1. Chapter 5: Stock Valuation
Professor Thomson
Finance 3013

2. Debt vs. Equity: Debt
Debt securities represent a legally enforceable claim.
Debt securities offer fixed or floating cash flows.
Bondholders don’t have any control over how the company is run.

3. Debt vs. Equity: Equity Common stockholders are residual claimants.
No claim to earnings or assets until all senior claims are paid in full
High risk, but historically also high return
Stockholders have voting rights on important company decisions.
Debt and equity have substantially different marginal benefits and marginal costs.

4. Preferred Stock
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 (i.e. preferred stock is typically “cumulative”)
- Preferred stockholders usually do not have voting rights.
- May be convertible to common stock

5. Valuing Preferred Stock
Because preferred stock pay a constant dividend, they are easy to value because the dividends are a perpetuity.
Recall the present value of a perpetuity is:
Where : D1 is the constant dividend whose first payment is one period from today

6. Example 5.1: Valuing preferred
You purchase a preferred stock with a $12 per year dividend. For a 10% market rate, what is its value?

7. 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. They are declared by the board of directors, and typically paid quarterly if it is a dividend paying stock. Dividends typically increase over time

8. Little economic relevance today Number of shares owned by stockholders
Common Stock
Par value
Little economic relevance today
Shares authorized
Shares authorized by stockholders to be sold by the board of directors without further stockholders approval
Shares issued and outstanding
Number of shares owned by stockholders
Additional paid-in capital
Amount received in excess of par value when corporation initially sold stock

9. 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. e.g. A stock selling for $50 per share will sell for $25 per share after a 2 for 1 stock split

10. Largest firms by market capitalization in the S&P 500 (5/31/2006)
Rank
Name 1
ExxonMobil Corp 2
General Electric 3
Citigroup 4
Bank of America 5
Microsoft 6
Johnson & Johnson 7
Procter & Gamble 8
Pfizer 9
American International Group, Inc

11. Stock Valuation
Like other assets in finance, the value of a stock is the PV of its CF’s
Stocks are typically valued as perpetual securities as corporations potentially have an infinite life, and thus can pay dividends forever.

12. How to make money in the stock market
The standard answer – “Buy Low, Sell High” i.e. Earn capital gains
From dividends – Over the long run, historically speaking almost ½ of the total return to stock market investors was from dividends.

13. Example 5.2. Stock valuation with a one year holding period
You expect that JK Corp stock will sell for $25 one year from today. You expect to receive $1.20 in dividends over the year you hold this stock. For a 15% required rate of return for this stock, how much should you pay for it? What is your projected capital gain?

14. Example 5.3. Stock valuation with a two year holding period
You expect to sell MyCo for $28 two years from today. You expect to receive $1 dividend the first year, and a $1.10 dividend the second year. For a 16% discount rate, what is the maximum you should pay for this stock?

15. Example 5.4. Stock valuation with a three year holding period
What you be willing to pay for a stock which pays a $2 dividend the first year, a $2.10 dividend the second year, and $2.21 in the third year if you will sell the stock for $40 after three years? Discount rate is 13%

16. Model assumption
Probably the biggest weakness in the previous three examples was that we had to predict a selling price.
The buyer of the stock, when we sell it, will presumably go through a similar procedure to value the stock – in other words the buyer will be using future dividends to value the stock.
The selling price of the stock should thus be the value of all future dividends.

17. Valuation of Common Stock Assume 1 year holding
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 or price of stock today
P1 = Price of stock next period
D1 = Dividends received in first period
i = discount rate

18. Stock Value next year: Use same approach
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:

19. Valuation Fundamentals: Common Stock
How was 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:
Must be able to predict future dividends to use this model

22. Zero Growth Valuation Model
To value common stock, you must make assumptions about future dividend growth.
Zero growth model assumes a constant,
non-growing dividend stream. (Think preferred stock)
D1 = D2 = ... = D
Assume the dividend of Disco Company is expected to remain at $1.75/share indefinitely, and the required return on Disco’s stock is 15%. P0 is determined to be $11.67
Plugging constant value D into the common stock valuation formula reduces to simple equation for the present value of a perpetuity:

23. 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:
Note: D1 = D0(1+g)
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
Also called a DDM : Dividend Discount Model

24. Dividends over time
In the Gordon growth model:

25. Review Notation D0 = Current Dividend (time period 0)
D1 = Dividend one period from now
r = appropriate discount rate or rate of return for the particular stock (adjusts for time value of money and risk)
g = constant growth rate in dividends
P0 = the present value of the infinite series of dividends, which is the estimate stock price

26. Use the Gordon model when . . .
A dividend is paid on a regular basis
Growth rate in the dividends is constant
r>g

27. 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?

