Stock Valuation

Chapter 8: Stock Market Valuation

Learning Goals

  • Differentiate between debt and equity.

  • Discuss the rights, characteristics, and features of both common and preferred stock.

  • Describe the process of issuing common stock, including venture capital, going public, the investment banker’s role, and stock quotations.

  • Understand the concept of market efficiency and basic common stock valuation under the zero growth, constant growth, and variable growth models.

  • 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.

  • Look at the Sterbenz model.

  • Explain the relationship among financial decisions, return, risk, and the firm’s value.

Differences Between Debt & Equity

Table 7.1: Key Differences Between Debt and Equity Capital

  • Type of Capital

    • Debt: Is a liability that must be repaid under contractual obligations.

    • Equity: Represents ownership in the firm.

  • Voice in Management

    • Debt: No

    • Equity: Yes

    • Explanation: In case of contractual obligation violation, debtholders and preferred stockholders may receive a voice; otherwise, only common stockholders have voting rights.

  • Claims on Income and Assets

    • Debt: Senior to equity

    • Equity: Subordinate to debt

  • Maturity

    • Debt: Stated

    • Equity: None (permanent)

  • Tax Treatment

    • Debt: Interest deductible

    • Equity: No deduction

    • Implication: The cost of debt is lower due to tax-deductibility compared to equity.

The Nature of Equity Capital

Voice in Management

  • Equity capital holders are owners of the firm.

  • Common equity holders have the right to vote electing the board of directors and deciding on critical issues, unlike bondholders and preferred stockholders.

Claims on Income & Assets

  • Equity holders have residual claims on income and assets.

  • Their claims are settled only after all creditor claims (both interest and principal) are paid.

  • Due to their position, equity holders expect higher returns due to the risks involved.

Maturity

  • Equity is a permanent financing source with no maturity date.

  • The firm is not obligated to repay equity capital.

Tax Treatment

  • Interest on debts is tax-deductible, while dividends to preferred and common stockholders are not.

Common Stock

  • Common stockholders are the true owners of the firm, also referred to as residual claimants, as they receive returns after all other obligations are settled.

  • Common stock can be privately owned, closely held, or publicly traded.

Common Stock Ownership

  • Characteristics:

    • Privately owned by individuals or small groups, often not actively traded.

    • Publicly owned by a diverse set of investors with active trades on major exchanges.

Common Stock Par Value

  • Common stock can be sold without a par value, and the par value, often low (e.g., $1), is established by corporate charter, with practical implications for taxation.

Common Stock Preemptive Rights

  • Preemptive Rights: Allow existing shareholders to maintain their ownership proportion when new shares are issued, protecting against dilution.

Common Stock Authorized, Outstanding, and Issued Shares

  • Authorized Shares: Number specified in corporate charter

  • Outstanding Shares: Shares held by the public

  • Treasury Stock: Shares repurchased by the firm

  • Issued Shares: Includes outstanding and treasury shares

Common Stock Voting Rights

  • Each common share entitles the holder to one vote for directors and special issues.

  • Votes can be assigned via proxy because many shareholders do not attend annual meetings.

Common Stock Dividends

  • Dividend payments are at the discretion of the board, and are paid only after satisfying all obligations.

Common Stock International Stock Issues

  • The international market for common stocks is smaller than for debt but growing due to investor demand for portfolio diversification.

  • Firms tend to issue shares in foreign markets or use ADRs in the U.S. to represent foreign stock ownership.

Issuing Common Stock

  • Initial financing often comes from founders, followed by private equity investors.

  • Firms eventually go public to raise capital broadly.

Preferred Stock

  • Preferred stock is an equity instrument with a fixed dividend and priority over common stock in earnings and assets liquidation.

  • If dividends are unpaid, they can accumulate (cumulative preferred stocks).

Venture Capital

  • Initial financing for startups often from venture capital, which includes formal funds and angel investors who provide equity and oversight.

The Initial Public Offering (IPO)

Going Public

  • Firms have options when selling securities: public offerings, rights offerings, or private placements.

IPO Process

  • Firms must secure shareholder approval, hire an investment banker, and file a registration statement with the SEC, which includes a prospectus.

The Investment Banker's Role

  • Investment bankers underwrite the securities, buy them from the company, and manage the offering risk.

  • Underwriting syndicates are created for larger issues to reduce risk and ensure distribution.

  • Returns for investment bankers are earned through the underwriting spread.

Interpreting Stock Price Quotations

  • Stock quotes provide information on price changes, yields, volumes, and other performance metrics.

The Efficient Market Hypothesis

  • The theory states that securities are in equilibrium and fairly priced, reflecting all public information and reacting quickly to new inputs.

Common Stock Valuation

Stock Returns

  • Returns come from dividends and capital gains, with expectations around stock price movements shaping investment decisions.

Market Adjustment to New Information

  • Prices adjust based on the difference between expected and required returns, leading to possible buying or selling pressures until new equilibrium is established.

Expected, Required, and Realized Returns

  1. Expected Return: Anticipated income/price appreciation.

    • Analogy: Expecting a high grade in class (e.g., an “A”) without guaranteed results.

  2. Required Return: Return necessary to justify taking risk.

    • Analogy: Needing at least a “B” to qualify for tuition reimbursement.

  3. Realized Return: The actual return earned.

    • Analogy: Actual grade received, perhaps lower than expected.

Stock Valuation Models

  1. Basic Stock Valuation Equation: P<em>o=D</em>1(1+k<em>s)+D</em>2(1+ks)2+…P<em>o = \frac{D</em>1}{(1 + k<em>s)} + \frac{D</em>2}{(1 + k_s)^2} + …

    • Where: (Po) = price of common stock, (D1) = expected dividend end of year, (k_s) = required return on common stock.

  2. Zero Growth Model: Assumes constant dividend payments.

    • Price calculation: V=DkV = \frac{D}{k}.

    • Example: Dividend = $2.50, required return = 15%, price = $16.67.

  3. Constant Growth Model: Assumes dividends grow at a constant rate.

    • Price calculation: V=D0(1+g)k−gV = \frac{D_0(1+g)}{k-g}.

    • Example: Current dividend = $2.50, expected growth = 5%, price calculation provided.

  4. Variable Growth Model: Assumes different growth rates for dividends across time periods.

    • Involves calculations to find expected cash flows and discount rates for valuation.

    • Detailed example provided outlining steps for growth rates of 10% and 5%.

The Sterbenz Model

  • A reality-based method for valuing stocks that do not pay dividends.

The Free Cash Flow Model

  • Valuation based on estimating free cash flow rather than dividends, subtracting debt/preferred stock values from the company total.

  • Detailed steps outlined for calculating free cash flow value of a company, shown in tabular format detailing cash flows and present values.