Chapter 7

Stock Valuation

Copyright 2012 Pearson Education

The Nature of Equity Capital:

Voice in Management
Unlike bondholders and other credit holders,
holders of equity capital are owners of the
firm.
Common equity holders have voting rights
that permit them to elect the firms board of
directors and to vote on special issues.
Bondholders and preferred stockholders
receive no such privileges.

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The Nature of Equity Capital:

Claims on Income & Assets
Equity holders are have a residual claim on the firms
income and assets.
Their claims can not be paid until the claims of all
creditors, including both interest and principle
payments on debt have been satisfied.
Because equity holders are the last to receive
distributions, they expect greater returns to
compensate them for the additional risk
they bear.
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The Nature of Equity Capital:

Maturity
Unlike debt, equity capital is a permanent form
of financing.
Equity has no maturity date and never has to be
repaid by the firm.

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The Nature of Equity Capital:

Tax Treatment
While interest paid to bondholders is taxdeductible to the issuing firm, dividends paid
to preferred and common stockholders of the
corporation is not.
In effect, this further lowers the cost of debt
relative to the cost of equity as a source of
financing to the firm.

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Differences Between Debt &

Equity

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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 leftthe residualafter all other claims on
the firms income and assets have been satisfied.
Because of this uncertain position, common
stockholders expect to be compensated with
adequate dividends and ultimately,
capital gains.
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Common Stock: Ownership

The common stock of a firm can be privately owned
by an individual, closely owned by a small group of
investors, or publicly owned by a broad group of
investors.
Typically, small corporations are privately or closely
owned and if their shares are traded, this occurs
infrequently and in small amounts.
Large corporations are typically publicly owned and
have shares that are actively traded on major
securities exchanges.
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Common Stock: Preemptive

Rights
A preemptive right allows common stockholders to
maintain their proportionate ownership in a
corporation when new shares are issued.
This allows existing shareholders to maintain voting
control and protect against the dilution of their
ownership.
In a rights offering, the firm grants rights to its
existing shareholders, which permits them to
purchase additional shares at a price below the
current price.
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Common Stock: Authorized,

Outstanding, and Issued
Shares
Authorized shares are the number of shares of
common stock that a firms corporate charter allows.
Outstanding shares are the number of shares of
common stock held by the public.
Treasury stock is the number of outstanding shares
that have been purchased by the firm.
Issued shares are the number of shares that have
been put into circulation and includes both
outstanding shares and treasury stock.

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Common Stock: Authorized,

Outstanding, and Issued
Shares (cont.)
Golden Enterprises, a producer of medical pumps, has the
following stockholders equity account on December 31st.

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Common Stock: Voting Rights

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.
Many firms have issued two or more classes of stock differing
mainly in having unequal voting rights.

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Common Stock: Voting Rights

(cont.)
Because most shareholders do not attend the
annual meeting to vote, they may sign a
proxy statement giving their votes to another
party.

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Common Stock: Dividends

Payment of dividends is at the discretion of the board
of directors.
Dividends may be made in cash, additional shares of
stock, and even merchandise.
Because stockholders are residual claimantsthey
receive dividend payments only after all claims have
been settled with the government, creditors, and
preferred stockholders.

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Common Stock:
International Stock Issues
The international market for common stock is
not as large as that for international debt.
However, cross-border trading and issuance of
stock has increased dramatically during the
past 20 years.
Much of this increase has been driven by the
desire of investors to diversify their portfolios
internationally.

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Common Stock:
International Stock Issues
(cont.)
Stock Issued in Foreign Markets
A growing number of firms are beginning to list
their stocks on foreign markets.
Issuing stock internationally both broadens the
companys ownership base and helps it to
integrate itself in the local business scene.

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Preferred Stock
Preferred stock is an equity instrument that usually
pays a fixed dividend and has a prior claim on the
firms earnings and assets in case of liquidation.
The dividend is expressed as either a dollar amount or
as a percentage of its par value.
Therefore, unlike common stock a preferred stocks
par value may have real significance.
If a firm fails to pay a prefered stock dividend, the
dividend is said to be in arrears.
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Preferred Stock (cont.)

In general, and arrearage must be paid before common
stockholders receive a dividend.
Preferred stocks which possess this characteristic are called
cumulative preferred stocks.
Preferred stocks are also often referred to as hybrid securities
because they possess the characteristics of both common
stocks and bonds.
Preferred stocks are like common stock because they are
perpetual securities with no maturity date.

