BFINEL4X​ ​ ​ ​ ​ ​ ​ ​ ​ MIDTERMS

ELECTIVE 4 - SECURITY ANALYSIS

➔​CASH
LESSON 1: ANALYSIS OF ➔​ACCOUNTS RECEIVABLE
FINANCIAL STATEMENTS ➔​MARKETABLE SECURITIES
➔​INVENTORY
WHAT ARE FINANCIAL
➔​Accumulated Depreciation
STATEMENTS
➔​Equipment
❖​Financial statements are formal records that ➔​Property
provide a summary of a company’s financial -​ In Liabilities :
performance, position, and cash flows over a
specific period. ➔​ACCOUNTS PAYABLE
❖​They are essential tools for stakeholders, such ➔​NOTES PAYABLE
as investors, creditors, and management, to ➔​ACCRUALS
assess the company’s financial health and make ➔​Long – Term debt
informed decisions.

THE FOUR KEY FINANCIAL

STATEMENTS
1.​ INCOME STATEMENT
-​Provide a financial summary of the firm’s
operating results during a specific period.

3.​ STATEMENT OF RETAINED EARNINGS

-​It is the abbreviated form of “Statement of
Stockholders‘ equity”

2.​ BALANCE SHEET -​Reconciles the net income earned during a

-​Summary statement of the firm’s financial given year, and any cash dividends paid, with
position at a given point in time. the change in retained earnings between the
start and the end of that year.
-​In Assets :

1
 EACH OF THE FOUR MAJOR
FINANCIAL STATEMENTS
❖​ The income statement shows profitability by
detailing revenues and expenses over a period
❖​The balance sheet provides a snapshot of the
company’s financial position by listing assets,
liabilities, and equity at a specific date
4.​ STATEMENT OF CASH FLOWS ❖​The statement of retained earnings explains
-​ Provides a summary of the firm’s operating, changes in retained earnings by outlining profits
investment and financing cash flows and retained in the business after dividends, and ;
reconciles them with changes in its cash and ❖​The statement of cash flows summarizes cash
marketable securities during the period. inflows and outflows from operating, investing,
and financing activities to assess liquidity and
cash management.

Why are the notes to the financial statements

important to professional securities analysts?

❖​Because it helps the analysts accurately assess

the company’s financial health, risks, and
long-term performance and to avoid mistakes in
making financial statements that could possibly
lead to a bigger problem.

USING FINANCIAL RATIOS

WHAT IS RATIO?

❖​In business, a RATIO is a numerical comparison

between two related values. It helps assess the
relationship between different financial or
operational aspects of a company.

RATIO ANALYSIS
NOTES TO THE FINANCIAL STATEMENTS ❖​Involves methods of calculating and interpreting
❖​Explanatory notes are extra details in financial financial ratios to analyze and monitor the firm’s
statements that explain how the numbers were performance.
calculated, the rules followed, and provide ❖​INTERESTED PARTIES :
important information about the company’s 1.​Current & Prospective Shareholders
financial activities. 2.​Creditors
3.​Firm‘s own Management

TYPES OF RATIO COMPARISON

1.​ CROSS – SECTIONAL ANALYSIS
-​Comparison of different firms‘ financial
ratios at the same point of time; involves
SUMMARY OF THE PURPOSE OF comparing the firm’s ratios with those of

2
 other firms in its industry or with industry ❖​Benchmarking: A company like Nike might
averages. benchmark its customer service performance
-​Type of C.S.A : BENCHMARKING against industry leaders like Amazon, using
➔​A type of cross – sectional analysis in Amazon’s practices as a standard to improve its
which the firm’s ratio values are own service quality.
compared with those of a key
CAUTIONS ABOUT USING RATIO ANALYSIS
competitors that it wishes to imitate.
2.​ TIME – SERIES ANALYSIS 1.​ Ratio that reveal large deviations from the norm
-​ Evaluation of the firm’s financial performance merely indicate the possibility of a problem.
over time using financial ratio analysis. Additional analysis is typically needed to determine
-​ EXAMPLE : Amazon stock may have upward whether there is a problem and to isolate the
trends around major sales events (ex. Prime causes of the problem.
Day or Black Friday), giving stockholders an 2.​ The single ratio does not generally provide
opportunity to plan their investment strategy sufficient information from which to judge the
based on these recurring patterns. overall performance of the firm. However, if an
3.​ COMBINED ANALYSIS analysis is concerned only with the specific aspects
-​ The most useful way to do ratio analysis is by of a firm’s financial position, one or two ratios may
combining cross- sectional and time – series suffice.
analysis. This lets you see how a company’s 3.​ The ratios being compared should be calculated
ratios change over time and compare them to using financial statements dated at the same point
the overall industry trend. in time during the year. If they are not, the effects
-​ By doing both, you can better understand of seasonality may product erroneous conclusions
how the company is performing compared to and decisions
others in the industry. 4.​ It is preferable to use audited financial statements
for ratio analysis. If they have not been audited, the
Summary
data in them may not reflect the firm’s true
❖​Cross-sectional analysis compares a company’s financial condition.
performance with other companies at the same 5.​ The financial data being compared should have
point in time. been developed in the same way. The use of
❖​Time-series analysis looks at a company’s differing accounting treatments especially relative
performance over a period of time to spot trends. to inventory and depreciation can distort the result
❖​Benchmarking is comparing a company’s of ratio comparisons, regardless of whether cross
performance against the best in the industry to – sectional or time – series analysis is used.
set goals and improve. 6.​ Results can be distorted by inflation, which can
cause the book values of inventory and depreciable
EXAMPLES
assets to differ greatly from their replacement
❖​Cross-sectional analysis: A company like values. Inventory costs and depreciation write –
Coca-Cola might compare its profitability ratio offs can differ from their true values, thereby
(e.g., profit margin) with that of Pepsi in the same distorting profits. Without adjustment, inflation
year to see how well it performed relative to its tends to cause older assets to appear more
competitor. efficient and profitable than newer assets. Clearly,
❖​Time-series analysis: Apple could track its in using ratios, you must be careful when comparing
revenue growth over the past five years to see older with new assets or comparing an asset to
how sales have changed year by year. This helps itself over a long period of time.
them identify trends like steady growth or
seasonal spikes.

3
In financial ratio analysis, how do the viewpoints held -​Similar to the current ratio except that it
by the firm’s present and prospective shareholders, excludes inventory, which is the least liquid
creditors, and management differ? current asset.
-​Inventory is the least liquid current asset
❖​Current shareholders want to see strong returns
because it takes time to sell. Unlike cash or
on their investment.
receivables, inventory needs to be sold and
❖​Prospective shareholders look for future growth
possibly converted into cash, which can take
and profits.
longer. It’s not immediately ready to use for
❖​Creditors focus on the company’s ability to repay
payments.
loans while;
❖​Management is concerned with overall
performance and efficiency to keep the business
running smoothly.

