Ch 7 Learning Goals

1. Characteristics of common and preferred stock.

2. Differences between debt and equity.

3. The process of issuing common stock and going

public.

4. Concept of market efficiency.

5. Common stock valuation.1

The Nature of Equity CapitalVoice in Management

• Common stockholders own the firm.

• Common stockholders elect the firm’s board

of directors and vote on special issues.

• Bondholders and preferred stockholders

receive no such privileges.

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Common Stock: Voting Rights

• Some firms have two or more classes of stock differing mainly in having unequal voting rights.

• Usually, class _____ common stock is nonvoting while class _____ is voting.

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Common Stock: Voting Rights (cont.)

• Because most shareholders do not attend the annual meeting to vote, they may sign a ________________ statement giving their votes to another party (usually to management).

• Occasionally outsiders wage a proxy fight to gain control of the firm.

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The Nature of Equity CapitalClaims on Income & Assets

• Common stockholders have a ____________

claim on the firm’s income and assets: they are

not paid until the claims of creditors have been

paid.

• What do equity holders get to compensate

them for the additional risk they bear?

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The Nature of Equity Capital: Maturity

• Unlike debt, equity capital is a _________________ form of financing.

• Equity has no maturity date and never has to be repaid by the firm.

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The Nature of Equity CapitalTax Treatment

• Interest paid to bondholders is a __________

__________________________ expense for

the issuing firm.

• Dividends paid are not tax-deductible.

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Preferred Stock

• Preferred stock is equity that pays a __________

dividend.

• The dividend is expressed as a dollar amount or as

a percentage of par value. Examples:

$10 dollar preferred pays annual dividend of $10

Preferred stock with $100 par and 8% dividend pays $8 per year

• Preferred stock is in between common stock and

bonds; it has characteristics of both.8

• Initial financing for most firms typically comes from

the firm’s founders

• Additional financing often comes from ___________

capitalists

• After establishing itself, a firm will often “go public” in

an IPO: Initial Public Offering.

• Most public offerings are made with the assistance

of investment bankers

Issuing Common Stock

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Going Public

• When a firm wishes to sell its stock in the primary market, it has three alternatives:– A public offering. – A rights offering, in which new shares are sold to

existing shareholders.– A private placement.

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Going Public (cont.)

• For a public offering, the company must file a __________________________________ statement with the SEC.

• Part of the registration statement is a ____________________________________, which describes the key aspects of the issue, the issuer, and its management and financial position.

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Going Public (cont.)

• Investment bankers and company officials promote the company through a road show.

• This helps investment bankers gauge the demand for the offering which helps them to set the initial offer price.

• In most cases, the investment banker will underwrite the issue, guaranteeing a price. The investment banker charges the issuing corporation expenses plus a spread.

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Common Stock Returns

• Stockholders receive returns on their investment in

the form of ___________________________

and/or _________________________.

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Common Stock ReturnsThe expected return on stock may be expressed as

follows:

E(r) = D/P + g

For example, a firm’s stock price is $25, it pays a $1 dividend that is expected to grow at

7%, the expected return is:

E(r) = 1/25 + .07 = 11%

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Common Stock Valuation

• Investors purchase shares when they feel they are

undervalued and sell them when they believe they are

overvalued.

• Stock is undervalued if the market price is less than

the stock is worth to investors (its “fundamental” or

“intrinsic” value).

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Common Stock Valuation

• If securities markets are efficient:

– Securities will be fairly priced: __________ equals fundamental _________________.

– Expected returns equal required returns.

– Security prices reflect all available information and react quickly to new information.

The Efficient Market Hypothesis

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Common Stock Valuation

• If securities markets are efficient, it is a waste

of time for investors to look for undervalued or

overvalued securities.

• However, if markets are not completely

efficient, it is worthwhile to estimate the

fundamental value of stocks and compare them

to market prices.

The Efficient Market Hypothesis

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Common Stock Valuation

• Methods of estimating common stock value:

– Dividend approach

– Cash flow approach

– Earnings approach

– Liquidation value

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Common Stock Valuation

• Methods of estimating common stock value:

– Dividend approach

– Cash flow approach

– Earnings approach

– Liquidation value

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• The constant growth model assumes that the stock

will pay dividends that grow at a constant rate each

year.

Stock Valuation ModelsThe Constant Growth Model

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Constant Growth Model

• Requirements to use the constant growth

model:

• Firm must pay dividends

• kS must be __________________ than g

• Growth rate must be constant

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Free Cash Flow Model

Stock Valuation Models

• The free cash flow model is a more sophisticated method of valuing a firm’s stock.

• It estimates the value of a firm’s stock based on the firm’s free cash flows rather than dividends.

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Free Cash Flow Model

Stock Valuation Models

• Advantages of free cash flow model:

– Dividends are often a small part of total returns

– Many firms don’t pay dividends

– Unlike earnings, cash flows are not subject to manipulation

• Disadvantages of free cash flow model:

– It is difficult to forecast free cash flow

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Other Approaches to Stock Valuation

• An alternative approach to stock valuation is based on the average P/E ratio for the firm’s industry.

• The model may be written as:

P = (av P/E)(EPS)

For example, if industry av P/E is 15, and a

stock’s earnings are $5.00/share, the estimated value of the stock would be P = 15*5 =

$75/share.

Valuation Using P/E Ratios

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1. The firm might be worth more or less (on a relative basis) than other firms in the industry.

2. Stock prices for the entire industry might be too high or too low.

3. Earnings are subject to manipulation and there is more than one earnings number.

Other Approaches to Stock ValuationWeaknesses of Using P/E Ratios

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Stock Valuation: Liquidation Value

• Liquidation value per share is based on the market value of assets, minus liabilities.

• This measure is more realistic than book value because it is based on current market values of the firm’s assets.

• However, it still fails to consider the earning power of those assets, and requires us to estimate the market value of assets.

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