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Going Public
When a firm wishes to sell its stock in the primary
market, it has three alternatives.
A public offering or IPO, in which it offers its shares
for sale to the general public (our focus).
A rights offering, in which new shares are sold to
existing shareholders.
A private placement, in which the firm sells new
securities directly to an investor or a group of
investors.
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Going Public (cont.)

IPOs are typically made by small, fast-growing
companies that either:
require additional capital to continue expanding, or
have met a milestone for going public that was established
in a contract to obtain VC funding.

The firm must obtain approval of current shareholders,

and hire an investment bank to underwrite the
offering.
The investment banker is responsible for promoting
the stock and selling its shares.
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The Investment Bankers Role

Most public offerings are made with the assistance of
investment bankers which are financial
intermediaries that specialize in selling new
securities and advising firms with regard to major
financial transactions.
The main activity of the investment banker is
underwriting, which involves the purchase of the
security issue from the issuing company at an
agreed-on price and bearing the risk of selling it to
the public at a profit.
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The Investment Bankers Role

(cont.)
Underwriting syndicates are typically formed when
companies bring large issues to the market.
Each investment banker in the syndicate normally
underwrites a portion of the issue in order to reduce
the risk of loss for any single firm and insure wider
distribution of shares.
The syndicate does so by creating a selling group
which distributes the shares to the investing public.

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The Investment Bankers Role

(cont.)

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Common Stock Valuation

Stockholders expect to be compensated for their
investment in a firms shares through periodic
dividends and capital gains.
Investors purchase shares when they feel they are
undervalued and sell them when they believe they
are overvalued.
This section describes specific stock valuation
techniques after first discussing the concept of
market efficiency.
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Common Stock Valuation:

Basic Common Stock Valuation Equation
The value of a share of common stock is equal to the present
value of all future cash flows (dividends) that it is expected
to provide.

where

P0 = value of common stock

Dt = per-share dividend expected at the end of year
t
Rs = required return on common stock
P0 = value of common stock

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Common Stock Valuation:

The Zero Growth Model
The zero dividend growth model assumes that the stock will
pay the same dividend each year, year after year.

The equation shows that with zero growth, the value of a

share of stock would equal the present value of a perpetuity
of D1 dollars discounted at a rate rs.
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Stock Valuation Models:

The Zero Growth Model (cont.)
The dividend of Denham Company, an established textile
manufacturer, is expected to remain constant at $3 per
share indefinitely. What is the value of Denhams stock if the
required return demanded by investors is 15%?
P0 = $3/0.15 = $20

Note that the zero growth model is also the appropriate

valuation technique for valuing preferred stock.
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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.

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Common Stock Valuation:

Constant-Growth Model (cont.)
Lamar Company, a small cosmetics company, paid the
following per share dividends:

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Common Stock Valuation:

Constant-Growth Model (cont.)
Using a financial calculator or a spreadsheet, we find that
the historical annual growth rate of Lamar Company
dividends equals 7%.

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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.
To determine the value of a share of stock in the case of
variable growth, we use a four-step procedure.

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Common Stock Valuation:

Variable-Growth Model (cont.)
Step 1. Find the value of the cash dividends at the end of
each year, Dt, during the initial growth period, years 1
though N.
Dt=D0(1+g1)t

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Common Stock Valuation:

Variable-Growth Model (cont.)
Step 2. Find the present value of the dividends expected
during the initial growth period.

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Common Stock Valuation:

Variable-Growth Model (cont.)
Step 3. Find the value of the stock at the end of the initial
growth period, PN = (DN+1)/(rs g2), which is the present
value of all dividends expected from year N + 1 to infinity,
assuming a constant dividend growth rate, g2.

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Common Stock Valuation:

Variable-Growth Model (cont.)
Step 4. Add the present value components found in Steps 2
and 3 to find the value of the stock, P0.

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Common Stock Valuation:

Variable-Growth Model (cont.)
The most recent annual (2012) dividend payment of Warren
Industries, a rapidly growing boat manufacturer, was $1.50 per share.
The firms financial manager expects that these dividends will increase
at a 10% annual rate, g1, over the next three years. At the end of three
years (the end of 2015), the firms mature product line is expected to
result in a slowing of the dividend growth rate to 5% per year, g2, for
the foreseeable future. The firms required return, rs, is 15%.
Steps 1 and 2 are detailed in Table 7.3 on the following slide.