Each group has different priorities, but all are

interested in the company’s financial Health. ​
​
Why is it preferable to compare ratios calculated
BELOW 1.00 = BAD​
using financial statements that are dated at the same
ABOVE 1.00 = GOOD
point in time during the year?
-​Under what circumstances would the current
❖​It is preferable to compare ratios from financial
ratio be the preferred measure of overall firm
statements at the same time of year because
liquidity? Under what circumstances would the
companies can have seasonal changes in sales,
quick ratio be preferred?
expenses, or operations. Comparing at the same
➔​The current ratio is preferred when
point ensures you get a fair and accurate
inventory can be quickly sold, such as in
comparison.
retail, and you want a broad look at all
current assets.
LIQUIDITY RATIOS
➔​The quick ratio is preferred when you
LIQUIDITY need a stricter view of liquidity, focusing
only on easily liquid assets like cash and
❖​ A firm’s ability to satisfy its SHORT –
receivables, especially if inventory is
TERM obligations as they come due.
harder to sell or takes longer to turn
1.​ CURRENT RATIO
over.
-​ A measure of liquidity calculated by dividing
the firm’s current assets by its current
ACTIVITY RATIOS
liabilities
-​ It measures the firm’s ability to meet it’s ACTIVITY RATIO
short term obligations.
❖​Activity ratios measure how efficiently a
Current Ratio = CURRENT ASSETS ÷ company uses its assets to generate sales or
CURRENT LIABILITIES​ revenue. They show how well the business is
​ managing things like inventory or receivables to
Answers below 1.00 = BAD​ keep operations running smoothly.
Answers above 1.00 = GOOD​ 1.​ INVENTORY TURNOVER
​ -​ Measures the activity, liquidity, of a firm’s
If 1.00 = not bad, stable but there’s no safety inventory.
net if something unexpected happens

2.​ QUICK (Acid – Test) RATIO

4
 ❖​For the average payment period, you need credit
purchases and average accounts payable.
❖​This information helps calculate how long the firm
takes to collect payments from customers and
how long it takes to pay its suppliers.

-​ AVERAGE AGE OF INVENTORY

DEBT RATIOS
Average number of days’ sales in ❖​The debt ratio measures a company's financial
inventory. ​ risk by showing the percentage of its assets
(365 ÷ Answer in I.T) financed by debt.
❖​Debt can finance a business because companies
2.​ AVERAGE COLLECTION PERIOD
often borrow money (debt) to fund their
-​The average amount of time needed to collect
operations, growth, or investment needs.
accounts receivable.
❖​This allows them to use borrowed funds to
acquire assets, such as equipment or inventory,
or cover expenses without immediately using
their own cash. The business repays the debt
over time, typically with interest.
❖​So, a portion of the company's assets is financed
through loans or credit rather than from the
owners' equity or cash reserves.
❖​In general, the more debt a firm uses in relation
3.​ AVERAGE PAYMENT PERIOD
to its total assets, the greater its financial
-​The average amount of time needed to pay
leverage
accounts payable.
❖​Financial Leverage – the magnification of risk
and return through the use of fixed – cost
financing, such as debt and preferred stock.
❖​It means a company takes on more risk by
borrowing money or using preferred stock,
because it has to pay back the loan or give
dividends no matter what. If the company makes
a lot of profit, the returns to the owners can be
bigger. But if the company doesn't do well, it still
has to pay, making it riskier.
4.​ TOTAL ASSET TURNOVER
-​Indicates the efficiency with which the firm DEBT OF INDEBTEDNESS
uses its assets to generate sales.
❖​Measures the amount of debt relative to other
significant balance sheet amounts.
❖​It shows how much debt a company has
compared to things like its assets or equity. This
helps understand if the company relies heavily on
To assess the firm’s average collection period and borrowing money to fund its operations or if it
average payment period ratios, what additional uses its own resources.
information is needed, and why?

❖​To assess the average collection period, you need

credit sales and average accounts receivable.

5
ABILITY TO SERVICE DEBTS -​The time interest earned ratio shows how
easily a company can pay its interest on debt.
❖​The ability of a firm to make the payments
A higher ratio means the company makes
required on a scheduled basis over the life of a
enough money to cover its interest payments
debt.
comfortably.
COVERAGE RATIOS 4.​ FIXED – PAYMENT COVERAGE RATIO
-​Measures the firm’s ability to meet all fixed –
❖​Ratios that measure the firm’s ability to pay payment obligations.
certain fixed charges.​

1.​ DEBT RATIO

-​ Measures the proportion of total assets
financed by the firm’s creditors. The higher
this ratio, the greater the amount of other
people’s money being used to generate -​The fixed payment coverage ratio measures
profits. how well a company can pay its fixed financial
obligations, like interest and lease payments,
using its earnings. A higher ratio means the
company is in a better position to meet its
fixed payment obligations.

2.​ DEBT – TO – EQUITY RATIO FINANCIAL LEVERAGE

-​ Measures the relative proportion of total ❖​Financial leverage is the use of borrowed money
liabilities and common stock equity used to (debt) to increase the potential return on
finance the firm’s total assets. investment. It means a company uses loans or
other forms of debt to fund its operations or
investments, hoping to earn more from those
investments than it pays in interest on the debt. If
successful, this can lead to higher profits, but it
also increases risk because the company must
repay the borrowed money regardless of its
-​ The debt-to-equity ratio shows how much a financial performance.
company is borrowing (debt) compared to the ❖​Financial leverage is like borrowing money to
money invested by its owners (equity). A invest in something with the hope of making a
higher ratio means the company is using more profit. For example, if you borrow money from a
borrowed money than its own to fund the friend to buy and sell bicycles, you can buy more
business, which can increase risk. bikes than you could with just your own money. If
3.​ TIME INTEREST EARNED RATIO you sell the bikes for a profit, you can pay back
-​Measure the firm’s ability to make contractual your friend and keep the extra money. However, if
interest payments ; sometimes called the you can’t sell the bikes for enough money, you still
interest coverage ratio. have to repay your friend, which makes it riskier.
So, using borrowed money can help you make
more money, but it also increases your financial
risk.

6
In summary, what ratio measures the firm’s degree of 1.​ GROSS PROFIT MARGIN
indebtedness? What ratios assess the firm’s ability to -​ Gross profit margin shows how much money a
service debts? company keeps from its sales after covering
the cost of making the product.
❖​The debt ratio measures how much a company
-​ A higher margin means the company is making
owes compared to its assets, showing its level of
more profit from each sale.
indebtedness. To assess how well a company can
pay its debts, you can look at the interest
coverage ratio, which compares earnings to
interest expenses, and the fixed payment

coverage ratio, which looks at how easily the company

can cover all its fixed payments, like interest and lease
payments, with its earnings.
2.​ OPERATING PROFIT MARGIN
PROFITABILITY RATIO -​Operating profit margin shows how much
profit a company makes from its core business
PROFITABILITY RATIOS activities after covering operating costs, like
❖​A profitability ratio measures how much profit a rent and salaries, but before paying interest
company makes relative to its revenue, assets, or and taxes.
equity. It helps assess the company's ability to -​A higher margin means the company is more
generate earnings and is useful for comparing efficient at making profit from its operations.
performance over time or against other
companies.
❖​A useful tool for evaluating profitability in
relation to sales is the common – size income
statement.

