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Stocks valuation - Global Financial Management Valuation of...

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1 Global Financial Management Valuation of Stocks Copyright 1999 by Alon Brav, Stephen Gray, Campbell R Harvey and Ernst Maug. All rights reserved. No part of this lecture may be reproduced without the permission of the authors. Latest Revision: August 23, 1999 3.0 Introduction This lecture provides an overview of equity securities (stocks or shares). These securities provide an ownership interest in the firm whereas debt securities (loans, bonds or other fixed-interest securities) establish a creditor relationship with the firm. After a brief overview of some of the institutional details of these securities, this module focuses on valuing equity securities by making some simplifying assumptions. This leads us to a discussion of financial ratios that are widely used in practice, in particular, dividend yields and price/earnings multiples. After completing this module, you should be able to: Understand basic transactions involving stocks Demonstrate why stocks can always be valued as the present value of future dividends. Determine the value of a stock that pays a constant dividend Determine the value of a stock that pays a dividend that grows at a constant rate. Use the dividend growth model to infer the expected return on equity if you know the expected growth rate of a company. Use the dividend growth model to infer the expected growth rate of future dividends for a company where you know the expected rate of return on equity. Value a company using appropriate P/E-multiples and understand the limitations of this methodology. Show how the value of a company can be decomposed into the value of growth options and value of a constant earnings stream.
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2 3.1 Introduction to Stocks Stocks represent an ownership interest in a company and confer three rights on the owner of a share: Vote at company meetings: Shareholders vote on meetings on issues ranging from merger proposals to changes in the corporate charter to the election of corporate directors. Collect periodic dividend payments. Unlike interest payments dividends are not contractually fixed and can vary. Omission of dividends does not trigger bankruptcy. Sell the share at his or her discretion. In some countries this right can be limited. In this lecture we focus on the valuation of stocks. Therefore, we are mainly concerned with the second and third point. However, the first point is important for understanding the market for corporate control and corporate governance. Stocks are first issued to investors through what is known as the primary or new issues market. Typically, companies are founded by one or few entrepreneurs and initially held by a small number of investors. At some point the company decides to raise capital by offering shares to the general public. This is known as an initial public offering (IPO). The company may decide to raise more capital through selling shares in the future. These subsequent offerings are called seasoned equity offerings (SEO). IPOs and SEOs together form the equity primary market. In
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