Stock Valuation

1. Stock Valuation Professor Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics Fußzeile

2. Debt vs. Equity: Debt • Debt securities represent a legally enforceable claim. • Debt securities offer fixed or floating cash flows. • Bondholders don’t have any control over how the company is run. Fußzeile

3. Debt vs. Equity: Equity • Common stockholders are residual claimants. • No claim to earnings or assets until all senior claims are paid in full • High risk, but historically also high return • Stockholders have voting rights on important company decisions. Debt and equity have substantially different marginal benefits and marginal costs. Fußzeile

4. Preferred Stock • 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. Preferred stock is a hybrid having some features similar to debt and other features similar to equity. 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. Fußzeile

5. 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. Fußzeile

6. Common Stock Par value Little economic relevance today Shares authorized by stockholders to be sold by the board of directors without further stockholders approval Shares authorized Shares issued and outstanding Number of shares owned by stockholders Additional paid-in capital Amount received in excess of par value when corporation initially sold stock Fußzeile

7. Common Stock Market capitalization • Market price per share x number of shares outstanding Stock repurchased by corporation; Usually purchased for stock options Treasury stock Two-for-one split issues one new share for each already held; reduces per share price. Stock split Fußzeile

8. Investment Banks’ Role in Equity Offerings Trading Investment banking lines of business Asset management Corporate finance Seasoned offering • Equity issues by firms that already have common stock outstanding. Unseasoned offering • Initial public offering (IPO): issue of securities that are not traded yet. Investment banks provide advice with structuringseasoned and unseasoned issues. Fußzeile

9. Investment Banks’ Role in Equity Offerings Firms can choose an investment bank through Direct negotiated offer Competitive bidding Best efforts • The bank promises its best efforts to sell the firm’s securities. No guarantees though about the success of the offering. • Underwritten offerings, bank guarantees certain proceeds. • Vast majority of US security offerings are underwritten. Firm commitment Public security issues can be Fußzeile

10. Investment Bank Services and Costs Services provided by investment banks prior to security offering • Primary pre-issue role: provide advice and help plan offer • Firm seeking capital selects lead underwriter(s). • Top firm is the lead manager, others are co-managers. • Offering syndicate organized early in process Prior to offering, lead investment bank negotiates underwriting agreement • Sets offer price and spread; details lock-up agreement • Bulge bracket underwriter’s spread usually 7.0% for IPOs • Initial offer price set as range; final price set day before offer Fußzeile

11. Services Provided during and after a Security Offering Lead underwriter sets each syndicate member’s participation. How many shares each member must sell and compensation for each sale 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. Fußzeile

12. Secondary Market Securities exchanges • Centralized locations in which listed securities are bought and sold • NYSE: the largest exchange in the world, with almost 360 billionshares listed. Other exchanges: AMEX, regional exchanges The Over-the-counter market (OTC) • OTC has no central, physical location; linked by a mass telecommunication network. • A part of the OTC market is made up of stockstraded on NASDAQ, EUREX On the secondary market, investors deal among themselves. Fußzeile

13. PS0 = Preferred stock’s market price • Dp = next period’s dividend payment • rp = discount rate An example: Investors require an 11% return on a preferred stock that pays a $2.30 annual dividend.  What is the price? Valuation Fundamentals:Preferred Stock Preferred stock is an equity security that is expected to pay a fixed annual dividend indefinitely. Fußzeile

14. Valuation Fundamentals:Common Stock Value of a Share of Common Stock • P0 = Present value of the expected stock price at the end of period #1 • D1 = Dividends received • r = discount rate Fußzeile

15. Valuation Fundamentals:Common 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 today’s price equals PV of the entire dividend stream the stock will pay in the future: Fußzeile

16. Zero growth model assumes a constant, non-growing dividend stream. • D1 = D2= ... = D • Plugging constant value D into the common stock valuation formula reduces to simple equation for a perpetuity: Zero Growth Valuation Model • To value common stock, you must make assumptions about future dividend growth. Fußzeile

17. 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 year’s dividend as D1: Commonly called the Gordon growth model Fußzeile

18. 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 Dynasty’s dividends to grow at 3% per year? Fußzeile

19. 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%. Fußzeile

20. Variable Growth ModelValuation Steps 1 and 2 • Compute the value of dividends in year 1, 2, and 3 as (1+g1)=1.08 times the previous year’s dividend Div1= Div0 x (1+g1) = $4 x 1.08 = $4.32 Div2= Div1 x (1+g1) = $4.32 x 1.08 = $4.67 Div3= Div2 x (1+g1) = $4.67 x 1.08 = $5.04 • Find the PV of these three dividend payments: PV of Div1= Div1 (1+r)1 = $ 4.32  (1.12) = $3.86 PV of Div2= Div2 (1+r)2 = $ 4.67  (1.12)2 = $3.72 PV of Div3= Div3 (1+r)3 = $ 5.04  (1.12)3 = $3.59 Sum of discounted dividends = $3.86 + $3.72 + $3.59 = $11.17 Fußzeile

21. 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 1+g2, the lower constant growth rate: D4 = D3 x (1+ g2) = $ 5.04 x (1.05) = $5.292 • Then use D4=$5.292, g =0.05, r =0.12 in Gordon model: Fußzeile

22. Variable Growth ModelValuation Step 3 • Find the present value of this stock price by discounting P3 by (1+r)3 Fußzeile

23. 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. Fußzeile

24. Valuing the Enterprise: Free Cash Flow Valuation Discount Use weighted average cost of capital (WACC) to discount the free cash flows. 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 firm’s shares? Fußzeile

25. Value of firm’s shares An example.... Morton Restaurant Group (MRG) First quarter of 2001, traded in the $20 - $25 range VS = VF– VD - VP • VS = value of firm’s common shares • VF = total enterprise value • VD = value of firm’s debt • VP = value of firm’s preferred stock We can use the free cash flow approach to estimate the value of MRG shares. Fußzeile

26. An Example: Mortons Restaurant Group • At end of 2000, MRG’s debt market value was $66 million. • No preferred stock • 4,148,002 shares outstanding • Free cash flow in 2000 was $4.8 million. • Revenues and operating profits grew at 14% between 1998 and 2000. MRG Assume that Mortons will experience 14% FCF growth from 2000 to 2004 and 7% annual growth thereafter. Mortons’ WACC is approximately 11%. Fußzeile

27. An Example: Mortons Restaurant Group Use variable growth equation to estimate Mortons enterprise value. Fußzeile

28. An Example: Mortons Restaurant Group Fußzeile

29. An Example: Mortons Restaurant Group VF = 163,386,865 VD = $66,000,000 VP = $0 VS = $163,386,865 - $66,000,000 - $0 = $97,386,865 Divide total share value by 4,148,002 shares outstanding to obtain per-share value: Fußzeile

30. Book value • The value shown on the balance sheet of the assets of the firm, net of liabilities shown on the balance sheet Liquidation value • Actual net amount per share likely to be realized upon liquidation and payment of liabilities • Reflects the amount investors will pay for each dollar of earnings per share • P / E multiples differ between and within industries. • Especially helpful for privately-held firms. P / E multiples Common Stock ValuationOther Options Fußzeile

31. 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 Fußzeile