chapter 7 - stock valuation

How are assets divided in bankruptcy?

1. Secured creditors: secured bank loans or secured bonds are paid first

2. Unsecured creditors: unsecured bank loans or unsecured bonds, suppliers, or customers have the next claim

3. Equity holders: equity holders or the owners of the company have the last claim on assets, and they may not receive anything if the secured and unsecured creditors’ claims are not fully repaid

Common Stock Ownership

• Privately Owned

  • The common stock of a firm is owned by private investors; this stock is not publicly traded

• Publicly Owned

  • The common stock of a firm is owned by public investors; this stock is publicly traded

• Closely Owned

  • The common stock of a firm is owned by an individual or a small group of investors (such as a family); they are usually privately owned companies

• Widely Owned

  • The common stock of a firm is owned by many unrelated individual and institutional investors

Common Stock - Par Value Common Stock

Par Value Common Stock

• An arbitrary value that is established for legal purposes in the firm’s corporate charter and that can be used to find the total number of shares outstanding by dividing it into the book value

Common Stock - Preemptive Rights

Preemptive Rights

• Allows common stockholders to maintain their proportionate ownership in the corporation when new shares are issued, protecting them from dilution of ownership

• Dilution of Ownership

  • A reduction in each previous shareholder’s fractional ownership resulting from the sale of new common shares

• Dilution of Earnings

  • A reduction in each previous shareholder’s fractional claim on the firm’s earnings resulting from the sale of new common shares

• Rights

  • Financial instruments that allows stockholders to purchase additional shares at a price below the market

Common Stock - 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

Common Stock - Voting Rights

Proxy Statement

• A statement transferring the votes of a stockholder to another party

Proxy Battle

• The attempt by a non management 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 Shares

• 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

Common Stock - Dividends

• The payment of dividends to the firm’s shareholders is at the discretion of the company’s board of directors

• Most corporations that pay dividends distribute them quarterly

• Cash dividends are the most common

Common Stock - International Stock Issues

American Depositary Shares (ADSs)

• Dollar-denominated receipts for the stocks of foreign companies that are held by a US financial institution overseas

American Depositary Receipts (ADRs)

• Securities, backed by American depositary shares (ADSs), that permit US investors to hold shares of non US companies and trade them in US markets

Preferred Stock

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

Preferred Stock

• Most corporations don’t issue preferred stock, but preferred shares are common in some industries such as financial services

• Preferred stock gives its holders privileges that make them senior to common stockholders

• Preferred stockholders are promised a fixed periodic dividend, stated either as a percentage or as a dollar amount

Preferred Stock - Basic Rights of Preferred Stockholders

• Preferred stock specifies a fixed periodic payment, but unlike debt, preferred stock has no maturity date

• Preferred stockholders are also given preference over common stockholders in the liquidation of assets in a legally bankrupt firm, although they must “stand in line” behind creditors

Preferred Stock - Features of Preferred Stock

Restrictive Covenants

• These covenants include provisions about passing dividends, the sale of senior securities, mergers, sales of assets, minimum liquidity requirements, and repurchases of common stock

Cumulative

• Preferred stock for which all passed (unpaid) dividends in liabilities, along with the current dividend, must be paid before dividends can be paid to common stockholders

Noncumulative

• Preferred stock for which unpaid dividends do not accumulate

Callable Feature

• 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

• A feature of convertible preferred stock that allows holders to change each share into a stated number of shares of common stock

Market Efficiency and Stock Valuation

• Because the flow of new information related to a stock is continual and the content of that information is unpredictable, stock prices fluctuate, always moving toward a new equilibrium that reflects the most recent information available

• 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”

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

Other Approaches to Common Stock Valuation - Liquidation Value

• The actual amount per share of common stock that would be received if all the firm’s assets were sold for their market value, liabilities were paid, and any remaining money were divided among the common stockholders

Other Approaches to Common Stock Valuation - Price/Earnings (P/E) Multiples

• A popular technique used to estimate the firm’s share value; calculated by multiplying the firm’s expected earnings per share by the average price/earnings ratio for the industry

Change in Expected Dividends

• Any management action that would cause stockholders to raise their dividend expectations should increase the firm’s value

Changes in Risk

• Any action taken by the financial manager that increases the risk shareholders must bear will also raise the risk premium required by shareholders and the required return

• Any action by the financial manager that increases risk contributes to a reduction in value, and any action that decreases risk contributes to an increase in value

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