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Chapter 7 - Stock Evaluation
- 2. Learning Goals
LG1 Differentiate between debt and equity.
LG2 Discuss the features of both common and preferred
stock.
LG3 Describe the process of issuing common stock,
including venture capital, going public and the
investment banker.
© 2012 Pearson Education 7-2
- 3. Learning Goals (cont.)
LG4 Understand the concept of market efficiency and basic
stock valuation using zero-growth, constant-growth,
and variable-growth models.
LG5 Discuss the free cash flow valuation model and the
book value, liquidation value, and price/earnings
(P/E) multiple approaches.
LG6 Explain the relationships among financial decisions,
return, risk, and the firm’s value.
© 2012 Pearson Education 7-3
- 4. Differences Between Debt and
Equity
• Debt includes all borrowing incurred by a firm, including bonds,
and is repaid according to a fixed schedule of payments.
• Equity consists of funds provided by the firm’s owners (investors
or stockholders) that are repaid subject to the firm’s performance.
• Debt financing is obtained from creditors and equity financing is
obtained from investors who then become part owners of the firm.
• Creditors (lenders or debtholders) have a legal right to be repaid,
whereas investors only have an expectation of being repaid.
© 2012 Pearson Education 7-4
- 5. Table 7.1 Key Differences between
Debt and Equity Capital
© 2012 Pearson Education 7-5
- 6. Differences Between Debt and
Equity: Voice in Management
• Unlike creditors, holders of equity (stockholders) are
owners of the firm.
• Stockholders generally have voting rights that permit
them to select the firm’s directors and vote on special
issues.
• In contrast, debtholders do not receive voting privileges
but instead rely on the firm’s contractual obligations to
them to be their voice.
© 2012 Pearson Education 7-6
- 7. Differences Between Debt and
Equity: Claims on Income and
Assets
• Equityholders’ claims on income and assets are secondary
to the claims of creditors.
– Their claims on income cannot be paid until the claims of all
creditors, including both interest and scheduled principal
payments, have been satisfied.
• Because equity holders are the last to receive
distributions, they expect greater returns to compensate
them for the additional risk they bear.
© 2012 Pearson Education 7-7
- 8. Matter of Fact
How Are Assets Divided in Bankruptcy?
– According to the U.S. Securities and Exchange Commission,
in bankruptcy assets are divided up as follows:
• Secured Creditors – secured bank loans or secured bonds, are paid first.
• Unsecured Creditors – unsecured bank loans or unsecured bonds,
suppliers, or customers, have the next claim.
• Equityholders – equityholders 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.
© 2012 Pearson Education 7-8
- 9. Differences Between Debt and
Equity: Maturity
• Unlike debt, equity capital is a permanent form of
financing.
• Equity has no maturity date and never has to be repaid by
the firm.
© 2012 Pearson Education 7-9
- 10. Differences Between Debt and
Equity: Tax Treatment
• Interest payments to debtholders are treated as tax-
deductible expenses by the issuing firm.
• Dividend payments to a firm’s stockholders are not tax-
deductible.
• The tax deductibility of interest lowers the corporation’s
cost of debt financing, further causing it to be lower than
the cost of equity financing.
© 2012 Pearson Education 7-10
- 11. Common and Preferred Stock:
Common Stock
• Common stockholders, who are sometimes referred to as residual
owners or residual claimants, are the true owners of the firm.
• As residual owners, common stockholders receive what is left—the
residual—after all other claims on the firms income and assets have
been satisfied.
• They are assured of only one thing: that they cannot lose any more
than they have invested in the firm.
• Because of this uncertain position, common stockholders expect to
be compensated with adequate dividends and ultimately, capital
gains.
© 2012 Pearson Education 7-11
- 12. Common Stock: Ownership
• The common stock of a firm can be privately owned by an private
investors, closely owned by an individual investor or a small group
of investors, or publicly owned by a broad group of investors.
• The shares of privately owned firms, which are typically small
corporations, are generally not traded; if the shares are traded, the
transactions are among private investors and often require the
firm’s consent.
• Large corporations are publicly owned, and their shares are
generally actively traded in the broker or dealer markets .
