earnings, market appetite, the company's growth story, and comparable companies' valuations, especially using ratios like the price-to-earnings ratio, or PE. You might also hear the term par value, but don't confuse it with the issue price. Par value is simply a nominal amount, like one dollar or even one cent, listed on the company's books. The actual price investors pay is almost always much higher, and the difference between the issue price and the par value is recorded as additional paid-in capital, also known as share premium. Let's consider an example. Suppose a new tech startup issues common shares with a par value of one dollar. But based on strong demand and investor confidence, the company sets the issue price at $25 per share. That $25 is the true selling price, and it reflects market conditions, not dividend expectations. Once the shares are listed and start trading on the stock exchange, their market price will fluctuate daily. At that stage, future dividend models can be used to estimate the fair value. But during the initial sale, pricing is primarily a function of market forces, underwriter expertise, and investor demand. So to summarize, the selling price of new issue common shares is determined in the primary market through a structured pricing process, not through dividend-based models. Understanding this distinction is essential, not just for your CMA exam, but for grasping how companies raise equity capital in the real world. Next, we'll dive into a more advanced share valuation technique called the dual-stage dividend growth model, and we'll make it simple and easy to follow. So far, we've seen how to calculate the value of a share when dividends grow at a constant rate. But in real life, companies often go through different stages of growth. A business might grow very fast for a few years, and then settle into a more stable phase. That's where the dual-stage model comes in. It assumes two phases of dividend growth, an initial high-growth phase followed by a long-term stable-growth phase. This approach gives us a more realistic estimate of the share price, especially for rapidly growing companies. Let's go through a simple example together. In this example, expected return is 14%, and first three years' growth rate is 20% from year four, the stable growth of 7%. Assume a company is expected to pay a dividend of $1 in the upcoming year, which is year one. This dividend is not the dividend just paid, it is the dividend expected to be paid next year. That's why we will discount it using the present value factor for year one, not year zero. Now, this company is projected to experience strong growth in the early years. Specifically, dividends are expected to grow at a rate of 20% per year for the next three years. After that, starting from year four, the growth rate is expected to slow down and stabilize at 7% per year into perpetuity. As investors, we require a return of 14% on this investment, and we'll use that required return to discount all future dividends to their present value. The present value factors at a 14% discount rate are as follows. For year one, it is 0.877, for year two, it is 0.769, and for year three, it is 0.675. Now, let's calculate the expected dividends for the first three years. In year one, the expected dividend is $1. In year two, we apply the 20% growth rate. $1 multiplied by 1.2 gives us $1.20. In year three, we again apply the 20% growth rate. $1.20 multiplied by 1.2 results in $1.44. So, the expected dividends are $1 in year one, $1.20 in year two, and $1.44 in year three. Now, let's discount these future dividends to find their present value. For year one, we multiply $1 by the year one PV factor of 0.877, which gives us a present value of 88 cents. For year two, we multiply $1.20 by the PV factor of 0.769. This equals $0.92. For year three, we multiply $1.44 by the year three PV factor of 0.675, which gives us a present value of $0.97. Now, let's add these present values together. 88 cents plus $0.92 plus $0.97 gives us a total of $2.77. This means that the present value of the dividends we expect to receive over the first three years, during the high growth period, is $2.77. This completes the first phase of our calculation. In the next step, we'll estimate the terminal value, that is, the value of all dividends expected from year four onward, assuming they grow at a stable rate of 7%. We'll calculate that using the Gordon growth model, and then discount that terminal value back to the present. Now, we move on to the second and final stage, calculating the value of the stock from year four onward, where the dividend is expected to grow at a stable long-term rate of 7% per year. This is where we use the Gordon growth model, also known as the constant dividend growth model. Let's start with the dividend expected in year four. Since the year three dividend was $1.44, we apply a 7% growth rate to find the So we take $1.44 and multiply it by $1.07, giving us approximately $1.54. More precisely, it's $1.5408. Now, here's an important concept to understand. We are going to calculate the price of the share at the end of year three, based on all the dividends the investor expects to receive from year four onward, assuming a constant growth rate. This is known as the terminal value, and we denote it as P3, because it represents the price at the end of year three. Why are we calculating the price at year three? Because the constant growth phase starts in year four. So at the end