Chapter 7

Stock Valuation

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All rights reserved.

Differences Between Debt and

Equity
Debt includes all borrowing incurred by a firm, including bonds,
and is repaid according to a fixed schedule of payments.
Equity consists of funds provided by the firms owners (investors
or stockholders) that are repaid subject to the firms performance.
Debt financing is obtained from creditors and equity financing is
obtained from investors who then become part owners of the firm.
Creditors (lenders or debtholders) have a legal right to be repaid,
whereas investors only have an expectation of being repaid.

2012 Pearson Prentice Hall. All rights reserved.

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Table 7.1 Key Differences between

Debt and Equity Capital

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Differences Between Debt and

Equity: Voice in Management
Unlike creditors, holders of equity (stockholders) are
owners of the firm.
Stockholders generally have voting rights that permit
them to select the firms directors and vote on special
issues.
In contrast, debtholders do not receive voting privileges
but instead rely on the firms contractual obligations to
them to be their voice.

2012 Pearson Prentice Hall. All rights reserved.

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Matter of Fact
How Are Assets Divided in Bankruptcy?
According to the U.S. Securities and Exchange Commission,
in bankruptcy assets are divided up as follows:
1. Secured Creditors secured bank loans or secured bonds, are paid first.
2. Unsecured Creditors unsecured bank loans or unsecured bonds,
suppliers, or customers, have the next claim.
3. Equityholders equityholders or the owners of the company have the
last claim on assets, and they may not receive anything if the Secured
and Unsecured Creditors claims are not fully repaid.

2012 Pearson Prentice Hall. All rights reserved.

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Differences Between Debt and

Equity: Maturity
Unlike debt, equity capital is a permanent form of
financing.
Equity has no maturity date and never has to be repaid by
the firm.

2012 Pearson Prentice Hall. All rights reserved.

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Differences Between Debt and

Equity: Tax Treatment
Interest payments to debtholders are treated as taxdeductible expenses by the issuing firm.
Dividend payments to a firms stockholders are not taxdeductible.
The tax deductibility of interest lowers the corporations
cost of debt financing, further causing it to be lower than
the cost of equity financing.

2012 Pearson Prentice Hall. All rights reserved.

7-7

Types of Stock
Common Stock We take a closer look at this is
subsequent slides
Preferred Stock a hybrid with characteristics of debt
and equity
Debt Characteristics Par value, pays fixed dividend
which takes senior position to common stock dividend,
some actually have maturity date and can be valued like
bond.
Equity Characteristics Par value, dividend can be
passed by directors if financial conditions warrant.
8

Common Stock
Common stockholders, who are sometimes referred to as residual
owners or residual claimants, are the true owners of the firm.
As residual owners, common stockholders receive what is leftthe
residualafter all other claims on the firms income and assets have
been satisfied.
They are assured of only one thing: that they cannot lose any more
than they have invested in the firm.
Because of this uncertain position, common stockholders expect to
be compensated with adequate dividends and ultimately, capital
gains.

2012 Pearson Prentice Hall. All rights reserved.

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Common Stock: Par Value

The par value of common stock is an arbitrary value established
for legal purposes in the firms corporate charter, and can be used to
find the total number of shares outstanding by dividing it into the
book value of common stock.
When a firm sells news shares of common stock, the par value of
the shares sold is recorded in the capital section of the balance
sheet as part of common stock.
At any time the total number of shares of common stock
outstanding can be found by dividing the book value of common
stock by the par value.

2012 Pearson Prentice Hall. All rights reserved.

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Common Stock: Authorized,

Outstanding, and Issued Shares
Authorized shares are the shares of common stock that a firms
corporate charter allows it to issue.
Outstanding shares are issued shares of common stock held by
investors, this includes private and public investors.
Treasury stock are issued shares of common stock held by the
firm; often these shares have been repurchased by the firm.
Issued shares are shares of common stock that have been put into
circulation.
Issued shares = outstanding shares + treasury stock

2012 Pearson Prentice Hall. All rights reserved.

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Common Stock: Authorized,

Outstanding, and Issued Shares (cont.)
Golden Enterprises, a producer of medical pumps, has the
following stockholders equity account on December 31st.

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Common Stock: Voting Rights

Generally, each share of common stock entitles its holder to one
vote in the election of directors and on special issues.
Votes are generally assignable and may be cast at the annual
stockholders meeting.
A proxy statement is a statement transferring the votes of a
stockholder to another party.
Because most small stockholders do not attend the annual meeting to vote,
they may sign a proxy statement transferring their votes to another party.
Existing management generally receives the stockholders proxies, because it
is able to solicit them at company expense.

