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Ch 7. Valuation of Stocks and Corporations

Ch 7. Valuation of Stocks and Corporations. Goals. To understand characteristics of common and preferred stocks To understand stock valuations. 1. Legal Rights and Privileges of Common Stockholders 1) Control of the Firm

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Ch 7. Valuation of Stocks and Corporations

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  1. Ch 7. Valuation of Stocks and Corporations

  2. Goals • To understand characteristics of common and preferred stocks • To understand stock valuations

  3. 1. Legal Rights and Privileges of Common Stockholders 1) Control of the Firm • Common stockholders have the right to elect a firm’s directors who, in turn, elect the officers who manage the business. • Each shares of stocks has one vote • Proxy: A document giving one person the authority to act for another, typically the power to vote shares of common stock. Managers always solicits stockholders’ proxies and usually gets them

  4. Proxy fight: An attempt by a person or group to gain control of a firm by getting its stockholders to grant that person or group the authority to vote their shares to replace the current management. • Takeover: An action whereby a person or group succeeds in outstanding a firm’s management and taking control of the company.

  5. 2) Preemptive right: a provision in the corporate charter or by laws that gives common stockholders the right to purchase pro rata basis new issues of common stock (or convertible securities) • 2 Purposes: 1) to maintain control 2) to protect stockholders against a dilution of value

  6. 3) Different type of common stocks • Classified Stock: Common stock that is given a special designation, such as class A, Class B and so forth to meet special needs of company • Tracking Stock: stock with dividends tied to a particular part of a company • 4) Stock Market Reporting • http://finance.yahoo.com/

  7. 3. Common stock valuation: Cash flow patterns from holding a stock: Dividend payment & Capital gains Basic starting formula (here K is a required rate of return):

  8. Dividend Yield = D1/P0 P hat: expected price of stock at the end of each year t. Dt: dividend payment at time t Pt: stock price at time t Expected Total Return = expected dividend yield + expected capital gain yield

  9. As shown before, stock prices mainly rely on the dividend payments. And depending on the patterns of dividend payments, we can come up with three types of stock pricing models. • (1) Constant Growth Model (Gordon Model) • This model assumes that dividend payments will grow at a certain % every period

  10. Ex) Assume that allied food products just paid a dividend of $1.15. Its stock has a required rate of return of 13.4% and investors expect the dividend to grow at 8 % in future. Price =1.15(1.08)/(0.134-0.08)=23.00 • Necessary condition for the model is k>g.

  11. (2) Zero Growth Model. • It assumes that dividend payment is constant. • P= D/k • It is used to evaluate the price of preferred stock (3) Nonconstant Growth Model • It assumes no consistent patterns • Horizon or terminal value • Summation of present values has to be used to calculate the stock price

  12. 4. Valuing the entire corporation New or small growth oriented companies tend not to pay dividends. In this case, we have to use different approach to evaluate equity value. It is called as a total company valuation model. In this model, at first calculate the total value of firm and then subtract the market value of the debt and preferred stocks. Then divide by the number of shares outstanding

  13. (1) Free Cash Flow Approach • Terminal value is calculated assuming constant growth rate after Year N. Terminal Value is the sum of the PVs of the FCFs for N+1 and all subsequent years.

  14. Terminal Value = FCFN+1/(WACC-g) • Stock Price = (Value of operations+ value of non-operating assets – all debt – preferred stocks)/ number of shares • Non-operating assets: financial assets such as investments in marketable securities and noncontorlling interests in the stock of other companies.

  15. (2) Comparing the total company and dividend growth models. • Dividend growth model: - values of mature companies whose dividends are expected to grow steadily. • Total company model: • companies in the high-growth stage of its life cycle • A new company going public • A division which is supposed to be sold

  16. (3) Market Multiple Analysis • E.g) Price = average of P/E ratios of comparable firms * target firm’s EPS • Entity multiple = EBITDA multiple = an average of [(market value of equity and debts) / EBITDA] for a group of similar publicly traded companies.

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