© 2012 Pearson Education 7-12
- 13. Common Stock: Par Value
• The par value of common stock is an arbitrary value established
for legal purposes in the firm’s corporate charter, and can be used
to find the total number of shares outstanding by dividing it into the
book value of common stock.
• When a firm sells news shares of common stock, the par value of
the shares sold is recorded in the capital section of the balance sheet
as part of common stock.
• At any time the total number of shares of common stock
outstanding can be found by dividing the book value of common
stock by the par value.
© 2012 Pearson Education 7-13
- 14. Common Stock: Preemptive
Rights
• A preemptive right allows common stockholders to maintain their
proportionate ownership in the corporation when new shares are
issued, thus protecting them from dilution of their ownership.
• Dilution of ownership is a reduction in each previous
shareholder’s fractional ownership resulting from the issuance of
additional shares of common stock.
• Dilution of earnings is a reduction in each previous shareholder’s
fractional claim on the firm’s earnings resulting from the issuance
of additional shares of common stock.
© 2012 Pearson Education 7-14
- 15. Common Stock: Preemptive
Rights (cont.)
• Rights are financial instruments that allow stockholders
to purchase additional shares at a price below the market
price, in direct proportion to their number of owned
shares.
• Rights are an important financing tool without which
shareholders would run the risk of losing their
proportionate control of the corporation.
• From the firm’s viewpoint, the use of rights offerings to
raise new equity capital may be less costly than a public
offering of stock.
© 2012 Pearson Education 7-15
- 16. Common Stock: Authorized,
Outstanding, and Issued Shares
• Authorized shares are the shares of common stock that a firm’s
corporate charter allows it to issue.
• Outstanding shares are issued shares of common stock held by
investors, this includes private and public investors.
• Treasury stock are issued shares of common stock held by the
firm; often these shares have been repurchased by the firm.
• Issued shares are shares of common stock that have been put into
circulation.
Issued shares = outstanding shares + treasury stock
© 2012 Pearson Education 7-16
- 17. Common Stock: Authorized,
Outstanding, and Issued Shares (cont.)
Golden Enterprises, a producer of medical pumps, has the
following stockholder’s equity account on December 31st.
© 2012 Pearson Education 7-17
- 18. Common Stock: Voting Rights
• Generally, each share of common stock entitles its holder to one
vote in the election of directors and on special issues.
• Votes are generally assignable and may be cast at the annual
stockholders’ meeting.
• A proxy statement is a statement transferring the votes of a
stockholder to another party.
– Because most small stockholders do not attend the annual meeting to vote,
they may sign a proxy statement transferring their votes to another party.
– Existing management generally receives the stockholders’ proxies, because it
is able to solicit them at company expense.
© 2012 Pearson Education 7-18
- 19. Common Stock: Voting Rights
(cont.)
• A proxy battle is an attempt by a nonmanagement group to gain
control of the management of a firm by soliciting a sufficient
number of proxy votes.
• Supervoting shares is 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 stock is 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.
© 2012 Pearson Education 7-19
- 20. Common Stock: Dividends
• The payment of dividends to the firm’s shareholders is at the
discretion of the company’s board of directors.
• Dividends may be paid in cash, stock, or merchandise.
• Common stockholders are not promised a dividend, but they come
to expect certain payments on the basis of the historical dividend
pattern of the firm.
• Before dividends are paid to common stockholders any past due
dividends owed to preferred stockholders must be paid.
© 2012 Pearson Education 7-20
- 21. Common Stock:
International Stock Issues
• The international market for common stock is not as large as that
for international debt.
• However, cross-border issuance and trading of common stock have
increased dramatically during the past 30 years.
• Stock Issued in Foreign Markets
– A growing number of firms are beginning to list their stocks on foreign
markets.
– Issuing stock internationally both broadens the company’s ownership base
and helps it to integrate itself in the local business environment.
– Locally traded stock can facilitate corporate acquisitions, because shares can
be used as an acceptable method of payment.
© 2012 Pearson Education 7-21
- 22. Common Stock: International
Stock Issues (cont.)
Foreign Stocks in U.S. Markets
– American depositary receipts (ADRs) are dollar-denominated
receipts for the stocks of foreign companies that are held by a
U.S. financial institution overseas.
– American depositary shares (ADSs) are securities, backed by
American depositary receipts (ADRs), that permit U.S. investors
to hold shares of non-U.S. companies and trade them in U.S.
markets.