2012 Pearson Prentice Hall. All rights reserved.

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Buy or Sell?
Is there such a thing as undervalued or
overvalued stock? If so then:
Undervalued Stock investors want to buy
Overvalued Stock investors want to sell
Will discuss this in more detail a little later.

14

Types of Stock Market Transactions

Primary market additional shares are sold by
publicly help corporation
Secondary market sale of seasoned
(previously owned) securities
IPO (initial public offering) public stock sale by
privately held firmalso called going public

15

Approaches for Valuing

Common Stock
Dividend Growth Modelswill focus on these
Free Cash Flow Valuation Model
Read on your own in chapter

Book Value Approach

Read on your own in chapter

Liquidation Value Approach

Read on your own in chapter

P/E Multiples

Read on your own in chapter

16

Stock Value = PV of Dividends

^

P0 =

D1
(1 + rs)1

D2
(1 + rs)2

D3
(1 + rs)3

++

(1 + rs)

The value of a share of stock is the

present value of the expected future cash
flows.
Expected future cash flows come from:
1. Dividends
2. Capital gain or loss
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Zero Growth Model

Assumes a stocks dividends do not grow
Valued like a perpetuity
Can also be used for preferred stock

0 r = 13% 1
s
2.00
P0 =

PMT
r

$2.00
0.13

2.00

2.00

= $15.38.
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Valuing Preferred Stock with Zero

Growth Model
Value share of preferred stock if annual
dividend = $5 and required return is 10%:

$5
Vps
.10

19

Constant Growth Model

(Gordon Model)
Dividends are expected to grow at a constant rate per period.
D1 = D0(1 + g)1
D2 = D0(1 + g)2
Dt = D0(1 + g)t
If g is constant and less than rs, then:

P0 =

^ D0(1 + g)

D1

Dividendr growth
g (g) must be less than
r thegstocks required return (r)
s

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Intrinsic Stock Value:

D0 = $2.00, rs = 13%, g = 6%
Constant growth model:
^
P0 =

D0(1 + g)
rs g
$2.12

0.13 0.06

D1
=
rs g
$2.12
=
0.07

= $30.29.

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Expected Dividend Yield and

Capital Gains Yield (Year 1)
D1 $2.12
Dividend yield =
=
= 7.0%.
$30.29
P0
P1
CG Yield =

P0

$32.10 $30.29
=
$30.29

P
0
= 6.0%.

22

Non-Constant Growth Model

This model is used to value stocks whose
dividends do not grow at the same rate each
year.
More technical to calculate than the previous
two models.
You are only responsible for knowing the
definition of the non-constant growth model
given aboveno calculations.
23

Whats the Efficient Market

Hypothesis (EMH)?
Securities are normally in equilibrium and are fairly
priced. One cannot beat the market except through
good luck or inside information.
Security prices at all times reflect all public information, and
prices react swiftly to new information. EMH does not
assume all investors are rational.
EMH assumes that stock market prices track intrinsic
values fairly closely and investors should not waste their
time trying to find mispriced securities.
Not everyone believes in the EMH.
(More)
24

EMH (continued)
If stock prices deviate from intrinsic values,
investors will quickly take advantage of
mispricing.
Prices will be driven to new equilibrium
level based on new information.
It is possible to have irrational investors in a
rational market.

25

Weak-form EMH
Cant profit by looking at past trends or
historical information.
A recent decline is no reason to think
stocks will go up (or down) in the future.
Evidence supports weak-form EMH, but
technical analysis is still used.

26

Semistrong-form EMH
All publicly available information is
reflected in stock prices, so it doesnt pay to
pore over annual reports looking for
undervalued stocks.
U.S. stock markets have been proven to be
mostly semistrong-form efficient.

27

Strong-form EMH
All information, even inside information,
is embedded in stock prices.
Thus, investor could not make unusually
large profits knowing inside information.
Not trueinsiders can gain by trading on
the basis of insider information, but thats
illegal.

28

Markets are generally efficient because:

100,000 or so trained analystsMBAs,

CFAs, and PhDswork for firms like Fidelity,
Morgan, and Prudential.
These analysts have similar access to data
and megabucks to invest.
Thus, news is reflected in P0 almost
instantaneously.

29

Market Efficiency
For most stocks, for most of the time, it is
generally safe to assume that the market
is reasonably efficient.
However, periodically major shifts can and
do occur, causing most stocks to move
strongly up or down.
Thus, markets can overreact to various
crises.
30

Trading Stock in the Real World

31

Trading Stock in the Real World

32

Trading Stock in the Real World

33

Trading Stock in the Real

World

34

Questions ????
Questions about stock valuation, trading,
etc?

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