STOCK VALUATION
Group 1 : Charles Gerard B. Beluan
Fern Ann M. Beluan
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)
and is repaid subject to the firm’s performance
Common and Preferred Stock
COMMON STOCK
Common stockholders sometimes referred to as residual owners because
they receive what is left—the residual—after all other claims on the firm’s
income and assets have been satisfied .
● they cannot lose anymore than they have invested in the firm.
● expect to be compensated with adequate dividends and, ultimately,
capital gains
COMMON STOCK
Ownership
● can be privately owned by private investors or publicly
owned by public investors.
● privately owned (stock):The common stock of a firm is
owned by private investors; this stock is not publicly traded.
● publicly owned (stock) : The common stock of a firm is
owned by public investors; this stock is publicly traded.
Ownership
● closely owned (stock) : The common stock of a firm is owned
by an individual or a small group of investors (such as a
family); these are usually privately owned companies.
● widely owned (stock) : The common stock of a firm is owned
by many unrelated individual or institutional investors .
Par Value
● par value of common stock is an arbitrary value
established for legal purposes in the firm’s corporate
charter and is generally set quite low, often an amount of
$1 or less.
● can be used to find the total number of shares
outstanding by dividing it into the book value of common
stock.
Preemptive Rights
● Allows common stockholders to maintain their proportionate
ownership in the corporation when new shares are issued, thus
protecting them from dilution of their ownership.
● A dilution of ownership is a reduction in each previous
shareholder’s fractional ownership resulting from the issuance
of additional shares of common stock.
Preemptive Rights
● Preemptive rights allow pre existing shareholders to maintain
their preissuance voting control and protects them against the
dilution of earnings.
● dilution of earnings : 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,
indirect proportion to their number of owned shares.
● an important financing tool without which shareholders would
run the risk of losing their proportionate control of the
corporation.
Authorized, Outstanding, and Issued Shares
● authorized shares : Shares of common stock that a firm’s
corporate charter allows it to issue.
● outstanding shares : Issued shares of common stock held by
investors, including both private and public investors.
● treasury stock : Issued shares of common stock held by the
firm; often these shares have been repurchased by the firm .
● issued shares : Shares of common stock that have been put into
circulation; the sum of outstanding shares and treasury stock.
Voting Rights
● 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.
● proxy statement : A statement transferring the votes of a stockholder to
another party.
● proxy battle : The attempt by a nonmanagement group to gain
control of the management of a firm by soliciting a sufficient number of proxy
votes.
● supervoting shares :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 : 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.
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.
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. How the dividend is specified
depends on whether the preferred stock has a par value.
Par-value preferred stock has a stated face value, and its annual
dividend is specified as a percentage of this value.
No-par preferred stock has no stated face value, but its annual
dividend is stated in dollars.
Basic Rights of Preferred Stockholders
Preferred stock is often considered quasi-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.
● given preference over common stockholders in
the liquidation of assets in a legally bankrupt firm, although they
must “stand in line” behind creditors.
● not normally given a voting right, although preferred stockholders are
sometimes allowed to elect one member of the board of directors.
Features of Preferred Stock
● Restrictive Covenants The restrictive covenants in a preferred
stock issue focus on ensuring the firm’s continued existence and
regular payment of the dividend.
● covenants include provisions about passing dividends, the sale of
senior securities, mergers, sales of assets, minimum liquidity
requirements, and repurchases of common stock.
Features of Preferred Stock
Cumulation.
cumulative (preferred stock) 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) Preferred stock for which passed (unpaid) dividends do not accumulate.
callable .
callable feature (preferred stock) A feature of callable preferred
stock that allows the issuer to retire the shares within a certain period of time and at a specified price.
conversion feature (preferred stock) A feature of convertible preferred stock that allows
holders to change each share into a stated number of shares of common stock.
ISSUING COMMON STOCK
Venture Capital : The initial external equity financing privately raised
by firms, typically early stage firms with attractive growth prospects.
Venture capitalists (VCs) : Providers of venture capital; typically,
formal businesses that maintain strong oversight over the firms they
invest in and that have clearly defined exit strategies.
angel capitalists (angels) : Wealthy individual investors who do not
operate as a business but invest in promising early-stage companies in
exchange for a portion of the firm’s equity.
Deal Structure and Pricing
● venture capital investments are made under a legal contract that clearly allocates
responsibilities and ownership interests between existing owners (founders) and the
VC fund or limited partnership.
● To control the VC’s risk, various covenants are included in the agreement, and the
actual funding may be pegged to the achievement of measurable milestones.
● The VC will negotiate numerous other provisions into the contract, both to ensure
the firm’s success and to control its risk exposure. The contract will have an explicit
exit strategy for the VC that may be tied both to measurable milestones and to time.
