The document discusses stock valuation methods, emphasizing the complexities of evaluating common stocks compared to bonds due to uncertain future cash flows and perpetual investment life. It outlines key concepts such as the zero growth model, constant growth model, and the impact of retained earnings, flotation costs, and various financial ratios on stock valuation. Additionally, it explains the importance of understanding shareholder rights and the implications of different classes of common stock on corporate control.

1. AnIntroductionto
SecurityValuationPT 2
INVINCIBLES

2. StockValuation
In financial market Stock Valuation is
the method of calculating theoretical
values of companies and their stock
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3. Unlike bonds, valuating common stock is more difficult
why?
• The timing and amount of future cash flows is not
known
• The life of investment is essentially forever
• There’s no way to observe the rate of return that the
market requires
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4. CommonStock
Valuation
To help us value a dividend of a stock, we need
to make three simple assumptions about the
pattern of future dividend
The three cases are ,
• The dividend has zero growth rate
• The dividend grows at a constant rate
• The dividend grows at a constant rate after
some length of time
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5. Common Stock Features
• The term common stock usually implies that the shareholder
has no special preference either in dividend or in bankruptcy
• Shareholders however control the corporation through their
rights to elect the directors. The directors in turn hire
management to carry out their directives.
• Directors are elected on an annual shareholders’ meeting by
a holding of a majority of shares present and entitled to vote.
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Share holders usually have the
following rights also
Right to share proportionally in dividends
Right to share proportionally in assets remaining after
liabilities and preferred shareholders have been paid in
liquidation
Right to vote on stockholder matters of great
importance such as merger or new share
issuance

6. Classes of Common Stock
• Some firms have more than one class of common stock;
often, the classes are created with unequal voting rights.
• Canadian tire corporation is an example of a company
with non-voting common stock trading in the market
• Non-voting shares must receive dividends no lower than
voting shares.
• A primary reason for creating dual classes of stock has to
do with control of the firm
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7. Anik Costa & Tanvir Hasan Plabon
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8. Zero Growth Model
The zero growth dividend growth model assumes that the stock will pay the
same dividend each year, year after year.
Formula:
Po= D1/r
Example: The dividend of Denham Company, an established textile manufacture
is expected to remain constant at $3 per share indefinitely. What is the value of
Denham’s stock if the required return demanded by investors is 15%?
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9. Constant Growth Model
The constant dividend growth model assumes that the stock will pay dividends
that grow at a constant rate each year , year after year forever.
Formula
Po= D1 / (r-g)
For example, consider a company that pays a $5 dividend per share, requires a
10 percent rate of return from investors and is seeing its dividend grow at a 5
percent rate . what is the value of that company share?
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10. RetainedEarning
Retained earnings represent a
business cumulative earning
since its inception that if has not
paid out as dividends to
common share holders.

11. CostofNew
Equity
The cost of a newly issued common
stock that takes into account the
flotation cost of the new issue
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12. Flotation Cost
Flotation costs are incurred by a publicly treaded company when it issues new Securities and includes expenses such as
underwriting fees legal fees and registration fees
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The following formula is used to calculate cost of new equity:
Cost of New Equity = D1 + g
P0 × (1 − F)
Where,
D1 is dividend in next period
P0 is the issue price of a share of stock
F is the ratio of flotation cost to the issue price
g is the dividend growth rate
XY Systems raised $300 million in fresh issue of commons stocks. The issue price was $25
per share, 4% of which was paid to the investment bankers. The company is expected to
pay $2 in dividend per share next year. Dividends are expected to increase by 5% per year.
Calculate the cost of new equity and compare it to the cost of (existing) equity

13. Components of Required Return
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14. Components of Required Return
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15. Components of Required Return
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16. Infinite Period Dividend
Discount Model and
Growth Companies
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1.Dividend grow at a constant
rate.
2.The constant growth rate will
continue for an infinite period.
3.The required rate of return (k)
is greater than the infinite
growth rate (g). If it is not, the
model gives meaningless result
because the denominator
becomes negative.

17. Present value of
operating free cash
flow
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In this model, you are delivering the value of the total
firm because you are discounting the operating free cash
flow prior to the payment of interest to the debt holders
but after deducting funds needed to maintain the firms
asset base(capital expenditures).Also you are discounting
the firms total operating free cash flow, you would use
the firms weighted average cist of capital(WACC)as your
discount rate. So, once you estimate the value of the total
firm, you subtract the value of debt, assuming your goal
is to estimate the value of the firms equity.

18. 18
The total value of the firm is equal to:
Vj= ƩOFCFt/(1+WACCj)^t
Where:
Vj=Value of the firm
n=Number of periods assumed to be infinite
OFCF=Operating free cash flow at the period 't'.
WACCj=Firms 'j' Weighted average cost of capita

19. Present value of free
cash flows to equity
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The third discounted cash flow technique deals with free cash flows
to equity, which would be derived after operating have been adjusted
for debt payments(interest and principal).Also, these cash flows
precede dividend payments to the common stockholder. Such cash
flows are referred to as free because they are what is left after
providing the funds needed to maintain the firms asset base(similar
to the operating free cash flow).They're specified as free cash flows to
equity because they also adjust for payments to debt holders and to
preferred stockholders. Notably, because these are cash flows
available to equity owners, the discount rate used is the firms cost of
equity (k) rather than firms WACC.

20. 20
Vj=ƩFCFEj/(1+Kj)^t
where;
vj=value of the stock of firm j
n=number of the year assumed
to be infinite
FCFEj=the firms free cash flow
to equity in period t.

21. 21
Price to Earnings Ratio

22. 22
Calculation

23. 23
Example

24. 24
Price to Book Ratio

25. 25
Calculation

26. 26
Summing Up

27. Price/CF Ratio
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The price-to-cash flow (also denoted as price/cash flow or P/CF)
ratio is a financial multiple that compares a company’s market value
to its operating cash flow (or the company’s stock price per share to
its operating cash flow per share)

28. Price-to-Sales (P/S) Ratio
The price-to-sales (P/S) ratio is a valuation ratio that
compares a company’s stock price to its revenues. It is an
indicator of the value placed on each dollar of a company’s
sales or revenues.
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