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Chapter 7

Stock Valuation
Learning Goals

LG1 Differentiate between debt and equity.

LG2 Discuss the features of both common and


preferred stock.

LG3 Describe the process of issuing common stock,


including venture capital, going public, and the
investment banker.

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Learning Goals (cont.)

LG4 Understand the concept of market efficiency and


basic stock valuation using zero-growth,
constant-growth, and variable-growth models.

LG5 Discuss the free cash flow valuation model and


the book value, liquidation value, and
price/earnings (P/E) multiple approaches.

LG6 Explain the relationships among financial


decisions, return, risk, and the firms value.

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Differences Between Debt and Equity

Debt includes all borrowing incurred by a firm,


including bonds, and is repaid according to a fixed
schedule of payments.
Equity consists of funds provided by the firms
owners (investors or stockholders) that are repaid
subject to the firms performance.

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Table 7.1 Key Differences between Debt
and Equity

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Differences Between Debt and Equity:
Voice in Management
Unlike creditors, holders of equity (stockholders)
are owners of the firm.
Stockholders generally have voting rights that
permit them to select the firms directors and vote
on special issues.
In contrast, debtholders do not receive voting
privileges but instead rely on the firms contractual
obligations to them to be their voice.

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Differences Between Debt and Equity:
Claims on Income and Assets
Equityholders claims on income and assets are
secondary to the claims of creditors.
Their claims on income cannot be paid until the claims of
all creditors, including both interest and scheduled
principal payments, 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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Differences Between Debt and Equity:
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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Differences Between Debt and Equity: Tax
Treatment
Interest payments to debtholders are treated as
tax-deductible expenses by the issuing firm.
Dividend payments to a firms stockholders are not
tax-deductible.
The tax deductibility of interest lowers the
corporations cost of debt financing, further causing
it to be lower than the cost of equity financing.

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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 leftthe residualafter 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.

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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
firms consent.
Large corporations are publicly owned, and their
shares are generally actively traded in the broker or
dealer markets.

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Common Stock: Par Value

The par value of common stock is an arbitrary


value established for legal purposes in the firms
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.

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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 shareholders fractional ownership
resulting from the issuance of additional shares of
common stock.
Dilution of earnings is a reduction in each
previous shareholders fractional claim on the firms
earnings resulting from the issuance of additional
shares of common stock.

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Common Stock: Preemptive Rights (cont.)

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.
Rights are an important financing tool without
which shareholders would run the risk of losing
their proportionate control of the corporation.
From the firms viewpoint, the use of rights
offerings to raise new equity capital may be less
costly than a public offering of stock.

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Common Stock: Authorized, Outstanding,
and Issued Shares
Authorized shares are the shares of common
stock that a firms corporate charter allows it to
issue.
Outstanding shares are issued shares of common
stock held by investors, this includes private and
public investors.
Treasury stock are issued shares of common stock
held by the firm; often these shares have been
repurchased by the firm.
Issued shares are shares of common stock that
have been put into circulation.
Issued shares = outstanding shares + 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: Dividends

The payment of dividends to the firms shareholders


is at the discretion of the companys 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.

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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.

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Preferred Stock: Basic Rights of Preferred
Stockholders
Preferred stock is often considered quasi-debt because,
much like interest on debt, it specifies a fixed periodic
payment (dividend).
Preferred stock is unlike debt in that it has no maturity
date.
Because they have a fixed claim on the firms income
that takes precedence over the claim of common
stockholders, preferred stockholders are exposed to
less risk.
Preferred stockholders are not normally given a voting
right, although preferred stockholders are sometimes
allowed to elect one member of the board of directors.

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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.

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Preferred Stock: Features of Preferred
Stock (cont.)
A callable feature is a feature of callable preferred
stock that allows the issuer to retire the shares
within a certain period time and at a specified price.
A conversion feature is a feature of convertible
preferred stock that allows holders to change each
share into a stated number of shares of common
stock.

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Issuing Common Stock

Initial financing for most firms typically comes from


a firms 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.

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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 firms stock.

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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 facilitating the sale of the companys
IPO shares.

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Going Public (cont.)

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.
A red herring is a preliminary prospectus made
available to prospective investors during the waiting
period between the registration statements filing
with the SEC and its approval.

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Figure 7.1 Cover of a Preliminary
Prospectus for a Stock Issue

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Going Public (cont.)

Investment bankers and company officials promote


the company through a road show, a series of
presentations to potential investors around the
country and sometimes overseas.
This helps investment bankers gauge the demand
for the offering which helps them to set the initial
offer price.
After the underwriter sets the terms, the SEC must
approve the offering.

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Going Public:
The Investment Bankers 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.

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Going Public: The Investment Bankers
Role (cont.)
An underwriting syndicate is a group of other
bankers formed by an investment banker to share
the financial risk associated with underwriting new
securities.
The syndicate shares the financial risk associated
with buying the entire issue from the issuer and
reselling the new securities to the public.
The selling group is a large number of brokerage
firms that join the originating investment
banker(s); each accepts responsibility for selling a
certain portion of a new security issue on a
commission basis.

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Going Public: The Investment Bankers
Role (cont.)
Compensation for underwriting and selling services
typically comes in the form of a discount on the sale
price of the securities.
For example, an investment banker may pay the issuing
firm $24 per share for stock that will be sold for $26 per
share.
The investment banker may then sell the shares to
members of the selling group for $25.25 per share. In this
case, the original investment banker earns $1.25 per share
($25.25 sale price $24 purchase price).
The members of the selling group earn 75 cents for each
share they sell ($26 sale price $25.25 purchase price).

