Financial Management :

Theory & Practice

Professor Dr. Hussein Seoudy
January 2016
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Chapter 7
Stocks, Stock Valuation, and
Stock Market Equilibrium

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Topics in Chapter

Differences Between Debt and Equity

Features of Common Stock

Determining Common Stock Values

Efficient Markets

Preferred Stock
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Differences Between Debt

and Equity

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Differences Between Debt and Equity

Debt includes all borrowing incurred by a
firm, including bonds, and is repaid
according to a fixed schedule of payments.
Equity consists of funds provided by the
firms owners (investors or shareholders) that
are repaid subject to the firms performance.
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Differences Between Debt and Equity:

Voice in Management
Unlike creditors, holders of equity (shareholders)

are owners of the firm.

shareholders generally have voting rights that

permit them to select the firms directors and

vote on special issues.
In contrast, debtholders do not receive voting
privileges but instead rely on the firms
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contractual obligations to them to be their voice.

Differences Between Debt and Equity:

Claims on Income and Assets
Equity holders claims on income and assets are
secondary to the claims of creditors.

Their claims on income cannot be paid until the

claims of all creditors, including both interest and

scheduled principal payments, have been

satisfied.
Because equity holders are the last to receive
distributions, they expect greater returns to
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compensate them for the additional risk they bear.

Differences Between Debt and Equity:

Maturity

Unlike debt, equity capital is a permanent

form of financing.
Equity has no maturity date and never has to
be repaid by the firm.

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Differences Between Debt and Equity:

Tax Treatment
Interest payments to debtholders are treated as
tax-deductible expenses by the issuing firm.
Dividend payments to a firms shareholders are
not tax-deductible.
The tax deductibility of interest lowers the
corporations cost of debt financing, further

causing it to be lower than the cost of equity

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financing.

Features of common stock

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Features of Common stock

Represents ownership.
Ownership implies control.
shareholders elect directors.
Directors hire management.
Since managers are agents of shareholders,
their goal should be: Maximize stock price.
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Common Stock: Ownership

The common stock of a firm can be privately

owned by an private investors, closely owned

by an individual investor or a small group of
investors, or publicly owned by a broad
group of investors.

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Common Stock: Ownership (cont.)

The shares of privately owned firms, which

are typically small corporations, are generally

not traded; if the shares are traded, the
transactions are among private investors and
often require the firms consent.
Large corporations are publicly owned, and
their shares are generally actively traded in
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the stock markets.

Common Stock: Preemptive Rights

A preemptive right allows common

shareholders to maintain their proportionate

ownership in the corporation when new
shares are issued, thus protecting them from
dilution of their ownership.

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Common Stock: Preemptive Rights (cont.)

Dilution of ownership is a reduction in each

previous shareholders fractional ownership

resulting from the issuance of additional
shares of common stock.
Dilution of earnings is a reduction in each
previous shareholders fractional claim on the
firms earnings resulting from the issuance of
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additional shares of common stock.

Common Stock: Authorized, Outstanding,

and Issued Shares
Authorized shares are the shares of common
stock that a firms corporate charter allows it
to issue.
Outstanding shares are issued shares of

common stock held by investors, this includes

private and public investors.
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Common Stock: Authorized, Outstanding,

and Issued Shares (cont.)
Treasury stock are issued shares of common

stock held by the firm; often these shares have

been repurchased by the firm.

Issued shares are shares of common stock that

have been put into circulation.
Issued shares = outstanding shares + treasury stock
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Common Stock: Authorized, Outstanding,

and Issued Shares (cont.)
Golden Enterprises, a producer of medical pumps,

has the following stockholders equity account on

December 31st.

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Common Stock:
Claim on Income (Dividends)
Common shareholders have the right to the

firms income that remains after bondholders and

preferred shareholders have been paid.
The common shareholders either receive cash
payments in the form of dividends or the firms
management reinvests the earnings in the firm.

The right to residual income means that the

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potential return is unlimited.

Common Stock:
Claim on Income (Dividends) (cont.)

The payment of dividends to the firms

shareholders is at the discretion of the companys
board of directors.
Dividends may be paid in cash, stock, or

merchandise.

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Common Stock: Voting Rights

Generally, each share of common stock

entitles its holder to one vote in the election of
directors and on special issues.
Votes are generally assignable and may be
cast at the annual shareholders meeting.

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Common Stock: Voting Rights (cont.)

