Chapter 7
Stock Valuation
Learning Goals
LG1 Differentiate between debt and equity.
LG2 Discuss the features of both common and preferred stock.
LG3 Describe the process of issuing common stock, including
venture capital, going public and the investment banker.
LG4 Understand the concept of market efficiency and basic
stock valuation using
zero-growth, constant-growth, and variable-growth models.
Differences Between Debt and Equity
• Debt includes all borrowing incurred by a firm, including bonds, and is repaid according to a fixed schedule
of payments.
• Equity consists of funds provided by the firm’s owners (investors or stockholders) that are repaid subject to
the firm’s performance.
• Debt financing is obtained from creditors and equity financing is obtained from investors who then become
part owners of the firm.
• Creditors (lenders or debt holders) have a legal right to be repaid, whereas investors only have an
expectation of being repaid.
Common and Preferred Stock: Common Stock
• Common stockholders, who are sometimes referred to as residual owners or
residual claimants, are the true owners of the firm.
• As residual owners, common stockholders receive what is left—the residual—after
all other claims on the firms income and assets have been satisfied.
• They are assured of only one thing: that they cannot lose any more than they have
invested in the firm.
• Because of this uncertain position, common stockholders expect to be
compensated with adequate dividends and ultimately, capital gains.
Common Stock: Par Value
• The par value of common stock is an arbitrary value established for legal
purposes in the firm’s corporate charter, and can be used to find the total
number of shares outstanding by dividing it into the book value of common
stock.
• When a firm sells new shares of common stock, the par value of the shares
sold is recorded in the capital section of the balance sheet as part of common
stock.
• At any time the total number of shares of common stock outstanding can be
found by dividing the book value of common stock by the par value.
Common Stock: Preemptive Rights
• A preemptive right allows common stockholders to maintain their proportionate ownership in the
corporation when new shares are issued, thus protecting them from dilution of their ownership.
• Dilution of ownership is a reduction in each previous shareholder’s fractional ownership resulting
from the issuance of additional shares of common stock.
• Dilution of earnings is a reduction in each previous shareholder’s fractional claim on the firm’s
earnings resulting from the issuance of additional shares of common stock.
• Rights are financial instruments that allow stockholders to purchase additional shares at a
price below the market price, in direct proportion to their number of owned shares.
• Rights are an important financing tool without which shareholders would run the risk of
losing their proportionate control of the corporation.
• From the firm’s viewpoint, the use of rights offerings to raise new equity capital may be
less costly than a public offering of stock.
Common Stock: Authorized, Outstanding, and Issued
Shares
• Authorized shares are the shares of common stock that a firm’s corporate charter
allows it to issue.
• Outstanding shares are issued shares of common stock held by investors, this
includes private and public investors.
• Treasury stock are issued shares of common stock held by the firm; often these
shares have been repurchased by the firm.
• Issued shares are shares of common stock that have been put into circulation.
Issued shares = outstanding shares + treasury stock
Common Stock: Authorized, Outstanding, and Issued
Shares (cont.)
• Golden Enterprises, a producer of medical pumps, has the following stockholder’s
equity account on December 31st.
Common Stock: Voting Rights
• Generally, each share of common stock entitles its holder to one vote in the election of directors and
on special issues.
• Votes are generally assignable and may be cast at the annual stockholders’ meeting.
• A proxy statement is a statement transferring the votes of a stockholder to another party.
–Because most small stockholders do not attend the annual meeting to vote, they may sign a proxy statement
transferring their votes to another party.
• A proxy battle is an attempt by a non-management group to gain control of the management
of a firm by soliciting a sufficient number of proxy votes.
• Super voting shares is stock that carries with it multiple votes per share rather than the
single vote per share typically given on regular shares of common stock.
• Nonvoting common stock is common stock that carries no voting rights; issued when the
firm wishes to raise capital through the sale of common stock but does not want to give up its
voting control.
Common Stock: Dividends
• The payment of dividends to the firm’s shareholders is at the
discretion of the company’s board of directors.
• Dividends may be paid in cash, stock, or merchandise.
• Common stockholders are not promised a dividend, but they come
to expect certain payments on the basis of the historical dividend
pattern of the firm.
• Before dividends are paid to common stockholders any past due
dividends owed to preferred stockholders must be paid.
Preferred Stock
• Preferred stock gives its holders certain privileges that make them
senior to common stockholders.
• Preferred stockholders are promised a fixed periodic dividend, which
is stated either as a percentage or as a dollar amount.
• Par-value preferred stock is preferred stock with a stated face
value that is used with the specified dividend percentage to determine
the annual dollar dividend.
• No-par preferred stock is preferred stock with no stated face value
but with a stated annual dollar dividend.
Preferred Stock :
Basic Rights of Preferred Stockholders
• Preferred stock is often considered quasi-debt because, much like
interest on debt, it specifies a fixed periodic payment (dividend).
• Preferred stock is unlike debt in that it has no maturity date.
• Because they have a fixed claim on the firm’s income that takes
precedence over the claim of common stockholders, preferred
stockholders are exposed to less risk.
• Preferred stockholders are not normally given a voting right,
although preferred stockholders are sometimes allowed to elect one
member of the board of directors.
