1. 7 - 1 CHAPTER 7 Stocks and Their Valuation Features of common stock Determining common stock values Efficient markets Preferred stock

2. 7 - 2 Represents ownership. Ownership implies control. Stockholders elect directors. Directors hire management. Since managers are “agents” of shareholders, their goal should be: Maximize stock price. Common Stock: Owners, Directors, and Managers

3. 7 - 3 Classified stock has special provisions. Could classify existing stock as founders’ shares, with voting rights but dividend restrictions. New shares might be called “Class A” shares, with voting restrictions but full dividend rights. What’s classified stock? How might classified stock be used?

4. 7 - 4 The dividends of tracking stock are tied to a particular division, rather than the company as a whole. Investors can separately value the divisions. Its easier to compensate division managers with the tracking stock. But tracking stock usually has no voting rights, and the financial disclosure for the division is not as regulated as for the company. What is tracking stock?

5. 7 - 5 When is a stock sale an initial public offering (IPO)? A firm “goes public” through an IPO when the stock is first offered to the public. Prior to an IPO, shares are typically owned by the firm’s managers, key employees, and, in many situations, venture capital providers.

6. 7 - 6 What is a seasoned equity offering (SEO)? A seasoned equity offering occurs when a company with public stock issues additional shares. After an IPO or SEO, the stock trades in the secondary market, such as the NYSE or Nasdaq.

7. 7 - 7 Dividend growth model Using the multiples of comparable firms Free cash flow method (covered in Chapter 15) Different Approaches for Valuing Common Stock

8. 7 - 8 One whose dividends are expected to grow forever at a constant rate, g. Stock Value = PV of Dividends What is a constant growth stock?

9. 7 - 9 For a constant growth stock, If g is constant, then:

10. 7 - 10 $ 0.25 Years (t) 0

11. 7 - 11 What happens if g > r s ? If r s < g, get negative stock price, which is nonsense. We can’t use model unless (1) g  r s and (2) g is expected to be constant forever. Because g must be a long- term growth rate, it cannot be  r s.

12. 7 - 12 Assume beta = 1.2, r RF = 7%, and RP M = 5%. What is the required rate of return on the firm’s stock? r s = r RF + (RP M )b Firm = 7% + (5%) (1.2) = 13%. Use the SML to calculate r s :

13. 7 - 13 D 0 was $2.00 and g is a constant 6%. Find the expected dividends for the next 3 years, and their PVs. r s = 13%. 01 2.2472 2 2.3820 3 g=6% 4 1.8761 1.7599 1.6508 D 0 =2.00 13% 2.12

14. 7 - 14 What’s the stock’s market value? D 0 = 2.00, r s = 13%, g = 6%. Constant growth model: = = $30.29. 0.13 - 0.06 $2.12 0.07

15. 7 - 15 What is the stock’s market value one year from now, P 1 ? D 1 will have been paid, so expected dividends are D 2, D 3, D 4 and so on. Thus, ^

16. 7 - 16 Find the expected dividend yield and capital gains yield during the first year. Dividend yield = = = 7.0%. $2.12 $30.29 D1D1 P0P0 CG Yield = = P 1 - P 0 ^ P0P0 $32.10 - $30.29 $30.29 = 6.0%.

17. 7 - 17 Find the total return during the first year. Total return = Dividend yield + Capital gains yield. Total return = 7% + 6% = 13%. Total return = 13% = r s. For constant growth stock: Capital gains yield = 6% = g.

18. 7 - 18 Rearrange model to rate of return form: Then, r s = $2.12/$30.29 + 0.06 = 0.07 + 0.06 = 13%. ^

19. 7 - 19 What would P 0 be if g = 0? The dividend stream would be a perpetuity. 2.00 0123 r s =13% P 0 = = = $15.38. PMT r $2.00 0.13 ^

20. 7 - 20 If we have supernormal growth of 30% for 3 years, then a long-run constant g = 6%, what is P 0 ? r is still 13%. Can no longer use constant growth model. However, growth becomes constant after 3 years. ^

21. 7 - 21 Nonconstant growth followed by constant growth: 0 2.3009 2.6470 3.0453 46.1135 1234 r s =13% 54.1067 = P 0 g = 30% g = 6% D 0 = 2.00 2.603.38 4.394 4.6576 ^

22. 7 - 22 What is the expected dividend yield and capital gains yield at t = 0? At t = 4? Dividend yield = = = 4.8%. $2.60 $54.11 D1D1 P0P0 CG Yield = 13.0% - 4.8% = 8.2%. At t = 0: (More…)

23. 7 - 23 During nonconstant growth, dividend yield and capital gains yield are not constant. If current growth is greater than g, current capital gains yield is greater than g. After t = 3, g = constant = 6%, so the t t = 4 capital gains gains yield = 6%. Because r s = 13%, the t = 4 dividend yield = 13% - 6% = 7%.

