Chapter 7 Stock Valuation

Chapter 7
Stock Valuation
Copyright © 2003 Pearson Education, Inc. Slide 7-1

Learning Goals
1. Differentiate between debt and equity.
2. Discuss the rights, characteristics, and features of
both common and preferred stock.
3. Describe the process of issuing common stock,
including venture capital, going public, the investment
banker’s role, and stock quotations.
4. Understand the concept of market efficiency and
basic common stock valuation under the zero growth,
constant growth, and variable gwoth models.
Learning Goals
5. Discuss the free cash flow valuation model and the
use of book value, liquidation value, and
price/earnings (P/E) multiples to estimate common
stock values.
6. Explain the relationship among financial decisions,

return, risk, and the firm’s value.

Differences Between Debt & Equity

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.
Claims on Income & Assets
• Equity holders are have a residual claim on the firm’s
income and assets.
• Their claims can not be paid until the claims of all
creditors, including both interest and principal
payments on debt have been satisfied.
• Because equity holders are the last to receive
distributions, they expect greater returns to
compensate them for the additional risk they bear.
Maturity
• Unlike debt, equity capital is a permanent form of

financing.
• Equity has no maturity date and never has to be
repaid by the firm.

Tax Treatment
• While interest paid to bondholders is tax-deductible to

the issuing firm, dividends paid to preferred and
common stock holders is not.
• In effect, this further lower the cost of debt relative to
the cost of equity as a source of financing to the firm.

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.
• Because of this uncertain position, common
stockholders expect to be compensated with adequate
dividends and ultimately, capital gains.
Common Stock
Ownership
• The common stock of a firm can be privately owned by
an individual, closely owned by a small group of
investors, or publicly owned by a broad group of
investors.
• Typically, small corporations are privately or closely
owned and if their shares are traded, this occurs
infrequently and in small amounts.
• Large corporations are typically publicly owned and
have shares that are actively traded on major
securities exchanges.
Common Stock
Par Value
• Unlike bonds, common stock may be sold without par

value.
• The par value of a common stock is generally low (P1)
and is a relatively useless value established in the
firm’s corporate charter.
• A low par value may be advantageous in states where
certain corporate taxes are based on the par value of
the stock.
Common Stock
Preemptive Rights
• A preemptive right allows common stockholders to
maintain their proportionate ownership in a corporation
when new shares are issued.
• This allows existing shareholders to maintain voting
control and protect against the dilution of their
ownership.
• In a rights offering, the firm grants rights to its existing
shareholders, which permits them to purchase
additional shares at a price below the current price.
Common Stock
Authorized, Outstanding, and Issued Shares
• Authorized shares are the number of shares of
common stock that a firm’s corporate charter allows.
• Outstanding shares are the number of shares of
common stock held by the public.
• Treasury stock is the number of outstanding shares
that have been purchased by the firm.
• Issued shares are the number of shares that have
been put into circulation and includes both outstanding
shares and treasury stock.
Common 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.
• Many firms have issued two or more classes of stock
differing mainly in having unequal voting rights.
• Usually, class A common stock is designated as
nonvoting while class B is designated as voting.
Common Stock
Voting Rights
• Because most shareholders do not attend the annual
meeting to vote, they may sign a proxy statement
giving their votes to another party.
• Occasionally, when the firm is widely owned, outsiders
may wage a proxy battle to unseat existing
management and gain control.

Common Stock
Dividends
• Payment of dividends is at the discretion of the board
of directors.
• Dividends may be made in cash, additional shares of
stock, and even merchandise.
• Because stockholders are residual claimants -- they
receive dividend payments only after all claims have
been settled with the government, creditors, and
preferred stockholders.
Preferred Stock
• Preferred stock is an equity instrument that usually
pays a fixed dividend and has a prior claim on the
firm’s earnings and assets in case of liquidation.
• The dividend is expressed as either a peso amount or
as a percentage of its par value.
• Therefore, unlike common stock a preferred stock’s
par value may have real significance.
• If a firm fails to pay a preferred stock dividend, the
dividend is said to be in arrears.
Preferred Stock
• In general, and arrearage must be paid before
common stockholders receive a dividend.
• Preferred stocks which possess this characteristic are
called cumulative preferred stocks.
• Preferred stocks are also often referred to as hybrid
securities because they possess the characteristics of
both common stocks and bonds.
• Preferred stocks are like common stock because they
are perpetual securities with no maturity date.
Preferred Stock
• Preferred stocks are like bonds because they are fixed
income securities. Dividends never change.
• Because preferred stocks are perpetual, many have call
features which give the issuing firm the option to retire
them should the need or advantage arise.
• In addition, some preferred stocks have mandatory sinking
funds which allow the firm to retire the issue over time.
• Finally, participating preferred stock allows preferred
stockholders to participate with common stockholders in
the receipt of dividends beyond a specified amount.