COMMON – SIZE INCOME STATEMENT

3.​ NET PROFIT MARGIN
❖​An income statement which each item is -​Net profit margin shows how much profit a
expressed as a percentage of sales. company keeps from its total sales after all
expenses, including operating costs, interest,
and taxes, are paid.
-​A higher net profit margin means the company
is keeping more of its sales as profit.

4.​ EARNINGS PER SHARE (EPS)

-​Earnings per share (EPS) is a measure of how
much profit a company makes for each share
of its stock.
-​A higher EPS means the company is making
more money per share, which is good for
investors.

7
 MARGIN
❖​ A company might have a high gross profit
margin but a low net profit margin if it spends
a lot on things like rent, salaries, or debt
5.​ RETURN ON TOTAL ASSETS
payments. Even though it makes good money
-​ Return on Total Assets (ROA) or also called
from its sales after paying for the products,
return on investment (ROI) shows how
these extra costs lower the profit it keeps in
efficiently a company uses its assets to
the end.
generate profit.
-​ A higher ROA means the company is better
at using its assets to make money. WHICH MEASURE OF
PROFITABILITY IS PROBABLY OF
GREATEST INTEREST TO THE
INVESTING PUBLIC? WHY?
❖​Investors are most interested in earnings per
share (EPS) because it tells them how much
6.​ RETURN ON EQUITY (ROE) profit the company makes for each share they
-​ Return on Equity (ROE) shows how much own. It helps them see if the company is making
profit a company makes with the money good money and if their investment is growing.
invested by its shareholders.
-​ A higher ROE means the company is using MARKET RATIOS
its investors' money more effectively to
generate profits. ❖​Market ratios help investors understand how
the stock market values a company. They
compare things like the company’s stock price to
its earnings or book value. These ratios give an
idea of whether the company’s stock is priced
fairly, too high, or too low based on its financial
performance.
WHAT THREE RATIOS OF
PROFITABILITY ARE FOUND IN BOOK VALUE
COMMON-SIZE INCOME
❖​Book value is essentially what a company is
STATEMENT?
worth based on its financial statements. It's
❖​In a common-size income statement, you’ll find calculated by taking the total value of everything
the gross profit margin, which shows how much the company owns (assets) and subtracting what
of the sales revenue is left after covering the it owes (liabilities).
cost of goods sold. ❖​In simple terms, it’s like saying if a company sold
❖​There’s also the operating profit margin, which all its stuff and paid off all its debts, the book
tells you what percentage of sales is left after value would be the amount of money left over for
paying for operating expenses. the owners or shareholders.
❖​Finally, the net profit margin shows how much of
the sales revenue is kept as profit after all PRICE / EARNINGS (P/E) RATIO
expenses, including taxes and interest, are paid. ❖​The price/earnings (P/E) ratio is a way to see
how much investors are willing to pay for each
WHAT WOULD EXPLAIN A FIRM’S dollar of a company’s earnings.
HAVING A HIGH GROSS PROFIT ❖​A high P/E ratio might suggest that investors
MARGIN AND A LOW NET PROFIT expect future growth, while a low P/E ratio

8
 might indicate that the stock is undervalued or sense of whether the firm is seen as a solid
the company is facing challenges. investment opportunity or a risky bet.

TWO POPULAR APPROACHES TO A

COMPLETE RATIO ANALYSIS
1.​ SUMMARIZING ALL RATIOS
-​This approach tends to view all aspects of the
MARKET / BOOK (M/B) RATIO firm’s financial activities to isolate key areas
❖​The market/book ratio compares a company’s of responsibility.
current stock price (its market value) to its book 2.​ DuPont System of Analysis
value (the value of its assets minus liabilities as -​This approach acts as a search technique
reported on its financial statements). This ratio aimed at finding the key areas responsible for
helps investors understand how the stock is the firm financial condition.
valued relative to the company’s actual worth.
❖​A high market/book ratio suggests that SUMMARIZING ALL RATIOS
investors believe the company will grow and is (Bartlett Company Ratios)
worth more than its assets on paper, while a low
ratio may indicate the stock is undervalued.

—---------------------------------

CALCULATE FIRM’S M/B RATIO

1.​Find the book value per share of common stock

-​it's the amount of money each shareholder
would get if the company sold all its assets and
settled all its debts.

CALCULATE THE FIRM’S M/B RATIO

2.​After calculating book value per share of common

stock, proceed to m/b ratio

HOW DO THE PRICE/EARNINGS (P/E)

RATIO AND THE MARKET/BOOK
(M/B) RATIO PROVIDE A FEEL FOR
THE FIRM’S RETURN AND RISK?
❖​These ratios help investors gauge market
expectations and perceived risk levels, giving a

9
 ❖​A higher FLM means more borrowing, which can
DuPont FORMULA
be risky, while a lower FLM means less
❖​ The DuPont system first brings together the net borrowing.
profit margin, which measures the firm's profitability
on sales, with its total asset turnover, which indicates
DIFFERENCE OF DuPont FORMULA
how efficiently the firm has used its assets to
AND MODIFIED DuPont FORMULA
generate sales. In the DuPont formula, the product of
these two ratios results in the return on total assets ❖​the DuPont formula focuses on profitability and
(ROA):​ efficiency in generating sales ;
​ ❖​while the modified DuPont formula includes the
ROA = Net profit margin x Total asset turnover effect of financial leverage, providing a fuller
picture of how both operations and financing
❖​ When you multiply the net profit margin by the impact ROE.
total asset turnover, you get the Return on
Assets (ROA). This tells you how well a FINANCIAL RATIO ANALYSIS IS
company is using its assets to generate profit. OFTEN DIVIDED INTO FIVE AREAS:
❖​ In simple terms, the DuPont formula for ROA
explains that a company's ability to generate Liquidity, activity, debt, profitability, and market ratios.
profit from its assets can be improved by either Differentiate each of those areas of analysis from the
increasing the profit it makes on each sale (net others. Which is the greatest concern to creditors?
profit margin) or by using its assets more ❖​Liquidity Ratios: These show if a company can
effectively to generate more sales (total asset pay its short-term bills, like rent or salaries,
turnover). using current assets like cash.
❖​ A value below 5% is commonly viewed as low, ❖​Activity Ratios: These measure how efficiently a
especially when compared to industry averages company uses its assets, like how quickly it sells
and competitors. inventory or collects money from customers.
MODIFIED DuPont FORMULA ❖​Debt Ratios: These indicate how much of a
company’s assets are financed by borrowing
❖​The second step in the DuPont system employs
versus owner investment. It shows the level of
the modified DuPont formula.
financial risk.
❖​This formula relates the firm's return on total
❖​Profitability Ratios: These reveal how well a
assets (ROA) to its return on equity (ROE). The
company generates profit from its sales or
latter is calculated by multiplying the return on
operations.
total assets (ROA) by the financial leverage
❖​Market Ratios: These assess a company’s stock
multiplier (FLM), which is the ratio of total
performance, like the price investors are willing
assets to common stock equity:​
to pay for its earnings or book value.
❖​Creditors are most concerned with liquidity and
ROE = ROA X FLM
debt ratios because they want to ensure the
company can pay back its loans and manage its
debt responsibly.
FINANCIAL LEVERAGE
MULTIPLIER
❖​FLM shows how much of the company’s assets
are financed by debt (borrowed money)
compared to equity (owners’ money).

