Stock Valuation Prepared by Keldon Bauer FIL 240 Capital Market Instruments The capital market is the market for financial instruments that mature in more than a year There are two forms of capital Debt The right to an agreed cash flow Bonds notes etc Equity The ownership interest in the business therefore the residual cash flow Common and preferred stock Debt versus Equity Voice in Management Voice of lenders limited by contract Equity investors have voting rights for the board of directors Claims on Income and Assets Debt Contractual claimant Equity Residual claimant Maturity Tax Treatment Common Stock Ownership Private corporation Closely held corporation Publicly traded corporation Par Value Preemptive Rights Dilution of ownership Rights offering Common Stock Technical Issues Authorized shares Outstanding shares Treasury shares Issued shares Voting Rights Supervoting nonvoting shares Proxy statement Proxy battle Common Stock Dividends International Stocks Listing on foreign exchanges American Depository Receipts ADRs Preferred Stock Par value vs Non par Preferred Stock Rights Voting Earnings distribution and liquidation Restrictive covenants Cumulation Callable Convertible Raising Equity Capital Investment Bankers Publicly Held Venture Capitalist Privately or Closely Held Organization Investment stages Deal Structure Pricing Angel Capitalist Privately or Closely Held Raising Equity Capital Going Public Initial Public Offering IPO Prospectus Red Herring How Does a Firm Go Public Underwriter Investment Bank Underwriting syndicate Selling group Efficient Market Hypothesis The Efficient Market Hypothesis EMH states Stocks are always in equilibrium It is impossible to consistently beat the market The market protects fools There are three forms of market efficiency Efficient Market Hypothesis Weak Form All historical information is already included in the stock price Semi Strong Form All current publicly available information is already included in the stock price Strong Form All relevant information public or private is included in stock prices Introduction The valuation of all financial securities is based on the expected PV of future cash flows E CF n E CF 1 E CF 2 P0 E CF0 2 n 1 k 1 k 1 k n E CF t 1 k t 0 t Introduction n E CFt 1 k P0 t 0 t E CFt Expected cash flow at time t k The required return based on economic conditions riskiness Value increases as cash flow increases or k decreases Dividend Based Models The first economic based valuation models assessed the present value of expected dividends Myron Gordon applied the previous equation to expected dividends assuming a constant growth rate Since stocks never mature n must be allowed to approach infinity Dividend Based Models The Gordon Constant Growth Model D0 1 g D0 1 g D0 1 g P0 2 1 k s 1 k s 1 k s 2 1 2 1 g multiplying both sides by 1 k s 1 g P D0 1 g 2 D0 1 g 3 D0 1 g 1 k s 0 1 k s 2 1 k s 3 1 k s Gordon Constant Growth Model Subtracting 2 from 1 P0 1 g P D0 1 g 0 1 k s 1 k s 1 ks 1 g P0 1 ks 1 ks D0 1 g 1 k s k s g D0 1 g P0 1 k s 1 ks Gordon Constant Growth Model Solving for PV k s g 1 k s D0 1 g 1 k s P0 1 k s k s g 1 k s k s g D0 1 g P0 ks g Free Cash Flow Models Many stocks do not offer a dividend If the same assumptions are made except that free cash flow not dividends are being valued the same process can be used to derive another valuation model FCF0 1 g P0 ks g What Affects Stock Prices FCF0 1 g P0 ks g Stock prices should therefore depend on Expected cash flow Growth rate The company s required return What Affects Stock Prices Required return is a function of the Capital Asset Pricing Model CAPM k s R F k m R F s Therefore ks depends on Interest rates Systematic risk of the firm Market risk aversion Non Constant Growth Valuation Since constant growth is unlikely we will now consider how to value stock under non constant growth First project dividends or free cash flows as far as practical From there estimate a constant growth rate Then take the PV as we discussed in an earlier chapter Non Constant Growth Example If Buford s Bulldozer is expected to pay the following dividends and then grow indefinitely at 4 5 assuming a discount rate of 14 50 what would its stock value be Non Constant Growth Example First we consider the price of the stock at time five P5 D 5 1 g k s g 3 2 0 1 0 0 4 5 3 3 4 4 0 1 4 5 0 0 4 5 0 1 0 3 3 4 4 Non Constant Growth Example Next we sum all period cash flows Non Constant Growth Example 0 14 5 1 1 25 2 2 75 1 09 2 10 1 00 1 63 18 62 24 44 Present Value 3 1 50 4 2 80 5 36 64 Other Valuation Methods Book Value Method Liquidation Value Method Price Earnings P E Multiples