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Stock Valuation Professor Dr. Rainer Stachuletz Corporate Finance Berlin School of Economics Berlin, 04.01.2006 Fußzeile 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. Berlin, 04.01.2006 Fußzeile 2 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. Berlin, 04.01.2006 Fußzeile 3 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. Berlin, 04.01.2006 Fußzeile 4 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. Berlin, 04.01.2006 Fußzeile 5 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 Berlin, 04.01.2006 Fußzeile 6 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. Berlin, 04.01.2006 Fußzeile 7 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 Berlin, 04.01.2006 • Equity issues by firms that already have common stock outstanding. • Initial public offering (IPO): issue of securities that are not traded yet. Fußzeile 8 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 Berlin, 04.01.2006 • 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. Fußzeile 9 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 Berlin, 04.01.2006 Fußzeile 10 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. Berlin, 04.01.2006 Fußzeile 11 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) Berlin, 04.01.2006 – 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 Fußzeile 12 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 = Berlin, 04.01.2006 Dp rp = $2.3 = $20.90 / share 0.11 Fußzeile 13 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 Berlin, 04.01.2006 Fußzeile 14 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 ) Berlin, 04.01.2006 Fußzeile 15 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 Berlin, 04.01.2006 Fußzeile 16 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 rg Eq.4.6 Commonly called the Gordon growth model Berlin, 04.01.2006 Fußzeile 17 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 Berlin, 04.01.2006 Fußzeile 18 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%. Berlin, 04.01.2006 Fußzeile 19 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 Berlin, 04.01.2006 Fußzeile 20 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 Berlin, 04.01.2006 Fußzeile 21 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 Berlin, 04.01.2006 Fußzeile 22 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. Berlin, 04.01.2006 Fußzeile 23 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? Berlin, 04.01.2006 Fußzeile 24 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. Berlin, 04.01.2006 Fußzeile 25 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%. Berlin, 04.01.2006 Fußzeile 26 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. Berlin, 04.01.2006 Fußzeile 27 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 Berlin, 04.01.2006 Fußzeile 28 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 Berlin, 04.01.2006 $97,386,865 $23.40 4,148,002 Fußzeile 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 Berlin, 04.01.2006 • 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. Fußzeile 30 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 Berlin, 04.01.2006 Fußzeile 31