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Stock Valuation

Stock Valuation. Professor Trainor. 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.

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Stock Valuation

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  1. Stock Valuation Professor Trainor

  2. 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.

  3. 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.

  4. Market capitalization • Market price per share x number of shares outstanding Stock repurchased by corporation; Usually purchased for stock options Treasury stock Two-for-one split issues one new share for each already held; reduces per share price. Stock split Common Stock

  5. Firms can choose an investment bank through Direct negotiated offer Competitive bidding Best efforts • The bank promises its best efforts to sell the firm’s securities. No guarantees though about the success of the offering. • Underwritten offerings, bank guarantees certain proceeds. • Vast majority of US security offerings are underwritten. Firm commitment Investment Banks’ Role in Equity Offerings Public security issues can be

  6. 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 Investment Bank Services and Costs

  7. Show Netscape Video and Smart Finance: Womack Smart Finance

  8. PS0 = Preferred stock’s market price • Dp = next period’s dividend payment • rp = discount rate An example: Investors require an 11% return on a preferred stock that pays a $2.30 annual dividend.  What is the price? Valuation Fundamentals:Preferred Stock Preferred stock is an equity security that is expected to pay a fixed annual dividend indefinitely.

  9. Value of a Share of Common Stock Valuation Fundamentals:Common Stock • P0 = Present value of the expected stock price at the end of period #1 • D1 = Dividends received • r = discount rate

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

  11. 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: Commonly called the Gordon growth model

  12. 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?

  13. Video: French Smart Finance

  14. Free Cash Flow to Equity A much better model is to apply discount models to FCFE which may more accurately reflect a firms value. FCFE = Net Income + depreciation – Cap. Expend. – change in working capital – principal debt repayments + new debt issues. Apply model as per usual.

  15. Free Cash Flow to Firm • FCFF = EBIT(1-tax rate) + Dep. – Cap. Expenditures – Change in WC – Change in other assets. • Again, proceed as normal(replace dividends with FCFF) but discount at firms cost of capital. • You find value of firm. To find value of equity, simply subtract off debt.

  16. Firm multiples method • Analysts often use the following multiples to value stocks. • P / E • P / CF • P / Sales • EXAMPLE: Based on comparable firms, estimate the appropriate P/E. Multiply this by expected earnings to back out an estimate of the stock price.

  17. Weaknesses of Using P/E Ratios • Determining the appropriate P/E ratio. • Possible Solution: use the industry average P/E ratio • Determining the appropriate definition of earnings. • Possible Solution: adjust EPS for extraordinary items • Determining estimated future earnings • forecasting future earnings is extremely difficult

  18. Video: Shiller Smart Finance

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