PowerPointPrsentation

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Stock Valuation
Professor Dr. Rainer Stachuletz Corporate
Finance Berlin School of Economics
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Debt vs. Equity Debt
Debt securities represent a legally enforceable
claim.
Debt securities offer fixed or floating cash
flows.
Bondholders dont have any control over how the
company is run.
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Debt vs. Equity Equity
Stockholders have voting rights on important
company decisions.
Debt and equity have substantially different
marginal benefits and marginal costs.
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Preferred Stock
Preferred stock is a hybrid having some features
similar to debt and other features similar to
equity.

• Claim on assets and cash flow senior to common
  stock
• As equity security, dividend payments are not tax
  deductible for the corporation.
• For tax reasons, straight preferred stock held
  mostly by corporations.

Promises a fixed annual dividend payment, but not
legally enforceable. Firms cannot pay common
stock dividends if preferred stock is in arrears.
Preferred stockholders usually do not have voting
rights.
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Rights of Common Stockholders
Common stockholders voting rights can be
exercised in person or by proxy.
Most US corporations have majority voting, with
one vote attached to each common share.
Cumulative voting gives minority shareholders
greater chance of electing one or more directors.
Shareholders have no legal rights to receive
dividends.
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Common Stock
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Common Stock
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Investment Banks Role in Equity Offerings
Investment banks provide advice with structuring
seasoned and unseasoned issues.
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Investment Banks Role in Equity Offerings
Public security issues can be
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Investment Bank Services and Costs
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Services Provided during and after a Security
Offering
Almost all IPOs and SEOs have a green shoe
option over-allotment option to cover excess
demand.
Lead underwriter responsible for price
stabilization after offering.
After offering, lead underwriter serves as
principal market maker.
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Secondary Market
On the secondary market, investors deal among
themselves.
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Valuation FundamentalsPreferred Stock

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

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Valuation FundamentalsCommon Stock

• P0 Present value of the expected stock price at
  the end of period 1
• D1 Dividends received
• r discount rate

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Valuation FundamentalsCommon 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 find that
  todays price equals PV of the entire dividend
  stream the stock will pay in the future

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Zero Growth Valuation Model

• To value common stock, you must make assumptions
  about future dividend growth.

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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 years dividend as D1

Commonly called the Gordon growth model
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Example

• Dynasty Corp. will pay 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
Dynastys dividends to grow at 3 per year?
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Variable Growth Model Example

• Estimate the current value of Morris Industries'
  common stock, P0
• Assume
• The most recent annual dividend payment of Morris
  Industries was 4 per share.
• Investors expect that these dividends will
  increase at an 8 annual rate over the next 3
  years.
• After three years, dividend growth will level out
  at 5.
• The firm's required return, r , is 12.

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Variable Growth ModelValuation Steps 1 and 2

• Compute the value of dividends in year 1, 2, and
  3 as (1g1)1.08 times the previous years
  dividend
• Div1 Div0 x (1g1) 4 x 1.08 4.32
• Div2 Div1 x (1g1) 4.32 x 1.08 4.67
• Div3 Div2 x (1g1) 4.67 x 1.08 5.04
• Find the PV of these three dividend payments
• PV of Div1 Div1 ? (1r)1 4.32 ? (1.12)
  3.86
• PV of Div2 Div2 ? (1r)2 4.67 ? (1.12)2
  3.72
• PV of Div3 Div3 ? (1r)3 5.04 ? (1.12)3
  3.59
• Sum of discounted dividends 3.86 3.72
  3.59 11.17

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Variable Growth ModelValuation Step 3

• Find the value of the stock at the end of the
  initial growth period using the constant growth
  model.
• Calculate next period dividend by multiplying D3
  by 1g2, the lower constant growth rate
• D4 D3 x (1 g2) 5.04 x (1.05) 5.292
• Then use D45.292, g 0.05, r 0.12 in Gordon
  model

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Variable Growth ModelValuation Step 3

• Find the present value of this stock price by
  discounting P3 by (1r)3

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Variable Growth ModelValuation Step 4

• Add the PV of the initial dividend stream (Step
  2) to the PV of stock price at the end of the
  initial growth period (P3)
• P0 11.17 53.81 64.98

Current (end of year 0) stock price
Remember Because future growth rates might
change, the variable growth model allows for a
changes in the dividend growth rate.
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Valuing the Enterprise Free Cash Flow Valuation
Discount estimates of free cash flow that the
firm will generate in the future.
WACC after-tax weighted average required return
on all types of securities that firm issues.
We have an estimate of total value of the firm.
How can we use this to value the firms shares?
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Value of firms shares
VS VF VD - VP

• VS value of firms common shares
• VF total enterprise value
• VD value of firms debt
• VP value of firms preferred stock

We can use the free cash flow approach to
estimate the value of MRG shares.
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An Example Mortons Restaurant Group
Assume that Mortons will experience 14 FCF
growth from 2000 to 2004 and 7 annual growth
thereafter.
Mortons WACC is approximately 11.
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An Example Mortons Restaurant Group
Use variable growth equation to estimate Mortons
enterprise value.
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An Example Mortons Restaurant Group
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An Example Mortons Restaurant Group
Divide total share value by 4,148,002 shares
outstanding to obtain per-share value
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Common Stock ValuationOther Options
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Stock Valuation

• Preferred stock has both debt and equity-like
  features.
• Common stock represents residual claims on firms
  cash flows
• Investment bankers play an important role in
  helping firms issue new securities
• The same principles apply to valuation of both
  preferred and common stock