Chapter 4

CHAPTER 4: COMMON STOCK VALUATION

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INTRODUCTION

•Whereas bond issues -commit the firm to make a series of specified interest
payments to the lenders, stock issues are more like taking on new partners.
•Why should investors care for, how stocks are valued? investors need to know what
determines price of stocks for at least two reasons.

•First, they may wish to check that any shares that they own are fairly priced and to
gauge their beliefs against the rest of the market.

•Second, corporations need to have some understanding of how the market values firms
in order to make good capital budgeting decisions.

A project is attractive if it increases shareholder wealth. But investors can’t judge

that unless they know how shares are valued.

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 4.1 STOCK CHARACTERISTICS

4.1.1 Differences between Debt and Equity Capital

Types of capital
Debt Equity
Voice in management a No Yes
Claims on income and assets Senior to equity Subordinate to
debt
Maturity Stated None
Tax treatment Interest No deduction
deduction
a
In the event that the issuer violates its stated contractual
obligations to them, debt holders and preferred stockholders may
receive a voice in management; otherwise, only common
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stockholders have voting rights.
 4.1.2 Differences between Common and Preferred Stocks

• A firm can obtain equity, or ownership, capital by selling

either common or preferred stock. All corporations initially
issue common stock to raise equity capital.
• Some of these firms later issue either additional common
stock or preferred stock to raise more equity capital
Type of stock
Characteristics of Common Stock
Ownership – residual owners. Owned by individuals, closely related
family/friends or may be publicly owned
Par Value - common stock may be sold with or without a par value.
Preemptive Rights - It allows existing shareholders to maintain
voting control and protects them against the dilution of their
Common stock

ownership
Voting Rights - Generally, each share of common stock entitles its
holder to one vote in the election of directors and on special issues.
Dividends - Common stockholders are not promised a dividend, but4
 Characteristics of Preferred Stock
Restrictive covenants/agreements - These covenants include provisions
about passing dividends, the sale of senior securities, mergers, sales of
assets, minimum liquidity requirements, and repurchases of common stock.

Par Value - Par-value preferred stock has a stated face value, and its annual
dividend is specified as a percentage of this value. No-par preferred stock
has no stated face value, but its annual dividend is stated in monetary
values (Birr or dollar).
Voting Rights – no voting rights
Accumulation/Cumulating – Most preferred stock is cumulative with respect
to any dividends passed. That is, all dividends in arrears, along with the
current dividend, must be paid before dividends can be paid to common
stockholders. If preferred stock is noncumulative, passed (unpaid) dividends
do not accumulate. In this case, only the current dividend must be paid
before dividends can be paid to common stockholders.-Callable – the issuer
Preferred stock

can retire outstanding stock within a certain period of time at a specified

price.
a.

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4.2 COMMON STOCK VALUATION MODELS

a. Dividend Discount Models

• Like the value of bonds, the value of a share of
common stock is equal to the present value of all
future cash flows (dividends) that it is expected to
provide over an infinite time horizon.

• Although a stockholder can earn capital gains by

selling stock at a price above that originally paid,
what is really sold is the right to all future dividends

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• The basic valuation model can be specified for common stock, as given in
the following Equation:

•Where
•P0 = value of common stock
•Dt = per-share dividend expected at the end of year t
•Ks = required return on common stock

There are three models of growth:

i. zero-growth,

ii. constant-growth, and

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iii. variable-growth.
1. Zero-Growth Model

•The simplest approach to dividend valuation, the zero-growth

model, assumes a constant, non-growing dividend stream.
• In terms of the notation: D1 = D2 = . . . = D∞. When we let D1
represent the amount of the annual dividend the Equation under
zero growth reduces to:

•Present Value Interest Factor of Annuity = (PVIFA)

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Example:
• The dividend of Denture Company, an
established textile producer, is expected to
remain constant at Birr 3 per share indefinitely.
If the required return on its stock is 15%, what is
the stock’s value per share?

• Solution

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 2. Constant-Growth Model – Gordon model

•The constant-growth model assumes that dividends will grow at a

constant rate, but a rate that is less than the required return.
Assumptions
• g, is less than the required return ks,
•earnings and dividends grow at the same rate.
•This assumption is true only in cases in which a firm pays out a
fixed percentage of its earnings each year (has a fixed payout ratio).
• In the case of a declining industry, a negative growth rate (g <
0%) might exist.
By letting D0 represent the most recent dividend, we can rewrite

the zero growth equation as follows: 10

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• If we simplify the Equation, it can be rewritten as:

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Example

•The constant-growth model is commonly called the Gordon model.