of year three, an investor would consider how much the stock is worth going forward, based on the stable dividend growth. The terminal value is effectively the present value, as of year three, of all dividends from year four to infinity, discounted using the required rate of return. Now let's use the Gordon growth formula, P3 equals D4 divided by R minus G. Here, D4 is the year four dividend, which is $1.5408. R is the required rate of return, 14%. G is the stable growth rate, 7%. So we have $1.5408 divided by 0.14 minus 0.07, which is 1.5408 divided by 0.07. This gives us a terminal value of approximately $22. But remember, this price is as of the end of year three. We want to know what that amount is worth today in present value terms. So we discount it using the present value factor for year three, which is 0.675. Multiplying $22 by 0.675 gives us a present value of $14.85. Now we come to the final step. We already calculated the present value of the first three years of dividends as $2.77. Adding that to the present value of the terminal value, $14.85, gives us a total intrinsic value of the share today, which we call P0. So the final calculation is P0 equals 2.77 plus 14.85 equals 17.62. Therefore, based on the two-stage growth model, with high growth in the first three years and stable growth afterward, the estimated fair value of this common share today is $17.62. This is the process how we calculate the dual-stage dividend growth model. Now we learned how to value common shares using dividend growth models, both single-stage and dual-stage. Now we take a broader view of valuation, one that combines dividends with the potential for capital gains. This approach reflects the two primary ways in which shareholders earn returns from their investment in common stock. Let's begin with a fundamental question. Why do investors buy common shares? The answer lies in two key benefits that common shareholders typically expect to receive. First, dividend income. Dividends are periodic payments made by a company to its shareholders from its earnings. For investors, this is a direct source of income. Some companies pay dividends quarterly, others annually, and some may not pay dividends at all. But when dividends are paid, they provide a steady stream of cash flow to shareholders. This is especially important for income-seeking investors who prefer to earn regular returns on their investment. The amount of dividend paid often depends on the company's profitability, cash reserves, and dividend policy. Well-established companies with stable earnings are more likely to pay consistent dividends. Over time, if the company grows and profits increase, the dividends may also increase, thereby providing a growing income stream for the investor. Second, capital gain. This is the increase in the market value of the share over time. When an investor buys a stock and later sells it at a higher price, the difference between the selling price and the purchase price is called capital gain. For example, if you buy a stock for $20 and later sell it for $30, you've earned a $10 capital gain. Capital gains are especially appealing to growth-focused investors who are less concerned about receiving regular dividends and more interested in the appreciation of their investment over time. The potential for capital gain is driven by many factors, such as the company's financial performance, industry prospects, economic conditions, and overall investor sentiment. So in summary, when we talk about valuing common shares, we are essentially looking at the total return to the investor, which comes from two sources, dividend income and capital gain. Let's now discuss how to calculate selling price using dividend and capital gain. When investors consider buying a share of common stock, they want to know what it's worth today based on what they expect to receive in the future. The total return they expect is made up of two things, the dividend they'll receive during the year and the price at which they expect to sell the share at the end of the year. To capture both of these elements in a single formula, we use the following equation. P0 equals D1 plus P1 divided by 1 plus R. Let's break this down carefully. P0 is the current price that's what we're trying to calculate. D1 is the dividend expected to be received next year, not the dividend that was just paid, but the future dividend because we're using a forward looking model. P1 is the expected price at which the investor plans to sell the share at the end of one year. This is where the capital gain comes in. If the investor expects the share's value to rise over the next year, P1 will be higher than P0 and that increase represents the capital gain. R is the required rate of return. This is the minimum return the investor expects to earn on this investment given the risk involved. It is also sometimes referred to as the discount rate. So when we add D1 and P1, we're adding the two sources of return, the dividend income and the capital gain. Dividing the sum by 1 plus R means we are discounting these future values back to present to find their value today. This formula reflects the principle of time value of money, where a dollar received in the future is worth less than a dollar received today. By discounting the expected future cash flows, both the dividend and the resale value, we can estimate the fair price an investor should be willing to pay for the stock today. Now, let's see this formula in action with