berlin, 04.01.2006fußzeile1 stock valuation professor dr. rainer stachuletz corporate finance...
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Berlin, 04.01.2006 Fußzeile 1
Stock Valuation
Professor Dr. Rainer Stachuletz
Corporate Finance
Berlin School of Economics
Berlin, 04.01.2006 Fußzeile 2
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 3
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.
Berlin, 04.01.2006 Fußzeile 4
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 5
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 6
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
Berlin, 04.01.2006 Fußzeile 7
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.
Berlin, 04.01.2006 Fußzeile 8
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.
Berlin, 04.01.2006 Fußzeile 9
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
Berlin, 04.01.2006 Fußzeile 10
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
Berlin, 04.01.2006 Fußzeile 11
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 12
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.
Berlin, 04.01.2006 Fußzeile 13
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$
Berlin, 04.01.2006 Fußzeile 14
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
Berlin, 04.01.2006 Fußzeile 15
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
Berlin, 04.01.2006 Fußzeile 16
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:
Berlin, 04.01.2006 Fußzeile 17
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
Berlin, 04.01.2006 Fußzeile 18
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?
Berlin, 04.01.2006 Fußzeile 19
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 20
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
Berlin, 04.01.2006 Fußzeile 21
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
Berlin, 04.01.2006 Fußzeile 22
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
Variable Growth ModelValuation Step 3
Berlin, 04.01.2006 Fußzeile 23
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
Variable Growth ModelValuation Step 4
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 24
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?
Berlin, 04.01.2006 Fußzeile 25
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.
Berlin, 04.01.2006 Fußzeile 26
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 27
An Example: Mortons Restaurant Group
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 = $8,674,499
Use variable growth equation to estimate Mortons enterprise value.
Berlin, 04.01.2006 Fußzeile 28
2
1
102
210
1
110
)1(
1
)1(
1...
)1(
1
)1(
1
gr
FCF
r
r
gFCF
r
gFCF
r
gFCFV
NN
N
N
F
An Example: Mortons Restaurant Group
865,386,163$
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
Berlin, 04.01.2006 Fußzeile 29
An Example: Mortons Restaurant Group
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:
Berlin, 04.01.2006 Fußzeile 30
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.
Berlin, 04.01.2006 Fußzeile 31
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
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