FLM = TOTAL ASSETS / TOTAL EQUITY

10
 single asset or a portfolio— a collection or group
of assets.
LESSON 2: VALUATION OF ❖​In the most basic sense, risk is a measure of the
SECURITIES ​ uncertainty surrounding the return that an
investment will earn. Investments whose returns
VALUATION FUNDAMENTALS are more uncertain are generally riskier.
❖​More formally, the term risk is used
Valuation interchangeably with uncertainty to refer to the
variability of returns associated with a given
❖​ is the process that links risk and return to
determine the worth of an asset. It is a relatively asset.
simple process that can be applied to expected ❖​A $1,000 government bond that guarantees its
streams of benefits from bonds, stocks, income holder $5 interest after 30 days has no risk
properties, oil wells, and so on. because there is no variability associated with
❖​ The basic valuation equation can be customized the return.
for use in valuing specific securities: ❖​A $1,000 investment in a firm’s common stock is
-​Bonds, very risky because the value of that stock may
-​common stock, and
move up or down substantially over the same 30
-​preferred stock.
❖​ To determine an asset’s worth at a given point in days.
time, a financial manager uses the time value-of-
money techniques and the concepts of risk and Risk
return.
❖​ A measure of the uncertainty surrounding the
Time-Value-of-Money return that an investment will earn or, more
formally, the variability of returns associated with
❖​ The time value of money refers to the observation a given asset.
that it is better to receive money sooner than
later. Money that you have in hand today can be Return
invested to earn a positive rate of return,
producing more money tomorrow. ❖​ If we are going to assess risk on the basis of
❖​ For that reason, a dollar today is worth more than variability of return, we need to be certain we
a dollar in the future. In business, managers know what return is and how to measure it.
constantly face trade-offs in situations in which ❖​ Total Rate of Return is the total gain or loss
actions that require outflows of cash today may experienced on an investment over a given period
produce inflows of cash later. Because the cash of time; calculated by dividing the asset’s cash
that comes in the future is worth less than the distributions during the period, plus change in
cash that firms spend up front, managers need a value, by its beginning-of period investment value.
set of tools to help them compare cash inflows
and outflows that occur at different times. KEY INPUTS IN VALUATION
There are three key inputs to the valuation process:
RISK AND RETURN
FUNDAMENTALS 1.​ Cash Flows (Returns)
❖​In most important business decisions there are -​The value of any asset depends on the cash
two key financial considerations: risk and return. flow(s) it is expected to provide over the
ownership period.
❖​Each financial decision presents certain risk and
-​To have value, an asset does not have to
return characteristics, and the combination of provide an annual cash flow; it can provide an
these characteristics can increase or decrease a intermittent(irregular) cash flow or even a
firm’s share price. single cash flow over the period.
❖​Analysts use different methods to quantify risk, -​Personal Finance Example:
depending on whether they are looking at a

11
 ➔​Celia Sargent wishes to estimate the value prevailing risk-free rate of 3% as the
of three assets she is considering investing required return when calculating the value
in: common stock in Michaels Enterprises, of the painting.
an interest in an oil well, and an original ➔​Scenario 2: High Risk - The values of
painting by a well-known artist. Her cash original paintings by this artist have
flow estimates for each are as follows: fluctuated widely over the past 10 years.
-​ Stock in Michaels Enterprises - Although Celia expects to be able to sell
Expect to receive cash dividends of the painting for $85,000, she realizes
$300 per year indefinitely. that its sale price in 5 years could range
-​ Oil well - Expect to receive cash flow between $30,000 and $140,000.
of $2,000 at the end of year 1, Because of the high uncertainty
$4,000 at the end of year 2, and surrounding the painting’s value, Celia
$10,000 at the end of year 4, when believes that a 15% required return is
the well is to be sold. appropriate.
-​ Original painting - Expect to be able
to sell the painting in 5 years for Key inputs in valuation
$85,000.
➔​With these cash flow estimates, Celia has -​ Let’s return to Celia Sargent’s task of
taken the first step toward placing a value placing a value on the original painting and
on each of the assets. consider two scenarios.
2.​ Timing -​ These two estimates of the appropriate
-​In addition to making cash flow estimates, we required return illustrate how this rate
must know the timing of the cash flows. captures risk. The often subjective nature of
Although cash flows can occur at any time such estimates is also evident.
during a year, for computational convenience
as well as custom, we will assume that they
occur at the end of the year unless otherwise
BASIC VALUATION MODEL
noted. ❖​Simply stated, the value of any asset is the
-​For example, Celia expects the cash flows of present value of all future cash flows it is
$2,000, $4,000, and $10,000 for the oil well expected to provide over the relevant time
to occur at the ends of years 1, 2, and 4,
period. The time period can be any length, even
respectively.
-​The combination of the cash flow and its infinity.
timing fully defines the return expected from ❖​The value of an asset is therefore determined by
the asset. discounting the expected cash flows back to
3.​ Risk and Required Return their present value, using the required return
-​The level of risk associated with a given cash commensurate with the asset’s risk as the
flow can significantly affect its value. In appropriate discount rate.
general, the greater the risk of (or the less Basic Valuation Model
certain) a cash flow, the lower its value.
❖​Using the present value techniques, we can
-​Greater risk can be incorporated into a
valuation analysis by using a higher required express the value of any asset at time zero, V0,
return or discount rate. The higher the risk, as:
the greater the required return, and the lower
the risk, the less the required return.
-​Let’s return to Celia Sargent’s task of placing
a value on the original painting and consider
two scenarios.
➔​Scenario 1: Certainty - A major art gallery
has contracted to buy the painting for
$85,000 at the end of 5 years. Because
this contract is considered a certain
situation, Celia views this asset as “money
in the bank.” She thus would use the

12
 ❖​Bonds are long-term debt instruments used by
business and government to raise large sums of
money, typically from a diverse group of lenders.
❖​Most corporate bonds pay interest semiannually
(every 6 months) at a stated coupon interest
rate, have an initial maturity of 10 to 30 years,
and have a par value, or face value, of 1,000
pesos (in the Philippines) that must be repaid at
maturity.
❖​Personal Finance Example:
-​ Tim Sanchez wishes to determine the
current value of the Mills Company bond.
Assuming that interest on the Mills Company
bond issue is paid annually and that the
required return is equal to the bond’s coupon
interest rate, I = $100, rd = 10,, M = $1,000,
and n = 10 years. The computations involved
in finding the bond value are depicted
graphically on the following time line:

-​ Calculator use using the Mills Company’s

inputs shown at the left, you should find the
bond value to be exactly $1,000. Note that
the calculated bond value is equal to its par
value, which will always be the case when the
required return is equal to the coupon
❖​The value of a bond is the present value of the interest rate.
payments its issuer is contractually obligated to
make, from the current time until it matures. The
basic model for the value, B0, of a bond is given
by:

