Stock Valuation

Professor Trainor

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 Preferred Stock
Preferred stock is a hybrid having some features
similar to debt and other features similar to equity.
 Claim on assets and cash flow senior to common stock
 As equity security, dividend payments are not tax deductible
for the corporation.
 For tax reasons, straight preferred stock held mostly by
corporations.

Promises a fixed annual dividend payment, but not

legally enforceable. Firms cannot pay common stock
dividends if preferred stock is in arrears.

Preferred stockholders usually do not have voting

rights.
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Rights of Common Stockholders
Common stockholders’ voting rights can be
exercised in person or by proxy.

Most US corporations have majority voting, with

one vote attached to each common share.

Cumulative voting gives minority shareholders

greater chance of electing one or more directors.

Shareholders have no legal rights to receive

dividends.
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 Common Stock

Market Market price per share x number of

capitalization shares outstanding

Treasury Stock repurchased by corporation;

stock Usually purchased for stock options

Two-for-one split issues one new share

Stock split for each already held; reduces per share
price.

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 Investment Banks’ Role in Equity
Offerings
Firms can choose an investment bank through

Direct negotiated offer Competitive bidding

Public security issues can be

Best • The bank promises its best efforts to sell

the firm’s securities. No guarantees
efforts though about the success of the offering.

• Underwritten offerings, bank

Firm guarantees certain proceeds.
commitment • Vast majority of US security offerings
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are underwritten.
Investment Bank Services and Costs

Services provided by investment banks prior to

security offering

– Primary pre-issue role: provide advice and help plan offer

– Firm seeking capital selects lead underwriter(s).
– Top firm is the lead manager, others are co-managers.
– Offering syndicate organized early in process
Prior to offering, lead investment bank negotiates
underwriting agreement

– Sets offer price and spread; details lock-up agreement

– Bulge bracket underwriter’s spread usually 7.0% for IPOs
– Initial offer price set as range; final price set day before
offer 9-6
Show Netscape Video and
Smart Finance: Womack

Smart Finance

9-7
 Valuation Fundamentals:
Preferred Stock
Preferred stock is an equity security that is expected
to pay a fixed annual dividend indefinitely.

• PS0 = Preferred stock’s market

Dp price
PS 0 = • Dp = next period’s dividend
rp payment
• rp = discount rate

An example: Investors require an 11% return on a preferred

stock that pays a $2.30 annual dividend. What is the price?
Dp $2.3
PS 0 = = = $20.90 / share
rp 0.11 9-8
 Valuation Fundamentals:
Common Stock
Value
of a D1  P1
Share P0 
of
Common Stock (1  r )1

• P0 = Present value of the expected stock price at the end of

period #1
• D1 = Dividends received
• r = discount rate

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 Valuation Fundamentals:
Common Stock
 How is P1 determined?
 PV of expected stock price P2, plus dividends
 P2 is the PV of P3 plus dividends, etc...
 Repeating this logic over and over, you find that
today’s price equals PV of the entire dividend
stream the stock will pay in the future:

D1 D2 D3 D4 D5
P0       ....
(1  r ) (1  r ) (1  r ) (1  r ) (1  r )
1 2 3 4 5

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 Constant Growth Valuation Model
 Assumes dividends will grow at a constant rate
(g) that is less than the required return (r)
 If dividends grow at a constant rate forever, you
can value stock as a growing perpetuity, denoting
next year’s dividend as D1:

D1
P0  Eq.4.6
rg
Commonly called the Gordon growth model
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 Example
Dynasty Corp. will pay a $3 dividend in one year. If investors
expect that dividend to remain constant forever, and they require a
10% return on Dynasty stock, what is the stock worth?

D1 $3
P0    $30
r 0.1
What is the stock worth if investors expect Dynasty’s dividends
to grow at 3% per year?

D1 $3
P0    $42.86
r  g 0.10  0.03 9-12
Video: French

Smart Finance

9-13
Free Cash Flow to Equity
A much better model is to apply discount
models to FCFE which may more
accurately reflect a firms value.
FCFE = Net Income + depreciation –
Cap. Expend. – change in working
capital – principal debt repayments +
new debt issues.
Apply model as per usual.
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Free Cash Flow to Firm
 FCFF = EBIT(1-tax rate) + Dep. – Cap.
Expenditures – Change in WC – Change in
other assets.
 Again, proceed as normal(replace dividends
with FCFF) but discount at firms cost of
capital.
 You find value of firm. To find value of
equity, simply subtract off debt.

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Firm multiples method
 Analysts often use the following multiples
to value stocks.
 P/E
 P / CF
 P / Sales
 EXAMPLE: Based on comparable firms,
estimate the appropriate P/E. Multiply this
by expected earnings to back out an
estimate of the stock price.
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 Weaknesses of Using P/E Ratios

 Determining the appropriate P/E ratio.

 Possible Solution: use the industry average P/E ratio
 Determining the appropriate definition of earnings.
 Possible Solution: adjust EPS for extraordinary
items
 Determining estimated future earnings
 forecasting future earnings is extremely difficult

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Video: Shiller

Smart Finance

9-18