© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Company Analysis & Stock Valuation

2 Issuing Common Stock Sell to existing shareholders or to new shareholders? Initial Public Offering (IPO) Role of Investment Bankers –Underwriting –Best efforts Pricing the issue

Common Stock and Its Features Basic Terms Authorized Shares Issued Shares Outstanding Shares Common Stock Common Stock -- Securities that represent the ultimate ownership (and risk) position in a corporation.

Company Analysis Firm’s Overall Strategic Approach –Industry competitive environment –SWOT analysis  Strengths  Weaknesses  Opportunities  Threats Firm’s Valuation Approaches –Present value of cash flows –Relative valuation ratio techniques 14-4 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Estimating Intrinsic Value Present value of cash flows (PVCF) –Present value of dividends (DDM) Relative valuation techniques –Price earnings ratio (P/E) 14-5 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Example of Value $1 par value Common stock ($1 par value; 100,000 shares issued and outstanding)$ 100,000 Additional paid-in capital 400,000 Retained earnings 650,000 Total shareholders’ equity$1,150,000 par value $1 per share The par value is $1 per share. This value is not likely to change over time from normal day-to-day operations.

7 Intrinsic Value DividendsCapital Appreciation CONCEPT The intrinsic value of a share is the present value of all future cash flows to be received in respect of the ownership of that share, computed at an appropriate discount rate i.e. Cost of Equity.

8 The investment decision of the fundamental analyst to buy or sell a share is based on a comparison between the intrinsic value of a share and its current market price. a)If the market price of a share is currently lower than its intrinsic value, such a share would be bought because it is perceived to be under priced. b)A share whose current market price is higher than its intrinsic value would be considered as overpriced and hence sold.

9 One Year Holding Period Here an investor intends to purchase a share now, hold it for one year and sell it off at the end of one year. In this case, the investor would be expected to receive an amount of dividend as well as the selling price after one year. The present value of the share may be expressed as:

© 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part The Present Value Approach. n Cash flows Estimated Value of security=  ( 1+ k) t t=1 Where, K = the appropriate discount rate or required rate of return. To use such a model, an investor must: Estimate an appropriate required rate of return. Estimate the amount and timing of the future stream of cash flows. Use these two components in a present value model

11 Multiple Year Holding Period Here an investor may hold a share for a certain number of years and sell it off at the end of his holding period. In this case, he would receive annual dividends each year and the sale price of the share at the end of the holding period. The present value of the share may be expressed as:

12 Constant Growth Model In this model it is assumed that dividends will grow at the same rate (g) into the indefinite future and that the discount rate k is greater than the dividend growth rate g. The present value model for share valuation may now be written as: When 'n' approaches infinity, this formula can be simplified as:

13 A company has declared a dividend of Afs per share for the current year. The company has been following a policy of enhancing its dividends by 10 per cent every year and is expected to continue this policy in the future also. An investor who is considering the purchase of the shares of this company has a required rate of return of 15 per cent. Example- Example The intrinsic value of the company's share can be calculated as:

14 Time: 0123 PV = ? 15% 4 10% Div Growth up to infinity Div = * * *1.1/ (15%-10%) = 55 Afs. Example-2 TIME LINE P 0 = D 1 __ = 1.07____ K - g = 13.38

15 Features of Preferred Stock A hybrid security with both debt and equity characteristics. Has priority over common stock in receipt of dividends and in liquidation. Dividends are fixed as a percentage of par value. Only participating preferred stock (which is rare) shares in the residual income with the common stockholders.

16 Preferred Stock Where V p is the value of the preferred stock D p is the preferred dividend r p is the required rate of return.

Preferred Stock Preferred Stock -- A type of stock that promises a (usually) fixed dividend, but at the discretion of the board of directors. Preferred Stock and Its Features Basic Terms Par Value Dividend Rate Maturity

Cumulative Dividends Feature For example, if the board of directors omits a $6 preferred dividend for two years, it must pay preferred shareholders $12 per share ($100 par value) before any dividend can be paid to common shareholders. The corporation does not have to make up the dividend even if it is profitable, as long as the firm has no plans to pay dividends to common shareholders. Cumulative Dividends Feature Cumulative Dividends Feature -- A requirement that all cumulative unpaid dividends on the preferred stock be paid before a dividend may be paid on the common stock.

Participating Feature Preferred stockholders have a prior claim on income and an opportunity for additional return if the dividends to common stockholders exceed a certain amount. A 6% participating preferred issue ($100 par) allows holders to share equally in any dividend in excess of $6. A $7 common dividend results in an extra $1 dividend to the participating preferred shareholders. Participating Preferred Stock Participating Preferred Stock -- Preferred stock where the holder is allowed to participate in increasing dividends if the common stockholders receive increasing dividends.

u Two methods of voting: (1) in person or (2) by proxy Proxy Proxy -- A legal document giving one person authority to act for another. Voting Rights SEC regulates the solicitation of proxies and requires companies to disseminate information to their shareholders through proxy mailings. Most shareholders, if satisfied with company performance, sign proxies in behalf of management. u Shareholders are generally geographically widely dispersed.

Voting Procedures Majority-rule voting statutory votingMajority-rule voting -- a method of electing corporate directors, where each common share held carries one vote for each director position that is open; also called statutory voting. Cumulative votingCumulative voting -- a method of electing corporate directors, where each common share held carries as many votes as there are directors to be elected and each shareholder may accumulate these votes and cast them in any fashion for one or more particular directors. The board of directors are elected under either:

Voting Procedures Example Under majority-rule votingUnder majority-rule voting: You may cast 100 votes (1 per share) for each of the 9 director positions open for a maximum of 100 votes per position. Under cumulative votingUnder cumulative voting: You may cast 900 votes (100 votes x 9 positions) for a single position or divide the votes amongst the 9 open positions in any manner you desire. You are a shareholder of FunFinMan, Inc. You own 100 shares and there are 10 director positions to be filled.

Minimum Votes to Elect a Director -- Cumulative 30,001 voting sharesFor example, to elect 3 directors out of 9 director positions at FunFinMan, Inc., (100,000 voting shares outstanding) would require 30,001 voting shares. (100,000 shares) x (3 directors) 10 Total number of voting shares Specific number of directors sought Total number of directors to be elected + 1 X ,001 shares + 1 = 30,001 shares

Minimum Votes to Elect a Director -- Cumulative Notice that slightly over 30% of total voting shares are necessary to guarantee the election of three of the nine director positions -- less than a majority. Management can reduce the influence of minority shareholders by reducing the number of directors or staggering the election terms of directors so fewer positions are open at each vote. Reducing the number of directors up for election from 9 to 4 would increase the votes necessary to elect 3 directors to 60,001 shares (twice as many)!