24. 7 - 24 The current stock price is $54.11. The PV of dividends beyond year 3 is $46.11 (P 3 discounted back to t = 0). The percentage of stock price due to “long-term” dividends is: Is the stock price based on short-term growth? ^ = 85.2%. $46.11 $54.11

25. 7 - 25 If most of a stock’s value is due to long- term cash flows, why do so many managers focus on quarterly earnings? Sometimes changes in quarterly earnings are a signal of future changes in cash flows. This would affect the current stock price. Sometimes managers have bonuses tied to quarterly earnings.

26. 7 - 26 Suppose g = 0 for t = 1 to 3, and then g is a constant 6%. What is P 0 ? 0 1.7699 1.5663 1.3861 20.9895 1234 r s =13% 25.7118 g = 0% g = 6% 2.00 2.00 2.00 2.12 2.12.  P 3 007 30.2857  ^...

27. 7 - 27 What is dividend yield and capital gains yield at t = 0 and at t = 3? t = 0: D1D1 P0P0 CGY = 13.0% - 7.8% = 5.2%.  2.00 $25.72 7.8%. t = 3: Now have constant growth with g = capital gains yield = 6% and dividend yield = 7%.

28. 7 - 28 If g = -6%, would anyone buy the stock? If so, at what price? Firm still has earnings and still pays dividends, so P 0 > 0: ^ = = = $9.89. $2.00(0.94) 0.13 - (-0.06) $1.88 0.19

29. 7 - 29 What are the annual dividend and capital gains yield? Capital gains yield = g = -6.0%. Dividend yield= 13.0% - (-6.0%) = 19.0%. Both yields are constant over time, with the high dividend yield (19%) offsetting the negative capital gains yield.

30. 7 - 30 Dividend growth model Using the multiples of comparable firms Free cash flow method Different Approaches for Valuing Common Stock

31. 7 - 31 Analysts often use the following multiples to value stocks: P/E P/CF or P/EBITDA P/Sales P/Customer Example: Based on comparable firms, estimate the appropriate P/E. Multiply this by expected earnings to back out an estimate of the stock price. Using the Multiples of Comparable Firms to Estimate Stock Price

32. 7 - 32 Analysts often use the P/E multiple (the price per share divided by the earnings per share) or the P/CF multiple (price per share divided by cash flow per share, which is the earnings per share plus the dividends per share) to value stocks. Example: Estimate the average P/E ratio of comparable firms. This is the P/E multiple. Multiply this average P/E ratio by the expected earnings of the company to estimate its stock price. Using the Stock Price Multiples to Estimate Stock Price

33. 7 - 33 The entity value (V) is: the market value of equity (# shares of stock multiplied by the price per share) plus the value of debt. Pick a measure, such as EBITDA, Sales, Customers, Eyeballs, etc. Calculate the average entity ratio for a sample of comparable firms. For example, V/EBITDA V/Customers Using Entity Multiples

34. 7 - 34 Find the entity value of the firm in question. For example, Multiply the firm’s sales by the V/Sales multiple. Multiply the firm’s # of customers by the V/Customers ratio The result is the total value of the firm. Subtract the firm’s debt to get the total value of equity. Divide by the number of shares to get the price per share. Using Entity Multiples (Continued)

35. 7 - 35 It is often hard to find comparable firms. The average ratio for the sample of comparable firms often has a wide range. For example, the average P/E ratio might be 20, but the range could be from 10 to 50. How do you know whether your firm should be compared to the low, average, or high performers? Problems with Market Multiple Methods

36. 7 - 36 Analysis of Free Cash Flow Cash Investments Cash Earnings Free Cash Flow CAPEX Acquisitions Divestitures Cash available for distribution to all claim holders A/R A/P Inventories  Working Capital Tax Provision (Deferred Taxes, Tax Shield) Cash Taxes (R&D, Leases ) Operating Margin Volume Pricing Sales Expenses