13
 REQUIRED RETURNS AND BOND
VALUE
❖​Whenever the required return on a bond differs
from the bond’s coupon interest rate, the bond’s
value will differ from its par value. The required
return is likely to differ from the coupon interest
-​ Spreadsheet use The value of the Mills rate because either
Company bond also can be calculated as 1.​ economic conditions have changed since the
shown in the following Excel spreadsheet. bond was issued, causing a shift in the cost of
funds; or
2.​ the firm’s risk has changed. Increases in the
cost of funds or in risk will raise the required
return; decreases in the cost of funds or in
risk will lower the required return.
❖​Regardless of the exact cause, what is important
is the relationship between the required return
and the coupon interest rate:
1.​ When the required return is greater than the
BOND VALUE BEHAVIOR coupon interest rate, the bond value, B0, will
❖​In practice, the value of a bond in the be less than its par value, M. In this case, the
marketplace is rarely equal to its par value. In bond is said to sell at a discount, which will
the bond data (see Table 6.2 ), you can see that equal M - B0.
the prices of bonds often differ from their par 2.​ When the required return falls below the
values of 100 (100 percent of par, or $1,000). coupon interest rate, the bond value will be
Some bonds are valued below par (current price greater than par. In this situation, the bond is
below 100), and others are valued above par said to sell at a premium, which will equal B0
(current price above 100). - M.Required Returns and Bond Values
❖​A variety of forces in the economy, as well as ❖​Regardless of the exact cause, what is important
the passage of time, tend to affect value. is the relationship between the required return
Although these external forces are in no way and the coupon interest rate:
controlled by bond issuers or investors, it is 1.​ Discount - The amount by which a bond sells
useful to understand the impact that required below its par value.
return and time to maturity have on bond value. 2.​ Premium- The amount by which a bond sells
above its par value.

TIME TO MATURITY AND BOND

VALUE

14
 ❖​Whenever the required return is different from bond value differs from par, the yield to maturity
the coupon interest rate, the amount of time to will differ from the coupon interest rate.
maturity affects bond value. An additional factor
is whether required returns are constant or
SEMI ANNUAL INTEREST AND
change over the life of the bond.
BOND VALUES
❖​ Constant Required Returns - When the
required return is different from the coupon ❖​The procedure used to value bonds paying
interest rate and is constant until maturity, the interest semiannually is similar for compounding
value of the bond will approach its par value as interest more frequently than annually, except
the passage of time moves the bond’s value that here we need to find present value instead
closer to maturity. (Of course, when the of future value. It involves the following changes:
required return equals the coupon interest rate, 1.​ Converting annual interest, I, to semiannual
the bond’s value will remain at par until it interest by dividing I by 2.
matures.) 2.​ Converting the number of years to maturity,
❖​ Changing Required Returns - The chance that n, to the number of 6-month periods to
interest rates will change and thereby change maturity by multiplying n by 2.
3.​ Converting the required stated (rather than
the required return and bond value is called
effective) annual return for similar-risk bonds
interest rate risk. Bondholders are typically that also pay semiannual interest from an
more concerned with rising interest rates annual rate, rd, to a semiannual rate by
because a rise in interest rates, and therefore in dividing rd by 2.
the required return, causes a decrease in bond
value. The shorter the amount of time until a Problem:
bond’s maturity, the less responsive is its market
value to a given change in the required return. Lahey Industries has outstanding a $1,000
❖​In other words, short maturities have less
par-value bond with an 8% coupon interest
interest rate risk than long maturities when all
other features (coupon interest rate, par value, rate. The bond has 12 years remaining to its
and interest payment frequency) are the same.
❖​This statement is true because of the maturity date.
mathematics of time value; the present values of
short-term cash flows change far less than the If interest is paid annually, find the value of the bond
present values of longer-term cash flows in when the required return is
response to a given change in the discount rate
(1) 7%, (2) 8%, and (3) 10%.
(required return).

YIELD TO MATURITY (YTM)

❖​When investors evaluate bonds, they commonly
consider yield to maturity (YTM), which is the
compound annual rate of return earned on a debt
security purchased on a given day and held to
maturity. (The measure assumes, of course, that
the issuer makes all scheduled interest and
principal payments as promised.)
❖​The yield to maturity on a bond with a current
price equal to its par value (that is, B0 = M) will
always equal the coupon interest rate. When the

15
 sometimes referred to as residual owners
because they receive what is left—the
residual—after all other claims on the firm’s
income and assets have been satisfied.
❖​ They are assured of only one thing: that they
cannot lose any more than they have invested in
the firm. As a result of this generally uncertain
position, common stockholders expect to earn
relatively high returns. Those returns may come
in the form of dividends, capital gains, or both.

Ownership

❖​ The common stock of a firm can be privately

owned by private investors or publicly owned by
public investors. Private companies are usually
smaller than public companies and they are often
Risk and Required Return
closely owned by an individual investor or a small
group of private investors (such as a family).
❖​ The level of risk associated with a given cash
❖​ Public companies are widely owned by many
flow can significantly affect its value. In
unrelated individual or institutional investors. The
general, the greater the risk of (or the less
shares of privately owned firms generally do not
certain) a cash flow, the lower its value.
trade actively in the stock market; if the shares
❖​ Greater risk can be incorporated into a
are traded, the transactions are among private
valuation analysis by using a higher required
investors and often require the firm’s consent.
return or discount rate. The higher the risk,
❖​ Large corporations, which are emphasized in the
the greater the required return, and the
following discussions, are publicly owned, and
lower the risk, the less the required return.
their shares are generally actively traded in the
stock markets
LESSON 3: VALUATION OF
SECURITIES ​ Par Value

❖​ The market value of common stock is completely

STOCK VALUATION
unrelated to its par value. The par value of
Common and Preferred Stock common stock is an arbitrary value established
for legal purposes in the firm’s corporate charter
❖​ A firm can obtain equity capital by selling either and is generally set quite low, often an amount of
common or preferred stock. All corporations $1 or less.
initially issue common stock to raise equity ❖​ Recall that when a firm sells new shares of
capital. Some of these firms later issue either common stock, the par value of the shares sold is
additional common stock or preferred stock to recorded in the capital section of the balance
raise more equity capital. sheet as part of common stock. One benefit of
❖​ Although both common and preferred stock are this recording is that at any time the total number
forms of equity capital, preferred stock has some of shares of common stock outstanding can be
similarities to debt that significantly differentiate found by dividing the book value of common stock
it from common stock. by the par value.
❖​ Setting a low par value is advantageous in states
where certain corporate taxes are based on the
par value of stock. A low par value is also
beneficial in states that have laws against selling
COMMON STOCK
stock at a discount to par. For example, a
❖​ The true owners of a corporate business are the company whose common stock has a par value of
common stockholders. Common stockholders are $20 per share would be unable to issue stock if

