BUSINESS

FINANCE
Aya Selim
Fall 2023
Equity Valuation
 Equity Valuation
■ Difference between Debt & Equity
■ Types of Equity
– Common Stock
– Preferred Stock
■ Common Stock issuing
– Venture Capital
– Going Public
■ Common Stock Basic Valuation
■ Common Stock Valuation Models
– Zero growth
– Constant growth
– Variable growth
■ Other approaches to common stock valuation
Difference between Debt & Equity
■ They are both sources of external financing:
– Debt  Funds provided by creditors; it includes all borrowing incurred by a firm,
including bonds, and is repaid according to a fixed schedule of payments.
– Equity  Funds provided by the firm’s owners (investors or stockholders) that
are repaid subject to the firm’s performance. Can be obtained internally, by
retaining earnings rather than paying them out as dividends to its stockholders, or
externally, by selling common or preferred stock.
Types of Equity
■ Common Stock  Common stockholders are also called residual owners because they receive
what is left “the residual” after all other claims on the firm’s income and assets have been
satisfied.
– Privately owned: The common stock of a firm that is owned by private investors; this stock
is not publicly traded.
– Publicly owned: The common stock of a firm that is owned by public investors; this stock is
publicly traded.
– Closely owned: The common stock of a firm that is owned by an individual or a small
group of investors (such as a family); these are usually privately owned companies.
– Widely owned: The common stock of a firm that is owned by many unrelated individual or
institutional investors.
■ Preferred Stock  Preferred stock gives its holders certain privileges that make them senior to
common stockholders. They are promised a fixed periodic dividend.
– Par-value preferred stock: 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: Preferred stock with no stated face value but with a stated annual
dollar dividend.
Common Stock Issuing
■ Venture Capital  The initial external equity financing privately raised by firms, usually
early - stage firms with potential high growth prospect. The financing is typically done by
formal business entities that maintain strong oversight over the firms they invest in and that
have clearly defined exit strategies.
■ Going Public  When a firm wishes to sell its stock in the primary market
– Private placement: the firm sells new securities directly to an investor or group of investors
– Public offering: it offers its shares for sale to the general public
– Rights offering: new shares are sold to existing stockholders
 Common Stock Valuation
■ The basic dividend valuation model  Used when one is valuing firms that pay stated dividends.
P0 = + + … +
Where
P0 = value of common stock
Dt = per-share dividend expected at the end of year t
r = required return on common stock

■ Free cashflow valuation model  An alternative to the basic dividend valuation model; used when one is valuing firms that
have no dividend history or are startups or when one is valuing an operating unit or division of a larger public company.
Vc = + + … +
Where
Vc = value of the entire company
FCFt = free cashflow expected at the end of year t
r = the firm’s weighted average cost of capital which is its expected average future cost of funds

**Because the value of the entire company, VC , is the market value of the entire enterprise, to find common stock value, VS,
we must subtract the market value of all of the firm’s debt, VD, and preferred stock, VP
VS = VC - VD - VP
Common Stock Valuation Cont’d
■ Example:
Nabor Industries is considering going public but is unsure of a fair offering price for the company. Before hiring an
investment banker to assist in making the public offering, managers at Nabor have decided to make their own estimate of
the firm’s common stock value. The firm’s CFO has gathered data for performing the valuation using the free cash flow
valuation model. The firm’s weighted average cost of capital is 11%, and it has $500,000 of debt at market value and
$400,000 of preferred stock at its assumed market value. The estimated free cash flows over the next 5 years, 2013
through 2017, are given below.
a) Estimate the value of Nabor Industries’ entire company by using
the free cash flow valuation model.
b) Use your finding in part a, along with the data provided above,
to find Nabor Industries’ common stock value.
Common Stock Valuation Models
■ Zero growth  An approach to dividend valuation that assumes a constant,
nongrowing dividend stream.

■ Constant growth  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 of
common stock.
– Gordon growth model: A simplified model of the constant-growth model that is widely
cited in dividend valuation.

■ Variable growth  A dividend valuation approach that allows for a change in the
dividend growth rate.
1) Zero Growth Model
■ The simplest approach to dividend valuation, that assumes a constant, nongrowing
dividend stream  D1 = D0 * (1+g) Hence D0 = D1 = D2 = … = D

P0 =
**The equation shows that with zero growth, the value of a stock would equal the present value of a
perpetuity of D1 dollars discounted at a rate r.

