1. Stock Valuation
Professor Trainor

2. 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.

3. 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.

4. 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.

5. 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.

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 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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8. 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

9. 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

10. 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:

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:
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

12. 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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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.

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.

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.

17. 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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