4333 FIN - Financial Management
Stocks and Their Valuation (BD 5; Adair 9)
Features of common stock Determining common stock values Efficient markets Preferred stock
1
Common Stock: Owners, Directors, and Managers
Represents ownership. Ownership implies control. Stockholders elect directors. Directors hire management. Since managers are "agents" of
shareholders, their goal should be: Maximize stock price.
2
Stock Offerings: IPOs & SEOs
A firm "goes public" through an IPO
when the stock is first offered to the public. owned by the firm's managers, key employees, and, in many situations, venture capital providers. when a company with public stock issues additional shares. in the secondary market, such as the NYSE or Nasdaq.
Prior to an IPO, shares are typically
A seasoned equity offering occurs
After an IPO or SEO, the stock trades
3
Different Approaches for Valuing Common Stock
Dividend Growth Model Using the Multiples of Comparable
Firms
Free Cash Flow Method
4
Common Stock Valuation
Price = PV of Future Cash Flows How much would you pay today for a share of stock which pays a $10 dividend at the end of the year and you think you can for $70? Use 25% for r. PV = (10 + 70) / 1.25 = $64 But, we don't usually know the future price:
D1 P0 = (1 + r)1 and D2 P1 = (1 + r)1 + (1 + r)1 P2 + (1 + r)1 P1
substituting for P1 gives D1 P0 = (1 + r)1 + (1 + r)2 D2 + (1 + r)2 P2
5
Common Stock Valuation (cont.)
extending out forever
D1
D2
D3
Pn
P0 = + + +...+ If we go out far enough, the PV of Pn is approximately 1 (1 + r)2 (1 + r)3 (1 + r)n zero, (1 + r) therefore:
D1 P0 = (1 + r)1 D0(1+g)1 P0 = (1 + r)1 D0(1 + g) P = = + +
D2 + (1 + r)2 D0(1+g)2 + (1 + r)2 D1
D3 +... (1 + r)3 D0(1+g)3
The Dividend +... (or Gordon) Growth (1 + r)3 Model
6
Estimating the Value of a Stock under Different Assumptions
Constant Growth
P0 =
D1 D (1 + g ) = 0 rs - g rs - g
D P0 = rs
Perpetuities
Nonconstant Growth Find PV of Nonconstant-Growth Dividends
PVNC Div =
t =1
n
DNC t (1 + rs ) t
Find PV of Constant-Growth Dividends
PVConst -Growth Div = Pt =
Dt +1 rs - g
P0 = PV NC Dividends + PV Const Dividends
7
The Return Form of the Dividend Growth Model
Rearrange model to rate of return form:
D1 D1 ^ = P0 to r s = +g rs - g P0
Then, rs
= $2.12/$30.29 + 0.06 = 0.07 + 0.06 = 13%
8
Using Stock Price Multiples to Estimate Stock Price
Analysts often use the P/E multiple (the
price per share divided by the earnings per share) or the P/CF multiple (price per share divided by cash flow per share, which is the earnings per plus share the dividends per share) to value stocks.
Example:
Estimate the average P/E ratio of comparable firms. This is the P/E multiple. Multiply this average P/E ratio by the expected earnings of the company to estimate its stock price.
9
Using Entity Multiples
The entity value (V) is:
the market value of equity (# shares of stock multiplied by the price per share) plus the value of debt.
Pick a measure, such as EBITDA, Sales, etc. Calculate the average entity ratio for a sample
of comparable firms. For example, V/EBITDA For example, Multiply the firm's sales by the V/Sales multiple. Multiply the firm's # of customers by the V/Customers ratio
Find the entity value of the firm in question.
The result is the total value of the firm. Subtract the firm's debt to get the total value
of equity.
Divide by the number of shares to get the
price per share.
10
Problems with Using Market Multiple Methods
It is often hard to find comparable firms. The average ratio for the sample of
comparable firms often has a wide range. For example, the average P/E ratio might be 20, but the range could be from 10 to 50. How do you know whether your firm should be compared to the low, average, or high performers?
11
Market Efficiency
The Efficient Markets Hypothesis (EMH) Markets are in equilibrium New information quickly incorporated into market prices Not possible to consistently "beat" the market Types of Efficiency Weak Form All information contained in past price movements are fully reflected in current market p...