Essentials of Managerial Finance

1
Chapter 7 Stocks (Equity) Characteristics and
Valuation
2
Background on Stock

• A stock is a certificate representing partial
  ownership in a corporation
• Stock is issued by firms to obtain long-term
  funds
• Owners of stock
• Can benefit from the growth in the value of the
  firm
• Are susceptible to large losses
• Individuals and financial institutions are common
  purchasers of stock
• The primary market enables corporations to issue
  new stock
• The secondary market creates liquidity for
  investors who invest in stock
• Some corporations distribute earnings to
  investors in the form of dividends

3
Background on Stock (contd)

• Ownership and voting rights
• The owners are permitted to vote on key matters
  concerning the firm
• Election of the board of directors
• Authorization to issue new shares
• Approval of amendments to the corporate charter
• Adoption of bylaws
• Voting is often accomplished by proxy
• Management typically receives the majority of the
  votes and can elect its own candidates as
  directors

4
Background on Stock (contd)

• Preferred stock
• Preferred stock represents an equity interest in
  a firm that usually does not allow for
  significant voting rights
• A cumulative provision on most preferred stock
  prevents dividends from being paid on common
  stock until all preferred dividends have been
  paid
• Preferred stock is less risky because dividends
  on preferred stock can be omitted
• Preferred stock is a less desirable source of
  funds than bonds because
• Dividends are not tax deductible
• Investors must be enticed to purchase the
  preferred stock since dividends do not legally
  have to be paid

5
Background on Stock (contd)

• Issuers participating in stock markets
• The ownership feature attracts many investors who
  want to have an equity interest but do not
  necessarily want to manage their own firm
• A firm issuing stock for the first time engages
  in an IPO
• If a firm issues additional stock after the IPO,
  it engages in a secondary offering

6
Initial Public Offerings

• An IPO is a first-time offering of shares by a
  specific firm to the public
• Usually, a growing firm first obtains private
  equity funding from VC firms
• An IPO is used to obtain new funding and to offer
  VC firms a way to cash in their investment
• Many VC firms sell their shares in the secondary
  market between 6 and 24 months after the IPO

7
Initial Public Offerings (contd)

• Going public
• An investment banking firm normally serves as the
  lead underwriter for the IPO
• Developing a prospectus
• The issuing firm develops a prospectus and files
  it with the SEC
• The prospectus contains detailed information
  about the firm and includes financial statements
  and a discussion of risks
• The prospectus is intended to provide investors
  with the information they need to decide whether
  to invest in the firm
• Once approved by the SEC, the prospectus is sent
  to institutional investors
• Underwriters and managers meet with institutional
  investors in the form of a road show

8
Initial Public Offerings (contd)

• Going public (contd)
• Pricing
• The offer price is determined by the lead
  underwriter
• During the road show, the number of shares
  demanded at various prices is assessed
• Bookbuilding
• In some countries, an auction process is used for
  IPOs
• Transaction costs
• The issuing firm typically pays 7 percent of the
  funds raised
• The lead underwriter typically forms a syndicate
  with other firms who receive a portion of the
  transaction costs

9
Initial Public Offerings (contd)

• Underwriter efforts to ensure price stability
• The lead underwriters performance can be
  measured by the movement in the IPO shares
  following the IPO
• If stocks placed by a securities firm perform
  poorly, investors may no longer purchase shares
  underwritten by that firm
• The underwriter may require a lockup provision
• Prevents the original owners from selling shares
  for a specified period
• Prevents downward pressure
• When the lockup period expires, the share price
  commonly declines significantly

10
Initial Public Offerings (contd)

• IPO Timing
• IPOs tend to occur more frequently during bullish
  stock markets
• Prices are typically higher
• In the 20002001 period, many firms withdrew
  their IPO plans
• Initial returns of IPOs
• First-day return averaged about 20 percent over
  the last 30 years
• In 1998, the mean one-day return for Internet
  stocks was 84 percent
• Most IPO shares are offered to institutional
  investors
• About 2 percent of IPO shares are offered as
  allotments to brokerage firms

11
Initial Public Offerings (contd)

• Abuses in the IPO market
• In 2003, regulators attempted to impose new
  guidelines that would prevent abuses
• Spinning is the process in which an investment
  bank allocated IPO shares to executives requiring
  the help of an investment bank
• Laddering involves increasing the price above the
  offer price on the first day of issue in response
  to substantial demand
• Excessive commissions are sometimes charged by
  brokers when there is substantial demand for the
  IPO

12
Initial Public Offerings (contd)

• Long-term performance following IPOs
• IPOs perform poorly on average over a period of a
  year or longer
• Many IPOs are overpriced at the time of issue
• Investors may be overly optimistic about the firm
• Managers may spend excessively and be less
  efficient with the firms funds than they were
  before the IPO

13
Secondary Stock Offerings

• A secondary stock offering is
• A new stock offering by a firm whose stock is
  already publicly traded
• Undertaken to raise more equity to expand
  operations
• Usually facilitated by a securities firm
• In the late 1990s, the volume of publicly placed
  stock increased substantially
• From 2000 to 2002, the volume of publicly placed
  stock declined as a result of the weak economy
• Existing shareholders often have the preemptive
  right to purchase newly-issued stock

14
Secondary Stock Offerings (contd)

• Shelf-registration
• A corporation can fulfill SEC requirements up to
  two years before issuing new securities
• Allows firms quick access to funds
• Potential purchasers must realize that
  information disclosed in the registration is not
  continually updated

15
Basic Valuation

• The (market) value of any investment asset is
  simply the present value of expected cash flows.
• The interest rate that these cash flows are
  discounted at is called the assets required
  return.
• The higher expected cash flows, the greater the
  assets value.
• It makes sense that an investor is willing to pay
  (invest) some amount today to receive future
  benefits (cash flows).

16
Basic Valuation Model
V0 CF1 CF2 CFn
(1 k)1 (1 k)2
(1 k)n
Where V0 value of the asset at time zero CFt
cash flow expected at the end of year t k
appropriate required return (discount rate) n
relevant time period
17
Common Stock Valuation

• If an investor buys a share of stock, it is
  expected to receive cash in two ways
• The company pays dividends
• The investor sell shares, either to another
  investor in the market or back to the company
• As with bonds, the price of the stock is the
  present value of these expected cash flows

18
Common Stock Valuation - Example
Suppose an investor is thinking of purchasing the
stock of Moore Oil, Inc. and he expects it to pay
a 2 dividend in one year, and he believes that
he can sell the stock for 14 at that time. If he
requires a return of 20 on investments of this
risk, what is the maximum he would be willing to
pay?
Solution Compute the PV of the expected cash
flows Price (14 2) / (1.2) 13.33
Now what if he decides to hold the stock for two
years? In addition to the dividend in one year,
he expects a dividend of 2.10 in and a stock
price of 14.70 at the end of year 2. Now how
much would he be willing to pay?

Solution PV 2 / (1.2) (2.10 14.70) /
(1.2)2 13.33

19
Developing the valuation model
The price of the stock is just the present
value of all expected future dividends




20
Stock Valuation Models
The Zero Growth Model

• The zero dividend growth model assumes that the
  stock will pay the same dividend each year, year
  after year.

21
The Zero Growth Model
22
Stock Valuation Models
The 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.

23
The Constant Growth Model
24
The Efficient Markets Hypothesis

• Weak form efficiencypast price information is
  contained in current prices
• Semistrong form efficiencypublicly available
  information is contained in current prices
• Strong form efficiencyall information, public
  and private, is contained in current prices