– ADSs are issued in dollars to U.S. investors and are subject to
U.S. securities laws.
– ADSs give investors the opportunity to diversify their portfolios
internationally.
© 2012 Pearson Education 7-22
- 23. Preferred Stock
• Preferred stock gives its holders certain privileges that
make them senior to common stockholders.
• Preferred stockholders are promised a fixed periodic
dividend, which is stated either as a percentage or as a
dollar amount.
• Par-value preferred stock is 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 is preferred stock with no stated
face value but with a stated annual dollar dividend.
© 2012 Pearson Education 7-23
- 24. Preferred Stock: Basic Rights
of Preferred Stockholders
• Preferred stock is often considered quasi-debt because, much like
interest on debt, it specifies a fixed periodic payment (dividend).
• Preferred stock is unlike debt in that it has no maturity date.
• Because they have a fixed claim on the firm’s income that takes
precedence over the claim of common stockholders, preferred
stockholders are exposed to less risk.
• Preferred stockholders are not normally given a voting right,
although preferred stockholders are sometimes allowed to elect one
member of the board of directors.
© 2012 Pearson Education 7-24
- 25. Preferred Stock:
Features of Preferred Stock
• Restrictive covenants including provisions about passing
dividends, the sale of senior securities, mergers, sales of
assets, minimum liquidity requirements, and repurchases
of common stock.
• Cumulative preferred stock is preferred stock for which
all passed (unpaid) dividends in arrears, along with the
current dividend, must be paid before dividends can be
paid to common stockholders.
• Noncumulative preferred stock is preferred stock for
which passed (unpaid) dividends do not accumulate.
© 2012 Pearson Education 7-25
- 26. Preferred Stock: Features of
Preferred Stock (cont.)
• A callable feature is a feature of callable preferred stock
that allows the issuer to retire the shares within a certain
period time and at a specified price.
• A conversion feature is a feature of convertible preferred
stock that allows holders to change each share into a
stated number of shares of common stock.
© 2012 Pearson Education 7-26
- 27. Issuing Common Stock
• Initial financing for most firms typically comes from a
firm’s original founders in the form of a common
stock investment.
• Early stage debt or equity investors are unlikely to make
an investment in a firm unless the founders also have a
personal stake in the business.
• Initial non-founder financing usually comes first from
private equity investors.
• After establishing itself, a firm will often “go public” by
issuing shares of stock to a much broader group.
© 2012 Pearson Education 7-27
- 28. Issuing Common Stock:
Venture Capital
• Venture capital is privately raised external equity capital
used to fund early-stage firms with attractive growth
prospects.
• Venture capitalists (VCs) are providers of venture
capital; typically, formal businesses that maintain strong
oversight over the firms they invest in and that have
clearly defined exit strategies.
• Angel capitalists (angels) are wealthy individual
investors who do not operate as a business but invest in
promising early-stage companies in exchange for a
portion of the firm’s equity.
© 2012 Pearson Education 7-28
- 30. Venture Capital:
Deal Structure and Pricing
• Venture capital investments are made under legal
contracts that clearly allocate responsibilities and
ownership interests between existing owners (founders)
and the VC fund or limited partnership
• Terms depend on factors related to the (a) original
founders, (b) business structure, (c) stage of development,
and (d) other market and timing issues.
• Specific financial terms depend upon (a) the value of the
enterprise, (b) the amount of funding required, and (c) the
perceived risk of the investment.
© 2012 Pearson Education 7-30
- 31. Venture Capital: Deal Structure
and Pricing (cont.)
• To control the VC’s risk, various covenants are included
in agreements and the actual funding provided may be
staggered based on the achievement of measurable
milestones.
• The contract will also have a defined exit strategy.
• The amount of equity to which the VC is entitled depends
on (a) the value of the firm, (b) the terms of the contract,
(c) the exit terms, and (d) minimum compound annual
rate of return required by the VC on its investment.
© 2012 Pearson Education 7-31
- 32. Going Public
When a firm wishes to sell its stock in the primary market, it
© 2012 Pearson Education 7-32
- 33. Going Public (cont.)
• IPOs are typically made by small, fast-growing
companies that either:
– require additional capital to continue expanding, or
– have met a milestone for going public that was established in a
contract to obtain VC funding.