37. 7 - 37

38. 7 - 38 Was 15%

39. 7 - 39 Was 40%

40. 7 - 40 Was 0%

41. 7 - 41 Was 75%

42. 7 - 42 Was $3,100,000

43. 7 - 43 Why are stock prices volatile? r s = r RF + (RP M )b i could change. Inflation expectations Risk aversion Company risk g could change. ^

44. 7 - 44 Stock value vs. changes in r s and g D 1 = $2, r s = 10%, and g = 5%: P 0 = D 1 / (r s -g) = $2 / (0.10 - 0.05) = $40. What if r s or g change? ggg r s 4%5%6% 9%40.0050.0066.67 10%33.3340.0050.00 11%28.5733.3340.00

45. 7 - 45 Are volatile stock prices consistent with rational pricing? Small changes in expected g and r s cause large changes in stock prices. As new information arrives, investors continually update their estimates of g and r s. If stock prices aren’t volatile, then this means there isn’t a good flow of information.

46. 7 - 46 What is market equilibrium? ^ In equilibrium, stock prices are stable. There is no general tendency for people to buy versus to sell. The expected price, P, must equal the actual price, P. In other words, the fundamental value must be the same as the price. (More…)

47. 7 - 47 In equilibrium, expected returns must equal required returns: r s = D 1 /P 0 + g = r s = r RF + (r M - r RF )b. ^

48. 7 - 48 How is equilibrium established? If r s = + g > r s, then P 0 is “too low.” If the price is lower than the fundamental value, then the stock is a “bargain.” Buy orders will exceed sell orders, the price will be bid up, and D 1 /P 0 falls until D 1 /P 0 + g = r s = r s. ^ ^ D1P0D1P0 ^

49. 7 - 49 Why do stock prices change? r i = r RF + (r M - r RF )b i could change. Inflation expectations Risk aversion Company risk g could change. ^

50. 7 - 50 What’s the Efficient Market Hypothesis (EMH)? Securities are normally in equilibrium and are “fairly priced.” One cannot “beat the market” except through good luck or inside information. (More…)

51. 7 - 51 1.Weak-form EMH: Can’t profit by looking at past trends. A recent decline is no reason to think stocks will go up (or down) in the future. Evidence supports weak-form EMH, but “technical analysis” is still used.

52. 7 - 52 2.Semistrong-form EMH: All publicly available information is reflected in stock prices, so it doesn’t pay to pore over annual reports looking for undervalued stocks. Largely true.

53. 7 - 53 3.Strong-form EMH: All information, even inside information, is embedded in stock prices. Not true--insiders can gain by trading on the basis of insider information, but that’s illegal.

54. 7 - 54 Markets are generally efficient because: 1.100,000 or so trained analysts--MBAs, CFAs, and PhDs--work for firms like Fidelity, Merrill, Morgan, and Prudential. 2.These analysts have similar access to data and megabucks to invest. 3.Thus, news is reflected in P 0 almost instantaneously.

55. 7 - 55 Preferred Stock Hybrid security. Similar to bonds in that preferred stockholders receive a fixed dividend which must be paid before dividends can be paid on common stock. However, unlike bonds, preferred stock dividends can be omitted without fear of pushing the firm into bankruptcy.

56. 7 - 56 What’s the expected return on preferred stock with V ps = $50 and annual dividend = $5?

57. 7 - 57 Dilution and Anti-dilution Hoje Jo Santa Clara University

58. 7 - 58 Dilution and Anti-dilution Suppose NewCo. issue: 1 mil. Common stock  founders own all common stock (c/s) 1 mil. convertible p/s  investors (VCs) own all convertible preferred stock (cp/s)

59. 7 - 59 Case A: Suppose Newco desperately needs $25,000 cash. So, the firm issues 50,000 shares of c/s at $0.5/share

60. 7 - 60 Full Ratchet: Before Founder: 1m/2m = 50% VC: 1m/2m = 50% New investor’s position 0

61. 7 - 61 Full Ratchet: After New shares = 50,000 From convertible preferred stock, VC can convert into 2 mil. Shares of common stock (=1 mil./$0.5) founder’s equity Position: 1m/(1m+2m+50,000)  32.79% VC’s equity Position: 2m/(1m+2m+50,000)  65.57% New investor’s position=50,000/3.05m = 1.64%

