1. Berlin, 04.01.2006Fußzeile1 Stock Valuation Professor Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics

2. Berlin, 04.01.2006Fußzeile2 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.

3. Berlin, 04.01.2006Fußzeile3 Debt vs. Equity: Equity Debt and equity have substantially different marginal benefits and marginal costs. 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.

4. Berlin, 04.01.2006Fußzeile4 Preferred Stock 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.

5. Berlin, 04.01.2006Fußzeile5 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.

6. Berlin, 04.01.2006Fußzeile6 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 Additional paid-in capital Amount received in excess of par value when corporation initially sold stock Shares issued and outstanding Number of shares owned by stockholders

7. Berlin, 04.01.2006Fußzeile7 Common 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.

8. Berlin, 04.01.2006Fußzeile8 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. Unseasoned offering Initial public offering (IPO): issue of securities that are not traded yet.

9. Berlin, 04.01.2006Fußzeile9 Investment Banks’ Role in Equity Offerings 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. Direct negotiated offerCompetitive bidding Firms can choose an investment bank through

10. Berlin, 04.01.2006Fußzeile10 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

11. Berlin, 04.01.2006Fußzeile11 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.

12. Berlin, 04.01.2006Fußzeile12 Secondary Market 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, EUREX On the secondary market, investors deal among themselves.

13. Berlin, 04.01.2006Fußzeile13 Valuation Fundamentals: Preferred Stock Preferred stock is an equity security that is expected to pay a fixed annual dividend indefinitely. PS 0 = Preferred stock’s market price D p = next period’s dividend payment r p = discount rate An example: Investors require an 11% return on a preferred stock that pays a $2.30 annual dividend. What is the price?

14. Berlin, 04.01.2006Fußzeile14 Valuation Fundamentals: Common Stock P 0 = Present value of the expected stock price at the end of period #1 D 1 = Dividends received r = discount rate Value of a Share of Common Stock

15. Berlin, 04.01.2006Fußzeile15  How is P 1 determined? -PV of expected stock price P 2, plus dividends -P 2 is the PV of P 3 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: Valuation Fundamentals: Common Stock

16. Berlin, 04.01.2006Fußzeile16 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. D 1 = D 2 =... = D Plugging constant value D into the common stock valuation formula reduces to simple equation for a perpetuity:

17. Berlin, 04.01.2006Fußzeile17 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 D 1 : Commonly called the Gordon growth model

18. Berlin, 04.01.2006Fußzeile18 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? What is the stock worth if investors expect Dynasty’s dividends to grow at 3% per year?

19. Berlin, 04.01.2006Fußzeile19 Variable Growth Model Example  Estimate the current value of Morris Industries' common stock, P 0  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%.

20. Berlin, 04.01.2006Fußzeile20 Variable Growth Model Valuation Steps 1 and 2  Compute the value of dividends in year 1, 2, and 3 as (1+g 1 )=1.08 times the previous year’s dividend Div 1 = Div 0 x (1+g 1 ) = $4 x 1.08 = $4.32 Div 2 = Div 1 x (1+g 1 ) = $4.32 x 1.08 = $4.67 Div 3 = Div 2 x (1+g 1 ) = $4.67 x 1.08 = $5.04  Find the PV of these three dividend payments: PV of Div 1 = Div 1  (1+r) 1 = $ 4.32  (1.12) = $3.86 PV of Div 2 = Div 2  (1+r) 2 = $ 4.67  (1.12) 2 = $3.72 PV of Div 3 = Div 3  (1+r) 3 = $ 5.04  (1.12) 3 = $3.59 Sum of discounted dividends = $3.86 + $3.72 + $3.59 = $11.17

21. Berlin, 04.01.2006Fußzeile21  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 D 3 by 1+g 2, the lower constant growth rate: D 4 = D 3 x (1+ g 2 ) = $ 5.04 x (1.05) = $5.292  Then use D 4 =$5.292, g =0.05, r =0.12 in Gordon model: Variable Growth Model Valuation Step 3

22. Berlin, 04.01.2006Fußzeile22  Find the present value of this stock price by discounting P 3 by (1+r) 3 Variable Growth Model Valuation Step 3

23. Berlin, 04.01.2006Fußzeile23  Add the PV of the initial dividend stream (Step 2) to the PV of stock price at the end of the initial growth period (P 3 ): P 0 = $11.17 + $53.81 = $64.98 Variable Growth Model Valuation Step 4 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.

24. Berlin, 04.01.2006Fußzeile24 Valuing the Enterprise: Free Cash Flow Valuation Discount estimates of free cash flow that the firm will generate in the future. WACC: after-tax weighted average required return on all types of securities that firm issues. Use weighted average cost of capital (WACC) to discount the free cash flows. Discount We have an estimate of total value of the firm. How can we use this to value the firm’s shares?

25. Berlin, 04.01.2006Fußzeile25 Value of firm’s shares V S = V F – V D - V P V S = value of firm’s common shares V F = total enterprise value V D = value of firm’s debt V P = 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.

26. Berlin, 04.01.2006Fußzeile26 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%.

27. Berlin, 04.01.2006Fußzeile27 An Example: Mortons Restaurant Group End of YearGrowth StatusGrowth Rate (%)FCF Calculation 2000HistoricGiven$4,800,000 2001Fast14$4,800,000 x (1.14) 1 = $5,472,000 2002Fast14$4,800,000 x (1.14) 2 = $6,238,080 2003Fast14$4,800,000 x (1.14) 3 = $7,111,411 2004Fast14$4,800,000 x (1.14) 4 = $8,107,009 2005Stable7$8,107,009 x (1.07) 1 = $8,674,499 Use variable growth equation to estimate Mortons enterprise value.

28. Berlin, 04.01.2006Fußzeile28 An Example: Mortons Restaurant Group

29. Berlin, 04.01.2006Fußzeile29 An Example: Mortons Restaurant Group V F = 163,386,865 V D = $66,000,000 V P = $0 V S = $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:

30. Berlin, 04.01.2006Fußzeile30 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 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.

31. Berlin, 04.01.2006Fußzeile31 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