Chapter 9 Stocks and Their Valuation

Issues Regarding the Corporate Valuation Model

-Often preferred to the discounted dividend model, especially when considering number of firms that don't pay dividends or when dividends are hard to forecast. -Similar to discounted dividend model, assumes at some point free cash flow will grow at a constant rate. -Horizon value (HVN) represents value of firm at the point that growth becomes constant.

proxy

A document that gives one party the authority to act for another party is a proxy. This includes the power to vote shares of common stock. Proxies can be important tools relating to control of firms.

constant growth stock

A stock whose dividends are expected to grow forever at a constant rate, g.

true or false

According to the valuation models developed in this chapter, the value that an investor assigns to a share of stock is dependent on the length of time the investor plans to hold the stock. false Even if a company is paying steady dividends, much can be learned from the corporate model; so analysts today use it for all types of valuations. The process of projecting future financial statements can reveal a great deal about a company's operations and financing needs. Also, such an analysis can provide insights into actions that might be taken to increase the company's value; and for this reason, it is integral to the planning and forecasting process.

corporate valuation model

Also called the free cash flow method. Suggests the value of the entire firm equals the present value of the firm's free cash flows (which is the MV of its operations) plus the market value of its non-operating assets. Remember, free cash flow is the firm's after-tax operating income less the net capital investment. if a company doesn't pay dividends model is an alternative model used to value a firm, especially one that does not pay dividends or is privately held. This model calculates the firm's free cash flows and then finds their present values at the firm's weighted average cost of capital to determine a firm's value.

DCF stock valuation model

An investor using the DCF stock valuation model would assign a value based on the length of time he or she plans to hold the stock. false The investor needs to consider the value during the holding period as well as the price at which the share will be sold to someone else.

"Comps": Firm Multiples Method

Analysts often use the following multiples to value stocks. • P/E • P/CF • P/Sales • EXAMPLE: Based on comparable firms, estimate the appropriate P/E.Multiply this by expected earnings to back out an estimate of the stock price. • Enterprise-Based Multiples• EV/EBITDA = (MV of firm)/EBITDA not a lot of information about our company

Using comps in valuation

Can be useful to get a range of estimates for the stock price • Only useful if the comps truly match to the firm you are trying to value, and if the comps are correctly valued themselves • Using different multiples will give you different price ranges—then what? • Could see where the ranges overlap• An easy way to estimate price, but use with caution

stock classes

Class A available to the public, class B available to employees Some classes of common stock are entitled to more votes per share than other classes.

common stock

Corporation's basic ownership share; also generically called capital stock. Common stock represents the ownership position in a firm, and is valued as the present value of its expected future dividend stream. Common stock dividends are not specified by contract—they depend on the firm's earnings. Two models are used to estimate a stock's intrinsic value: the discounted dividend model and the corporate valuation model. Because stock has a residual claim rather than a contractual obligation, the cash flows associated with common stock are more difficult to estimate than those related to bonds.

classified stock

Different types of shares with different voting rights(eg. Google, NYTimes Co.) • Class A shares have 1 vote per share (public) • Class B shares have 10 votes per share (founders, family) Classified stock is the differentiation of different shares of common stock. It gives companies a way to meet special needs such as when owners of a start-up firm need additional equity capital but do not want to relinquish voting control. The type of classified stock where the shares are owned by the firm's founders is called founder's shares. With founders' shares, shareholders generally have more votes per share than with other classes of common stock.

preemptive right

Existing shareholders get to purchase any new shares issued • Retain control • Prevents management from selling new shares to itself and consolidating control In order to prevent dilution of control or dilution of value, shareholders use preemptive rights to purchase, on a pro rata basis, any new shares issued by the firm.

Applying the Corporate Valuation Model

Find the market value (MV) of the firm's operations, by finding the PV of the firm's future FCFs. • Add the market value of the firm's non-operating assets .• Subtract MV of firm's debt and preferred stock to get MV of common stock. • Divide MV of common stock by the number of shares outstanding to getintrinsic stock price (value)

preferred stock

Hybrid security Like bonds, preferred stockholders receive a fixed dividend that must be paid before dividends are paid to common stockholders.must be paid before dividends are paid to common stockholder However, companies can omit preferred dividend payments without fear of pushing the firm into bankruptcy. .Because dividend is fixed, value like a no-growth perpetuity

What happens if g is GREATER than rs?