■ Example:
Sara estimates that the dividend of ABC Company, is expected to remain constant at $3 per
share indefinitely. If his required return on its stock is 15%, calculate the value of the stock
P0 =
**This model is typically used for valuing preferred stocks given that they are promised a fixed
periodic dividend
1) Zero Growth Model Cont’d
■ Example:
Kelsey Drums, Inc., is a well-established supplier of fine percussion instruments to
orchestras all over the United States. The company’s class A common stock has paid a
dividend of $5.00 per share per year for the last 15 years. Management expects to continue
to pay at that amount for the foreseeable future. Sally purchased 100 shares of Kelsey class
A common 10 years ago at a time when the required rate of return for the stock was 16%.
She wants to sell her shares today. The current required rate of return for the stock is 12%.
How much capital gain or loss will Sally have on her shares?
2) Constant Growth Model
■ The most widely cited valuation approach, that assumes that dividends will grow at a
constant rate, but a rate that is less than the required return on common stock.
P0 = + + … +
■ When simplified, it is called the Gordon Growth Model
P0 =
Example:
Lamar Company, paid a constant per share dividend from 2017 to 2022 that grows at an annual rate of
7%, If the company estimates that its dividend in 2017 will equal $1.50 and its required return is 15%,
calculate the value of the stock
P0 = = $18.75 per share
2) Constant Growth Model Cont’d
■ Example:
Stacker Weight Loss currently pays an annual year-end dividend of $1.20 per share. It plans
to increase this dividend by 5% next year and maintain it at the new level for the
foreseeable future. If the required return on this firm’s stock is 8%, what is the value of
Stacker’s stock?
**If the Stacker Weight Loss stock is currently selling in the market at $46, would it be a
wise investment to buy this stock?
3) Variable Growth Model
■ Because in real world future growth rates might shift up or down because of changing business
conditions, it is useful to consider a variable-growth model that allows for a change in the dividend
growth rate
– Step 1: Find the value of the cash dividends at the end of each year, D t, during the initial growth
period with g1, years 1 through year N. Therefore, for the first N years,
Dt =D0 x (1+g1)t

– Step 2: Find the present value of the dividends expected during the initial growth period. Using
the notation presented earlier, we can give this value as
=

– Step 3: Find the value of the stock at the end of the initial growth period, which is the present
value of all dividends expected from year N + 1 to infinity, assuming a constant dividend growth
rate, g2
3) 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, P 0

+ [ ]

Present value of dividends Present value of stock at

during initial growth end of initial growth
period period
 3) Variable Growth Model Cont’d
Example:
Soha is considering purchasing the common stock of Warren Industries. She finds that the firm’s most
recent (2012) annual dividend payment was $1.50 per share. Soha estimates that these dividends will
increase at a 10% annual rate, g1, over the next 3 years (2013, 2014, and 2015) because of the introduction
of a hot new boat. At the end of the 3 years (the end of 2015), she expects the firm’s mature product line to
result in a slowing of the dividend growth rate to 5% per year, g2, for the foreseeable future. Soha’s
required return, r, is 15%. To estimate the current (end-of-2012) value of Warren’s common stock, P0 =
P2012, she applies the four-step procedure to these data.

Step 1 Column 1, 2 & 3

Step 2 Column 3, 4 & 5
3) Variable Growth Model Cont’d
Step 3
The value of the stock at the end of the initial growth period (N = 2025) can be found by first calculating DN+1
= D2016 D2016 = D2015 x (1 + 0.05) = $2.00 x (1.05) = $2.10
By using D2016 = $2.10, a 15% required return, and a 5% dividend growth rate, the value of the stock at the end
of 2015 is calculated as follows: P2015 = D2016 ÷ r - g2 $2.10 ÷ 0.15 – 0.05 = $21
Finally, in Step 3, the share value of $21 at the end of 2015 must be converted into a present (end-of-2012)
value. Using the 15% required return, we get P2015 ÷ ( 1+ r )3 $21 ÷ ( 1 + 0.15)3 = $13.78
Step 4
Adding the present value of the initial dividend stream (found in Step 2) to the present value of the stock at the
end of the initial growth period (found in Step 3), the current (end-of-2012) value of Warren Industries stock
is:
P2012 = $4.12 + $13.78 = $17.90 per share
Other approaches to common stock valuation
■ 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 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. **A
more realistic approach

■ Price/Earnings (P/E) ratio  Calculated by dividing the current stock price of the firm by its
earnings per share (EPS) and compare it to the average price/earnings (P/E) ratio for the industry
to know if the firm is over or undervalued. ** Helpful in valuing firms that are not publicly
traded