28. Example 5.5: Applying the DDM
Sombria industries recently paid a $2 dividend, and its dividends have been growing at 5% per year. The appropriate discount rate for this stock is 12%.
What should its current price be?
What do you projects its price to be 5 years from now?

29. Example 5.6: Rate of Return
Ootsa Corp. is trading for $50 per share. Next year you expect it to pay a $2 dividend, and dividends have been growing at a 6% rate. What rate of return do investors require from this stock? What is the dividend yield? What is the capital gain yield?

30. Example 5.7: Delayed Dividends
Joogle is high tech start up that is not expected to pay a dividend for 10 years. At that time you expect it will pay an $8 dividend, with a growth rate of 7%. For a 12% required return, what should you be willing to pay for Joogle today? What will its stock price be 5 years from today?

31. Example 5.8: Variable Growth Model Example
Estimate the current value of Morris Industries' common stock, P0
Assume:
The most recent annual dividend payment of Morris Industries was $4 per share.
Investors expect that these dividends will increase at an 8% annual rate over the next 3 years.
After three years, dividend growth will level out at 5%.
The firm's required return, r , is 12%.
Find the value of the dividends at the end of each year, Dt, during the initial high-growth phase.
Find the PV of the dividends during this high-growth phase, and sum the discounted cash flows.
Using the Gordon growth model, find the value of the stock at the end of the high-growth phase using the next period’s dividend (after one year’s growth at g2).
Then compute PV of this price by discounting back to time 0.
Determine the value of the stock today (P0) by adding the PV of the stock price computed in step 3 to the sum of the discounted dividend payments from step 2.
Allows for a change in the dividend growth rate as future growth rates might change
Let g1 = the initial, higher growth rate and g2 = the lower, subsequent growth rate, and assume a single shift in growth rates from g1 to g2.
Model can be generalized for two or more changes in growth rates, but keep simple now.

32. Review Smart Animation
• Chapter 5. “See a demonstration of the variable growth model.”

33. Other valuation models
Free cash flow analysis
Similar to the DDM model, but rather than discounting the dividend, one discounts the free cash flows (see Chapter 2)
The discount rate used is the WACC (Weighted Average Cost of Capital) which is the weighted average of the discount rates for the firm’s bonds, stocks and preferred stocks.

34. Common Stock Valuation Other Options
Book value
The value shown on the balance sheet of the assets of the firm, net of liabilities shown on the balance sheet
Liquidation value
Actual net amount per share likely to be realized upon liquidation and payment of liabilities
-Yield to Maturity (YTM) is the rate of return investors earn if they buy the bond at P0 and hold it until maturity.
The YTM on a bond selling at par (P0 = Par) will always equal the coupon interest rate.
When P0  Par, the YTM will differ from the coupon rate.
YTM is the discount rate that equates the PV of a bond’s cash flows with its price. If P0, CFs, n known, can find YTM
Use T-Bond with n=2 years, 2n=4, C/2=$20, P0=$992.43
P / E multiples
Reflects the amount investors will pay for each dollar of earnings per share
P / E multiples differ between and within industries.
Especially helpful for privately-held firms.

35. View Chapter 5 Videos

36. Trading Stock Why does any security trade?
Primary Market – a market for newly minted stock – funds go to the company whose name is on the stock
Initial Public Offering – the first time a primary market offering is made for a company – it represents the transition from a private firm to a public firm whose stock is freely traded

37. Secondary Stock Market
Biggest stock market for existing stocks is the NYSE – New York Stock Exchange
Trading is at Wall and Broad Street
Second biggest market is the Nasdaq
Nasdaq was formerly, National Association of Securities Dealers Automatic Quotations
Trading is in cyberspace

38. How to choose stocks
If you are not a stock analyst, and do not have a lot of money to invest, I suggest choosing broad based mutual funds, especially index funds
In general, don’t choose stocks based on hot tips
I invest with the Vanguard family of mutual funds

40. Variable Growth Model Valuation Steps 1 and 2
Compute the value of dividends in year 1, 2, and 3 as (1+g1)=1.08 times the previous year’s dividend
Div1= Div0 x (1+g1) = $4 x 1.08 = $4.32
Div2= Div1 x (1+g1) = $4.32 x 1.08 = $4.67
Div3= Div2 x (1+g1) = $4.67 x 1.08 = $5.04
Find the PV of these three dividend payments:
PV of Div1= Div1  (1+r)1 = $ 4.32  (1.12) = $3.86
PV of Div2= Div2  (1+r)2 = $ 4.67  (1.12)2 = $3.72
PV of Div3= Div3  (1+r)3 = $ 5.04  (1.12)3 = $3.59
Sum of discounted dividends = $ $ $3.59 = $11.17