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Figure 7.2 The Selling Process for a Large
Security Issue

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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).

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Common Stock Valuation:
Market Efficiency
Economically rational buyers and sellers use their
assessment of an assets 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 pricethe market
valuefor 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.

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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.

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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.

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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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Personal Finance Example

Chuck Swimmer estimates that the dividend of


Denham Company, an established textile producer,
is expected to remain constant at $3 per share
indefinitely.

If his required return on its stock is 15%, the


stocks value is:
$20 ($3 0.15) per share

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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.

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Common Stock Valuation:
Variable-Growth Model
C (1+g1) g2
C C (1+g1)2

n
0 1 2 3 4

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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 2015, 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 (2016). 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 Expected Dividends
Assuming that economic conditions remain stable,
any management action that would cause current
and prospective stockholders to raise their dividend
expectations should increase the firms value.
Therefore, any action of the financial manager that
will increase the level of expected dividends without
changing risk (the required return) should be
undertaken, because it will positively affect owners
wealth.

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Decision Making and Common Stock Value:
Changes in Expected Dividends (cont.)
Assume that Lamar Company announced a major
technological breakthrough that would revolutionize
its industry. Current and prospective stockholders
expect that although the dividend next year, D1, will
remain at $1.50, the expected rate of growth
thereafter will increase from
7% to 9%.

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Decision Making and Common Stock
Value: Changes in Risk
Any measure of required return consists of two components: a
risk-free rate and a risk premium. We expressed this
relationship as in the previous chapter, which we repeat here
in terms of rs:

Any action taken by the financial manager that increases the


risk shareholders must bear will also increase the risk
premium required by shareholders, and hence the required
return.
Additionally, the required return can be affected by changes in
the risk free rateeven if the risk premium remains constant.

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Decision Making and Common Stock
Value: Changes in Risk (cont.)
Assume that Lamar Company manager makes a
decision that, without changing expected dividends,
causes the firms risk premium to increase to 7%.
Assuming that the risk-free rate remains at 9%, the
new required return on Lamar stock will be 16% (9%
+ 7%).

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Decision Making and Common Stock
Value: Combined Effect
If we assume that the two changes illustrated for
Lamar Company in the preceding examples occur
simultaneously, the key variable values would be D1 =
$1.50, rs = 0.16, and g = 0.09.

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Review of Learning Goals

LG1 Differentiate between debt and equity.


Holders of equity capital (common and preferred stock)
are owners of the firm. Typically, only common
stockholders have a voice in management. Equityholders
claims on income and assets are secondary to creditors
claims, there is no maturity date, and dividends paid to
stockholders are not tax-deductible.

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Review of Learning Goals (cont.)

LG2 Discuss the features of both common and


preferred stock.
The common stock of a firm can be privately owned, closely
owned, or publicly owned. It can be sold with or without a par
value. Preemptive rights allow common stockholders to avoid
dilution of ownership when new shares are issued. Some firms
have two or more classes of common stock that differ mainly in
having unequal voting rights. Proxies transfer voting rights from
one party to another. The decision to pay dividends to common
stockholders is made by the firms board of directors.

Preferred stockholders have preference over common


stockholders with respect to the distribution of earnings and
assets. They do not normally have voting privileges. Preferred
stock issues may have certain restrictive covenants, cumulative
dividends, a call feature, and a conversion feature.

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Review of Learning Goals (cont.)

LG3 Describe the process of issuing common stock,


including venture capital, going public, and the
investment banker.
The initial nonfounder financing for business startups
with attractive growth prospects typically comes from
private equity investors. These investors can be either
angel capitalists or venture capitalists (VCs).

The first public issue of a firms stock is called an initial


public offering (IPO). The company selects an investment
banker to advise it and to sell the securities. The lead
investment banker may form a selling syndicate with
other investment bankers. The IPO process includes
getting SEC approval, promoting the offering to
investors, and pricing the issue.

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Review of Learning Goals (cont.)

LG4 Understand the concept of market efficiency and


basic stock valuation using zero-growth,
constant-growth, and variable-growth models.
Market efficiency assumes that the quick reactions of
rational investors to new information cause the market
value of common stock to adjust upward or downward
quickly.

The value of a share of stock is the present value of all


future dividends it is expected to provide over an infinite
time horizon. Three dividend growth modelszero-
growth, constant-growth, and variable-growthcan be
considered in common stock valuation. The most widely
cited model is the constant-growth model.

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Review of Learning Goals (cont.)

LG5 Discuss the free cash flow valuation model and the
book value, liquidation value, and price/earnings
(P/E) multiple approaches.
The free cash flow valuation model finds the value of the
entire company by discounting the firms expected free cash
flow at its weighted average cost of capital. The common
stock value is found by subtracting the market values of the
firms debt and preferred stock from the value of the entire
company.

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 stock-
holders.

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Review of Learning Goals (cont.)

LG5 Discuss the free cash flow valuation model and


the book value, liquidation value, and
price/earnings (P/E) multiple approaches (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 the remaining
money were divided among the common stockholders.

The price/earnings (P/E) multiple approach estimates


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

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Review of Learning Goals (cont.)

LG6 Explain the relationships among financial


decisions, return, risk, and the firms value.
In a stable economy, any action of the financial manager
that increases the level of expected dividends without
changing risk should increase share value; any action
that reduces the level of expected dividends without
changing risk should reduce share value. Similarly, any
action that increases risk (required return) will reduce
share value; any action that reduces risk will increase
share value. An assessment of the combined effect of
return and risk on stock value must be part of the
financial decision-making process.

Pearson Education Limited, 2015. 7-62

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