16
 investors are unwilling to pay more than $16 per ❖​ Generally, each share of common stock entitles
share.Common Stock its holder to one vote in the election of directors
and on special issues. Votes are generally
Preemptive Rights assignable and may be cast at the annual
stockholders’ meeting.
❖​ The preemptive right allows common ❖​ Because most small stockholders do not attend
stockholders to maintain their proportionate the annual meeting to vote, they may sign a proxy
ownership in the corporation when new shares statement transferring their votes to another
are issued, thus protecting them from dilution of party. The solicitation of proxies from
their ownership. A dilution of ownership is a shareholders is closely controlled by the
reduction in each previous shareholder’s Securities and Exchange Commission to ensure
fractional ownership resulting from the issuance that proxies are not being solicited on the basis of
of additional shares of common stock. false or misleading information. Existing
❖​ Preemptive rights allow pre existing shareholders management generally receives the stockholders’
to maintain their pre-issuance voting control and proxies because it is able to solicit them at
protects them against the dilution of earnings. company expense.
Pre Existing shareholders experience a dilution of
earnings when their claim on the firm’s earnings is Dividends
diminished as a result of new shares being issued.
❖​ In a rights offering, the firm grants rights to its ❖​ The payment of dividends to the firm’s
shareholders. These financial instruments allow shareholders is at the discretion of the company’s
stockholders to purchase additional shares at a board of directors. Most corporations that pay
price below the market price, in direct proportion dividends pay them quarterly. Dividends may be
to their number of owned shares. paid in cash, stock, or merchandise. Cash
❖​ In these situations, rights are an important dividends are the most common, merchandise
financing tool without which shareholders would dividends the least.
run the risk of losing their proportionate control ❖​ Common stockholders are not promised a
of the corporation. From the firm’s viewpoint, the dividend, but they come to expect certain
use of rights offerings to raise new equity capital payments on the basis of the historical dividend
may be less costly than a public offering of stock. pattern of the firm. Before firms pay dividends to
common stockholders, they must pay any past due
Authorized, Outstanding, and Issued Shares dividends owed to preferred stockholders. The
firm’s ability to pay dividends can be affected by
❖​ A firm’s corporate charter indicates how many restrictive debt covenants designed to ensure
authorized shares it can issue. The firm cannot that the firm can repay its creditors.
sell more shares than the charter authorizes
without obtaining approval through a shareholder International Stock Issues
vote. To avoid later having to amend the charter,
firms generally attempt to authorize more shares ❖​ Although the international market for common
than they initially plan to issue. stock is not as large as the international market
❖​ Authorized shares become outstanding shares for bonds, cross-border issuance and trading of
when they are issued or sold to investors. If the common stock have increased dramatically in the
firm repurchases any of its outstanding shares, past 30 years.
these shares are recorded as treasury stock and ❖​ Some corporations issue stock in foreign
are no longer considered to be outstanding markets. For example, the stock of General
shares. Electric trades in Frankfurt, London, Paris, and
❖​ Issued shares are the shares of common stock Tokyo; the stocks of Time Warner and Microsoft
that have been put into circulation; they trade in Frankfurt and London; and the stock of
represent the sum of outstanding shares and McDonald’s trades in Frankfurt, London, and
treasury stock. Paris. The Frankfurt, London, and Tokyo markets
are the most popular.
Voting Rights ❖​ Issuing stock internationally broadens the
ownership base and helps a company integrate
into the local business environment. Having

17
 locally traded stock can facilitate corporate
acquisitions because shares can be used as an
STOCK VALUATION
acceptable method of payment. ISSUING COMMON STOCK

❖​Because of the high risk associated with a

PREFERRED STOCK
business startup, a firm’s initial financing typically
❖​Most corporations do not issue preferred stock, comes from its founders in the form of a common
but preferred shares are common in some stock investment. Until the founders have made
industries. Preferred stock gives its holders an equity investment, it is highly unlikely that
certain privileges that make them senior to others will contribute either equity or debt
common stockholders. Preferred stockholders capital.
are promised a fixed periodic dividend, which is ❖​Early-stage investors in the firm’s equity, as well
stated either as a percentage or as a dollar as lenders who provide debt capital, want to be
amount. How the dividend is specified depends on assured that they are taking no more risk than
whether the preferred stock has a par value. the founders. In addition, they want confirmation
❖​Par-value preferred stock has a stated face that the founders are confident enough in their
value, and its annual dividend is specified as a vision for the firm that they are willing to risk
percentage of this value. No-par preferred stock their own money.
has no stated face value, but its annual dividend is ❖​Typically, the initial non founder financing for
stated in dollars. Preferred stock is most often business startups with attractive growth
issued by public utilities, by financial institutions prospects comes from private equity investors.
such as banks and insurance companies, by Then, as the firm establishes the viability of its
acquiring firms in merger transactions, and by product or service offering and begins to
young firms receiving investment funds from generate revenues, cash flow, and profits, it will
venture capital firms. Like the dividends on often “go public” by issuing shares of common
common stock, preferred dividends are not tax stock to a much broader group of investors.
deductible for the firm that pays them.
Venture Capital
Basic Rights of Preferred Stockholders
❖​The initial external equity financing privately
❖​The basic rights of preferred stockholders are raised by firms, typically early stage firms with
somewhat stronger than the rights of common attractive growth prospects, is called venture
stockholders. Preferred stock is often capital. Those who provide venture capital are
considered quasi-debt because, much like interest known as venture capitalists (VCs). They typically
on debt, it specifies a fixed periodic payment are formal business entities that maintain strong
(dividend). Preferred stock is unlike debt in that it oversight over the firms they invest in and that
has no maturity date. Because they have a fixed have clearly defined exit strategies.
claim on the firm’s income that takes precedence ❖​Less visible early-stage investors called angel
over the claim of common stockholders, preferred capitalists (or angels) tend to be investors who do
stockholders are exposed to less risk. not actually operate as a business; they are often
❖​Preferred stockholders are also given preference wealthy individual investors who are willing to
over common stockholders in the liquidation of invest in promising early-stage companies in
assets in a legally bankrupt firm, although they exchange for a portion of the firm’s equity
must “stand in line” behind creditors. The amount
of the claim of preferred stockholders in Going Public
liquidation is normally equal to the par or stated
value of the preferred stock. Preferred ❖​When a firm wishes to sell its stock in the
stockholders are not normally given a voting primary market, it has three alternatives.
right, although preferred stockholders are 1.​ It can make (1) a public offering, in which it
sometimes allowed to elect one member of the offers its shares for sale to the general
board of directors. public;
2.​ a rights offering, in which new shares are
sold to existing stockholders; or