Assume, LM Company, a small cosmetics company, from 1998 through 2003 paid the
following per-share dividends:

Year 1998 1999 2000 2001 2002 2003

Dividend 1.00 1.05 1.12 1.20 1.29 1.40

s

The required return, Ks, is assumed to be 15%. , and the growth rate, is 7%

Required:

what is the value of the stock?

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Estimate the dividend in 2004 (which is D1). The company

D0 x (1+g) n = D2003 (1+0.07) = 1.4(1.07) = 1.498 = Birr 1.5 per

estimates that its dividend in 2004, D1, will equal Birr 1.50. D1 =

share.
By substituting these values into constant growth equation, we
find the value of the stock to be

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3. Variable-Growth Model

 The zero- and constant-growth common stock models

do not allow for any shift in expected growth rates.

• Future growth rates might shift up or down because of

changing expectations, it is useful to consider a
variable-growth model that allows for a change in the
dividend growth rate
• We will assume that a single shift in growth rates occurs
at the end of year N, and we will use g1 to represent the
initial growth rate and g2 for the growth rate after the
shift.
• To determine the value of a share of stock in the case of
variable growth, we use a four-step procedure.
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Step 1 Find the value of the cash dividends at the end of each year, Dt, during the
initial growth period, years 1 through N. Therefore, for the first N years,

Step 2 Find the present value of the dividends expected during

the initial growth period. Using the notation presented earlier,
we can give this value as:

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Step 3 Find the value of the stock at the end of the initial growth
period,
PN = (DN+1)/(ks – g2),
 which is the present value of all dividends expected from year
N+1 to infinity, assuming a constant dividend growth rate, g2.
This value is found by applying the constant-growth model to
the dividends expected from year N+1 to infinity.
 The present value of PN would represent the value today of all
dividends that are expected to be received from year N+1 to
infinity. This value can be represented by: PN=

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Step 4 Add the present value components found in Steps 2 and 3
to find the value of the stock, P0, given in the following equation

 the first section of this equation is the Present Value of Dividends during initial
growth period

 the second (right side) section of this equation is the present value of price of
stock at end of initial growth period

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Assignment= Solve the following and give the analysis
The most recent (2003) annual dividend payment of Warren
Industries, a rapidly growing boat manufacturer, was $1.50 per
share. The firm’s financial manager expects that these dividends
will increase at a 10% annual rate, g1, over the next 3 years
(2004, 2005, and 2006) because of the introduction of a hot new
boat. At the end of the 3 years (the end of 2006), the firm’s
mature product line is expected to result in a slowing of the
dividend growth rate to 5% per year, g2, for the foreseeable
future. The firm’s required return, ks, is 15%.
Required:
 estimate the current (end-of-2003) value of Warren’s
common stock?
• Hint: P0=P2003, apply the four-step procedure to these data.
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 4.2.2 Free Cash Flow Valuation Model

 In the free cash flow valuation model, instead of valuing the firm’s
expected dividends, we value the firm’s expected free cash flows.
 They represent the amount of cash flow available to investors—the
providers of debt (creditors) and equity (owners)—after all other
obligations have been met.
 I.E the present value of its expected free cash flows discounted at
its weighted average cost of capital(WACC), which is its expected
average future cost of funds over the long run.

Where,
• VC = value of the entire company
• FCFt = free cash flow expected at the end of year t
• Kd = the firm’s weighted average cost of capital (WACC) 20
Because the value of the entire company, VC, is the market value of the

entire enterprise (that is, of all assets), to find common stock value, VS, we
must subtract the market value of all of the firm’s debt, VD, and the market

value of preferred stock, VP, from VC.

•VS = VC – VD – VP

Vs= Common stock value

Vc= Market value of the entire enterprise
VD= Value of the firm’s debt
VP = Value of preferred stock
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 Cont…
• Example
Table 4.4: Dewhurst Inc.’s Data for Free Cash Flow Valuation Model

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 Required:
what is the value of the common stock?

