I?ll answer the first 3 questions about stock valuation using strict
financial theory -- but it?s important to note that the real world
works a little differently.
1. Menomonie Publishing has a total valuation of $48 million (1.2
million shares x $40/per share), so increases in the number of shares
should see a decrease in the stock price ? while lowering the number
of outstanding shares should increase the per-share price:
A 15% stock dividend will increase the number of shares to 1,380,000
and lower the price to $34.78 = $48,000,000 / 1,380,000
Thus, if you increase the number of shares by 15%, you lower the stock
price by 1/1.15 or about 13%.
2. A 4-for-3 stock split is a 33.3% increase to 1,600,000 shares so
the stock price should be $48,000,000 / 1,600,000 shares = $30 per
share. A 33.3% increase in shares would reduce the stock price by
1/1.333 or about 25%.
3. A reverse split is designed to increase the stock price, often for
regulatory reasons (see the next section, ?The Reality.?) A 3-for-1
split would take the company from 1.2 million shares to 400,000 shares
and the value would be $48,000,000 / 400,000 = $120
Companies like to keep their shares trading within certain ranges to
allow a broader ownership. In the U.S. it?s often $5 - $100, though
in the U.K. share prices are often in the 1 ? 10 pound range (and
share prices there are shown in pence).
Also, certain exchanges don?t allow low-priced stocks or so-called
?penny stocks,? so companies with declining share prices will often do
a reverse split to stay publicly listed. A good example cited here is
?Reverse Stock Split is Anything But Good News,? (Krantz, July 18, 2005)
When stocks split, theoretically only the number of shares change, as
this Investopedia article indicates. But the reality is that the
stock is more affordable in block trades to smaller investors ? and
more importantly, it?s generally considered a signal from the board of
directors that the company believes growth in sales and profits will
?Stock Splits,? (undated)
HUDSON - BALDWIN
There are a myriad of factors that can account for two companies
having a different return on equity. These can include:
? Baldwin being in a growing market, where it?s overhead costs as a
percentage of sales are shrinking ? while perhaps Hudson?s are
? Better use of assets by the 2 companies.
? Better management of assets.
? Different risk factors, if they?re in different markets. Perhaps
Baldwin is building casinos ? for which demand fluctuates highly in a
recession ? and Hudson builds homes with a constant demand.
I?ll treat one factor: a different weight-average cost-of-capital
(WACC) ? and provide a detailed example. The WACC is simply a mix of
debt and equity. Use of debt or leverage can increase the returns on
WEIGHTED-AVERAGE COST OF CAPITAL
The full weighted-average cost-of-capital (WACC) for a firm is given by:
WACC = Rc (E/VL) + rD(1-t)(D/VL)
Rc: return on equity
E/VL: proportion of equity in total firm value
rD: debt or bond percentages
t: tax rate (expressed as a decimal; 40% = 0.40)
D/VL: proportion of debt in total firm value
Just to simplify the Hudson-Baldwin example, we?ll ignore taxes here,
so WACC simplifies to:
WACC = Rc (E/VL) + rD (D/VL)
We know that the overall returns are $1 million in net income on $10M
in assets ? but we don?t know what their debt/equity structures are.
But we?ll eliminate debt costs (Rd), since it?s presumably equal for
the two firms.
If Hudson has $10M in assets ? made up of $9M in equity and $1 million
in debt, it?s returning 11.1%.
HUDSON WACC: 10% = 11.1% * (0.9) + Rd (0.1)
Baldwin can obtain higher returns by increasing its debt load:
BALDWIN WACC: 10% = 20% (0.5) + Rd (0.5)
So, by going from a 1/10 debt-to-equity ratio to a 5/10 debt-to-equity
ratio, Baldwin is able to almost double its Rc or return on equity.
Google search strategy:
?stock split? + ?stock price?