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Stock Valuation

Stock Valuation . 05/03/06. Differences between equity and debt. Unlike bondholders and other credit holders, holders of equity capital are owners of the firm.

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Stock Valuation

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  1. Stock Valuation 05/03/06

  2. Differences between equity and debt • Unlike bondholders and other credit holders, holders of equity capital are owners of the firm. • Common equity holders usually have voting rights that permit them to elect the firm’s board of directors and to vote on special issues. • Bondholders receive no such privileges.

  3. Differences between equity and debt • Equity holders have a residual claim on the firm’s income and assets. • Their claims can not be paid until the claims of all creditors, including both interest and principle payments on debt 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.

  4. Differences between equity and debt • Unlike debt, equity capital is a permanent form of financing. • Equity has no maturity date and never has to be repaid by the firm.

  5. Differences between equity and debt • While interest paid to bondholders is tax-deductible to the issuing firm, dividends paid to preferred and common stock holders is not. • In effect, this further lowers the cost of debt relative to the cost of equity as a source of financing to the firm.

  6. Common stock • Share Classifications • Authorized shares are the number of shares of common stock that a firm’s corporate charter allows. • Outstanding shares are the number of shares of common stock held by the public. The Securities and Exchange Commission (SEC) must okay any public sale of shares by a company. • Treasury stock is the number of outstanding shares that have been purchased by the firm or remain with the firm. • Float are the number of shares that are available for trading and is equal to the outstanding shares less the restricted (typically management owned) shares

  7. Common stock • Voting • Each share of common stock usually entitles its holder to one vote in the election of directors and on special issues. • Because most shareholders do not attend the annual meeting to vote, they may sign a proxy statement giving their votes to another party. • Many firms have issued two or more classes of stock differing mainly in having unequal voting rights.

  8. Common stock • Dividends • Payment of dividends is at the discretion of the Board of Directors. • Dividends may be made in cash or additional shares of stock. • Because stockholders are residual claimants -- they receive dividend payments only after all claims have been settled with the government, creditors, and preferred stockholders.

  9. Common stock • A preemptive right allows common stockholders to maintain their proportionate ownership in a corporation when new shares are issued. • This allows existing shareholders to maintain voting control and protect against the dilution of their ownership. • In a rights offering, the firm grants rights to its existing shareholders, which permits them to purchase additional shares at a price below the current price.

  10. Stock quotations

  11. Preferred stock • Preferred stock is an equity instrument that pays a fixed dividend and has a prior claim (to common stock) on the firm’s earnings and assets in case of liquidation. • The dividend is expressed as a percentage of its par value. • If a firm fails to pay a preferred stock dividend, the dividend is said to be in arrears. • Preferred stocks which require the company to pay dividends in arrears are called cumulative preferred stocks. • In general, any arrearage must be paid before common stockholders receive a dividend.

  12. Preferred stock • Preferred stocks are often referred to as hybrid securities because they possess the characteristics of both common stocks and bonds. • Preferred stocks are like common stock because they are perpetual securities with no maturity date. • Preferred stocks are like bonds because they are fixed income securities, i.e., dividends never change.

  13. Stock valuation models • As with any asset, the value of a stock is simply the present value of all its future cash flows. Where r is the required return on common stock • Dividend discount models use dividends as cash flows

  14. Stock valuation models • Special Case 1 • The zero dividend growth model assumes that the stock will pay the same dividend each year, year after year.

  15. Stock valuation models • Special Case 2 • The constant dividend growth model assumes that the stock will pay dividends that grow at a constant rate (g) each year -- year after year. • This is also referred to as the Gordon Growth Model

  16. Stock Valuation Models • Determining dividend growth rates • Dividend growth rates can be obtained: • From financial sources such as ValueLine Investment Survey. • Calculated using historical dividend information. The assumption here is that future growth will be similar to past growth. where D0 is the most recent dividend and D-n was the dividend n years ago.

  17. Stock Valuation Models • Special Case 3 • The two-stage growth model assumes that the stock will pay dividends that either grow at one rate or have an inconsistent growth rate during the first period (for n years), and then at a constant rate through perpetuity during the second period. Where

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