• The firm must obtain approval of current shareholders,
and hire an investment bank to underwrite the offering.
• The investment banker is responsible for promoting the
stock and facilitating the sale of the company’s IPO
shares.
© 2012 Pearson Education 7-33
- 34. Going Public (cont.)
• The company must file a registration statement with the
SEC.
• The prospectus is a portion of a security registration
statement that describes the key aspects of the issue, the
issuer, and its management and financial position.
• A red herring is a preliminary prospectus made available
to prospective investors during the waiting period
between the registration statement’s filing with the SEC
and its approval.
© 2012 Pearson Education 7-34
- 35. Figure 7.1 Cover of a Preliminary
Prospectus for a Stock Issue
© 2012 Pearson Education 7-35
- 36. Going Public (cont.)
• Investment bankers and company officials
promote the company through a road show, a
series of presentations to potential investors
around the country and sometimes overseas.
• This helps investment bankers gauge the demand
for the offering which helps them to set the initial
offer price.
• After the underwriter sets the terms, the SEC must
approve the offering.
© 2012 Pearson Education 7-36
- 37. Going Public:
The Investment Banker’s Role
• An investment banker is a financial intermediary that specializes
in selling new security issues and advising firms with regard to
major financial transactions.
• Underwriting is the role of the investment banker in bearing the
risk of reselling, at a profit, the securities purchased from an issuing
corporation at an agreed-on price.
• This process involves purchasing the security issue from the issuing
corporation at an agreed-on price and bearing the risk of reselling it
to the public at a profit.
• The investment banker also provides the issuer with advice about
pricing and other important aspects of the issue.
© 2012 Pearson Education 7-37
- 38. Going Public: The Investment
Banker’s Role (cont.)
• An underwriting syndicate is a group of other bankers
formed by an investment banker to share the financial risk
associated with underwriting new securities.
• The syndicate shares the financial risk associated with
buying the entire issue from the issuer and reselling the
new securities to the public.
• The selling group is a large number of brokerage firms
that join the originating investment banker(s); each
accepts responsibility for selling a certain portion of a
new security issue on a commission basis.
© 2012 Pearson Education 7-38
- 39. Figure 7.2 The Selling Process
for a Large Security Issue
© 2012 Pearson Education 7-39
- 40. Going Public: The Investment
Banker’s Role (cont.)
Compensation for underwriting and selling services
typically comes in the form of a discount on the sale price
of the securities.
– For example, an investment banker may pay the issuing firm
$24 per share for stock that will be sold for $26 per share.
– The investment banker may then sell the shares to members of
the selling group for $25.25 per share. In this case, the original
investment banker earns $1.25 per share ($25.25 sale price –
$24 purchase price).
– The members of the selling group earn 75 cents for each share
they sell ($26 sale price – $25.25 purchase price).
© 2012 Pearson Education 7-40
- 41. Common Stock Valuation
• Common stockholders expect to be rewarded through periodic cash
dividends and an increasing share value.
• Some of these investors decide which stocks to buy and sell based
on a plan to maintain a broadly diversified portfolio.
• Other investors have a more speculative motive for trading.
– They try to spot companies whose shares are undervalued—meaning that the
true value of the shares is greater than the current market price.
– These investors buy shares that they believe to be undervalued and sell
shares that they think are overvalued (i.e., the market price is greater than the
true value).
© 2012 Pearson Education 7-41
- 42. Common Stock Valuation:
Market Efficiency
• Economically rational buyers and sellers use their
assessment of an asset’s risk and return to determine its
value.
• In competitive markets with many active participants, the
interactions of many buyers and sellers result in an
equilibrium price—the market value—for each security.
• Because the flow of new information is almost constant,
stock prices fluctuate, continuously moving toward a new
equilibrium that reflects the most recent information
available. This general concept is known as market
efficiency.
© 2012 Pearson Education 7-42
- 43. Common Stock Valuation:
Market Efficiency
• The efficient-market hypothesis (EMH) is a
theory describing the behavior of an assumed
“perfect” market in which:
– securities are in equilibrium,
– security prices fully reflect all available information
and react swiftly to new information, and
– because stocks are fully and fairly priced, investors
need not waste time looking for mispriced securities.