A proxy statement is a statement transferring

the votes of a shareholder to another party.

Because most small shareholders do not

attend the annual meeting to vote, they may
sign a proxy statement transferring their votes
to another party.

Existing management generally receives the

shareholders proxies, because it is able to

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solicit them at company expense.

Common Stock: Agency Costs

In theory, common shareholders elect the board and

effectively control the firm through their

representatives on the board.
In reality, shareholders are given a slate of nominees
for the board selected by the management. As a
result, management effectively elects the board and

thus the board may have more allegiance to the

managers than to the shareholders. This may lead to
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agency problems.

Common Stock: Agency Costs (cont.)

Managers are employees of the firm but may

put their interests ahead of the firms

shareholders (its owners).

The costs associated with manager-

stockholder agency problems are difficult to

quantify, but it could be significant.
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Determining Common
Stock Values

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Different Approaches for Valuing

Common Stock

Dividend growth model

1.

2.

3.

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Using the multiples of

comparable firms

Free cash flow method

Valuing Common Stock Using the

Discounted Dividend Model
Like bonds, common stocks value is equal to

the present value of all future cash flows that

the stockholder expects to receive from

owning the shares of stock.

However, unlike bonds, the future cash flows

in the form of dividends are not fixed. Thus

the value of common stock is derived from
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discounting expected dividend.

Three Step Procedure for Valuing

Common Stock: Summary
Step 1 :

Estimate the amount and timing of future

cash flows the common stock is expected to

provide.

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Three Step Procedure for Valuing

Common Stock: Summary
Step 2 :
Evaluate the riskiness of the future dividends,
and determine the rate of return an investor

might expect to receive from a comparable

risk investment, which becomes the investors
required rate of return.
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Three Step Procedure for Valuing

Common Stock: Summary
Step 3 :
Calculate the present value of the expected
dividends by discounting them back to the
present at the investors required rate of return.

The three steps show that the value of a common

stock is equal to the present value of all future
dividends.
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Stock Value = PV of Dividends

D
D
D
D
3
1
2

...
0
1
2
3

1 rs 1 rs 1 rs
1 rs
What is a constant growth stock?

One whose dividends are expected to

grow forever at a constant rate, g.
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For a Constant Growth Stock

D1 = D0(1 + g)1
D2 = D0(1 + g)2

Dt = D0(1 + g)t
If g is constant, then:

P^0
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D0 (1 + g)
D1
= r g = r g.
s
s

For a Constant Growth Stock (cont.)

What happens if g > rs?

P0 =

D1
rs g

requires rs > g.

If rs< g, get negative stock price, which is

nonsense.
We cant use model unless (1) rs > g and
(2) g is expected to be constant forever.
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Systematic and Unsystematic Risk

Systematic risk is risk that influences a
large number of assets. Also called market
risk.
Unsystematic risk is risk that influences
a single company or a small group of
companies. Also called unique risk or
firm-specific risk.

Total risk = Systematic risk + Unsystematic risk

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The Security Market Line (SML)

The Security market line (SML) is a graphical

representation of the linear relationship

between systematic risk and expected return

in financial markets.
The term (rM rRF) is often called the

market risk premium because it is the risk

premium on a market portfolio.
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The Security Market Line (SML)

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Dividend Growth Model

Assume beta = 1.2, rRF = 7%, and rM = 12%. What
is the required rate of return on the firms stock ?

Use the Security Market Line (SML) to calculate rs:

rs =rRF + (rM rRF) bFirm

= 7% + (12% 7%) (1.2)

= 13%.
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Dividend Growth Model (Cont.)

D0 was $2.00 and g is a constant 6%.
Find the expected dividends
for the next 3 years, and their PVs. rs = 13%.

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g = 6%

D0 = 2.00 2.12
13%
1.8761
1.7599
1.6509

2
2.247

3
2.382

Dividend Growth Model (Cont.)

Whats the stocks market value?
D0 = 2.00, rs = 13%, g = 6%.

Constant growth model:

D1

$2.12
P0 =
=
rs g
0.13 0.06
=

$2.12
0.07

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= $30.29.

Dividend Growth Model (Cont.)

What is the stocks market value one year
^
from now, P1?
D1 will have been paid, so expected dividends
are D2, D3, D4 and so on. Thus

D2
$2.247
P1 =
=
rs g
0.13 0.06
= $32.10.
^

Could also find P1 as follows:

^

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P1 = P0 (1.06) = $32.10.