Common Stock Valuation
• Stockholders expect to be compensated for their

investment in a firm’s shares through periodic
dividends and capital gains.
• Investors purchase shares when they feel they are
undervalued and sell them when they believe they are
overvalued.

Cash Flows for Stockholders
• If you own a share of stock, you can
receive cash in two ways
– The company pays dividends
– You sell your shares, either to another investor
in the market or back to the company
• As with bonds, the price of the stock is the
present value of these expected cash flows
– Dividends → cash income
– Selling → capital gains

Estimating Dividends
Special Cases
• Constant dividend/Zero Growth
– Firm will pay a constant dividend forever
– Like preferred stock
– Price is computed using the perpetuity formula
• Constant dividend growth
– Firm will increase the dividend by a constant percent
every period
• Variable growth
– Dividend growth is not consistent initially, but settles
down to constant growth eventually
Common Stock Valuation
Stock Returns are derived from both dividends and
capital gains, where the capital gain results from the
appreciation of the stock’s market price.due to the
growth in the firm’s earnings. Mathematically, the
expected return may be expressed as follows:
E(r) = D/P + g
For example, if the firm’s $1 dividend on a $25

stock is expected to grow at 7%, the expected
return is:
E(r) = 1/25 + .07 = 11%

Stock Valuation Models
The Basic Stock Valuation Equation

The Zero Growth Model
• The zero dividend growth model assumes that the

stock will pay the same dividend each year, year after
year.

Using Excel
1. Zero Growth (Constant Dividend) Model
A. Solving for Price: V = D/k, where D = dividend and k = required return
What would an investor be willing to pay for a stock if she expected to receive
a dividend of $2.50 each year indefinitely and her required return is 15%?
D $ 2.50
k 15.00%
V? $ 16.67

Using Excel
B. Solving for Return: k = D/V
What rate of return would an investor expect if the current price of a stock
is $119 and she expected the firm to pay a constant dividend of $4/year?
V $ 119.00
D $ 4.00
k? 3.4%

The 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.

To Find R
Start with the formula:
D0 (1  g) D1
P0  
R-g R-g
Rearrange and solve for R:
D0 (1  g) D1
R g g
P0 P0

Finding the Required Return
Example
• A firm’s stock is selling for $10.50.

They just paid a $1 dividend and
dividends are expected to grow at
5% per year.
• What is the required return?

Example
• P0 = $10.50.
• D0 = $1
• g = 5% per year.
• What is the required return?

Example
• P0 = $10.50
• D0 = $1 D0 (1  g)
• g = 5% per year R  g
P0
• What is the dividend D1
R  g
yield? P0
1.00(1.05)
R  .05  15%
• What is the capital 10.50
gains yield? Dividend Capital Gains
Yield Yield

Using Excel
Valuation
(Note: The tables below have been w ritten using form ulas w hich allow you to alter the inform ation or assum ptions.)
1. Constant Growth Model
A. Solving for Price: V = D0(1+g)/k-g = D1/(k-g) , where D0 = current dividend, k = required return,
and g = growth rate
What would an investor be willing to pay for a stock if she just received a
dividend of $2.50, her required return is 15%, and she expected dividneds
to grow at a rate of 5% per year.
D0 $ 2.50
k 15.00%
g 5.00%
V? $ 26.25
Using Excel
B. Solving for Return: k = D0(1+g)/V + g = D1/V + g
What is my expected return on a stock that costs $26.50, just paid a

dividend of $2.50, and has an expected growth rate of 5%?
D0 $ 2.50
V $ 26.25
g 5.00%
k? 15.00%
Variable Growth Model
• The non-constant
dividend or variable
growth model
assumes that the
stock will pay
dividends that grow at
one rate during one
period, and at another
rate in another year or
thereafter.