© 2012 Pearson Education 7-43
- 44. Common Stock Valuation:
Market Efficiency
• Although considerable evidence supports the concept of
market efficiency, a growing body of academic evidence
has begun to cast doubt on the validity of this notion.
• Behavioral finance is 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.”
© 2012 Pearson Education 7-44
- 45. Focus on Practice
Understanding Human Behavior Helps Us Understand Investor
Behavior
– Regret theory deals with the emotional reaction people experience after
realizing they have made an error in judgment.
– Some investors rationalize their decision to buy certain stocks with
“everyone else is doing it.” (Herding)
– People have a tendency to place particular events into mental compartments,
and the difference between these compartments sometimes impacts behavior
more than the events themselves.
– Prospect theory suggests that people express a different degree of emotion
toward gains than losses.
– Anchoring is the tendency of investors to place more value on recent
information.
© 2012 Pearson Education 7-45
- 46. Common Stock Valuation:
Basic Common Stock Valuation Equation
The value of a share of common stock is equal to the present
value of all future cash flows (dividends) that it is expected
to provide.
where
P0 = value of common stock
Dt = per-share dividend expected at the end of year
t
Rs = required return on common stock
P0 = value of common stock
© 2012 Pearson Education 7-46
- 47. Common Stock Valuation:
The Zero Growth Model
The zero dividend growth model assumes that the stock will
pay the same dividend each year, year after year.
The equation shows that with zero growth, the value of a
share of stock would equal the present value of a perpetuity
of D1 dollars discounted at a rate rs.
© 2012 Pearson Education 7-47
- 48. Personal Finance Example
• Chuck Swimmer estimates that the dividend of Denham
Company, an established textile producer, is expected to
remain constant at $3 per share indefinitely.
• If his required return on its stock is 15%, the stock’s value
is:
$20 ($3 ÷ 0.15) per share
© 2012 Pearson Education 7-48
- 49. Common Stock Valuation:
Constant-Growth Model
The constant-growth model is 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.
The Gordon model is a common name for the constant-growth model
that is widely cited in dividend valuation.
© 2012 Pearson Education 7-49
- 51. Common Stock Valuation:
Constant-Growth Model (cont.)
Using a financial calculator or a spreadsheet, we find that
the historical annual growth rate of Lamar Company
dividends equals 7%.
© 2012 Pearson Education 7-51
- 52. Common Stock Valuation:
Variable-Growth Model
• The zero- and constant-growth common stock models do
not allow for any shift in expected growth rates.
• The variable-growth model is a dividend valuation
approach that allows for a change in the dividend growth
rate.
• To determine the value of a share of stock in the case of
variable growth, we use a four-step procedure.
© 2012 Pearson Education 7-52
- 53. Common Stock Valuation:
Variable-Growth Model (cont.)
Step 1. Find the value of the cash dividends at the end of
each year, Dt, during the initial growth period, years 1
though N.
Dt = D0 × (1 + g1)t
© 2012 Pearson Education 7-53
- 55. Common Stock Valuation:
Variable-Growth Model (cont.)
Step 3. Find the value of the stock at the end of the initial
growth period, PN = (DN+1)/(rs – g2), which is the present value
of all dividends expected from year N + 1 to infinity,
assuming a constant dividend growth rate, g2.
© 2012 Pearson Education 7-55
- 57. Common Stock Valuation:
Variable-Growth Model (cont.)
The most recent annual (2012) dividend payment of Warren
Industries, a rapidly growing boat manufacturer, was $1.50 per share.
The firm’s financial manager expects that these dividends will
increase at a 10% annual rate, g1, over the next three years. At the end
of three years (the end of 2015), the firm’s mature product line is
expected to result in a slowing of the dividend growth rate to 5% per
year, g2, for the foreseeable future. The firm’s required return, rs, is
15%.
Steps 1 and 2 are detailed in Table 7.3 on the following slide.
© 2012 Pearson Education 7-57
- 58. Table 7.3 Calculation of Present Value of
Warren Industries Dividends (2013–2015)
© 2012 Pearson Education 7-58
- 59. Common Stock Valuation:
Variable-Growth Model (cont.)
Step 3. The value of the stock at the end of the initial growth period
(N = 2015) can be found by first calculating DN+1 = D2016.
