Stock Valuation FIN 310

Common Stock

Represents ownership or equity in a corporation; separate legal entity from owners/managers; advantages: unlimited life, easy transfer, limited liability, raising capital; disadvantages: double taxation, setup and reporting costs

Ownership and Control

Stockholders elect directors → directors hire managers → managers’ goal is to maximize stock price

Stockholder Rights

Entitled to earnings (cash dividends or retained); last in line in bankruptcy after all creditors

Dividend

Distribution from earnings, usually cash but can be stock or property; may be regular, extra, or irregular

Dividend Policy

Decision to pay out or retain earnings; includes payout level, timing, and frequency; payout ratio = dividends ÷ earnings; retention ratio = 1 – payout ratio

Dividend Reluctance

Companies slow to raise dividends (want sustainability) and reluctant to cut dividends (signals weakness)

Dividend Payment Terms

Date of Record = shareholders entitled to dividend; Ex-Dividend Date = trades without dividend; Distribution Date = actual payment date

Dividend Reinvestment Plan (DRIP)

Shareholders reinvest dividends into additional stock rather than taking cash; still taxed

Stock Dividend

Firm issues new shares instead of cash dividend (e.g., 10% stock dividend = 10 extra shares per 100 owned)

Stock Split

Increases number of shares outstanding (e.g., 2-for-1 split doubles shares); total value unchanged but share price falls proportionally

Dilution

Reduction in EPS when new shares issued; same earnings spread over more shares

Preferred Stock

Class of stock senior to common; dividends contractual (cumulative or non-cumulative); paid before common; no voting rights; ahead of common in liquidation

Balance Sheet

Shows assets, liabilities, and equity at a point in time; snapshot of what firm owns and how it’s financed

Income Statement

Reports sales and profits for a period; details revenues, expenses, and net income

Cash Flow Statement

Shows cash inflows/outflows from operations, investing, and financing; key for solvency (“Cash is King”)

Liquidity Ratios

Measure short-term ability to pay obligations; Current Ratio = Current Assets ÷ Current Liabilities; Quick Ratio = (Current Assets – Inventory) ÷ Current Liabilities

Activity Ratios

Measure efficiency of asset use; e.g., Days Sales Outstanding = Receivables ÷ (Sales/365); Inventory Turnover = COGS ÷ Avg Inventory

Total Asset Turnover

Sales ÷ Total Assets; measures overall asset efficiency

Fixed Asset Turnover

Sales ÷ Net Fixed Assets; efficiency of plant/equipment use

Profitability Ratios

Show combined effects of operations; Net Profit Margin = Net Income ÷ Sales; Gross Profit Margin = Gross Profit ÷ Sales; Operating Profit Margin = EBIT ÷ Sales

Basic Earnings Power (BEP)

EBIT ÷ Total Assets; shows asset earning power before taxes/leverage

Return on Assets (ROA)

Net Income ÷ Total Assets; efficiency of using assets to generate net income

Return on Equity (ROE)

Net Income ÷ Shareholder Equity; shows return on shareholder investment

Debt Ratios

Measure leverage; Debt-to-Assets = Total Debt ÷ Total Assets; Debt-to-Equity = Debt ÷ Equity

Times Interest Earned (TIE)

EBIT ÷ Interest Expense; ability to cover interest costs

EBITDA Coverage Ratio

(EBIT + Depreciation + Amortization + Lease Payments) ÷ (Interest + Lease Payments)

Ratio Analysis Limitations

Industry differences, seasonality, window dressing, accounting differences, ratios are static

Qualitative Factors

Customer concentration, product reliance, supplier reliance, overseas exposure, competition, legal/regulatory risks

Valuation Basics

Stock value = PV of future cash flows (DCF approach); intrinsic value vs market price

Intrinsic Value vs Price

Value = PV of expected benefits; Price = market consensus; Value > Price = Buy, Value < Price = Sell, Value = Price = Hold

Expected Return

(dividend + change in price) ÷ beginning price = dividend yield + capital gains yield

Required Return

Minimum return given stock’s risk; estimated using CAPM and SML

Dividend Discount Model (DDM)

Value = D1 ÷ (k – g) under constant growth assumption

Nonconstant Growth DDM

Forecast varying dividends first, then horizon value with constant growth; PV of dividends + PV of horizon = stock value

DDM Considerations

Not all firms pay dividends; requires assumptions on growth and required return; sensitive to inputs

Price Multiple Valuation

Uses ratios like P/E, Price-to-Sales, Price-to-Cash-Flow, Price-to-Book; compares firms or industry averages

Price-to-Earnings (P/E)

Price per share ÷ EPS; shows how much investors pay per $ of earnings

PEG Ratio

P/E ÷ Growth Rate; adjusts P/E for growth

Market Multiple Issues

Comparables may differ; ranges are wide; ratios alone don’t prove over/undervaluation