18
 3.​ a private placement, in which the firm sells information about the new issue, road show
new securities directly to an investor or sessions help the investment bankers gauge the
group of investors. demand for the offering and set an expected
❖​Here we focus on public offerings, particularly the pricing range. After the underwriter sets terms
initial public offering (IPO), which is the first and prices the issue, the SEC must approve the
public sale of a firm’s stock. IPOs are typically offering.
made by small, rapidly growing companies that
either require additional capital to continue LESSON 4: VALUATIONS OF
expanding or have met a milestone for going public SECURITIES
that was established in a contract signed earlier
to obtain VC funding. APPROACHES TO COMMON STOCK
❖​To go public, the firm must first obtain the VALUATION
approval of its current shareholders, the
investors who own its privately issued stock. ❖​Common stockholders expect to be rewarded
Next, the company’s auditors and lawyers must through periodic cash dividends and an increasing
certify that all documents for the company are share value.
legitimate. The company then finds an investment ❖​Some of these investors decide which stocks to
bank willing to underwrite the offering. This buy and sell based on a plan to maintain a broadly
underwriter is responsible for promoting the diversified portfolio. Other investors have a more
stock and facilitating the sale of the company’s speculative motive for trading.
IPO shares. The underwriter often brings in
❖​They try to spot companies whose shares are
other investment banking firms as participants.
❖​The company files a registration statement with undervalued, meaning that the true value of the
the SEC. One portion of the registration shares is greater than the current market price.
statement is called the prospectus. It describes These investors buy shares that they believe to
the key aspects of the issue, the issuer, and its be undervalued and sell shares that they think are
management and financial position. During the overvalued (that is, the market price is greater
waiting period between the statement’s filing and than the true value).
its approval, prospective investors can receive a
preliminary prospectus. This preliminary version Market Efficiency
is called a red herring because a notice printed in
red on the front cover indicates the tentative
❖​Rational buyers and sellers use their assessment
nature of the offer.
of an asset’s risk and return to determine its
Issuing common stock value.
❖​To a buyer, the asset’s value represents the
❖​After the SEC approves the registration maximum purchase price, and to a seller, it
statement, the investment community can begin represents the minimum sale price.
analyzing the company’s prospects. However, ❖​In competitive markets with many active
from the time it files until at least 1 month after participants, such as a stock exchange, the
the IPO is complete, the company must observe a
interactions of many buyers and sellers result in
quiet period during which there are restrictions
on what company officials may say about the an equilibrium price—the market value—for each
company. The purpose of the quite period is to security.
make sure that all potential investors have access ❖​This price reflects the collective actions that
to the same information about the company—the buyers and sellers take on the basis of all
information presented in the preliminary available information.
prospectus—and not to any unpublished data that ❖​Buyers and sellers digest new information quickly
might give them an unfair advantage. as it becomes available and, through their
❖​The investment bankers and company executives
purchase and sale activities, create a new market
promote the company’s stock offering through a
road show, a series of presentations to potential equilibrium price.
investors around the country and sometimes ❖​Because the flow of new information is continual
overseas. In addition to providing investors with and the content of that information is

19
 unpredictable (otherwise, it would not be new validity of this notion. The research documents
information), stock prices fluctuate, always various anomalies—outcomes that are
moving toward a new equilibrium that reflects the inconsistent with efficient markets—in stock
most recent information available. returns.
❖​This general concept is known as market ❖​A number of academics and practitioners have
efficiency. also recognized that emotions and other
subjective factors play a role in investment
The Efficient Market Hypothesis decisions.
❖​This focus on investor behavior has resulted in a
❖​Active stock markets, such as the NYSE significant body of research, collectively referred
Euronext and the Nasdaq market, are efficient in to as behavioral finance. A growing body of
that they are made up of many rational investors research that focuses on investor behavior and
who react quickly and objectively to new its impact on investment decisions and stock
information. prices. Advocates are commonly referred to as
❖​The efficient-market hypothesis (EMH), which is “behaviorists.”
the basic theory describing the behavior of such a
market, specifically states that
1.​ Securities are typically in equilibrium, which
BASIC COMMON STOCK
means that they are fairly priced and that
VALUATION
their expected returns equal their required ❖​The value of a share of common stock is equal to
returns. the present value of all future cash flows
2.​ At any point in time, security prices fully (dividends) that it is expected to provide.
reflect all information available about the firm ❖​Although a stockholder can earn capital gains by
and its securities, and these prices react selling stock at a price above that originally paid,
swiftly to new information. what the buyer really pays for is the right to all
3.​ Because stocks are fully and fairly priced, future dividends.
investors need not waste their time trying to ❖​What about stocks that do not currently pay
find mispriced (undervalued or overvalued) dividends? Such stocks have a value attributable
securities. to a future dividend stream or to the proceeds
❖​Not all market participants are believers in the from the sale of the company. Therefore, from a
efficient-market hypothesis. Some believe that it valuation viewpoint, future dividends are relevant.
is worthwhile to search for undervalued or ❖​The basic valuation model for common stock is
overvalued securities and to trade them to profit given by:
from market inefficiencies.
❖​Others argue that it is mere luck that would allow
market participants to anticipate new information
correctly and as a result earn abnormal returns,
that is, actual returns greater than should be
expected given the risk of the investment.
❖​They believe that it is unlikely that market
participants can over the long run earn abnormal
returns

The Behavioral Finance Challenge

Zero-Growth Model
❖​Although considerable evidence supports the
concept of market efficiency, a growing body of
academic evidence has begun to cast doubt on the

20
 ❖​An approach to dividend valuation that assumes a ❖​Free Cash Flow valuation model is a model that
constant, nongrowing dividend stream. determines the value of an entire company as the
present value of its expected free cash flows
discounted at the firm’s weighted average cost of
capital, which is its expected average future cost
of funds over the long run.

❖​The equation shows that with zero growth, the

value of a share of stock would equal the present
value of a perpetuity (An annuity with an infinite
life, providing continual annual cash flow) of D1
dollars discounted at a rate rs.Basic Common
Stock Valuation

Constant-Growth Model
❖​Free Cash Flow Valuation Model Example
❖​A widely cited dividend valuation approach that -​ Dewhurst, Inc., wishes to determine the
assumes that dividends will grow at a constant value of its stock by using the free cash flow
rate, but a rate that is less than the required valuation model. To apply the model, the
return. By letting D0 represent the most recent firm’s CFO developed the data given in Table
dividend, we can rewrite Equation 7.1 as: 7.4. Application of the model can be
performed in four steps.

❖​The constant-growth model in Equation 7.4 is

commonly called the Gordon growth model, a
common name for the constant-growth model
that is widely cited in dividend valuation.

Variable-Growth Model

❖​A dividend valuation approach that allows for a

change in the dividend growth rate.

Free Cash Flow Valuation Model

❖​As an alternative to the dividend valuation

models, a firm’s value can be estimated by using
its projected free cash flows (FCFs).

21
 ❖​Liquidation value per share is the actual amount
per share of common stock that would be
received if all the firm’s assets were sold for their
market value, liabilities and preferred stock were
paid, and any remaining money were divided among
the common stockholders.
❖​This measure is more realistic than book
value—because it is based on the current market
value of the firm’s assets—but it still fails to
consider the earning power of those assets.

