Download Stock Valuation

Stock Valuation
Professor Dr. Rainer Stachuletz
Corporate Finance
Berlin School of Economics
Berlin, 04.01.2006
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1
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.
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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.
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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
Par value
Little economic relevance today
Shares
authorized
Shares authorized by stockholders to be
sold by the board of directors without
further stockholders approval
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
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Common Stock
Market
capitalization
Market price per share x number of
shares outstanding
Treasury
stock
Stock repurchased by corporation;
Usually purchased for stock options
Stock split
Two-for-one split issues one new share
for each already held; reduces per share
price.
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Investment Banks’ Role in Equity
Offerings
Trading
Investment banking
lines of business
Asset management
Corporate finance
Investment banks provide advice with structuring
seasoned and unseasoned issues.
Seasoned
offering
Unseasoned
offering
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• Equity issues by firms that already
have common stock outstanding.
• Initial public offering (IPO): issue of
securities that are not traded yet.
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Investment Banks’ Role in Equity
Offerings
Firms can choose an investment bank through
Direct negotiated offer
Competitive bidding
Public security issues can be
Best
efforts
Firm
commitment
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•
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.
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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
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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.
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Secondary Market
On the secondary market, investors deal among
themselves.
Securities exchanges
– Centralized locations in which listed securities are bought
and sold
– NYSE: the largest exchange in the world, with almost 360
billion shares listed. Other exchanges: AMEX, regional
exchanges
The Over-the-counter market (OTC)
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– OTC has no central, physical location; linked by a mass
telecommunication network.
– A part of the OTC market is made up of stocks traded on
NASDAQ, EUREX
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Valuation Fundamentals:
Preferred Stock
Preferred stock is an equity security that is expected to pay a fixed annual
dividend indefinitely.
PS 0 =
Dp
• PS0 = Preferred stock’s market
price
rp
•
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?
PS 0 =
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Dp
rp
=
$2.3
= $20.90 / share
0.11
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Valuation Fundamentals:
Common Stock
Value
of a
Share
of
Common Stock
D1  P1
P0 
1
(1  r )
• 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 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:
D2
D1
D3
D4
D5
P0 




 ....
1
2
3
4
5
(1  r ) (1  r ) (1  r ) (1  r ) (1  r )
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Zero Growth Valuation Model
 To value common stock, you must make
assumptions about future dividend growth.
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:
D1
P0 
r
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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 year’s dividend as D1:
D1
P0 
rg
Eq.4.6
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?
D1 $3
P0  
 $30
r 0.1
What is the stock worth if investors expect Dynasty’s dividends
to grow at 3% per year?
D1
$3
P0 

 $42,86
r  g 0.10  0.03
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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 Model
Valuation 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
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Variable Growth Model
Valuation 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:
$5.292
$5.292
D
4
=
=
= $75.60
P3 =
r - g 2 0.12 - 0.05
0.07
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Variable Growth Model
Valuation Step 3
 Find the present value of this stock price by
discounting P3 by (1+r)3
$75.60 $75.60
P
3
PV0 =
=
=
= $53.81
3
3
(1  r ) (1.12)
1.405
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Variable Growth Model
Valuation 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
Discount
will generate in the future.
Use weighted average cost of capital (WACC) to
discount the free cash flows.
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?
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Value of firm’s shares
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
An example....
First quarter of 2001, traded
in the $20 - $25 range
Morton Restaurant
Group (MRG)
We can use the free cash flow approach to estimate
the value of MRG shares.
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An Example:
Mortons Restaurant Group
MRG
• 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.
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
End of Year
Growth Status
Growth Rate (%)
FCF Calculation
Given
$4,800,000
2000
Historic
2001
Fast
14
$4,800,000 x (1.14)1 = $5,472,000
2002
Fast
14
$4,800,000 x (1.14)2 = $6,238,080
2003
Fast
14
$4,800,000 x (1.14)3 = $7,111,411
2004
Fast
14
$4,800,000 x (1.14)4 = $8,107,009
2005
Stable
7
$8,107,009 x (1.07)1 = $8,674,499
Use variable growth equation to estimate
Mortons enterprise value.
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An Example:
Mortons Restaurant Group
FCF0 1  g1 
FCF0 1  g1 
FCF0 1  g1 
VF 


...
(1  r )1
(1  r ) 2
(1  r ) N
1
2
N


1
FCFN 1 



N
(
1

r
)
r

g
2 

VF 2001 
$5,472,000 $6,238,080 $7,111,411 $8,107,009




1
2
3
4
(1.11)
(1.11)
(1.11)
(1.11)
 1
$8,674,499 



4
(
1
.
11
)
0
.
11

0
.
07


 $4,929,730  $5,062,966  $5,199,802  $5,340,338  $142,854,029
 $163,386,865
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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:
VF
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$97,386,865

 $23.40
4,148,002
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29
Common Stock Valuation
Other Options
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
P/E
multiples
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• 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.
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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
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