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Copyright © 2012 Pearson Prentice Hall.

All rights reserved.

Chapter 7

Stock Valuation

© 2012 Pearson Prentice Hall. All rights reserved. 7-2

Table 7.1 Key Differences between

Debt and Equity Capital


Matter of Fact

How Are Assets Divided in Bankruptcy?

– According to the U.S. Securities and Exchange Commission,

in bankruptcy assets are divided up as follows:

1. Secured Creditors – secured bank loans or secured bonds, are paid first.

2. Unsecured Creditors – unsecured bank loans or unsecured bonds,

suppliers, or customers, have the next claim.

3. Equityholders – equityholders or the owners of the company have the

last claim on assets, and they may not receive anything if the Secured

and Unsecured Creditors’ claims are not fully repaid.


Common and Preferred Stock:

Common Stock

• Common stockholders, who are sometimes referred to as residual

owners or residual claimants, are the true owners of the firm.

• As residual owners, common stockholders receive what is left—the

residual—after all other claims on the firms income and assets have

been satisfied.

• They are assured of only one thing: that they cannot lose any more

than they have invested in the firm.

• Because of this uncertain position, common stockholders expect to

be compensated with adequate dividends and ultimately, capital

gains.


Common Stock: Ownership

• The common stock of a firm can be privately owned by an private

investors, closely owned by an individual investor or a small group

of investors, or publicly owned by a broad group of investors.

• The shares of privately owned firms, which are typically small

corporations, are generally not traded; if the shares are traded, the

transactions are among private investors and often require the firm’s

consent.

• Large corporations are publicly owned, and their shares are

generally actively traded in the broker or dealer markets .


Common Stock: Par Value

• The par value of common stock is an arbitrary value established

for legal purposes in the firm’s corporate charter, and can be used to

find the total number of shares outstanding by dividing it into the

book value of common stock.

• When a firm sells news shares of common stock, the par value of

the shares sold is recorded in the capital section of the balance sheet

as part of common stock.

• At any time the total number of shares of common stock

outstanding can be found by dividing the book value of common

stock by the par value.


Outstanding shares

currently owned by an investor

Treasury Stock

repurchased by the corporation

Issued shares

Owned by an investor

Unissued Shares

never owned by anyone

Authorized Shares

total of number permitted to be issued per corporate charter

• Authorized shares are the number of shares of common stock that a

firm’s corporate charter allows.

– Unissued shares still in the corporations control

– Issued shares are the number of shares that have been put into

circulation and includes both outstanding shares and treasury stock.

• Outstanding shares are the number of shares of common stock held by the

public. (the only shares that vote or receive dividends)

• Treasury stock is the number of outstanding shares that have been purchased

by the firm.


Common Stock: Preemptive

Rights

• A preemptive right allows common stockholders to maintain their

proportionate ownership in the corporation when new shares are

issued, thus protecting them from dilution of their ownership.

• Dilution of ownership is a reduction in each previous shareholder’s

fractional ownership resulting from the issuance of additional

shares of common stock.

• Dilution of earnings is a reduction in each previous shareholder’s

fractional claim on the firm’s earnings resulting from the issuance

of additional shares of common stock.

• Rights are financial instruments that allow stockholders to purchase

additional shares at a price below the market price, in direct

proportion to their number of owned shares.


Common Stock: Voting Rights

• Generally, each share of common stock entitles its holder to one

vote in the election of directors and on special issues.

• Votes are generally assignable and may be cast at the annual

stockholders’ meeting.

• A proxy statement is a statement transferring the votes of a stockholder to

another party.


Common Stock: Dividends

• The payment of dividends to the firm’s shareholders is at the

discretion of the company’s board of directors.

• Dividends may be paid in cash, stock, or merchandise.

• Common stockholders are not promised a dividend, but they come

to expect certain payments on the basis of the historical dividend

pattern of the firm.

• Before dividends are paid to common stockholders any past due

dividends owed to preferred stockholders must be paid.


Common Stock: International

Stock Issues

Foreign Stocks in U.S. Markets

– American depositary receipts (ADRs) are dollar-denominated receipts for the stocks of foreign companies that are held by a U.S. financial institution overseas.

– American depositary shares (ADSs) are securities, backed by American depositary receipts (ADRs), that permit U.S. investors to hold shares of non-U.S. companies and trade them in U.S. markets.

– ADSs are issued in dollars to U.S. investors and are subject to U.S. securities laws.

– ADSs give investors the opportunity to diversify their portfolios internationally.


