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Valuing Stocks. Chapter 5. Debt versus Equity: Debt. Debt securities represent a legally enforceable claim. Debt securities offer fixed or floating cash flows. Bondholders do not have any control over how the company is run. Debt versus Equity: Equity.

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debt versus equity debt
Debt versus Equity: Debt
  • Debt securities represent a legally enforceable claim.
  • Debt securities offer fixed or floating cash flows.
  • Bondholders do not have any control over how the company is run.
debt versus equity equity
Debt versus Equity: Equity
  • Common stockholders are residual claimants.
  • No claim to earnings or assets until all senior claims are paid in full
  • High risk, but historically also high return
  • Stockholders have voting rights on important company decisions.

Debt and equity have substantially different marginal benefits and marginal costs.

preferred stock
Preferred Stock

Preferred stock have some features similar to debt and other features similar to equity.

  • Claim on assets and cash flow is senior to common stock.
  • Dividend payments are not tax deductible.
  • Preferred stock are held mostly by corporations.

Promises a fixed annual dividend payment, though this is not legally enforceable.

Preferred stockholders usually do not have voting rights.

common stock

Par value

Little economic relevance today.

The shares of a company’s stock that shareholders and the board authorize the firm to sell to the public.

Shares authorized

The shares of a company’s stock that have been issued or sold to the public.

Shares issued

Shares outstanding

The shares of a company’s stock that are currently held by the public.

The amount of money the firm received from selling stock, above and beyond the stock’s par value.

Additional paid-in capital

Common Stock
rights of common stockholders
Rights of Common Stockholders
  • Common stockholders’ voting rights can be exercised in person or by proxy.
  • Most US corporations practice majority voting, with one vote attached to each common share.
  • Proxy fight: An attempt to gain control of a firm by soliciting enough votes to unseat existing directors.

Shareholders have no legal rights to receive dividends.

primary markets and issuing new securities

market capitalization

primary market

  • The total number of shares outstanding multiplied by the current price per share.
  • The market in which firms originally issue new securities.
  • Common shares that have been issued but are no longer outstanding because the firm repurchased them.

treasury stock

Primary Markets and Issuing New Securities
the investment banker s role in equity issues

Trading

Key investment banking activities

Asset management

Corporate finance

Investment banks assist firms in the process of issuing securities to investors.

initial public offering (IPO)

  • The first public sale of company stock to outside investors.

unseasoned offering

  • An equity issue by a firm that already has common stock outstanding.
The Investment Banker’s Role in Equity Issues
the investment banker s role in equity issues1

negotiated offer

competitively bid offer

Best effort

  • The bank promises its best effort to sell the firm’s securities. If the demand is insufficient, the issue will be withdrawn.
  • The bank underwrites the securities.
  • Underwrite: Purchasing shares from the firm and reselling them to investors.

Firm commitment

The Investment Banker’s Role in Equity Issues

Firms can choose an investment bank through

The contract to sell equity can be

secondary markets for equity securities

Broker market

  • A market in which the buyer and seller are brought together on a “securities exchange” to trade securities.
  • A market in which the buyer and seller are not brought together directly, but instead have their orders executed by securities dealers that make markets in the given security.

Dealer

market

Secondary Markets for Equity Securities
stock valuation preferred stock

Using the formula for valuing a perpetuity:

  • PS0 = Preferred stock’s market price
  • Dp = next period’s dividend payment
  • rp = discount rate

An example: Investors require an 11% return on a preferred stock that pays a $2.30 annual dividend.  What is the price?

Stock Valuation: Preferred Stock

Preferred stock is an equity security that is expected to pay a fixed annual dividend indefinitely.

stock valuation common stock

Return on

investment

Value of a

Share of

Common Stock

Stock Valuation: Common Stock
  • Suppose that an investor buys a stock today for price P0 , receives a dividend equal to D1 at the end of one year, and immediately sells the stock for price P1.
stock valuation common stock1
Stock Valuation: Common Stock
  • How is P1 determined?
    • PV of expected stock price P2, plus dividends
    • P2 is the PV of P3 plus dividends, etc...
  • Repeating this logic over and over, you will find that today’s price equals the PV of the entire dividend stream that the stock will pay in the future:
zero growth valuation model

The zero growth model is the simplest approach to stock valuation that assumes a constant, non-growing dividend stream.

  • D1 = D2= ... = D
  • With constant value D for each dividend payment, the common stock valuation formula reduces to the simple equation for a perpetuity:
Zero Growth Valuation Model
constant growth valuation model
Constant Growth Valuation Model
  • Assumes dividends will grow at a constant rate (g) that is less than the required return (r)
  • If dividends grow at a constant rate forever, you can value stock as a growing perpetuity, denoting next year’s dividend as D1:

Commonly called the Gordon growth model

example
Example

Dynasty Corp. pays 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?

variable growth valuation model
Variable Growth Valuation Model
  • The variable growth model assumes that the dividend growth rate will vary during different periods of time.
stock valuation
Stock Valuation
  • How to estimate growth
    • Growth rate g = retention rate x ROE
    • Historical data
  • What if there are no dividends?
valuing the enterprise free cash flow approach

The net amount of cash flow remaining after the firm has met all operating needs and paid for investments, both long-term and short-term.

  • Represents the cash amount that a firm could distribute to investors after meeting all its other obligations.

Free cash flow (FCF)

Weighted average cost of capital (WACC)

  • The after-tax, weighted average required return on all types of securities issued by a firm, where the weights equal the percentage of each type of financing in a firm’s overall capital structure.
Valuing the Enterprise: Free Cash Flow Approach
valuing the enterprise free cash flow approach1
Valuing the Enterprise: Free Cash Flow Approach
  • Steps
    • Estimate the free cash flow that the firm will generate over time.
    • Discount the free cash flow at the firm’s weighted average cost of capital to derive the total value of the firm, VF .
    • Subtract the values of the firm’s debt, VD , and preferred stock, VP , from VF to obtain the value of the firm’s shares, VS .
    • Divide VS by the number of shares outstanding to calculate the value per share, P0 .
an example starbucks corp
An Example: Starbucks Corp

At the end of its 2006 fiscal year, Starbucks had

    • debt with a market value of about $250 million
    • no preferred stock
    • 765 million shares of common stock outstanding
    • free cash flow of $270 million
  • Revenues and operating profits grew at 21% between 2004 and 2006.
  • Assume 20% FCF growth from 2006 to 2010 and 10% annual growth thereafter.
  • WACC = 12%.
other approaches to common stock valuation

The value of a firm’s equity as recorded on the firm’s balance sheet.

Book value

Liquidation value

  • The amount of cash that remains if the firm’s assets are sold and all liabilities paid.
  • The amount investors are willing to pay for each dollar of earnings.
  • P/E ratios differ between and within industries.

Price/Earnings multiples

Other Approaches to Common Stock Valuation
valuing stocks1
Valuing Stocks
  • Preferred stock has both debt and equity-like features.
  • Common stock represents residual claims on the firm’s cash flows.
  • Investment bankers play an important role in helping firms issue new securities.
  • The same principles apply to the valuation of both preferred and common stock.