Copyright © 2009 Pearson Prentice Hall. All rights reserved. Chapter 7 Stock Valuation

The Nature of Equity Capital: Voice in Management Unlike bondholders and other creditors, shareholders are owners of the firm. Common stockholders have: –Voting rights –Preemptive rights 7-2

The Nature of Equity Capital: Claims on Income & Assets Equity holders have a residual claim on the firm’s income and assets. Unlike debt, equity capital is a permanent form of financing. 7-3

Preferred Stock Preferred stock is equity that pays a fixed dividend. The dividend is expressed as a dollar amount or as a percentage of par value. Preferred stock is between common stock and bonds; it has characteristics of both. 7-4

Initial financing for most firms typically comes from the firm’s founders Additional financing often comes from “angels” and venture capitalists After establishing itself, a firm will often “go public” in an IPO: Initial Public Offering. Investment bankers assist firms with the process of going public. Issuing Common Stock 7-5

Going Public For a public offering, the company must file a registration statement with the SEC and issue a prospectus. Investment bankers and company officials promote the company through a road show. In most cases, the investment banker underwrites the issue, guaranteeing a price. The investment banker charges the issuing corporation expenses plus a spread. 7-6

Common Stock Valuation “Value” investors purchase shares when they feel they are undervalued and sell them when they believe they are overvalued. Stock is undervalued if the market price is less than the stock is worth to investors (its “fundamental” or “intrinsic” value). 7-7

Common Stock Valuation If securities markets are efficient: –Securities will be fairly priced: market price equals fundamental value. –Security prices reflect all available information and react quickly to new information. The Efficient Market Hypothesis 7-8

Common Stock Valuation Because securities markets are not totally efficient, it is useful to determine stock value. Methods of estimating common stock value: –Dividend approach –Free cash flow approach –Valuation multiples (P/E, Market/Book) –Liquidation value 7-9

Constant Growth Model The constant growth dividend model assumes that the stock pays dividends that grow at a constant rate each year. Requirements to use the constant growth model: Firm must pay dividends r S must be greater than g Growth rate must be constant 7-10

Free Cash Flow Model Stock Valuation Models The free cash flow model is a more sophisticated method of valuing a firm’s stock. It estimates the value of a firm’s stock based on the cash flows rather than dividends. The free cash flow model estimates the value of the entire company, so debt and preferred stock must be subtracted to get the value of equity. 7-11

Stock Valuation Models Another approach to stock valuation is based on the average P/E ratio for the firm’s industry. Weaknesses of this approach: The firm might be worth more or less (on a relative basis) than other firms in the industry. Stock prices for the entire industry might be too high or too low. Earnings are subject to manipulation and there is more than one earnings number. Valuation Using P/E Ratios 7-12