• Step 1 Calculate the present value of the free cash flow

occurring from the end of 2009 to infinity, measured at the
beginning of 2009 (that is, at the end of 2008). Because a
constant rate of growth in FCF is forecast beyond 2008, we can
use the constant-growth dividend valuation model to
calculate the value of the free cash flows from the end of
2009 to infinity.

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Note that to calculate the FCF in 2009, we had to
increase the 2008 FCF value of $600,000 by the 3%
FCF growth rate,
• Step 2: Add the present value of the FCF from
2009 to infinity, which is measured at the end of
2008, to the 2008 FCF value to get the total FCF
in 2008.
• Total FCF2008 = $600,000 + $10,300,000

= $10,900,000

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• Step 3 Find the sum of the present values of the FCFs for 2004
through 2008 to determine the value of the entire company, VC.
This calculation is shown in Table 4.5, using present value
interest factors, PVIFs.
Table 4.5: Calculation of the Value of the Entire Company for Dewhurst Inc.

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• Step 4 Calculate the value of the common stock using
Equation VS = VC – VD – VP. Substituting the value of
the entire company, VC, calculated in Step 3, and the
market values of debt, VD, and preferred stock, VP,
given in Table 4.4,yields the value of the common
stock, VS:
• VS = $8,628,620 - $3,100,000 - $800,000
=$4,728,620
• The value of Dewhurst’s common stock is therefore
estimated to be $4,728,620.
• By dividing this total by the 300,000 shares of common
stock that the firm has outstanding, we get a common
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stock value of$15.76 per share ($4,728,620/300,000).
4.2.3 Balance sheet valuations

•Book Value
• Book value per share -is the amount per share of
common stock that would be received if all of the
firm’s assets were sold for their exact book
(accounting) value and the proceeds remaining after
paying all liabilities (including preferred stock) were
divided among the common stockholders.
Critics
 Reliance on historical balance sheet data and
 It ignores the firm’s expected earnings potential and generally
lacks any true relationship to the firm’s value in the
marketplace.
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 EXAMPLE:

• At year-end 2003, LM Company’s balance sheet shows

total assets of $6 million, total liabilities (including
preferred stock) of $4.5 million, and 100,000 shares of
common stock outstanding. Its book value per share
therefore would be:

• Because this value assumes that assets could be sold for their
book value, it may not represent the minimum price at which
shares are valued in the marketplace.

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Liquidation Value
•Liquidation value per share- is the actual amount per
share of common stock that would be received if all of
the firm’s assets were sold for their market value,
liabilities (including 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.
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 EXAMPLE
• Lamar Company found upon investigation that it could
obtain only $5.25 million if it sold its assets today. The
firm’s liquidation value per share therefore would be

• Ignoring liquidation expenses, this amount would be the firm’s

minimum value.

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Price/Earnings (P/E) Multiples

• The price/earnings (P/E) ratio -reflects the amount investors

are willing to pay for each dollar of earnings.

• Can be used as the guide to a firm’s value

• The price/earnings multiple approach is a popular technique
used to estimate the firm’s share value;
• It is calculated by multiplying the firm’s expected earnings
per share (EPS) by the average price/earnings (P/E) ratio for
the industry.
Firm value =EPS X P/E ratio

• The average P/E ratio for the industry can be obtained from a
source such as Standard & Poor’s Industrial Ratios
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 Cont…
• The use of P/E multiples is especially helpful in
valuing firms that are not publicly traded,
• Whereas market price quotations can be used to value
publicly traded firms.
 The price/earnings multiple approach is considered
superior to the use of book or liquidation values
because it considers expected earnings.

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Do IT:
• Lamar Company is expected to earn $2.60 per share
next year (2004). This expectation is based on an
analysis of the firm’s historical earnings trend and of
expected economic and industry conditions. The
average price/earnings (P/E) ratio for firms in the
same industry is 7. Multiplying Lamar’s expected
earnings per share (EPS) of $2.60 by this ratio gives
us a value for the firm’s shares of$18.20,
• assuming that investors will continue to measure the
value of the average firm at 7 times its earnings.
• So how much is Lamar Company’s stock really worth? That’s
a trick question, because there’s no one right answer.
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• The answer depends on the assumptions made and
the techniques used.
• Professional securities analysts typically use a variety
of models and techniques to value stocks.
• For example, the constant-growth model,
liquidation value, and price/earnings (P/E)
multiples to estimate the worth of a given stock.

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End of Chapter 5

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