D2016 = D2015 × (1 + 0.05) = $2.00 × (1.05) = $2.10
By using D2016 = $2.10, a 15% required return, and a 5% dividend
growth rate, we can calculate the value of the stock at the end of 2015
as follows:
P2015 = D2016 / (rs – g2) = $2.10 / (.15 – .05) = $21.00
© 2012 Pearson Education 7-59
- 60. Common Stock Valuation:
Variable-Growth Model (cont.)
Step 3 (cont.) Finally, the share value of $21 at the end of 2015 must
be converted into a present (end of 2012) value.
P2015 / (1 + rs)3 = $21 / (1 + 0.15)3 = $13.81
Step 4. Adding the PV of the initial dividend stream (found in Step 2)
to the PV of the stock at the end of the initial growth period (found in
Step 3), we get:
P2012 = $4.14 + $13.82 = $17.93 per share
© 2012 Pearson Education 7-60
- 61. Common Stock Valuation:
Free Cash Flow Valuation Model
A free cash flow valuation model determines the value of an entire
company as the present value of its expected free cash flows
discounted at the firm’s weighted average cost of capital, which is its
expected average future cost of funds over the long run.
where
VC = value of the entire company
FCFt = free cash flow expected at the end of year t end of year t
ra = the firm’s weighted average cost of capital
© 2012 Pearson Education 7-61
- 62. Common Stock Valuation:
Free Cash Flow Valuation Model (cont.)
Because the value of the entire company, VC, is the market
value of the entire enterprise (that is, of all assets), to find
common stock value, VS, we must subtract the market value
of all of the firm’s debt, VD, and the market value of
preferred stock, VP, from VC.
VS = VC – VD – VP
© 2012 Pearson Education 7-62
- 63. Table 7.4 Dewhurst, Inc.’s Data for
the Free Cash Flow Valuation Model
© 2012 Pearson Education 7-63
- 64. Common Stock Valuation:
Free Cash Flow Valuation Model (cont.)
Step 1. Calculate the present value of the free cash flow
occurring from the end of 2018 to infinity, measured at the
beginning of 2018.
© 2012 Pearson Education 7-64
- 65. Common Stock Valuation:
Free Cash Flow Valuation Model (cont.)
Step 2. Add the present value of the FCF from 2018 to infinity, which
is measured at the end of 2017, to the 2017 FCF value to get the total
FCF in 2017.
Total FCF2017 = $600,000 + $10,300,000 = $10,900,000
Step 3. Find the sum of the present values of the FCFs for 2013
through 2017 to determine the value of the entire company, VC. This
step is detailed in Table 7.5 on the following slide.
© 2012 Pearson Education 7-65
- 66. Table 7.5 Calculation of the Value of the
Entire Company for Dewhurst, Inc.
© 2012 Pearson Education 7-66
- 67. Common Stock Valuation:
Free Cash Flow Valuation Model (cont.)
Step 4. Calculate the value of the common stock.
VS = $8,626,426 – $3,100,000 – $800,000 = $4,726,426
The value of Dewhurst’s common stock is therefore
estimated to be $4,726,426. By dividing this total by the
300,000 shares of common stock that the firm has
outstanding, we get a common stock value of $15.76 per
share ($4,726,426 ÷ 300,000).
© 2012 Pearson Education 7-67
- 68. Common Stock Valuation:
Other Approaches to Stock Valuation
• 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
exact book (accounting) value and the proceeds remaining after
paying all liabilities (including preferred stock) were divided
among the common stockholders.
• This method lacks sophistication and can be criticized on the basis
of its reliance on historical balance sheet data.
• It ignores the firm’s expected earnings potential and generally lacks
any true relationship to the firm’s value in the marketplace.
© 2012 Pearson Education 7-68
- 69. Common Stock Valuation: Other
Approaches to Stock Valuation (cont.)
At year-end 2012, Lamar Company’s balance sheet shows
total assets of $6 million, total liabilities (including preferred
stock) of $4.5 million, and 100,000 shares of common stock
outstanding. Its book value per share therefore would be
© 2012 Pearson Education 7-69
- 70. Common Stock Valuation: Other
Approaches to Stock Valuation (cont.)
• 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 any remaining
money were divided among the common stockholders.