Preferred Stock

• Preferred stock gives its holders certain privileges that make them senior to common stockholders.

• Preferred stockholders are promised a fixed periodic dividend, which is stated either as a percentage or as a dollar amount.

• Par-value preferred stock is preferred stock with a stated face value that is used with the specified dividend percentage to determine the annual dollar dividend.

• No-par preferred stock is preferred stock with no stated face value but with a stated annual dollar dividend.


Preferred Stock:

Features of Preferred Stock

• Restrictive covenants including provisions about passing dividends, the sale of senior securities, mergers, sales of assets, minimum liquidity requirements, and repurchases of common stock.

• Cumulative preferred stock is preferred stock for which all passed (unpaid) dividends in arrears, along with the current dividend, must be paid before dividends can be paid to common stockholders.

• Noncumulative preferred stock is preferred stock for which passed (unpaid) dividends do not accumulate.


Issuing Common Stock

• Initial financing for most firms typically comes from a firm’s original founders in the form of a common stock investment.

• Early stage debt or equity investors are unlikely to make an investment in a firm unless the founders also have a personal stake in the business.

• Initial non-founder financing usually comes first from private equity investors.

• After establishing itself, a firm will often “go public” by issuing shares of stock to a much broader group.


Going Public

When a firm wishes to sell its stock in the primary market, it has three alternatives.

1. A public offering, in which it offers its shares for sale to the general public.

2. A rights offering, in which new shares are sold to existing shareholders.

3. A private placement, in which the firm sells new securities directly to an investor or a group of investors.

Here we focus on the initial public offering (IPO), which is the first public sale of a firm’s stock.


Going Public (cont.)

• The investment banker is responsible for promoting the stock and facilitating the sale of the company’s IPO shares.

• The company must file a registration statement with the

SEC.

• The prospectus is a portion of a security registration

statement that describes the key aspects of the issue, the

issuer, and its management and financial position.


Going Public:

The Investment Banker’s Role

• An investment banker is a financial intermediary that specializes

in selling new security issues and advising firms with regard to

major financial transactions.

• Underwriting is the role of the investment banker in bearing the

risk of reselling, at a profit, the securities purchased from an issuing

corporation at an agreed-on price.

• This process involves purchasing the security issue from the issuing

corporation at an agreed-on price and bearing the risk of reselling it

to the public at a profit.

• The investment banker also provides the issuer with advice about

pricing and other important aspects of the issue.

How the Stock Market works


http://www.youtube.com/watch?feature=player_detailpage&

v=GnJCOof2HJk

http://www.youtube.com/watch?feature=player_detailpage&v=GnJCOof2HJk

http://www.youtube.com/watch?feature=player_detailpage&v=GnJCOof2HJk


Common Stock Valuation

• Common stockholders expect to be rewarded through periodic cash

dividends and an increasing share value.

• Some of these investors decide which stocks to buy and sell based

on a plan to maintain a broadly diversified portfolio.

• Other investors have a more speculative motive for trading.

– They try to spot companies whose shares are undervalued—meaning that the

true value of the shares is greater than the current market price.

– These investors buy shares that they believe to be undervalued and sell shares

that they think are overvalued (i.e., the market price is greater than the true

value).


Common Stock Valuation:

Market Efficiency

• Economically rational buyers and sellers use their assessment of an asset’s risk and return to determine its value.

• In competitive markets with many active participants, the interactions of many buyers and sellers result in an equilibrium price—the market value—for each security.

• Because the flow of new information is almost constant, stock prices fluctuate, continuously moving toward a new equilibrium that reflects the most recent information available. This general concept is known as market efficiency.



Market Efficiency

• The efficient-market hypothesis (EMH) is a

theory describing the behavior of an assumed

“perfect” market in which:

– securities are in equilibrium,

– security prices fully reflect all available information

and react swiftly to new information, and

– because stocks are fully and fairly priced, investors

need not waste time looking for mispriced securities.



Market Efficiency

• Although considerable evidence supports the concept of

market efficiency, a growing body of academic evidence

has begun to cast doubt on the validity of this notion.

• Behavioral finance is a growing body of research that

focuses on investor behavior and its impact on investment

decisions and stock prices. Advocates are commonly

referred to as “behaviorists.”

http://www.youtube.com/watch?feature=player_detailpag

e&v=h5JDftgykcg

http://www.youtube.com/watch?feature=player_detailpage&v=h5JDftgykcg

http://www.youtube.com/watch?feature=player_detailpage&v=h5JDftgykcg


Focus on Practice

Understanding Human Behavior Helps Us Understand Investor Behavior

– Regret theory deals with the emotional reaction people experience after realizing they have made an error in judgment.

