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
© 2012 Pearson Prentice Hall. All rights reserved. 7-3
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.
© 2012 Pearson Prentice Hall. All rights reserved. 7-4
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.
© 2012 Pearson Prentice Hall. All rights reserved. 7-5
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 .
© 2012 Pearson Prentice Hall. All rights reserved. 7-6
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.
© 2012 Pearson Prentice Hall. All rights reserved. 7-7
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.
© 2012 Pearson Prentice Hall. All rights reserved. 7-8
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.
© 2012 Pearson Prentice Hall. All rights reserved. 7-9
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.
© 2012 Pearson Prentice Hall. All rights reserved. 7-10
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.
© 2012 Pearson Prentice Hall. All rights reserved. 7-11
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.
© 2012 Pearson Prentice Hall. All rights reserved. 7-12
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.
© 2012 Pearson Prentice Hall. All rights reserved. 7-13
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.
© 2012 Pearson Prentice Hall. All rights reserved. 7-14
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.
© 2012 Pearson Prentice Hall. All rights reserved. 7-15
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.
© 2012 Pearson Prentice Hall. All rights reserved. 7-16
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.
© 2012 Pearson Prentice Hall. All rights reserved. 7-17
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
© 2012 Pearson Prentice Hall. All rights reserved. 7-18
http://www.youtube.com/watch?feature=player_detailpage&
v=GnJCOof2HJk
© 2012 Pearson Prentice Hall. All rights reserved. 7-19
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).
© 2012 Pearson Prentice Hall. All rights reserved. 7-20
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.
© 2012 Pearson Prentice Hall. All rights reserved. 7-21
Common Stock Valuation:
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.
© 2012 Pearson Prentice Hall. All rights reserved. 7-22
Common Stock Valuation:
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
© 2012 Pearson Prentice Hall. All rights reserved. 7-23
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.
© 2012 Pearson Prentice Hall. All rights reserved. 7-24
Common Stock Valuation:
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.
© 2012 Pearson Prentice Hall. All rights reserved. 7-25
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?
© 2012 Pearson Prentice Hall. All rights reserved. 7-26
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
© 2012 Pearson Prentice Hall. All rights reserved. 7-27
Common Stock Valuation:
Constant-Growth Model (cont.)
Lamar Company, a small cosmetics company, paid the
following per share dividends:
Stock Valuation
© 2012 Pearson Prentice Hall. All rights reserved. 7-28
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%.
© 2012 Pearson Prentice Hall. All rights reserved. 7-29
Lamar Company stock valuation
Would you buy Lamar stock?
– Why or why not?
© 2012 Pearson Prentice Hall. All rights reserved. 7-30
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
© 2012 Pearson Prentice Hall. All rights reserved. 7-31
Common Stock Valuation:
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.
© 2012 Pearson Prentice Hall. All rights reserved. 7-32
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
© 2012 Pearson Prentice Hall. All rights reserved. 7-34
Common Stock Valuation:
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
--
© 2012 Pearson Prentice Hall. All rights reserved. 7-35
Common Stock Valuation:
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
© 2012 Pearson Prentice Hall. All rights reserved. 7-36
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.)
© 2012 Pearson Prentice Hall. All rights reserved. 7-38
Common Stock Valuation:
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
shares goutstandin of #
Stock Preferred-sLiabilitie Total - AssetsTotalBPS
© 2012 Pearson Prentice Hall. All rights reserved. 7-39
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?
shares goutstandin of #
Stock Preferred ValueMkt-sLiabilitie Total ValueMkt - AssetsTotal ValueMktLPS
© 2012 Pearson Prentice Hall. All rights reserved. 7-40
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
© 2012 Pearson Prentice Hall. All rights reserved. 7-41
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?
© 2012 Pearson Prentice Hall. All rights reserved. 7-42
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
© 2012 Pearson Prentice Hall. All rights reserved. 7-43