If g > rs, the constant growth formula leads to a negative stock price, which does not make sense. • The constant growth model can be used only if:• rs > g • g is expected to be constant forever.

debt

Money owed Debt is the only tax-deductible form of long-term financing.

intrinsic value and stock price

Outside investors, corporate insiders, and analysts use a variety of approaches to estimate a stock's intrinsic value ( ). • In equilibrium we assume that a stock's price equals its intrinsic value .• Outsiders estimate intrinsic value to help determine which stocks are attractive to buy and/or sell. • Stocks with a price below (above) its intrinsic value are undervalued(overvalued).

Facts about Common Stock

Represents ownership Ownership implies control Stockholders elect directors Directors elect management Management's goal: Maximize the stock price Remember stockholder/management conflicts • An outside group may stage a proxy fight in order to overthrow management • Large institutional investors (IB's, CalPERS) or large individual investors (Soros,Icahn) can lean on management

D1

The expected dividend, D1, is the first dividend included in the price of a stock. The wording to look for: next year's dividend, expected dividend, D1. D1 = D0 * (1+g)

Nonconstant Growth

The part of the life cycle of a firm in which its growth is either much faster or much slower than that of the economy as a whole.

dividend

The portion of corporate profits paid out to stockholders

Which of the following assumptions would cause the constant growth stock valuation model to be invalid?

The required rate of return is less than the growth rate.

difference between DDM and CVM

There are actually two differences between the discounted dividend and corporate valuation models: the expected cash flow stream and the discount rate used in the models are different. The discounted dividend model calculates the firm's stock price as the present value of the expected future dividends at the firm's required rate of return on equity, while the corporate valuation model calculates the firm's stock price as the present value of the expected free cash flows at the firm's weighted average cost of equity.

total firms corporate value

To find the firm's total corporate value, discount projected free cash flows at the firm's weighted average cost of capital.

Discounted Dividend Model (DDM)

Value of a stock is the present value of the future dividends expected to be generated by the stock. model values a common stock as the present value of its expected future cash flows at the firm's required rate of return on equity. Variations of this model are used to value constant growth stocks, zero growth stocks, and nonconstant growth stocks. the value of a stock today can be calculated as the present value of an infinite amount of dividends

investing

When investing in common stocks, an investor's goal is to purchase stocks that are undervalued

If the stock was expected to have negative growth (g = -4%),would anyone buy the stock, and what is its value?

Yes. Even though the dividends are declining, the stock is still producing cash flows and therefore has positive value.

D0

dividend just paid The current dividend is NOT included in the calculation of the Price of a stock. It is already reflected in the price. The wording to look for: current dividend, most recent dividend, just paid dividend. These all refer to D0.

Total return on a stock

dividend yield + capital gain rate

V0

enterprise/market value Enterprise value is the Market Value of the firm. It is essentially the acquisition value of the firm. To get to the Market Value of Equity, you need to subtract the Debt and Preferred Stock from the Enterprise Value.

constant growth model

irst, the required rate of return, rs, must be greater than the long-run growth rate, g. Second, the constant growth model is not appropriate unless a company's growth rate is expected to remain constant in the future. This condition almost never holds for start ups but exists for more mature companies

undervalued stock

price is below stocks intrinsic value

When stockholders assign their right to vote to another party, this is called _____.

proxy

supernormal growth

the part of the firm's life cycle in which it grows much faster than the economy as a whole' g is not constant have to find horizon/terminal value Three steps to find the stock price: 1. Calculate the dividends individually during the high growth period.(three years in this example) 2. Calculate the "terminal/horizon" value: 3. Discount steps 1. and 2. back to time 0

The marginal investor determines the price at which a new issue of stock will trade when it is brought to market.

true