– Some investors rationalize their decision to buy certain stocks with “everyone else is doing it.” (Herding)

– People have a tendency to place particular events into mental compartments, and the difference between these compartments sometimes impacts behavior more than the events themselves.

– Prospect theory suggests that people express a different degree of emotion toward gains than losses.

– Anchoring is the tendency of investors to place more value on recent information.



Constant-Growth Model

The constant-growth model is a widely cited dividend valuation

approach that assumes that dividends will grow at a constant rate, but

a rate that is less than the required return.

The Gordon model is a common name for the constant-growth model

that is widely cited in dividend valuation.


Stock Valuation

A preferred stock pays a dividend of $6. The

required return of the stock is 12%

– What is the growth rate?

– What is the stock’s value? 50$

12.

6

P0

==

Stock Valuation

KS 12.00% Stock Price $59.00

g 0.00% Expected return 10.169%

D1 $6.00

Stock Value $50.00

Dividends (TV)

To Find Ks First

RF Last (D0) $6.00

Km N

Beta g (if not given) #DIV/0!

Ks 0.00%

Would you buy?


Common stock

The most recent dividend was $2.65. Dividends

have historically grown at 5%. The required

return on the stock is 20%.

55.1815.

7825.2

05.20.

)05.1(*65.2P0

Would you buy?

KS 20.00% Stock Price $15.00

g 5.00% Expected return 23.550%

D1 $2.78

Stock Value $18.55

Dividends (TV)

To Find Ks First

RF Last (D0) $2.65



Constant-Growth Model (cont.)

Lamar Company, a small cosmetics company, paid the

following per share dividends:

Stock Valuation


Stock Valuation Models:

Determine the Required Return on Stocks

Utilize the Security Market Line formula

derived from the CAPM. (Chapter 5)

Assume the current YTM of a 30 year

Treasury Bond is 4.75%. Also assume that

Lamar Company has a beta of 1.45. The

stock market average has been 12%.


Lamar Company stock valuation

Would you buy Lamar stock?

– Why or why not?


Common Stock (homework variation)

A common stock will pay a $3.50 dividend next year. Historically it has grown at a 9% growth rate. The required return for the stock is 17%.

Stock Valuation

Would you buy?

75.4309.17.

50.3P0



Variable-Growth Model

• The zero- and constant-growth common stock models do not allow

for any shift in expected growth rates.

• The variable-growth model is a dividend valuation approach that

allows for a change in the dividend growth rate.

• The reason for the change could be new products, new production

operations, or increases in efficiency with decreases in costs.

• Sometimes referred to as a super-normal growth stock

• All of these could result in a short-term growth spurt in

earnings and dividends.


Variable Growth Example

DPS 15% for 3 years, then 8%. This years dividend was 2.00. The required return for the firm is 12%.

What is the value of this firm's stock? 1)D0 = 2.00 PVIF PV of div D1 = 2.00 * (1.15) = 2.30 .8929 2.054 D2 = 2.30 * (1.15) = 2.645 .7972 2.109 D3 = 2.645 * (1.15) = 3.042 .7118 2.165 6.328 2) D4 = 3.042 (1.08) = 3.285

P3 = (3.285) / (.12 - .08) = 82.13 PV of P3 = 82.13 (.7118) = 58.40 4) P = 6.328 + 58.46 = 64.78

© 2012 Pearson Prentice Hall. All rights reserved. 7-33 Supernormal Stock Valuation

Would you buy?

Current Dividend $2.00 Future Dividend PV of Dividend

Normal Growth Rate 8.00% 1 $2.054

Supernormal Growth Rate 15.00% 2 $2.109

Supernormal Growth Period 3.0 3 $2.165

Required Return 12.00% 4

Current Stock Price 61.75% 5

6

7

8

9

10

11

12

13

14

15

$6.327

$58.457

Value of the Stock $64.784



Free Cash Flow Valuation Model

A free cash flow valuation model determines the value of an entire

company as the present value of its expected free cash flows

discounted at the firm’s weighted average cost of capital, which is its

expected average future cost of funds over the long run.

where

VC = value of the entire company

FCFt = free cash flow year t

ra = the firm’s weighted average cost of capital

gr

g1*FCF

gr

FCFV

a

0

a

1C

--



Free Cash Flow Valuation Model (cont.)

