1. Stock Valuation 05/03/06

2. Differences between equity and debt Unlike bondholders and other credit holders, holders of equity capital are owners of the firm. Unlike bondholders and other credit holders, holders of equity capital are owners of the firm. Common equity holders usually have voting rights that permit them to elect the firm’s board of directors and to vote on special issues. Common equity holders usually have voting rights that permit them to elect the firm’s board of directors and to vote on special issues. Bondholders receive no such privileges. Bondholders receive no such privileges.

3. Equity holders have a residual claim on the firm’s income and assets. Equity holders have a residual claim on the firm’s 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. Because equity holders are the last to receive distributions, they expect greater returns to compensate them for the additional risk they bear. Differences between equity and debt

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

5. While interest paid to bondholders is tax- deductible to the issuing firm, dividends paid to preferred and common stock holders is not. While interest paid to bondholders is tax- deductible to the issuing firm, dividends paid to preferred and common stock holders 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. In effect, this further lowers the cost of debt relative to the cost of equity as a source of financing to the firm. Differences between equity and debt

6. Share Classifications Share Classifications – Authorized shares are the number of shares of common stock that a firm’s corporate charter allows. –Outstanding shares are the number of shares of common stock held by the public. The Securities and Exchange Commission (SEC) must okay any public sale of shares by a company. –Treasury stock is the number of outstanding shares that have been purchased by the firm or remain with the firm. –Float are the number of shares that are available for trading and is equal to the outstanding shares less the restricted (typically management owned) shares Common stock

7. Voting Voting –Each share of common stock usually entitles its holder to one vote in the election of directors and on special issues. –Because most shareholders do not attend the annual meeting to vote, they may sign a proxy statement giving their votes to another party. –Many firms have issued two or more classes of stock differing mainly in having unequal voting rights. Common stock

8. Dividends Dividends –Payment of dividends is at the discretion of the Board of Directors. –Dividends may be made in cash or additional shares of stock. –Because stockholders are residual claimants -- they receive dividend payments only after all claims have been settled with the government, creditors, and preferred stockholders. Common stock

9. A preemptive right allows common stockholders to maintain their proportionate ownership in a corporation when new shares are issued. 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. 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. 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. Common stock

10. Stock quotations

11. Preferred stock Preferred stock is an equity instrument that pays a fixed dividend and has a prior claim (to common stock) on the firm’s earnings and assets in case of liquidation. Preferred stock is an equity instrument that pays a fixed dividend and has a prior claim (to common stock) on the firm’s earnings and assets in case of liquidation. The dividend is expressed as a percentage of its par value. The dividend is expressed as a percentage of its par value. If a firm fails to pay a preferred stock dividend, the dividend is said to be in arrears. If a firm fails to pay a preferred stock dividend, the dividend is said to be in arrears. Preferred stocks which require the company to pay dividends in arrears are called cumulative preferred stocks. Preferred stocks which require the company to pay dividends in arrears are called cumulative preferred stocks. In general, any arrearage must be paid before common stockholders receive a dividend. In general, any arrearage must be paid before common stockholders receive a dividend.

12. Preferred stocks are often referred to as hybrid securities because they possess the characteristics of both common stocks and bonds. Preferred stocks are 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. Preferred stocks are like common stock because they are perpetual securities with no maturity date. Preferred stocks are like bonds because they are fixed income securities, i.e., dividends never change. Preferred stocks are like bonds because they are fixed income securities, i.e., dividends never change. Preferred stock

13. Stock valuation models As with any asset, the value of a stock is simply the present value of all its future cash flows. As with any asset, the value of a stock is simply the present value of all its future cash flows. Where r is the required return on common stock Dividend discount models use dividends as cash flows Dividend discount models use dividends as cash flows

14. Stock valuation models Special Case 1 Special Case 1 –The zero dividend growth model assumes that the stock will pay the same dividend each year, year after year.

15. Special Case 2 Special Case 2 –The constant dividend growth model assumes that the stock will pay dividends that grow at a constant rate (g) each year -- year after year. –This is also referred to as the Gordon Growth Model Stock valuation models

16. Determining dividend growth rates Determining dividend growth rates –Dividend growth rates can be obtained: From financial sources such as ValueLine Investment Survey. From financial sources such as ValueLine Investment Survey. Calculated using historical dividend information. The assumption here is that future growth will be similar to past growth. Calculated using historical dividend information. The assumption here is that future growth will be similar to past growth. where D 0 is the most recent dividend and D -n was the dividend n years ago. Stock Valuation Models

17. Special Case 3 Special Case 3 –The two-stage growth model assumes that the stock will pay dividends that either grow at one rate or have an inconsistent growth rate during the first period (for n years), and then at a constant rate through perpetuity during the second period. Where Stock Valuation Models