Using Excel
Valuation
(Note: The tables below have been w ritten using formulas
w hich allow you to alter the informatins or assumptions.)
1. Non-Constant Growth Model
A. Solving for Price: This model involves the computation of year-to-year dividends which
are then dicounted at the investors required rate of return.
to grow at a rate of 10% per year for the first two years, and then at a rate of
5% thereafter.
5% thereafter.
Step 1: Compute the expected dividends during the first growth period.
g 10.0%
D0 $ 2.50
D1 $ 2.75
D2 $ 3.03
5% thereafter.
Step 2: Compute the Estimated Value of the stock at the end of year 2
using the Constant Growth Model
D2 $ 3.03
k 15.00%
g 5.00%
V 2? $ 31.76
5% thereafter.
Step 3: Compute the Present Value of all expected cash flows
to find the price of the stock today.
Cash PV at
Flow 15%
1 D1 $ 2.75 $ 2.39
2 D2 $ 3.03 $ 2.29
3 V 2? $ 31.76 $ 20.88
V0 ? $ 25.56
Free Cash Flow Model
• The free cash flow model is based on the same
premise as the dividend valuation models except that
we value the firm’s free cash flows rather than
dividends.

• 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.

Dewhurst Inc. wishes to value its stock using the
free cash flow model. To apply the model, the
firm’s CFO developed the data given in Table 7.3.

Step 1: Calculate the present value of the free cash
flow occurring from the end of 2009 to infinity,
measured at the beginning of 2009.

Step 2: Add the PF of the FCF found in step 1 to

the FCF for 2008.
Total FCF2008 = $600,000 + $10,300,000 = $10,900,000
Step 3: Find the sum of the present values of the

FCFs for 2004 through 2008 to determine VC. This
is shown in Table 7.4 on the following slide.


Step 4: Calculate the value of the common stock

using equation 7.6.
VS = $8,628,620 - $3,100,000 = $4,728,620

Other Approaches to Stock Valuation
Book Value
• Book value per share is the amount per share that
would be received if all the firm’s assets were sold for
their exact book value and if the proceeds remaining
after paying all liabilities were divided among common
stockholders.
• This method lacks sophistication and its reliance on
historical balance sheet data ignores the firm’s
earnings potential and lacks any true relationship to
the firm’s value in the marketplace.
Liquidation Value
• Liquidation value per share is the actual amount per
share of common stock to be received if al of the firm’s
assets were sold for their market values, liabilities
were paid, and any remaining funds were divided
among common stockholders.
• 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.
Valuation Using P/E Ratios
• Some stocks pay no dividends. Using P/E ratios are
one way to evaluate a stock under these
circumstances.
• The model may be written as:
– P = (m)(EPS)
– where m = the estimated P/E multiple.
For example, if the estimated 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.
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
Decision Making and Common Stock Value
• Valuation equations measure the stock value at a
point in time based on expected return and risk.
• Any decisions of the financial manager that affect
these variables can cause the value of the firm to
change as shown in the Figure below.

Changes in Dividends or Dividend Growth
• Changes in expected dividends or dividend growth
can have a profound impact on the value of a stock.
Price Sensitivity to Changes in Dividends and Dividend Growth
(Using the Constant Growth Model)
D0 $ 2.00 $ 2.50 $ 3.00 $ 2.00 $ 2.00 $ 2.00

g 3.0% 3.0% 3.0% 3.0% 6.0% 9.0%
D1 $ 2.06 $ 2.58 $ 3.09 $ 2.06 $ 2.12 $ 2.18
kS 10.0% 10.0% 10.0% 10.0% 10.0% 10.0%
P $ 29.43 $ 36.79 $ 44.14 $ 29.43 $ 53.00 $ 218.00

Changes in Risk and Required Return
Price Sensitivity to Changes Risk (Required Return)

D0 $ 2.00 $ 2.00 $ 2.00 $ 2.00 $ 2.00 $ 2.00

g 3.0% 3.0% 3.0% 3.0% 3.0% 3.0%
D1 $ 2.06 $ 2.06 $ 2.06 $ 2.06 $ 2.06 $ 2.06
kS 5.0% 7.5% 10.0% 12.5% 15.0% 17.5%
P $ 103.00 $ 45.78 $ 29.43 $ 21.68 $ 17.17 $ 14.21

Changes in Risk and Required Return
Price Sensitivity to Changes in Both Dividends and Required Return