● The amount of equity to which the VC is entitled will, depends on the value of the
firm, the terms of the contract, the exit terms, and the minimum compound annual
rate of return required by the VC on its investment.
Going Public
(1) a public offering : offers its shares for sale to the general public;
(2) a rights offering : in which new shares are sold to existing
stockholders;
(3) a private placement: in which the firm sells new securities
directly to an investor or group of investors.
Public offering
Initial public offering (IPO) : the first public sale of a firm’s stock.
To go public :
1. the firm must first obtain the approval of its current shareholders,
the investors who own its privately issued stock.
2. the company’s auditors and lawyers must certify that all documents for the company are legitimate.
3. The company then finds an investment bank willing to underwrite the offering.
4. The company files a registration statement with the SEC.
● Prospectus : A portion of a security registration statement that describes the key aspects of the
issue, the issuer, and its management and financial position
● red herring : A preliminary prospectus made available to prospective investors during the waiting
period between the registration statement filing with the SEC and its approval.
1. the SEC approves the registration statement
● Quiet period : during which there are restrictions on what company officials may say about the
company.
1. the investment community can begin analyzing the company’s prospects.
investment banker : Financial intermediary that specializes in selling new
security issues and advising
firms with regard to major financial transactions.
Underwriting : The role of the investment banker in bearing the risk of
reselling, at a profit, the securities purchased from an issuing corporation at an
agreed-on price.
underwriting syndicate : A group of other bankers formed by an
investment banker to share the financial risk associated with
underwriting new securities.
selling group : A large number of brokerage firms that join the
originating investment banker(s); each accepts responsibility for
selling a certain portion of a new security issue on a commission
basis.
Common Stock Valuation
MARKET EFFICIENCY
The efficient-market hypothesis (EMH) : which is the basic theory describing
the
behavior of such a “perfect” market, specifically states that:
1. Securities are typically in equilibrium
2. At any point in time, security prices fully reflect all information
available about the firm and its securities, and these prices react swiftly
to new information.
3. Because stocks are fully and fairly priced, investors need not waste
their time trying to find mispriced (undervalued or overvalued)
securities.
The Behavioral Finance Challenge
Behavioral finance : A growing body of research that focuses on
investor behavior and its impact on investment decisions and stock
prices. Advocates are commonly referred to as “behaviorists.”
BASIC COMMON STOCK VALUATION EQUATION
The basic valuation model for common stock is given in Equation 7.1:
Constant-growth model : 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.
Variable-growth model : A dividend valuation approach that allows
for a change in the dividend growth rate.
We will assume that a single shift in growth rates occurs at the
end of year N, and we will use g1 to represent the initial growth
rate and g2 for the growth rate after the shift. To determine the
value of a share of stock in the case of variable growth, we use a
four-step procedure:
FREE CASH FLOW VALUATION MODEL
● A model that determines the value of an entire company as the present
value of its expected free cash flows discounted at the firm’s weighted
average cost of capital, which is its expected average future cost of funds
over the long run.
● The free cash flow valuation model estimates the value of the entire
company by finding the present value of its expected free cash flows
discounted at its weighted average cost of capital.
OTHER APPROACHES TO COMMON STOCK VALUATION
Book Value :
Book value per share : The amount per share of common stock
that would be received if all of the firm’s assets were sold for their
exact book (accounting) value and the proceeds remaining after
paying all liabilities (including preferred stock) were divided among
the common stockholders.
Liquidation Value
Liquidation value per share : The actual amount per share of common
stock that would be received if all of the firm’s assets were sold for their
market value, liabilities (including preferred stock) were paid, and any
remaining money were divided among the common stockholders.
price/earnings multiple approach :
A popular technique used to estimate the firm’s share value;
calculated by multiplying the firm’s expected earnings per share (EPS)
by the average price/earnings (P/E) ratio for the industry.
Decision Making and Common
Stock Value
1. CHANGES IN EXPECTED DIVIDENDS
- Assuming that economic conditions remain stable, any management action that would cause
current and prospective stockholders to raise their dividend expectations should increase the firm’s
value.
2. CHANGES IN RISK
- Any action taken by the financial manager that increases the risk shareholders must bear
will also increase the risk premium required by shareholders, and hence the required
[Link], the required return can be affected by changes in the risk free rate—
even if the risk premium remains constant.
COMBINED EFFECT
A financial decision rarely affects dividends and risk independently;
most decisions affect both factors often in the same direction. As
firms take on more risk, their shareholders expect to see higher
dividends. The net effect on value depends on the relative size of
the changes in these two variables.
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