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Chapter 7 - Stock Evaluation

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  • 1. Chapter 7 Stock ValuationCopyright © 2012 Pearson Education
  • 2. Learning GoalsLG1 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 andEquity• 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 betweenDebt and Equity Capital© 2012 Pearson Education 7-5
  • 6. Differences Between Debt andEquity: 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 andEquity: Claims on Income andAssets• 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 FactHow 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 andEquity: 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 andEquity: 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: PreemptiveRights• 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: PreemptiveRights (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 thefollowing 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: InternationalStock 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 Rightsof 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 ofPreferred 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
  • 29. Table 7.2 Organization of InstitutionalVenture Capital Investors© 2012 Pearson Education 7-29
  • 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 Structureand 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 PublicWhen 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 PreliminaryProspectus 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 InvestmentBanker’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 Processfor a Large Security Issue© 2012 Pearson Education 7-39
  • 40. Going Public: The InvestmentBanker’s Role (cont.)Compensation for underwriting and selling servicestypically comes in the form of a discount on the sale priceof 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 PracticeUnderstanding Human Behavior Helps Us Understand InvestorBehavior – 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 EquationThe value of a share of common stock is equal to the presentvalue of all future cash flows (dividends) that it is expectedto 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 ModelThe zero dividend growth model assumes that the stock willpay the same dividend each year, year after year.The equation shows that with zero growth, the value of ashare of stock would equal the present value of a perpetuityof 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 ModelThe constant-growth model is a widely cited dividend valuationapproach that assumes that dividends will grow at a constant rate, buta rate that is less than the required return.The Gordon model is a common name for the constant-growth modelthat is widely cited in dividend valuation.© 2012 Pearson Education 7-49
  • 50. Common Stock Valuation:Constant-Growth Model (cont.)Lamar Company, a small cosmetics company, paid thefollowing per share dividends:© 2012 Pearson Education 7-50
  • 51. Common Stock Valuation:Constant-Growth Model (cont.)Using a financial calculator or a spreadsheet, we find thatthe historical annual growth rate of Lamar Companydividends 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 ofeach year, Dt, during the initial growth period, years 1though N. Dt = D0 × (1 + g1)t© 2012 Pearson Education 7-53
  • 54. Common Stock Valuation:Variable-Growth Model (cont.)Step 2. Find the present value of the dividends expectedduring the initial growth period.© 2012 Pearson Education 7-54
  • 55. Common Stock Valuation:Variable-Growth Model (cont.)Step 3. Find the value of the stock at the end of the initialgrowth period, PN = (DN+1)/(rs – g2), which is the present valueof all dividends expected from year N + 1 to infinity,assuming a constant dividend growth rate, g2.© 2012 Pearson Education 7-55
  • 56. Common Stock Valuation:Variable-Growth Model (cont.)Step 4. Add the present value components found in Steps 2and 3 to find the value of the stock, P0.© 2012 Pearson Education 7-56
  • 57. Common Stock Valuation:Variable-Growth Model (cont.)The most recent annual (2012) dividend payment of WarrenIndustries, a rapidly growing boat manufacturer, was $1.50 per share.The firm’s financial manager expects that these dividends willincrease at a 10% annual rate, g1, over the next three years. At the endof three years (the end of 2015), the firm’s mature product line isexpected to result in a slowing of the dividend growth rate to 5% peryear, g2, for the foreseeable future. The firm’s required return, rs, is15%.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 ofWarren 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) = $2.10By using D2016 = $2.10, a 15% required return, and a 5% dividendgrowth rate, we can calculate the value of the stock at the end of 2015as 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 mustbe converted into a present (end of 2012) value. P2015 / (1 + rs)3 = $21 / (1 + 0.15)3 = $13.81Step 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 inStep 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 ModelA free cash flow valuation model determines the value of an entirecompany as the present value of its expected free cash flowsdiscounted at the firm’s weighted average cost of capital, which is itsexpected 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 marketvalue of the entire enterprise (that is, of all assets), to findcommon stock value, VS, we must subtract the market valueof all of the firm’s debt, VD, and the market value ofpreferred stock, VP, from VC. VS = VC – VD – VP© 2012 Pearson Education 7-62
  • 63. Table 7.4 Dewhurst, Inc.’s Data forthe 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 flowoccurring from the end of 2018 to infinity, measured at thebeginning 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, whichis measured at the end of 2017, to the 2017 FCF value to get the totalFCF in 2017. Total FCF2017 = $600,000 + $10,300,000 = $10,900,000Step 3. Find the sum of the present values of the FCFs for 2013through 2017 to determine the value of the entire company, VC. Thisstep is detailed in Table 7.5 on the following slide.© 2012 Pearson Education 7-65
  • 66. Table 7.5 Calculation of the Value of theEntire 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 = $4,726,426The value of Dewhurst’s common stock is thereforeestimated to be $4,726,426. By dividing this total by the300,000 shares of common stock that the firm hasoutstanding, we get a common stock value of $15.76 pershare ($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: OtherApproaches to Stock Valuation (cont.)At year-end 2012, Lamar Company’s balance sheet showstotal assets of $6 million, total liabilities (including preferredstock) of $4.5 million, and 100,000 shares of common stockoutstanding. Its book value per share therefore would be© 2012 Pearson Education 7-69
  • 70. Common Stock Valuation: OtherApproaches 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: OtherApproaches to Stock Valuation (cont.)Lamar Company found upon investigation that it couldobtain only $5.25 million if it sold its assets today. Thefirm’s liquidation value per share therefore would be© 2012 Pearson Education 7-71
  • 72. Common Stock Valuation: OtherApproaches 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: OtherApproaches to Stock Valuation (cont.)Lamar Company is expected to earn $2.60 per share nextyear (2013). Assuming a industry average P/E ratio of 7, thefirms per share value would be $2.60 × 7 = $18.20 per share© 2012 Pearson Education 7-73
  • 74. Focus on EthicsPsst—Have You Heard Any Good Quarterly Earnings ForecastsLately? – 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 FactTheory 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
  • 76. Figure 7.3 Decision Making andStock Value© 2012 Pearson Education 7-76
  • 77. Decision Making and Common StockValue: 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 majortechnological breakthrough that would revolutionize itsindustry. Current and prospective stockholders expect thatalthough the dividend next year, D1, will remain at $1.50, theexpected rate of growth thereafter will increase from7% to 9%.© 2012 Pearson Education 7-78
  • 79. Decision Making and CommonStock 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 StockValue: Changes in Risk (cont.)Assume that Lamar Company manager makes a decisionthat, without changing expected dividends, causes the firm’srisk premium to increase to 7%. Assuming that the risk-freerate remains at 9%, the new required return on Lamar stockwill be 16% (9% + 7%).© 2012 Pearson Education 7-80
  • 81. Decision Making and CommonStock Value: Combined EffectIf we assume that the two changes illustrated for LamarCompany 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 GoalsLG1 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
  • 89. Chapter Resources onMyFinanceLab• Chapter Cases• Group Exercises• Critical Thinking Problems© 2012 Pearson Education 7-89
  • 90. Integrative Case: EncoreInternational© 2012 Pearson Education 7-90
  • 91. Integrative Case: EncoreInternational 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