Valuing Stocks

Chapter 5

2009 Cengage Learning/South-Western

Debt versus Equity: Debt

Debt securities represent a legally enforceable claim.

Debt securities offer fixed or floating cash flows. Bondholders do not have any control over how the company is run.
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Debt versus Equity: Equity

Common stockholders are residual claimants.
No claim to earnings or assets until all senior claims are paid in full High risk, but historically also high return

Stockholders have voting rights on important company decisions.

Debt and equity have substantially different marginal benefits and marginal costs.
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Preferred Stock
Preferred stock have some features similar to debt and other features similar to equity.
Claim on assets and cash flow is senior to common stock. Dividend payments are not tax deductible.

Preferred stock are held mostly by corporations.

Promises a fixed annual dividend payment, though this is not legally enforceable. Preferred stockholders usually do not have voting rights.

Common Stock
Par value Shares authorized Shares issued Shares outstanding Additional paid-in capital
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Little economic relevance today. The shares of a companys stock that shareholders and the board authorize the firm to sell to the public.

The shares of a companys stock that have been issued or sold to the public.
The shares of a companys stock that are currently held by the public. The amount of money the firm received from selling stock, above and beyond the stocks par value.

Rights of Common Stockholders

Common stockholders voting rights can be exercised in person or by proxy. Most US corporations practice majority voting, with one vote attached to each common share.

Proxy fight: An attempt to gain control of a firm by

soliciting enough votes to unseat existing directors.

Shareholders have no legal rights to receive dividends.

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Primary Markets and Issuing New Securities

primary market market capitalization treasury stock
The market in which firms originally issue new securities. The total number of shares outstanding multiplied by the current price per share.

Common shares that have been issued but are no longer outstanding because the firm repurchased them.

The Investment Bankers Role in Equity Issues

Trading Key investment banking activities
Asset management

Corporate finance
Investment banks assist firms in the process of issuing securities to investors.

initial public offering (IPO)

unseasoned offering

The first public sale of company stock to outside investors. An equity issue by a firm that already has common stock outstanding.

The Investment Bankers Role in Equity Issues

Firms can choose an investment bank through
negotiated offer competitively bid offer

The contract to sell equity can be

Best effort Firm commitment
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The bank promises its best effort to sell the firms securities. If the demand is insufficient, the issue will be withdrawn. The bank underwrites the securities. Underwrite: Purchasing shares from the firm and reselling them to investors.

Key Steps in the Initial Public Offering Process

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Key Steps in the Initial Public Offering Process

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Key Steps in the Initial Public Offering Process

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Secondary Markets for Equity Securities

Broker market
A market in which the buyer and seller are brought together on a securities exchange to trade securities. A market in which the buyer and seller are not brought together directly, but instead have their orders executed by securities dealers that make markets in the given security.

Dealer market

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The Secondary Market

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Stock Valuation: Preferred Stock

Preferred stock is an equity security that is expected to pay a fixed annual dividend indefinitely.
Using the formula for valuing a perpetuity:

PS0 =

Dp rp

PS0 = Preferred stocks market price Dp = next periods dividend 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?

$2.3 = = $20.90 / share PS0 = rp 0.11

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Dp

Stock Valuation: Common Stock

Suppose that an investor buys a stock today for price P0 , receives a dividend equal to D1 at the end of one year, and immediately sells the stock for price P1.
Return on investment
Value of a Share of Common Stock
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D1 P P0 1 r P0

D1 P 1 P0 1 (1 r )

Stock Valuation: 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 will find that todays price equals the PV of the entire dividend stream that the stock will pay in the future:

D2 D1 D3 D4 D5 P0 .... 1 2 3 4 5 (1 r ) (1 r ) (1 r ) (1 r ) (1 r )
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Zero Growth Valuation Model

The zero growth model is the simplest approach to stock valuation that assumes a constant, nongrowing dividend stream.

D1 = D2 = ... = D
With constant value D for each dividend payment, the common stock valuation formula reduces to the simple equation for a perpetuity:

D1 P0 r
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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 years dividend as D1:

D1 P0 rg
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Eq.4.6

Commonly called the Gordon growth model

Example
Dynasty Corp. pays 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 Dynastys dividends to grow at 3% per year?

D1 $3 P0 $42 .86 r g 0.10 0.03

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Variable Growth Valuation Model

The variable growth model assumes that the dividend growth rate will vary during different periods of time.

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Valuing a Stock Using the Variable Growth Model

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Stock Valuation
How to estimate growth
Growth rate g = retention rate x ROE Historical data

What if there are no dividends?

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Valuing the Enterprise: Free Cash Flow Approach

Free cash flow (FCF)
The net amount of cash flow remaining after the firm has met all operating needs and paid for investments, both long-term and short-term. Represents the cash amount that a firm could distribute to investors after meeting all its other obligations. The after-tax, weighted average required return on all types of securities issued by a firm, where the weights equal the percentage of each type of financing in a firms overall capital structure.

Weighted average cost of capital (WACC)

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Valuing the Enterprise: Free Cash Flow Approach

Steps
1. Estimate the free cash flow that the firm will generate over time.
2. Discount the free cash flow at the firms weighted average cost of capital to derive the total value of the firm, VF . 3. Subtract the values of the firms debt, VD , and preferred stock, VP , from VF to obtain the value of the firms shares, VS . 4. Divide VS by the number of shares outstanding to calculate the value per share, P0 .
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An Example: Starbucks Corp

At the end of its 2006 fiscal year, Starbucks had
debt with a market value of about $250 million no preferred stock 765 million shares of common stock outstanding free cash flow of $270 million

Revenues and operating profits grew at 21% between 2004 and 2006.

Assume 20% FCF growth from 2006 to 2010 and 10% annual growth thereafter.
WACC = 12%.
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An Example: Starbucks Corp

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An Example: Starbucks Corp

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Other Approaches to Common Stock Valuation

Book value Liquidation value
Price/Earnings
The value of a firms equity as recorded on the firms balance sheet. The amount of cash that remains if the firms assets are sold and all liabilities paid. The amount investors are willing to pay for each dollar of earnings. P/E ratios differ between and within industries.

multiples
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Valuing Stocks
Preferred stock has both debt and equity-like features. Common stock represents residual claims on the firms cash flows.

Investment bankers play an important role in helping firms issue new securities.
The same principles apply to the valuation of both preferred and common stock.

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