Preferred Stock: Features of Preferred Stock
• Restrictive covenants including provisions about passing dividends, the sale of senior securities,
mergers, sales of assets, minimum liquidity requirements, and repurchases of common stock.
• Cumulative preferred stock is preferred stock for which all passed (unpaid) dividends in
arrears, along with the current dividend, must be paid before dividends can be paid to common
stockholders.
• Noncumulative preferred stock is preferred stock for which passed (unpaid) dividends do not
accumulate.
• A callable feature is a feature of callable preferred stock that allows the issuer to
retire the shares within a certain period time and at a specified price.
• A conversion feature is a feature of convertible preferred stock that allows holders
to change each share into a stated number of shares of common stock.
Going Public
•When a firm wishes to sell its stock in the primary market, it has three alternatives.
1. A public offering, in which it offers its shares for sale to the general public.
2. A rights offering, in which new shares are sold to existing shareholders.
3. A private placement, in which the firm sells new securities directly to an investor or a group of investors.
•Here we focus on the initial public offering (IPO), which is the first public sale of a firm’s stock.
• IPOs are typically made by small, fast-growing companies that:
–require additional capital to continue expanding
• offering.
The firm must obtain approval of current shareholders, and hire an investment bank to underwrite the
• The investment banker is responsible for
• promoting the stock and
• facilitating the sale of the company’s IPO shares.
Common Stock Valuation
• Common stockholders expect to be rewarded through periodic cash
dividends and an increasing share value.
• Some of these investors decide which stocks to buy and sell based on a plan
to maintain a broadly diversified portfolio.
• Other investors have a more speculative motive for trading.
–They try to spot companies whose shares are undervalued—meaning that the true value of
the shares is greater than the current market price.
–These investors buy shares that they believe to be undervalued and sell shares that they
think are overvalued (i.e., the market price is greater than the true value).
Common Stock Valuation: Market Efficiency
• Economically rational buyers and sellers use their assessment of an asset’s
risk and return to determine its value.
• In competitive markets with many active participants, the interactions of
many buyers and sellers result in an equilibrium price—the market value—
for each security.
• Because the flow of new information is almost constant, stock prices
fluctuate, continuously moving toward a new equilibrium that reflects the
most recent information available. This general concept is known as market
efficiency.
Common Stock Valuation:
Basic Common Stock Valuation Equation
• The value of a share of common stock is equal to the present value of all future cash flows
(dividends) that it is expected to provide.
P0 = value of common stock
Dt = per-share dividend expected at the end of
year t
Rs = required return on common stock
P0 = value of common stock
Common Stock Valuation: The Zero Growth Model
•The zero dividend growth model assumes that the stock will pay the same dividend each
year, year after year.
•The equation shows that with zero growth, the value of a share of stock would equal the
present value of a perpetuity of D1 dollars discounted at a rate rs.
Common Stock Valuation: Constant-Growth Model
•The constant-growth model is a widely cited dividend valuation approach that
assumes that dividends will grow at a constant rate, but a rate that is less than the
required return.
•The Gordon model is a common name for the constant-growth model that is widely
cited in dividend valuation.
Common Stock Valuation: Variable-Growth Model
• The zero- and constant-growth common stock models do not allow for any shift in expected growth rates.
• The variable-growth model is a dividend valuation approach that allows for a change in the dividend growth rate.
• To determine the value of a share of stock in the case of variable growth, we use a four-step procedure.
• Step 1. Find the value of the cash dividends at the end of each year, Dt, during the initial growth period,
years 1 though N.
Dt = D0 × (1 + g1)t
• Step 2. Find the present value of the dividends expected during the initial growth period.
• Step 3. Find the value of the stock at the end of the initial growth period, PN = (DN+1)/(rs – g2), which is the
present value of all dividends expected from year N + 1 to infinity, assuming a constant dividend growth
rate, g2.
Common Stock Valuation: Variable-Growth Model (Cont’d)
• Step 4. Add the present value components found in Steps 2 and 3 to
find the value of the stock, P0.
Common Stock Valuation: Variable-Growth Model(Cont’d)
• The most recent annual (2017) dividend payment of Warren Industries, a
rapidly growing boat manufacturer, was $1.50 per share. The firm’s financial
manager expects that these dividends will increase at a 10% annual rate, g1,
over the next three years. At the end of three years (the end of 2020), the firm’s
mature product line is expected to result in a slowing of the dividend growth
rate to 5% per year, g2, for the foreseeable future. The firm’s required return, rs,
is 15%.
•Step 3. The value of the stock at the end of the initial growth period (N = 2015) can
be found by first calculating DN+1 = D2016.
•D2016 = D2015 (1 + 0.05) = $2.00 (1.05) = $2.10
•By using D2016 = $2.10, a 15% required return, and a 5% dividend growth rate, we
can calculate the value of the stock at the end of 2015 as follows:
•P2015 = D2016 / (rs – g2) = $2.10 / (.15 – .05) = $21.00
• Finally, the share value of $21 at the end of 2015 must be converted into a present
(end of 2012) value.
•P2015 / (1 + rs)3 = $21 / (1 + 0.15)3 = $13.81
•Step 4. Adding the PV of the initial dividend stream (found in Step 2) to the PV of the
stock at the end of the initial growth period (found in Step 3), we get:
•P2012 = $4.14 + $13.82 = $17.93 per share