Because the value of the entire company, VC, is the market

value of the entire enterprise (that is, of all assets), to find

common stock value, VS, we must subtract the market value

of all of the firm’s debt, VD, and the market value of

preferred stock, VP, from VC.

PDCs VVVV


Free Cash Flow Model

The firm has estimated the growth of FCF to be 7% over the foreseeable future. The most recent FCF was $700,000. The firms WACC = 13%.

– What is the firms value?

The firm has no preferred stock but the market value of debt is 7,500,000. The firm has 100,000 shares.

– What is the value of equity? Per share?

333,483,12

06.

000,749

07.13.

07.1*000,700VC

333,983,4000,500,7333,483,12VS

© 2012 Pearson Prentice Hall. All rights reserved. 7-37 Free Cash Flow Model

WACC 13.00% Market Value of Debt 7500000

g 7.00% Market Value of Preferred

FCF1 $749,000 Market Value of Common $4,983,333

Value of Corp $12,483,333

Free CF

First

Last (FCF0) $700,000

N

g (if not given) #DIV/0!

If FCF1 given enter here

What types of business organizations could use this?

(hint: They do not have common stock that trade.)



Other Approaches to Stock Valuation

• Book value per share is the amount per share of common stock

that would be received if all of the firm’s assets were sold for their

exact book (accounting) value

• This method lacks sophistication and can be criticized on the basis

of its reliance on historical balance sheet data.

• It ignores the firm’s expected earnings potential and generally lacks

any true relationship to the firm’s value in the marketplace.

shares goutstandin of #

Equity Common


Stock Preferred-sLiabilitie Total - AssetsTotalBPS


Common Stock Valuation: Other

Approaches to Stock Valuation (cont.)

• Liquidation value per share is the actual amount per share of

common stock that would be received if all of the firm’s assets were

sold for their market value, liabilities (including preferred stock)

were paid

• This measure is more realistic than book value because it is based

on current market values of the firm’s assets.

• However, it still fails to consider the earning power of those assets.

• Do all assets have prices?


Stock Preferred ValueMkt-sLiabilitie Total ValueMkt - AssetsTotal ValueMktLPS


Common Stock Valuation: Other

Approaches to Stock Valuation (cont.)

• The price/earnings (P/E) ratio reflects the amount

investors are willing to pay for each dollar of earnings.

• The price/earnings multiple approach is a popular

technique used to estimate the firm’s share value;

For example, Lamar’s expected EPS is 2.60/share

and the industry average P/E multiple is 7,

then P0 = $2.60 X 7 = $18.20/share.

P0 = (EPSt+1) X (Industry Average P/E) tEPS

Price MktPE


Focus on Ethics

Psst—Have You Heard Any Good Quarterly Earnings Forecasts Lately?

– Companies used earnings guidance to lower analysts’ estimates; when the actual numbers came in higher, their stock prices jumped.

– The practice reached a fever pitch during the late 1990s when companies that missed the consensus earnings estimate, even by just a penny, saw their stock prices tumble.

– In March 2007 the CFA Centre for Financial Market Integrity and the Business Roundtable Institute for Corporate Ethics proposed a template for quarterly earnings reports that would, in their view, obviate the need for earnings guidance.

– What are some of the real costs a company must face in preparing quarterly earnings guidance?


Matter of Fact

Theory for P/E Valuation

– The price/earnings multiple approach to valuation does have a theoretical

explanation.

– If we view 1 divided by the price/earnings ratio, or the earnings/price ratio, as

the rate at which investors discount the firm’s earnings, and if we assume that

the projected earnings per share will be earned indefinitely (i.e., no growth in

earnings per share), the price/earnings multiple approach can be looked on as

a method of finding the present value of a perpetuity of projected earnings

per share at a rate equal to the earnings/price ratio.

– This method is, in effect, a form of the zero-growth model.

Buffet on Stocks

Value investing

http://www.youtube.com/watch?v=dX2L7JhpXl8&feature=player_detailpage

How to read stocks

http://www.youtube.com/watch?feature=player_detailpage&v=Lc791is6X0o

A formula (not tested in the market but

interesting information) http://www.youtube.com/watch?v=UOWrhGmCsIA&feature=player_detailpage


http://www.youtube.com/watch?v=dX2L7JhpXl8&feature=player_detailpage

http://www.youtube.com/watch?feature=player_detailpage&v=Lc791is6X0o

http://www.youtube.com/watch?v=UOWrhGmCsIA&feature=player_detailpage

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