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

2. Learning Goals 1.Characteristics of common and preferred stock. 2.Differences between debt and equity. 3.The process of issuing common stock and going public. 4.Concept of market efficiency. 5.Common stock valuation. 7-2

3. The Nature of Equity Capital: Voice in Management Unlike bondholders and other credit holders, holders of equity capital are owners of the firm. Common equity holders have voting rights that permit them to elect the firm’s board of directors and to vote on special issues. Bondholders and preferred stockholders receive no such privileges. 7-3

4. Common Stock: Voting Rights Some firms have two or more classes of stock differing mainly in having unequal voting rights. Usually, class ________ common stock is nonvoting while class ________ is voting. 7-4

5. Common Stock: Voting Rights (cont.) Because most shareholders do not attend the annual meeting to vote, they may sign a proxy statement giving their votes to another party (usually to management). Occasionally outsiders wage a proxy fight to gain control of the firm. 7-5

6. The Nature of Equity Capital: Claims on Income & Assets Equity holders are have a _______________________ claim on the firm’s income and assets. Their claims can not be paid until the claims of all creditors, including both interest and principle payments on debt have been satisfied. Because equity holders are the last to receive distributions, they expect greater __________________ to compensate them for the additional risk they bear. 7-6

7. The Nature of Equity Capital: Maturity Unlike debt, equity capital is a _________________ form of financing. Equity has no maturity date and never has to be repaid by the firm. 7-7

8. The Nature of Equity Capital Tax Treatment Interest paid to bondholders is a ___________ _____________________ expense for the issuing firm. Dividends paid are not tax-deductible. 7-8

9. 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. Examples: $10 dollar preferred pays annual dividend of $10 Preferred stock with $100 par and 8% dividend pays $8 per year Preferred stock is in between common stock and bonds; it has characteristics of both. 7-9

10. 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 _________________: Initial Public Offering. Most public offerings are made with the assistance of investment bankers Issuing Common Stock 7-10

11. Going Public When a firm wishes to sell its stock in the primary market, it has three alternatives: –A public offering. –A rights offering, in which new shares are sold to existing shareholders. –A private placement. 7-11

12. Going Public (cont.) For a public offering, the company must file a registration statement with the SEC. Part of the registration statement is a prospectus, which describes the key aspects of the issue, the issuer, and its management and financial position. 7-12

13. Going Public (cont.) Investment bankers and company officials promote the company through a road show. This helps investment bankers gauge the demand for the offering which helps them to set the initial offer price. In most cases, the investment banker will underwrite the issue, guaranteeing a price. The investment banker charges the issuing corporation expenses plus a spread. 7-13

14. Common Stock Returns Stockholders receive returns on their investment in the form of ___________________________ and/or ______________________________. 7-14

15. Common Stock Returns The expected return on stock may be expressed as follows: E(r) = D/P + g For example, a firm’s stock price is $25, it pays a $1 dividend that is expected to grow at 7%, the expected return is: E(r) = 1/25 +.07 = 11% 7-15

16. Common Stock Valuation 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). 7-16

17. Common Stock Valuation If securities markets are efficient: –Securities will be fairly priced: market price equals fundamental value. –Expected returns equal required returns. –Security prices reflect all available information and react quickly to new information. The Efficient Market Hypothesis 7-17

18. Common Stock Valuation Methods of estimating common stock value: –Dividend approach –Cash flow approach –Earnings approach –Liquidation value 7-18

19. Stock Valuation Models: Constant Growth Model The constant dividend growth model assumes that the stock will pay dividends that grow at a constant rate each year—year after year forever. 7-19

20. Constant Growth Model Requirements to use the constant growth model: Firm must pay ___________________ r S must be greater than _____________ Growth rate must be constant 7-20

21. 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 firm’s free cash flows rather than dividends. 7-21

22. Stock Valuation Models: Free Cash Flow Model (cont.) The free cash flow valuation model estimates the value of the entire company and uses the cost of capital as the discount rate. As a result, the value of the firm’s debt and preferred stock must be subtracted from the value of the company to estimate the value of equity. 7-22

23. Free Cash Flow Model Stock Valuation Models Advantages of free cash flow model: –Dividends are often a small part of total returns –Many firms don’t pay dividends –Unlike earnings, cash flows are not subject to manipulation Disadvantages of free cash flow model: –It is difficult to forecast free cash flow 7-23

24. Other Approaches to Stock Valuation An alternative approach to stock valuation is based on the average P/E ratio for the firm’s industry. The model may be written as: P = (av P/E)(EPS) For example, if industry av P/E is 15, and a stock’s earnings are $5.00/share, the estimated value of the stock would be P = 15*5 = $75/share. Valuation Using P/E Ratios 7-24

25. 1.The firm might be worth more or less (on a relative basis) than other firms in the industry. 2.Stock prices for the entire industry might be too high or too low. 3.Earnings are subject to manipulation and there is more than one earnings number. Other Approaches to Stock Valuation Weaknesses of Using P/E Ratios 7-25

26. Stock Valuation: Liquidation Value Liquidation value per share is based on the market value of assets, minus liabilities. This measure is more realistic than book value because it is based on current market values of the firm’s assets. However, it still fails to consider the earning power of those assets, and requires us to estimate the market value of assets. 7-26