• This measure is more realistic than book value because it
is based on current market values of the firm’s assets.
• However, it still fails to consider the earning power of
those assets.
© 2012 Pearson Education 7-70
- 71. Common Stock Valuation: Other
Approaches to Stock Valuation (cont.)
Lamar Company found upon investigation that it could
obtain only $5.25 million if it sold its assets today. The
firm’s liquidation value per share therefore would be
© 2012 Pearson Education 7-71
- 72. Common Stock Valuation: Other
Approaches to Stock Valuation (cont.)
• The price/earnings (P/E) ratio reflects the amount
investors are willing to pay for each dollar of earnings.
• The price/earnings multiple approach is a popular
technique used to estimate the firm’s share value;
calculated by multiplying the firm’s expected earnings per
share (EPS) by the average price/earnings (P/E) ratio for
the industry.
© 2012 Pearson Education 7-72
- 73. Common Stock Valuation: Other
Approaches to Stock Valuation (cont.)
Lamar Company is expected to earn $2.60 per share next
year (2013). Assuming a industry average P/E ratio of 7, the
firms per share value would be
$2.60 × 7 = $18.20 per share
© 2012 Pearson Education 7-73
- 74. Focus on Ethics
Psst—Have You Heard Any Good Quarterly Earnings Forecasts
Lately?
– Companies used earnings guidance to lower analysts’ estimates; when the
actual numbers came in higher, their stock prices jumped.
– The practice reached a fever pitch during the late 1990s when companies that
missed the consensus earnings estimate, even by just a penny, saw their stock
prices tumble.
– In March 2007 the CFA Centre for Financial Market Integrity and the
Business Roundtable Institute for Corporate Ethics proposed a template for
quarterly earnings reports that would, in their view, obviate the need for
earnings guidance.
– What are some of the real costs a company must face in preparing quarterly
earnings guidance?
© 2012 Pearson Education 7-74
- 75. Matter of Fact
Theory for P/E Valuation
– The price/earnings multiple approach to valuation does have a theoretical
explanation.
– If we view 1 divided by the price/earnings ratio, or the earnings/price ratio,
as the rate at which investors discount the firm’s earnings, and if we assume
that the projected earnings per share will be earned indefinitely (i.e., no
growth in earnings per share), the price/earnings multiple approach can be
looked on as a method of finding the present value of a perpetuity of
projected earnings per share at a rate equal to the earnings/price ratio.
– This method is, in effect, a form of the zero-growth model.
© 2012 Pearson Education 7-75
- 77. Decision Making and Common Stock
Value: Changes in Expected Dividends
• Assuming that economic conditions remain stable, any
management action that would cause current and
prospective stockholders to raise their dividend
expectations should increase the firm’s value.
• Therefore, any action of the financial manager that will
increase the level of expected dividends without changing
risk (the required return) should be undertaken, because it
will positively affect owners’ wealth.
© 2012 Pearson Education 7-77
- 78. Decision Making and Common Stock Value:
Changes in Expected Dividends (cont.)
Assume that Lamar Company announced a major
technological breakthrough that would revolutionize its
industry. Current and prospective stockholders expect that
although the dividend next year, D1, will remain at $1.50, the
expected rate of growth thereafter will increase from
7% to 9%.
© 2012 Pearson Education 7-78
- 79. Decision Making and Common
Stock Value: Changes in Risk
• Any measure of required return consists of two components: a risk-
free rate and a risk premium. We expressed this relationship as in
the previous chapter, which we repeat here in terms of rs:
• Any action taken by the financial manager that increases the risk
shareholders must bear will also increase the risk premium required
by shareholders, and hence the required return.
• Additionally, the required return can be affected by changes in the
risk free rate—even if the risk premium remains constant.
© 2012 Pearson Education 7-79
- 80. Decision Making and Common Stock
Value: Changes in Risk (cont.)
Assume that Lamar Company manager makes a decision
that, without changing expected dividends, causes the firm’s
risk premium to increase to 7%. Assuming that the risk-free
rate remains at 9%, the new required return on Lamar stock
will be 16% (9% + 7%).
© 2012 Pearson Education 7-80
- 81. Decision Making and Common
Stock Value: Combined Effect
If we assume that the two changes illustrated for Lamar
Company in the preceding examples occur simultaneously,
the key variable values would be D1 = $1.50, rs = 0.16, and g
= 0.09.