Price/Earnings (P/E) Multiples

❖​The price/earnings (P/E) ratio reflects the

OTHER APPROACHES TO COMMON amount investors are willing to pay for each dollar
STOCK VALUATION of earnings. The average P/E ratio in a particular
industry can be used as a guide to a firm’s value, if
Book Value it is assumed that investors value the earnings of
that firm in the same way they do the “average”
❖​Book value per share is simply the amount per
firm in the industry.
share of common stock that would be received if
❖​The price/earnings multiple approach is a popular
all the firm’s assets were sold for their exact
technique used to estimate the firm’s share value;
book (accounting) value and the proceeds
it is calculated by multiplying the firm’s expected
remaining after paying all liabilities (including
earnings per share (EPS) by the average
preferred stock) were divided among the common
price/earnings (P/E) ratio for the industry.
stockholders.
❖​This method lacks sophistication and can be
criticized on the basis of its reliance on historical
balance sheet data. It ignores the firm’s expected
earnings potential and generally lacks any true
relationship to the firm’s value in the marketplace.

DECISION MAKING AND COMMON

STOCK VALUE
❖​Valuation equations measure the stock value at a
point in time based on expected return and risk.
Any decisions of the financial manager that affect
these variables can cause the value of the firm to
Liquidation Value change. Figure 7.3 depicts the relationship among
financial decisions, return, risk, and stock value.

22
 residual cash flows of the firm. This claim is
subordinate to those of vendors, employees,
customers, lenders, the government (for taxes),
and preferred stockholders.
❖​The value of the common stockholders’ claim is
embodied in the future cash flows they are
entitled to receive. The present value of those
CHANGES IN EXPECTED DIVIDENDS expected cash flows is the firm’s share value.
❖​To determine this present value, forecast cash
❖​Assuming that economic conditions remain stable, flows are discounted at a rate that reflects their
any management action that would cause current risk. Riskier cash flows are discounted at higher
and prospective stockholders to raise their rates, resulting in lower present values than less
dividend expectations should increase the firm’s risky expected cash flows, which are discounted
value. at lower rates.
❖​In Equation 7.4, an increase in P0 will increase for ❖​The value of the firm’s common stock is therefore
any increase in D1 or g. Any action of the financial driven by its expected cash flows (returns) and
manager that will increase the level of expected risk (certainty of the expected cash flows).
dividends without changing risk (the required ❖​In pursuing the firm’s goal of maximizing the stock
return) should be undertaken because it will price, the financial manager must carefully
positively affect owners’ wealth. consider the balance of return and risk associated
with each proposal and must undertake only
CHANGES IN RISKS those actions that create value for owners.
❖​By focusing on value creation and by managing
❖​Any action taken by the financial manager that and monitoring the firm’s cash flows and risk, the
increases the risk shareholders must bear will financial manager should be able to achieve the
also increase the risk premium required by firm’s goal of share price maximization.
shareholders and hence the required return.
Additionally, the required return can be affected
by changes in the risk free rate, even if the risk REVIEW
premium remains constant. For example, if the Differentiate between debt and equity. Holders of
risk-free rate increases due to a shift in equity capital (common and preferred stock) are
government policy, the required return goes up, owners of the firm. Typically, only common
too. stockholders have a voice in management. Equity
❖​In Equation 7.1, an increase in the required return, Holders' claims on income and assets are secondary to
rs, will reduce share value, P0, and that a creditors' claims, there is no maturity date, and
decrease in the required return will increase dividends paid to stockholders are not tax deductible.
share value. Thus, any action of the financial
manager that increases risk contributes to a Discuss the features of both common and preferred
reduction in value, and any action that decreases stock. The common stock of a firm can be privately
risk contributes to an increase in value. owned, closely owned, or publicly owned. It can be sold
with or without a par value. Preemptive rights allow
STOCK VALUATION SUMMARY common stockholders to avoid dilution of ownership
when new shares are issued. Not all shares
❖​The price of each share of a firm’s common stock authorized in the corporate charter are outstanding. If
is the value of each ownership interest. Although a firm has treasury stock, it will have issued more
common stockholders typically have voting rights, shares than are outstanding. Some firms have two or
which indirectly give them a say in management, more classes of common stock that differ mainly in
their most significant right is their claim on the having unequal voting rights. Proxies transfer voting

23
rights from one party to another. The decision to pay The value of a share of stock is the present value of all
dividends to common stockholders is made by the future dividends it is expected to provide over an
firm's board of directors. Firms can issue stock in infinite time horizon. Three dividend growth
foreign markets. The stock of many foreign models-zero-growth, constant-growth, and
corporations is traded in U.S. markets in the form of variable-growth-can be considered in common stock
American depositary receipts (ADRs), which are valuation. The most widely cited model is the
backed by American depositary shares (ADSs). constant-growth model.
Preferred stockholders have preference over common
stockholders with respect to the distribution of Discuss the free cash flow valuation model and the
earnings and assets. They do not normally have voting book value, liquidation value, and price/earnings (P/E)
privileges. Preferred stock issues may have certain multiple approaches. The free cash flow valuation
restrictive covenants, cumulative dividends, a call model values firms that have no dividend history,
feature, and a conversion feature. startups, or an operating unit or division of a larger
public company. The model finds the value of the
Describe the process of issuing common stock, entire company by discounting the firm's expected free
including venture capital, going public, and the cash flow at its weighted average cost of capital. The
investment banker. The initial non founder financing common stock value is found by subtracting the
for business startups with attractive growth market values of the firm's debt and preferred stock
prospects typically comes from private equity from the value of the entire company. Book value per
investors. These investors can be either angel share is the amount per share of common stock that
capitalists or venture capitalists (VCs). VCs usually would be received if all the firm's assets were sold for
invest in both early-stage and later-stage companies their exact book (accounting) value and the proceeds
that they hope to take public so as to cash out their remaining after paying all liabilities (including preferred
investments. stock) were divided among the common stockholders.
The first public issue of a firm's stock is called an Liquidation value per share is the actual amount per
initial public offering (IPO). The company selects an share of common stock that would be received if all
investment banker to advise it and to sell the the firm's assets were sold for their market value,
securities. The lead investment banker may form a liabilities (including preferred stock) were paid, and the
selling syndicate with other investment bankers. The remaining money were divided among the common
IPO process includes getting SEC approval, stockholders. The price/earnings (P/E) multiple
promoting the offering to investors, and pricing the approach estimates stock value by multiplying the
issue. firm's expected earnings per share (EPS) by the
average price/earnings (P/E) ratio for the industry.
Understand the concept of market efficiency and basic
stock valuation using zero-growth, constant-growth, Explain the relationships among financial decisions,
and variable-growth models. Market efficiency return, risk, and the firm's value. In a stable economy,
assumes that the quick reactions of rational investors any action of the financial manager that increases the
to new information cause the market value of common level of expected dividends without changing risk
stock to adjust upward or downward quickly. The should increase share value; any action that reduces
efficient-market hypothesis (EMH) suggests that the level of expected dividends without changing risk
securities are fairly priced, that they reflect fully all should reduce share value. Similarly, any action that
publicly available information, and that investors increases risk (required return) will reduce share
should therefore not waste time trying to find and value; any action that reduces risk will increase share
capitalize on mispriced securities. value. An assessment of the combined effect of return
Behavioral finance advocates challenge this and risk on stock value must be part of the financial
hypothesis by arguing that emotion and other factors decision-making process.
play a role in investment decisions.

24