9-1

Stock Valuation

Professor Trainor

9-2

Preferred StockPreferred 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.

9-3

Rights of Common StockholdersCommon 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.

9-4

Common Stock

Market capitalizati

on

Market price per share x number of shares outstanding

Treasury stock

Stock repurchased by corporation; Usually purchased for stock

options

Stock split Two-for-one split issues one new

share for each already held; reduces per share price.

9-5

Investment Banks’ Role in Equity Offerings

Public security issues can be

Best efforts

• The bank promises its best efforts to sell the firm’s securities. No guarantees though about the success of the offering.

Firm

commitment

• Underwritten offerings, bank guarantees certain proceeds.

• Vast majority of US security offerings are underwritten.

Direct negotiated offer Competitive bidding

Firms can choose an investment bank through

9-6

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 processPrior 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

9-7

Show Netscape Video and Smart Finance: Womack

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9-8

Valuation Fundamentals:Preferred Stock

Preferred stock is an equity security that is expected to pay a fixed annual dividend indefinitely.

p

p0

r

D = PS

• PS0 = Preferred stock’s market price

• Dp = next period’s 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? share= =

r

D = PS

p

p0 /90.20$

11.0

3.2$

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Valuation Fundamentals:Common Stock

• P0 = Present value of the expected stock price at the end of period #1

• D1 = Dividends received

• r = discount rate

111

0 )1( r

PDP

Value of a

Share of

Common Stock

9-10

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:

Valuation Fundamentals:Common Stock

9-11

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:

Commonly called the Gordon growth model

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Example

86.42$03.010.0

3$10

gr

DP

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?

30$1.0

3$10

r

DP

What is the stock worth if investors expect Dynasty’s dividends to grow at 3% per year?

9-13

Video: French

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9-14

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.

9-15

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.

9-16

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.

9-17

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

Weaknesses of Using P/E Ratios

9-18

Video: Shiller

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