Stock Valuation Professor Trainor

Preferred stockholders usually do not have voting rights. Preferred 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.

Rights of Common Stockholders Common 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.

Common Stock Treasury stock Market capitalization 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.

Investment Banks’ Role in Equity Offerings Direct negotiated offer Competitive bidding Firms can choose an investment bank through 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.

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 process Prior 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

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Valuation Fundamentals: Preferred Stock Preferred stock is an equity security that is expected to pay a fixed annual dividend indefinitely. 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? Formula can be rearranged to compute required return, if price and dividend known: Equity Valuation As will be discussed in chapter 5, the required return on common stock is based on its beta, derived from the CAPM Valuing CS is the most difficult, both practically & theoretically Preferred stock valuation is much easier (the easiest of all) Whenever investors feel the expected return, rˆ, is not equal to the required return, r, prices will react: If exp return declines or reqd return rises, stock price will fall If exp return rises or reqd return declines, stock price will rise Asset prices can change for reasons besides their own risk Changes in asset’s liquidity, tax status can change price Changes in market risk premium can change all asset values Most dramatic change in market risk: Russian default Fall 98 Caused required return on all risky assets to rise, price to fall

Valuation Fundamentals: Common Stock Value of a Share of Common Stock Basic formula for valuing a share of stock easy to state; P0 is equal to the present value of the expected stock price at end of period 1, plus dividends received, as in Eq 4.4: But how to determine P1? This is the PV of expected stock price P2, plus dividends. P2 in turn, the PV of P3 plus dividends, and so on. Repeating this logic over and over, find that today’s price equals PV of the entire dividend stream the stock will pay in the future, as in Eq 4.5: P0 = Present value of the expected stock price at the end of period #1 D1 = Dividends received r = discount rate

Valuation Fundamentals: 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 find that today’s price equals PV of the entire dividend stream the stock will pay in the future:

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: The Gordon Company’s dividends have grown by 7% per year, reaching $1.40 per share. This growth is expected to continue, so D1=$1.40 x 1.07=$1.50. If required return is 15%: P(0) = $18.75 Commonly called the Gordon growth model

Example 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? The Gordon Company’s dividends have grown by 7% per year, reaching $1.40 per share. This growth is expected to continue, so D1=$1.40 x 1.07=$1.50. If required return is 15%: P(0) = $18.75 What is the stock worth if investors expect Dynasty’s dividends to grow at 3% per year?

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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.

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.

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.

Weaknesses of Using P/E Ratios 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

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