a practical example. Let's consider stock X. The company is expected to pay a dividend of $2 one year from now. This value represents the future dividend, which we call D1. In addition to the dividend, the investor expects the stock to be worth $25 at the end of one year. This future price is the expected selling price, which we call P1. The required rate of return, which represents the investor's expectation based on risk and opportunity cost, is 12% or 0.12. We will use the following equation to find the present value of the stock today. P0 equals D1 plus P1 divided by 1 plus R. Now let's plug in the values. P0 equals $2 plus $25 divided by 1 plus 0.12. First, let's add the dividend and the expected price. $2 plus $25 equals $27. Now divide $27 by 1.12. $27 divided by 1.12 equals $24.11. Therefore, the estimated fair value of the stock today is $24.11. This means that if an investor wants to earn a 12% return and they expect to receive a $2 dividend and sell the stock for $25 in one year, they should be willing to pay no more than $24.11 for the stock today. This example shows how the dividend and the expected capital gain work together to help investors determine what a share is worth in today's terms. In this slide, we are going to understand a very important topic in corporate finance, the cost of common shares, also referred to as the cost of retained earnings. You might be wondering, why do we call the cost of common shares the cost of retained earnings? Well, when a company earns profits, it has two options. It can either distribute those profits to shareholders in the form of dividends, or it can retain the earnings and reinvest them back into the business. If the company chooses to retain the earnings, those retained earnings still belong to the shareholders. So, when the company reinvests those retained earnings, instead of distributing them, it is using shareholders' money. Therefore, from a shareholder's point of view, they expect a return on that reinvested amount, just as they would expect a return if they had received it as dividends and invested it elsewhere. This expected return by the shareholders becomes a cost to the company. That is why we say the cost of retained earnings is equal to the cost of equity or the cost of common shares. It's the return the shareholders could have earned elsewhere had the company not retained the earnings. Now, let's talk about how to calculate this cost. We have two different situations when we are working with common equity. The first situation is when the company is using existing common shares. In other words, there is no new issue of stock. The second situation arises when the company is issuing new common shares to raise capital. In this slide, we'll focus only on the first case, that is, when we are dealing with existing shares. Now, even within this case, we can have two types of dividend behavior. One, when the dividend remains constant over time. Two, when the dividend is expected to grow over time. Let's start with the constant dividend case. As we already learned earlier, the price of a stock is calculated by dividing the dividend by the investor's required rate of return. So, if we rearrange that formula, we get the required return equals the dividend divided by the current market price of the share. Let me explain this clearly. If the price of the share is equal to the dividend divided by the required return, then logically the required return, which is also the cost of the company, must be equal to the dividend divided by the share price. In simple terms, cost of equity equals dividend divided by the current price of the share. Here, the dividend is what the investor expects to receive and the price is the current market price of the stock. This gives us a simple and direct formula to calculate the cost of retained earnings, or cost of equity, when dividends are constant and no new shares are being issued. Now, let's look at the situation where dividends are growing over time, which is more common in real-world scenarios. When dividends are expected to grow, the formula to calculate the price of the share changes. Instead of dividing just the dividend by the return, we use the dividend discount model, also known as the Gordon growth model. The formula to calculate the current price of a share when dividends are growing is price equals D1 divided by R minus G. Let's break that down. D1 is the dividend expected next year, not the most recent dividend, but the dividend forecasted for the upcoming year. R is the required rate of return by investors, the percentage return they expect from investing in this stock. G is the expected growth rate in Now remember, the required return by investors, that RR, is the same as the cost of equity for the company, because what the investor expects to earn becomes a cost for the company that is using shareholders' money. So the price formula is price equals next dividend divided by cost of equity minus growth rate. But what if we want to calculate the cost of equity, or in this case, We simply rearrange the formula to solve for R, the required return. This gives us Let me say that again slowly. Cost of retained earnings equals next year's dividend divided by the current market price of the share plus the dividend growth rate. This formula is extremely useful for companies that retain profits and want to understand the cost of using that retained money to grow the business, especially when they plan to increase dividends over