Professor XXXXX Course Name / Number Stock Valuation Professor XXXXX Course Name / Number

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.

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.

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.

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

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 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

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

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.

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.

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:

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. 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 a perpetuity:

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?

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.

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 = $3.86 + $3.72 + $3.59 = $11.17

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:

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

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 = $11.17 + $53.81 = $64.98 Current (end of year 0) stock price Remember: Because future growth rates might change, the variable growth model allows for a changes in the dividend growth rate.

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?

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.

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%.

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.

An Example: Mortons Restaurant Group

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:

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.

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