D0 $ 2.00 $ 2.50 $ 3.00 $ 2.00 $ 2.50 $ 3.00

g 3.0% 6.0% 9.0% 3.0% 6.0% 9.0%
D1 $ 2.06 $ 2.65 $ 3.27 $ 2.06 $ 2.65 $ 3.27
kS 5.0% 7.5% 10.0% 12.5% 15.0% 17.5%
P $ 103.00 $ 176.67 $ 327.00 $ 21.68 $ 29.44 $ 38.47

Chapter 7 Stock Valuation

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Chapter 7 Stock Valuation

Uploaded by

Copyright:

Available Formats

Chapter 7

Copyright © 2003 Pearson Education, Inc. Slide 7-1

6. Explain the relationship among financial decisions,

Copyright © 2003 Pearson Education, Inc. Slide 7-3

Copyright © 2003 Pearson Education, Inc. Slide 7-4

• Unlike debt, equity capital is a permanent form of

Copyright © 2003 Pearson Education, Inc. Slide 7-7

• While interest paid to bondholders is tax-deductible to

Copyright © 2003 Pearson Education, Inc. Slide 7-8

• Unlike bonds, common stock may be sold without par

Copyright © 2003 Pearson Education, Inc. Slide 7-15

Copyright © 2003 Pearson Education, Inc. Slide 7-19

• Stockholders expect to be compensated for their

Copyright © 2003 Pearson Education, Inc. Slide 7-20

Copyright © 2003 Pearson Education, Inc. Slide 7-21

For example, if the firm’s $1 dividend on a $25

E(r) = 1/25 + .07 = 11%

Copyright © 2003 Pearson Education, Inc. Slide 7-24

• The zero dividend growth model assumes that the

Copyright © 2003 Pearson Education, Inc. Slide 7-25

1. Zero Growth (Constant Dividend) Model

A. Solving for Price: V = D/k, where D = dividend and k = required return

Copyright © 2003 Pearson Education, Inc. Slide 7-26

B. Solving for Return: k = D/V

Copyright © 2003 Pearson Education, Inc. Slide 7-27

• The constant dividend growth model assumes that the

Copyright © 2003 Pearson Education, Inc. Slide 7-28

Copyright © 2003 Pearson Education, Inc. Slide 7-29

• A firm’s stock is selling for $10.50.

Copyright © 2003 Pearson Education, Inc. Slide 7-30

Copyright © 2003 Pearson Education, Inc. Slide 7-31

Copyright © 2003 Pearson Education, Inc. Slide 7-32

1. Constant Growth Model

B. Solving for Return: k = D0(1+g)/V + g = D1/V + g

What is my expected return on a stock that costs $26.50, just paid a

Copyright © 2003 Pearson Education, Inc. Slide 7-35

1. Non-Constant Growth Model

Copyright © 2003 Pearson Education, Inc. Slide 7-40

Copyright © 2003 Pearson Education, Inc. Slide 7-41

Copyright © 2003 Pearson Education, Inc. Slide 7-42

Copyright © 2003 Pearson Education, Inc. Slide 7-43

Step 2: Add the PF of the FCF found in step 1 to

Total FCF2008 = $600,000 + $10,300,000 = $10,900,000

Step 3: Find the sum of the present values of the

Copyright © 2003 Pearson Education, Inc. Slide 7-44

Copyright © 2003 Pearson Education, Inc. Slide 7-45

Step 4: Calculate the value of the common stock

VS = $8,628,620 - $3,100,000 = $4,728,620

Copyright © 2003 Pearson Education, Inc. Slide 7-46

• Determining the appropriate P/E ratio.

Copyright © 2003 Pearson Education, Inc. Slide 7-51

D0 $ 2.00 $ 2.50 $ 3.00 $ 2.00 $ 2.00 $ 2.00

Copyright © 2003 Pearson Education, Inc. Slide 7-52

Price Sensitivity to Changes Risk (Required Return)

D0 $ 2.00 $ 2.00 $ 2.00 $ 2.00 $ 2.00 $ 2.00

Copyright © 2003 Pearson Education, Inc. Slide 7-53

Price Sensitivity to Changes in Both Dividends and Required Return

D0 $ 2.00 $ 2.50 $ 3.00 $ 2.00 $ 2.50 $ 3.00

Copyright © 2003 Pearson Education, Inc. Slide 7-54

You might also like