time. So to summarize, when dividends are expected to grow, the cost of retained earnings is calculated as next year's dividend divided by current share price plus the expected growth rate of dividends. Next, we're going to discuss how the cost of common equity, also called the cost of retained earnings, is calculated when a company issues new common shares. Now you might be thinking, isn't this the same as calculating the cost of existing equity? The answer is not exactly. When new shares are issued to the public, the company often incurs additional costs such as underwriting fees, legal expenses, and administrative charges. These are known as issuance costs or more commonly floating costs. Because of these floating costs, the company doesn't receive the full price at For example, if a share is issued at $25 and the floating cost is $1 per share, the company actually receives only $24 per share in hand. So we need to adjust the formula to reflect what the company actually receives from the issue. Let's first look at the case when dividends are constant. In this case, the formula to calculate the cost of retained earnings or cost of equity capital from a new issue is cost of equity equals dividend divided by issue price minus floating cost. Let me explain that again clearly. We take the expected annual dividend, which remains constant, and divide it by the net proceeds per share, which is the issue price minus the floating cost. This gives us the effective cost of using that equity capital after accounting for the cost of issuing the shares. Now let's move to the second situation. When the dividends are expected to grow over time. Here we apply a similar logic, but we also include the expected growth rate in the formula. So the equation becomes cost of retained earnings equals next year's dividend divided by issue price minus floating cost plus the growth rate. To put it in words, we take the dividend expected next year, divide it by the net proceeds from issuing the share, which is the issue price minus the floating cost, and then add the expected growth rate in dividends. This version of the formula helps us determine the true cost of raising equity capital from a new share issue when dividends are growing each year. It's important to remember that the growth rate reflects what investors expect in the future and the floating cost reflects what the company actually receives in the present. Both are essential to accurately calculate the cost of new equity. Let's apply what we've learned to a simple example involving the cost of equity from a new issue using the dividend growth model. Imagine a company is planning to issue new common shares. The expected dividend next year, known as D1, is $2 per share. The issue price of the new share is $25, but the company incurs floating costs of $1 per share, which means it will actually receive $24 per share in net proceeds. In addition, dividends are expected to grow at a constant rate of 6% per year. We want to calculate the cost of equity, or the cost of retained earnings, using the formula. Cost of retained earnings equals next year's dividend divided by issue price minus floating cost plus the growth rate. Let's plug in the numbers. Cost equals $2 dividend divided by $25 issue price minus $1 floating cost, which gives us $24. So 2 divided by 24 equals 0.0833. Now we add the growth rate of 6%. So the total cost of equity equals 0.0833 plus 0.06, which equals 0.1433, or 14.33%. That means, after accounting for both the floating cost and expected dividend growth, the company's effective cost of equity from this new issue is 14.33%. This example shows how floating costs reduce the company's proceeds and increase the effective cost of raising equity, which is important for evaluating financing options in capital structure decisions. Before we wrap up this episode, let's take a quick moment to summarize everything we've learned today about common shares and their valuation. First, we started by understanding what common stock is, along with its key features, such as ownership rights, voting power, and residual claim on earnings. Then, we explored the difference between common stock and preference stock, highlighting how common shareholders take more risk, but also have more potential for reward. Next, we discussed how to calculate the selling price of common shares, and how it varies based on whether dividends are constant or growing. We then moved into the dual-stage dividend growth model, where we saw how dividends that grow at different rates in different time periods can be valued step-by-step using present value calculations. After that, we learned about the valuation of common stock using dividends and expected capital gains, showing how both income from dividends and capital appreciation contribute to the value of a share. Finally, we covered the cost of common shares, also known as the cost of retained earnings, both in the case of existing shares and new issues, and we explained how to adjust for floating costs when shares are newly issued. This brings us to the end of today's lesson. Thank you for watching and learning with CMA USA exam coach. Keep practicing your question bank, and don't forget to read your official CMA text for deeper understanding. The more you practice, the more confident you will become, and confidence is key to success in the CMA exam. Stay motivated, stay consistent, and I'll see you in the next episode. Until then, happy studying and all the best!