41. Variable Growth Model Valuation Step 3
Find the value of the stock at the end of the initial growth period using the constant growth model.
Calculate next period dividend by multiplying D3 by 1+g2, the lower constant growth rate:
D4 = D3 x (1+ g2) = $ 5.04 x (1.05) = $5.292
Then use D4=$5.292, g =0.05, r =0.12 in Gordon model:

42. Variable Growth Model Valuation Step 3
Find the present value of this stock price by discounting P3 by (1+r)3

43. Variable Growth Model Valuation Step 4
Add the PV of the initial dividend stream (Step 2) to the PV of stock price at the end of the initial growth period (P3):
P0 = $ $53.81 = $64.98
Current
stock price
Remember: Because future growth rates might
change, the variable growth model allows for a
changes in the dividend growth rate.

44. Valuing the Enterprise: Free Cash Flow Valuation
Discount estimates of free cash flow that the firm will generate in the future.
Use weighted average cost of capital (WACC) to discount the free cash flows.
Discount
WACC: after-tax weighted average required return on all types of securities that firm issues.
We have an estimate of total value of the firm.
How can we use this to value the firm’s shares?

45. First quarter of 2001, traded in the $20 - $25 range
Value of firm’s shares
VS = VF– VD - VP
VS = value of firm’s common shares
VF = total enterprise value
VD = value of firm’s debt
VP = value of firm’s preferred stock
An example....
Morton Restaurant Group (MRG)
First quarter of 2001, traded in the $20 - $25 range
We can use the free cash flow approach to estimate the value of MRG shares.

46. An Example: Mortons Restaurant Group
MRG
At end of 2000, MRG’s debt market value was $66 million.
No preferred stock
4,148,002 shares outstanding
Free cash flow in 2000 was $4.8 million.
Revenues and operating profits grew at 14% between 1998 and 2000.
Assume that Mortons will experience 14% FCF growth from 2000 to 2004 and 7% annual growth thereafter.
Mortons’ WACC is approximately 11%.

47. An Example: Mortons Restaurant Group
End of Year
Growth Status
Growth Rate (%)
FCF Calculation
2000
Historic
Given
$4,800,000
2001
Fast 14
$4,800,000 x (1.14)1 = $5,472,000
2002
$4,800,000 x (1.14)2 = $6,238,080
2003
$4,800,000 x (1.14)3 = $7,111,411
2004
$4,800,000 x (1.14)4 = $8,107,009
2005
Stable 7
$8,107,009 x (1.07)1 = $8,674,499
Use variable growth equation to estimate Mortons enterprise value.

48. An Example: Mortons Restaurant Group

49. An Example: Mortons Restaurant Group
VF = 163,386,865
VD = $66,000,000
VP = $0
VS = $163,386,865 - $66,000,000 - $0 = $97,386,865
Divide total share value by 4,148,002 shares outstanding to obtain per-share value:

50. Common stock represents residual claims on firms’ cash flows
Stock Valuation
Preferred stock has both debt and equity-like features.
Common stock represents residual claims on firms’ cash flows
Investment bankers play an important role in helping firms issue new securities
The same principles apply to valuation of both preferred and common stock

51. 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

52. Investment Banks’ Role in Equity Offerings
Asset management
Corporate finance
Trading
Investment banking lines of business
Investment banks provide advice with structuring seasoned and unseasoned issues.
Seasoned offering
Equity issues by firms that already have common stock outstanding.
seasoned
Unseasoned offering
Initial public offering (IPO): issue of securities that are not traded yet.
unseasoned

53. 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.

54. 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

55. Services Provided during and after a Security Offering
Lead underwriter sets each syndicate member’s participation.
How many shares each member must sell and compensation for each sale
Almost all IPOs and SEOs have a green shoe option: over-allotment option to cover excess demand.
Lead underwriter responsible for price stabilization after offering.
After offering, lead underwriter serves as principal market maker.

56. On the secondary market, investors deal among themselves.
Securities exchanges
Centralized locations in which listed securities are bought and sold
NYSE: the largest exchange in the world, with almost 360 billion shares listed. Other exchanges: AMEX, regional exchanges
The Over-the-counter market (OTC)
OTC has no central, physical location; linked by a mass telecommunication network.
A part of the OTC market is made up of stocks traded on NASDAQ.