berlin, 04.01.2006fußzeile1 stock valuation professor dr. rainer stachuletz corporate finance...

Berlin, 04.01.2006 Fußzeile 1

Stock Valuation

Professor Dr. Rainer Stachuletz

Corporate Finance

Berlin School of Economics


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.


Debt vs. Equity: Equity

Debt and equity have substantially different marginal benefits and marginal costs.

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.


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.


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.


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

Additional paid-in capital

Amount received in excess of par value when corporation initially

sold stock

Shares issued and outstandin

g

Number of shares owned by stockholders


Common Stock

Market capitalizati

on

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.


Investment Banks’ Role in Equity Offerings

Asset management

Corporate finance

Trading

Investment banking lines of

business

Investment banks provide advice with structuring seasoned and unseasoned issues.

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’ Role in Equity Offerings

Public security issues can be

Best efforts

• The bank promises its best efforts to sell the firm’s securities. No guarantees though about the success of the offering.

Firm

commitment

• Underwritten offerings, bank guarantees certain proceeds.

• Vast majority of US security offerings are underwritten.

Direct negotiated offer Competitive bidding

Firms can choose an investment bank through


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 processPrior 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


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.


Secondary Market

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)

– 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

On the secondary market, investors deal among themselves.


Valuation Fundamentals:Preferred Stock

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

p

p0

r

D = PS • 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?

share= =r

D = PS

p

p0 /90.20$

11.0

3.2$


Valuation Fundamentals:Common Stock

• P0 = Present value of the expected stock price at the end of period #1

• D1 = Dividends received

• r = discount rate

111

0 )1( r

PDP

Value of a

Share of

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:

Valuation Fundamentals:Common Stock


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

r

DP 10

• Plugging constant value D into the common stock valuation formula reduces to simple equation for a perpetuity:


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


Example

86,42$03.010.0

3$

gr

DP 1

0

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?

30$1.0

3$10

r

DP

What is the stock worth if investors expect Dynasty’s dividends to grow at 3% per year?


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%.


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 = $4.32Div2= 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


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:

60.7507

292.5

2

292.543 $ =

0.

$ =

0.05 -0.1

$ =

g -rD = P

2

Variable Growth ModelValuation Step 3


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

81.53405.1

60.75$

)12.1(

60.75$

)1( 333

0 $ = = = r

P =PV



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.


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.

Use weighted average cost of capital (WACC) to discount the free cash flows.

Discount

We have an estimate of total value of the firm. How can we use this to value the firm’s

shares?


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....

Morton Restaurant Group (MRG)

First quarter of 2001, traded in the $20 - $25

range

We can use the free cash flow approach to estimate the value of MRG shares.


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%.



End of Year Growth Status Growth Rate (%) FCF Calculation

2000 Historic Given $4,800,000

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.


2

1

102

210

1

110

)1(

1

)1(

1...

)1(

1

)1(

1

gr

FCF

r

r

gFCF

r

gFCF

r

gFCFV

NN

N

N

F


865,386,163$

029,854,142$338,340,5$802,199,5$966,062,5$730,929,4$

07.011.0

499,674,8$

)11.1(

1

)11.1(

009,107,8$

)11.1(

411,111,7$

)11.1(

080,238,6$

)11.1(

000,472,5$

4

43212001

FV



VF = 163,386,865

VD = $66,000,000

VP = $0VS = $163,386,865 - $66,000,000 - $0 =

$97,386,865

40.23$002,148,4

865,386,97$FV

Divide total share value by 4,148,002 shares outstanding to obtain per-share value:


Common Stock ValuationOther 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

• 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.


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, 04.01.2006fußzeile1 stock valuation professor dr. rainer stachuletz corporate finance...

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