© 2012 Pearson Education 7-81
- 82. Review of Learning Goals
LG1 Differentiate between debt and equity.
– Holders of equity capital (common and preferred stock) are owners of
the firm. Typically, only common stockholders have a voice in
management. Equityholders’ claims on income and assets are
secondary to creditors’ claims, there is no maturity date, and dividends
paid to stockholders are not tax-deductible.
© 2012 Pearson Education 7-82
- 83. Review of Learning Goals
(cont.)
LG2 Discuss the features 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. 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. The decision to
pay dividends to common stockholders is made by the firm’s board of
directors.
– Preferred stockholders have preference over common stockholders with
respect to the distribution of earnings and assets. They do not normally
have voting privileges. Preferred stock issues may have certain
restrictive covenants, cumulative dividends, a call feature, and a
conversion feature.
© 2012 Pearson Education 7-83
- 84. Review of Learning Goals
(cont.)
LG3 Describe the process of issuing common stock, including
venture capital, going public, and the investment banker.
– 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).
– 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. The IPO process includes
getting SEC approval, promoting the offering to investors, and pricing
the issue.
© 2012 Pearson Education 7-84
- 85. Review of Learning Goals
(cont.)
LG4 Understand the concept of market efficiency and basic stock
valuation using zero-growth, constant-growth, and variable-
growth models.
– Market efficiency assumes that the quick reactions of rational investors
to new information cause the market value of common stock to adjust
upward or downward quickly.
– The value of a share of stock is the present value of all future dividends
it is expected to provide over an infinite time horizon. Three dividend
growth models—zero-growth, constant-growth, and variable-growth—
can be considered in common stock valuation. The most widely cited
model is the constant-growth model.
© 2012 Pearson Education 7-85
- 86. Review of Learning Goals
(cont.)
LG5 Discuss the free cash flow valuation model and the book value,
liquidation value, and price/earnings (P/E) multiple
approaches.
– The free cash flow valuation model finds the value of the entire
company by discounting the firm’s expected free cash flow at its
weighted 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.
– 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 exact
book (accounting) value and the proceeds remaining after paying all
liabilities (including preferred stock) were divided among the common
stock-holders.
© 2012 Pearson Education 7-86
- 87. Review of Learning Goals
(cont.)
LG5 Discuss the free cash flow valuation model and the book value,
liquidation value, and price/earnings (P/E) multiple approaches
(cont.)
– 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 stockholders.
– The price/earnings (P/E) multiple approach estimates stock value by
multiplying the firm’s expected earnings per share (EPS) by the
average price/earnings (P/E) ratio for the industry.
© 2012 Pearson Education 7-87
- 88. Review of Learning Goals
(cont.)
LG6 Explain the relationships among financial decisions, return,
risk, and the firm’s value.
– In a stable economy, any action of the financial manager that increases
the level of expected dividends without changing risk should increase
share value; any action that reduces the level of expected dividends
without changing risk should reduce share value. Similarly, any action
that increases risk (required return) will reduce share value; any action
that reduces risk will increase share value. An assessment of the
combined effect of return and risk on stock value must be part of the
financial decision-making process.
© 2012 Pearson Education 7-88
- 91. Integrative Case: Encore
International
a. What is the firm’s current book value per share?
b. What is the firm’s current P/E ratio?
c. What is the current required return for Encore stock? What will be the new required return for
Encore stock assuming that they expand into European and Latin American markets as
planned?
d. If the securities analysts are correct and there is no growth in future dividends, what will be the
value per share of the Encore stock? (Note: use the new required return on the company’s
stock here)
e. If Jordan Ellis’s predictions are correct, what will be the value per share of Encore stock if the
firm maintains a constant annual 6% growth rate in future dividends? (Note: Continue to use
the new required return here.) If Jordan Ellis’s predictions are correct, what will be the value
per share of Encore stock if the firm maintains a constant annual 8% growth rate in dividends
per share over the next 2 years and 6% thereafter?
f. Compare the current (2012) price of the stock and the stock values found in parts a, d, and e.
Discuss why these values may differ. Which valuation method do you believe most clearly
represents the true value of the Encore stock?
© 2012 Pearson Education 7-91