Stock ValuationCapital Market InstrumentsDebt versus EquityCommon StockSlide 5Slide 6Preferred StockRaising Equity CapitalSlide 9Efficient Market HypothesisSlide 11IntroductionSlide 13Dividend Based ModelsSlide 15Gordon Constant Growth ModelSlide 17Free Cash Flow ModelsWhat Affects Stock Prices?Slide 20Non-Constant Growth ValuationNon-Constant Growth - ExampleSlide 23Slide 24Slide 25Other Valuation MethodsStock ValuationPrepared by Keldon BauerFIL 240Capital 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 TreatmentCommon Stock•Ownership•Private corporation•Closely held corporation•Publicly traded corporation•Par Value•Preemptive Rights•Dilution of ownership•Rights offeringCommon Stock•Technical Issues:•Authorized shares.•Outstanding shares.•Treasury shares.•Issued shares.•Voting Rights:•Supervoting/nonvoting shares•Proxy statement•Proxy battleCommon 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•ConvertibleRaising 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 groupEfficient 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.         ntttnnkCFEkCFEkC FEkCFECFEP0221001111Introduction•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.  ntttkCFEP001Dividend 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:      ssskgDkgDkgDP111111022000[1]          ssssskgDkgDkgDPkgkg1111111111by sidesboth gmultiplyin03302200[2]Gordon Constant Growth Model•Subtracting [2] from [1]:    sskgDPkgP1111000  sssskgDkgkkP11111100  ssskgDkgkP11100Gordon Constant Growth Model•Solving for PV:  gkkkgDgkkkgkPsssssss1111100  gkgDPs100Free 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:  gkgFCFPs100What Affects Stock Prices?•Stock prices should therefore depend on:•Expected cash flow.•Growth rate.•The company’s required return.  gkgFCFPs100What Affects Stock Prices?•Required return is a function of the Capital Asset Pricing Model (CAPM):•Therefore ks depends on:•Interest rates.•Systematic risk of the firm.•Market risk aversion. sFmFsRkRk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.   PD gk gs5513 2 0 1 0 0 4 50 1 4 5 0 0 4 53 3 4 40 1 04 4 . ( . ). ...$ 3 3 .Non-Constant Growth - Example•Next we sum all period cash flows.Non-Constant Growth - Example0 12 3 4 5$1.25 $2.75 $1.50 $2.80 $36.6414.5%$ 1.09$ 2.10$ 1.00$ 1.63$18.62 $24.44 = Present ValueOther Valuation Methods•Book Value Method.•Liquidation Value Method.•Price/Earnings (P/E)