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Table 7.3 Calculation of Present Value of

Warren Industries Dividends (20132015)

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Common Stock Valuation:

Variable-Growth Model (cont.)
Step 3. The value of the stock at the end of the initial growth period
(N = 2015) can be found by first calculating DN+1 = D2016.
D2016 = D2015 (1 + 0.05) = $2.00 (1.05) = $2.10
By using D2016 = $2.10, a 15% required return, and a 5% dividend
growth rate, we can calculate the value of the stock at the end of 2015
as follows:
P2015 = D2016 / (rs g2) = $2.10 / (.15 .05) = $21.00

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Common Stock Valuation:

Variable-Growth Model (cont.)
Step 3 (cont.) Finally, the share value of $21 at the end of 2015 must
be converted into a present (end of 2012) value.
P2015 / (1 + rs)3 = $21 / (1 + 0.15)3 = $13.81
Step 4. Adding the PV of the initial dividend stream (found in Step 2)
to the PV of the stock at the end of the initial growth period (found in
Step 3), we get:
P2012 = $4.14 + $13.82 = $17.93 per share

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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 firms 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 expected at the end of year t end of year t
ra = the firms weighted average cost of capital
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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 firms debt, VD, and the market value of
preferred stock, VP, from VC.
VS = VC VD VP

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Table 7.4 Dewhurst, Inc.s Data for

the Free Cash Flow Valuation Model

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Common Stock Valuation:

Free Cash Flow Valuation Model (cont.)
Step 1. Calculate the present value of the free cash flow
occurring from the end of 2018 to infinity, measured at the
beginning of 2018.

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Common Stock Valuation:

Free Cash Flow Valuation Model (cont.)
Step 2. Add the present value of the FCF from 2018 to infinity, which
is measured at the end of 2017, to the 2017 FCF value to get the total
FCF in 2017.
Total FCF2017 = $600,000 + $10,300,000 = $10,900,000
Step 3. Find the sum of the present values of the FCFs for 2013
through 2017 to determine the value of the entire company, VC. This
step is detailed in Table 7.5 on the following slide.

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Table 7.5 Calculation of the Value of the

Entire Company for Dewhurst, Inc.

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Common Stock Valuation:

Free Cash Flow Valuation Model (cont.)
Step 4. Calculate the value of the common stock.
VS = $8,626,426 $3,100,000 $800,000 = $4,726,426
The value of Dewhursts common stock is therefore
estimated to be $4,726,426. By dividing this total by the
300,000 shares of common stock that the firm has
outstanding, we get a common stock value of $15.76 per
share ($4,726,426 300,000).

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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 firms assets were sold for their
exact book (accounting) value and the proceeds remaining after
paying all liabilities (including preferred stock) were divided
among the common stockholders.
This method lacks sophistication and can be criticized on the basis
of its reliance on historical balance sheet data.
It ignores the firms expected earnings potential and generally lacks
any true relationship to the firms value in the marketplace.

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Common Stock Valuation: Other

Approaches to Stock Valuation (cont.)
At year-end 2012, Lamar Companys balance sheet shows
total assets of $6 million, total liabilities (including
preferred stock) of $4.5 million, and 100,000 shares of
common stock outstanding. Its book value per share
therefore would be

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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
firms assets were sold for their market value, liabilities
(including preferred stock) were paid, and any remaining
money were divided among the common stockholders.
This measure is more realistic than book value because it
is based on current market values of the firms assets.
However, it still fails to consider the earning power of
those assets.
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Common Stock Valuation: Other

Approaches to Stock Valuation (cont.)
Lamar Company found upon investigation that it could
obtain only $5.25 million if it sold its assets today. The
firms liquidation value per share therefore would be

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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 firms share value;
calculated by multiplying the firms expected earnings per
share (EPS) by the average price/earnings (P/E) ratio for
the industry.

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Common Stock Valuation: Other

Approaches to Stock Valuation (cont.)
Lamar Company is expected to earn $2.60 per share next
year (2013). Assuming a industry average P/E ratio of 7, the
firms per share value would be
$2.60 7 = $18.20 per share

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Figure 7.3 Decision Making and

Stock Value

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Decision Making and Common

Stock Value: Changes in Dividends
or Dividend Growth
Changes in expected dividends or dividend growth can
have a profound impact on the value of a stock.

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Decision Making and Common

Stock Value: Changes in Risk and
Required Return
Changes in expected dividends or dividend growth can
have a profound impact on the value of a stock.

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