Chapter 5: Stock Valuation. Professor Thomson Finance 3013. Debt vs. Equity: Debt. Debt securities represent a legally enforceable claim. Debt securities offer fixed or floating cash flows. Bondholders don’t have any control over how the company is run.
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Debt and equity have substantially different marginal benefits and marginal costs.
Preferred stock is a hybrid having some features similar to debt and other features similar to equity.
Promises a fixed annual dividend payment, but not legally enforceable. Firms cannot pay common stock dividends if preferred stock is in arrears (i.e. preferred stock is typically “cumulative”)
- Preferred stockholders usually do not have voting rights.
- May be convertible to common stock
Where : D1 is the constant dividend whose first payment is one period from today
Shareholders have no legal rights to receive dividends. They are declared by the board of directors, and typically paid quarterly if it is a dividend paying stock. Dividends typically increase over time
Little economic relevance today
Shares authorized by stockholders to be sold by the board of directors without further stockholders approval
Shares issued and outstanding
Number of shares owned by stockholders
Additional paid-in capital
Amount received in excess of par value when corporation initially sold stockCommon Stock
Stock repurchased by corporation; Usually purchased for stock options
Two-for-one split issues one new share for each already held; reduces per share price. e.g. A stock selling for $50 per share will sell for $25 per share after a 2 for 1 stock split
Stock splitCommon Stock
Must be able to predict future dividends to use this model
non-growing dividend stream. (Think preferred stock)
Note: D1 = D0(1+g)
Commonly called the Gordon growth model
Also called a DDM : Dividend Discount Model
Dynasty Corp. will pay a $3 dividend in one year. If investors expect that dividend to remain constant forever, and they require a 10% return on Dynasty stock, what is the stock worth?
What is the stock worth if investors expect Dynasty’s dividends to grow at 3% per year?
• Chapter 5. “See a demonstration of the variable growth model.”
P / E multiplesCommon Stock ValuationOther Options
Div1= Div0 x (1+g1) = $4 x 1.08 = $4.32
Div2= Div1 x (1+g1) = $4.32 x 1.08 = $4.67
Div3= Div2 x (1+g1) = $4.67 x 1.08 = $5.04
PV of Div1= Div1 (1+r)1 = $ 4.32 (1.12) = $3.86
PV of Div2= Div2 (1+r)2 = $ 4.67 (1.12)2 = $3.72
PV of Div3= Div3 (1+r)3 = $ 5.04 (1.12)3 = $3.59
Sum of discounted dividends = $3.86 + $3.72 + $3.59 = $11.17
D4 = D3 x (1+ g2) = $ 5.04 x (1.05) = $5.292
P0 = $11.17 + $53.81 = $64.98
Remember: Because future growth rates might
change, the variable growth model allows for a
changes in the dividend growth rate.
Use weighted average cost of capital (WACC) to discount the free cash flows.Valuing the Enterprise: Free Cash Flow Valuation
Discount estimates of free cash flow that the firm will generate in the future.
WACC: after-tax weighted average required return on all types of securities that firm issues.
We have an estimate of total value of the firm.
How can we use this to value the firm’s shares?
Morton Restaurant Group (MRG)
First quarter of 2001, traded in the $20 - $25 rangeValue of firm’s shares
VS = VF– VD - VP
We can use the free cash flow approach to estimate the value of MRG shares.
MRGAn Example: Mortons Restaurant Group
Assume that Mortons will experience 14% FCF growth from 2000 to 2004 and 7% annual growth thereafter.
Mortons’ WACC is approximately 11%.
Use variable growth equation to estimate Mortons enterprise value.
Preferred stock has both debt and equity-like features.
Common stock represents residual claims on firms’ cash flows
Investment bankers play an important role in helping firms issue new securities
The same principles apply to valuation of both preferred and common stock
An example: Investors require an 11% return on a preferred stock that pays a $2.30 annual dividend. What is the price?Valuation Fundamentals:Preferred Stock
Preferred stock is an equity security that is expected to pay a fixed annual dividend indefinitely.
Investment banking lines of business
Investment banks provide advice with structuringseasoned and unseasoned issues.
Direct negotiated offer
commitmentInvestment Banks’ Role in Equity Offerings
Public security issues can be
Prior to offering, lead investment bank negotiates underwriting agreement
Lead underwriter sets each syndicate member’s participation.
How many shares each member must sell and compensation for each saleServices Provided during and after a Security Offering
Almost all IPOs and SEOs have a green shoe option: over-allotment option to cover excess demand.
Lead underwriter responsible for price stabilization after offering.
After offering, lead underwriter serves as principal market maker.
The Over-the-counter market (OTC)
On the secondary market, investors deal among themselves.