Stock Valuation

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REVIEW OF LEARNING GOALS Differentiate between debt and equity capital. LG1 Holders of equity capital (common and preferred stock) are owners of the firm. Typically, only common stockholders have a voice in management through their voting rights. Equity holders have claims on income and assets that are secondary to the claims of creditors, there is no maturity date, and the firm does not benefit from tax deductibility of dividends paid to stockholders, as is the case for interest paid to debtholders. Discuss the rights, characteristics, and features LG2 of both common and preferred stock. The common stock of a firm can be privately owned, closely owned, or publicly owned. It can be sold with or without a par value. Preemptive rights allow common stockholders to avoid dilution of ownership when new shares are issued. Not all shares authorized in the corporate charter are outstanding. If a firm has treasury stock, it will have issued more shares than are outstanding. Some firms have two or more classes of common stock that differ mainly in having unequal voting rights. Proxies transfer voting rights from one party to another. Dividend distributions to common stockholders are made at the discretion of the firm’s board of directors. Firms can issue stock in foreign markets. The stock of many foreign corporations is traded in the form of American depositary receipts (ADRs) in U.S. markets. Preferred stockholders have preference over common stockholders with respect to the distribution of earnings and assets and so are normally not given voting privileges. Preferred stock issues may have certain restrictive covenants, cumulative dividends, a call feature, and a conversion feature. Describe the process of issuing common stock, LG3 including in your discussion venture capital, going public, the investment banker’s role, and stock quotations. The initial nonfounder financing for business startups with attractive growth prospects typically comes from private equity investors. These investors can be either angel capitalists or venture capitalists (VCs), which are more formal business entities. Institutional VCs can be organized in a number of ways, but the VC limited partnership is the most common. VCs usually invest in both early-stage and later-stage companies that CHAPTER 7 Stock Valuation 291 they hope to take public in order to cash out their investments. The first public issue of a firm’s stock is called an initial public offering (IPO). The company selects an investment banker to advise it and to sell the securities. The lead investment banker may form a selling syndicate with other investment bankers to sell the issue. The IPO process includes filing a registration statement with the Securities and Exchange Commission (SEC), getting SEC approval, promoting the offering to investors, pricing the issue, and selling the shares. Stock quotations, published regularly in the financial media, provide information on stocks, including calendar year change in price, 52-week high and low, dividend, dividend yield, P/E ratio, volume, latest price, and net price change from the prior trading day. Understand the concept of market efficiency LG4 and basic common stock valuation under the zero-growth and constant-growth models. Market efficiency suggests that rational investors react quickly to new information, causing the market value of common stock to adjust quickly upward or downward. The efficient-market hypothesis suggests that securities are fairly priced, that they reflect fully all publicly available information, and that investors should therefore not waste time trying to find and capitalize on mispriced securities. The value of a share of common stock is the present value of all future dividends it is expected to provide over an infinite time horizon. The basic stock valuation equation and the zero-growth and constant-growth valuation models are summarized in Table 7.5. The most widely cited model is the constant-growth model. Discuss the free cash flow valuation model and LG5 the use of book value, liquidation value, and price/earnings (P/E) multiples to estimate common stock values. The free cash flow valuation model is appealing when one is valuing firms that have no dividend history, startups, or operating units or divisions of a larger public company. The model finds the value of the entire company by discounting the firm’s expected free cash flow at its weighted
292 PART 2 Important Financial Concepts TABLE 7.5 Summary of Key Valuation Definitions and Formulas for Common Stock Definitions of variables Dtper-share dividend expected at the end of year t FCFtfree cash flow expected at the end of year t gconstant rate of growth in dividends kaweighted average cost of capital ksrequired return on common stock P0value of common stock VCvalue of the entire company VDmarket value of all the firm’s debt VPmarket value of preferred stock VSvalue of common stock Valuation formulas Basic stock value: Common stock value: Zero-growth: P0 . . . D ∞ [Eq. 7.1] (1 ks) ∞ D2 (1 ks) 2 D1 (1 ks) 1 P0 (also used to value preferred stock) [Eq. 7.2] Constant-growth: P0 [Eq. 7.4] FCF value of entire company: VC . . . FCF ∞ [Eq. 7.5] (1 ka) FCF common stock value: VSV CV DV P [Eq. 7.6] ∞ FCF2 (1 ka) 2 FCF1 (1 ka) 1 D1 ks D1 ksg average cost of capital. The common stock value is found by subtracting the market values of the firm’s debt and preferred stock from the value of the entire company. The two equations involved in this model are summarized in Table 7.5. Book value per share is the amount per share of common stock that would be received if all of the firm’s assets were sold for their book (accounting) value and the proceeds remaining after paying all liabilities (including preferred stock) were divided among the common stockholders. Liquidation value per share is 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 the remaining money were divided among the common
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Stock Valuation

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