62. 7 - 62 Weighted Average Ratchet A =The shares outstanding before the financing = 2m B =The shares outstanding after the financing.= 2,050,000 C =The shares which have been issued for the price paid if the old (i.e., higher) conversion price had been used.=25,000 D=The shares actually issued at the new price. = 50,000

63. 7 - 63 Weighted Average (Continued) P N = new conversion price =(A+C)/(B+D) =(2m+25,000)/(2,050,000+50,000)  $0.964/share (as opposed to $0.5/share)

64. 7 - 64 Weighted Average: Before Founder: 1m/2m = 50% VC = 50% New Investor’s Position = 0

65. 7 - 65 Weighted Average: After Founder’s equity position: 1m/[1m+(1m/$0.964)+50,000]  47.91% VC’s equity Position: 1,037,344/2,087,344  49.70% New investor’s position: 50,000/2,087,344  2.4%

66. 7 - 66 Case B: Suppose Newco needs $25,000 cash. But the firm issues 250,000 shares of c/s at $0.1/share.

67. 7 - 67 Full Ratchet: Before Founder: 50% VC: 50% New Investor: 0

68. 7 - 68 Full Ratchet: After New shares = 250,000 From cp/s = 10 million shares(=1 mil/$0.1) Founder’s equity position = 1m/1m+10m+0.25m  8.89% (has been burned out) VC’s equity position = 10 mil/11.25 mil  88.89% (become lion’s share) New investor’s position= 250,000/11.25m  2.22%

69. 7 - 69 Weighted Average A =The shares outstanding before the financing = 2 m B =The shares outstanding after the financing = 2.25 m C= The shares which have been issued for the price paid if the old (i.e., higher) conversion price had been used = 25,000 D =The shares actually issued at the new price = 250,000

70. 7 - 70 Weighted Average P N = new conversion price = (A+C)/(B+D) = (2m+25,000)/(2.25m + 250,000) = 2,025,000/2,500,000 = $0.81/share

71. 7 - 71 Weighted Average: Before Founder: 50% VC: 50% New investor’s postion: 0

72. 7 - 72 Weighted Average: After New shares = 250,000 From cp/s = 1m/$0.81  1,234,568 Founder’s eq. position = 1m/(1m+1,234,568+250,000) = 40.25% VC’s eq. position = 1,234,568/2,484,568 = 49.69% New investor’s position =250,000/2,484,568 = 10.06%

73. 7 - 73 Optional Bonus problem: Dilution and Anti-dilution Suppose a wireless Internet company, Halfdome Systems, desperately needs to finance $2 million in cash. Previously, founders own 5 million shares of common stock valued at $0.80 per share and other previous investors own 5 million shares of convertible preferred stock valued at $0.80 per share(Assume the price per share for common and convertible preferred is the same for simplicity). Due to their immediate need of new financing for their additional investment in R&D and for the recruitment of quality CEO, none of their previous investors wants to fund more because they are uncertain regarding the future of Halfdome. Instead, they recommend Battery Ventures who wants to invest into Halfdome Systems at $0.20 per share. While Battery Ventures wants to include a full ratchet anti-dilution in their term sheet, Chris Mais, founder of Halfdome wants to have a weighted-average ratchet. Since Chris is not quite familiar with this anti-dilution issue, he wants Santa Clara MBA consulting group to analyze the resulting ownership under two mutually exclusive anti-dilution methods, full ratchet vs. weighted average ratchet. Suppose you are a member of Santa Clara MBA consulting group.

74. 7 - 74 Optional Bonus problem: Dilution and Anti-dilution (Cont’d) What should be the final percentage ownership for Chris Mais, previous investors, and Battery Ventures under the full ratchet and weighted average ratchet methods. Try two separate weighted average ratchet methods. Weighted average ratchet #1 is based on [(A + C)/(B + D)] x old conversion price where A = the number of shares outstanding before the new investment; B = the number of shares after the new investment; C = the number of shares which have been issued for the price if the old or higher conversion price had been used; and D = the number of shares actually issued at the new price. Weighted average ratchet #2 is using NCP (new conversion price) = [(OB * OCP) + New$] / OA where OB represents outstanding shares before offering, OCP refers old conversion price, New$ means an amount raised in offering, and OA stands for outstanding shares after offering. From the results of (i), what inferences can you make for entrepreneurs and venture capitalists? Discuss briefly.