Valuing Stocks Chapter 5

Debt versus Equity: Debt Debt securities represent a legally enforceable claim. Debt securities offer fixed or floating cash flows. Bondholders do not have any control over how the company is run.

Debt versus 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 have some features similar to debt and other features similar to equity. Claim on assets and cash flow is senior to common stock. Dividend payments are not tax deductible. Preferred stock are held mostly by corporations. Promises a fixed annual dividend payment, though this is not legally enforceable. Preferred stockholders usually do not have voting rights.

Additional paid-in capital Common Stock Par value Little economic relevance today. Shares authorized The shares of a company’s stock that shareholders and the board authorize the firm to sell to the public. Shares issued The shares of a company’s stock that have been issued or sold to the public. Shares outstanding The shares of a company’s stock that are currently held by the public. Additional paid-in capital The amount of money the firm received from selling stock, above and beyond the stock’s par value.

Rights of Common Stockholders Common stockholders’ voting rights can be exercised in person or by proxy. Most US corporations practice majority voting, with one vote attached to each common share. Proxy fight: An attempt to gain control of a firm by soliciting enough votes to unseat existing directors. Shareholders have no legal rights to receive dividends.

Primary Markets and Issuing New Securities The market in which firms originally issue new securities. market capitalization The total number of shares outstanding multiplied by the current price per share. treasury stock Common shares that have been issued but are no longer outstanding because the firm repurchased them.

The Investment Banker’s Role in Equity Issues Asset management Corporate finance Trading Key investment banking activities Investment banks assist firms in the process of issuing securities to investors. initial public offering (IPO) The first public sale of company stock to outside investors. unseasoned offering An equity issue by a firm that already has common stock outstanding.

The Investment Banker’s Role in Equity Issues Firms can choose an investment bank through negotiated offer competitively bid offer The contract to sell equity can be Best effort The bank promises its best effort to sell the firm’s securities. If the demand is insufficient, the issue will be withdrawn. The bank underwrites the securities. Underwrite: Purchasing shares from the firm and reselling them to investors. Firm commitment

Key Steps in the Initial Public Offering Process

Key Steps in the Initial Public Offering Process

Key Steps in the Initial Public Offering Process

Secondary Markets for Equity Securities Broker market A market in which the buyer and seller are brought together on a “securities exchange” to trade securities. Dealer market A market in which the buyer and seller are not brought together directly, but instead have their orders executed by securities dealers that make markets in the given security.

The Secondary Market

Stock Valuation: 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 Using the formula for valuing a perpetuity: 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 An example: Investors require an 11% return on a preferred stock that pays a $2.30 annual dividend.  What is the price?

Stock Valuation: Common Stock Suppose that an investor buys a stock today for price P0 , receives a dividend equal to D1 at the end of one year, and immediately sells the stock for price P1. Return on investment 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: Value of a Share of Common Stock

Stock Valuation: 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 will find that today’s price equals the PV of the entire dividend stream that the stock will pay in the future:

Zero Growth Valuation Model The zero growth model is the simplest approach to stock valuation that assumes a constant, non-growing dividend stream. D1 = D2 = ... = D With constant value D for each dividend payment, the common stock valuation formula reduces to the simple equation for a perpetuity: 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

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. pays 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 Valuation Model The variable growth model assumes that the dividend growth rate will vary during different periods of time.

Valuing a Stock Using the Variable Growth Model

Stock Valuation How to estimate growth What if there are no dividends? Growth rate g = retention rate x ROE Historical data What if there are no dividends?

Valuing the Enterprise: Free Cash Flow Approach Free cash flow (FCF) The net amount of cash flow remaining after the firm has met all operating needs and paid for investments, both long-term and short-term. Represents the cash amount that a firm could distribute to investors after meeting all its other obligations. Weighted average cost of capital (WACC) The after-tax, weighted average required return on all types of securities issued by a firm, where the weights equal the percentage of each type of financing in a firm’s overall capital structure.

Valuing the Enterprise: Free Cash Flow Approach Steps Estimate the free cash flow that the firm will generate over time. Discount the free cash flow at the firm’s weighted average cost of capital to derive the total value of the firm, VF . Subtract the values of the firm’s debt, VD , and preferred stock, VP , from VF to obtain the value of the firm’s shares, VS . Divide VS by the number of shares outstanding to calculate the value per share, P0 .

An Example: Starbucks Corp At the end of its 2006 fiscal year, Starbucks had debt with a market value of about $250 million no preferred stock 765 million shares of common stock outstanding free cash flow of $270 million Revenues and operating profits grew at 21% between 2004 and 2006. Assume 20% FCF growth from 2006 to 2010 and 10% annual growth thereafter. WACC = 12%.

An Example: Starbucks Corp

An Example: Starbucks Corp

Other Approaches to Common Stock Valuation Book value The value of a firm’s equity as recorded on the firm’s balance sheet. Liquidation value The amount of cash that remains if the firm’s assets are sold and all liabilities paid. -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 Price/Earnings multiples The amount investors are willing to pay for each dollar of earnings. P/E ratios differ between and within industries.

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