Dividend Growth Model (Cont.)

Find the expected dividend yield, capital gains
yield, and total return during the first year.

D1
$2.12
Dividend yld =
=
= 7.0%.
P0
$30.29
^
P1 P0 $32.10 $30.29
Cap gains yld =
=
$30.29
P0
= 6.0%.
Total return = 7.0% + 6.0% = 13.0%.
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Dividend Growth Model (Cont.)

Rearrange model to rate of return form:

D
D
1
1
$
$

g.
to r s
P0
rs-g
P0
Then, rs = $2.12/$30.29 + 0.06
= 0.07 + 0.06 = 13%.`
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Dividend Growth Model (Cont.)

What would P0 be if g = 0?

The dividend stream would be a perpetuity.

13%

3
...

2.00

2.00

2.00

PMT
$2.00
P0 =
=
= $15.38.
r
0.13
^

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Dividend Growth Model (Cont.)

If g = -6%, would anyone buy the stock? If so,
at what price?

Firm still has earnings and still pays

dividends, so P0 > 0:

g
+
D
1
D
0
1
$0 =
=
P
-g
-g
rs
rs
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= $2.00(0.94) = $1.88 = $9.89.

0.13 (-0.06)
0.19

Dividend Growth Model

What is the annual D/P and capital gains
yield?

Capital gains yield = g = -6.0%,

Dividend yield= 13.0% (-6.0%) = 19%.

D/P and cap. gains yield are constant,

with high dividend yield (19%) offsetting
negative capital gains yield.
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Using Stock Price Multiples to

Estimate Stock Price
Analysts often use the P/E multiple (the price

per share divided by the earnings per share).

Example:

Estimate the average P/E ratio of comparable

firms. This is the P/E multiple.

Multiply this average P/E ratio by the

expected earnings of the company to estimate

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its stock price.

Using Entity Multiples

The entity value (V) is:

the market value of equity (# shares of stock

multiplied by the price per share)

plus the value of debt

Pick a measure, such as EBITDA, Sales,

Customers, Eyeballs, etc.
Calculate the average entity ratio for a sample of
comparable firms. For example,
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V/EBITDA
V/Customers

Problems with Market Multiple Methods

It is often hard to find comparable firms.

The average ratio for the sample of

comparable firms often has a wide range.

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For example, the average P/E ratio might be

20, but the range could be from 10 to 50. How
do you know whether your firm should be
compared to the low, average, or high
performers?

Using Stock Price Multiples to

Estimate Stock Price
Analysts often use the P/E multiple (the price

per share divided by the earnings per share).

Example:

Estimate the average P/E ratio of comparable

firms. This is the P/E multiple.

Multiply this average P/E ratio by the

expected earnings of the company to estimate

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its stock price.

Preferred Stock

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Preferred Stocks
Hybrid security.

Similar to bonds in that preferred stockholders

receive a fixed dividend that must be paid before

dividends can be paid on common stock.

However, unlike interest payments on bonds,
companies can omit dividend payments on
preferred stock without fear of pushing the firm
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into bankruptcy.

Preferred Stocks

Preferred stock gives its holders certain

privileges that make them senior to common

stockholders.
Preferred stockholders are promised a fixed

periodic dividend, which is stated either as a

percentage or as a dollar amount.
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Preferred Stocks (Cont.)

Par-value preferred stock is preferred stock

with a stated face value that is used with the

specified dividend percentage to determine

the annual dollar dividend.

No-par preferred stock is preferred stock with

no stated face value but with a stated annual

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dollar dividend.

Preferred Stock: Basic Rights of

Preferred Shareholders
Preferred stock is often considered quasi-debt

because, much like interest on debt, it specifies a

fixed periodic payment (dividend).
Preferred stock is unlike debt in that it has no
maturity date.
Because they have a fixed claim on the firms

income that takes precedence over the claim of

common stockholders, preferred stockholders are
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exposed to less risk.

Preferred Stock: Basic Rights of

Preferred Shareholders (cont.)
Preferred shareholders are not normally given a

voting right, although preferred shareholders

are sometimes allowed to elect one member of

the board of directors.

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Preferred Stock:
Features of Preferred Stock
Restrictive covenants including provisions

about passing dividends, the sale of senior

securities, mergers, sales of assets, minimum

liquidity requirements, and repurchases of

common stock.

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Preferred Stock:
Features of Preferred Stock
Cumulative preferred stock is preferred stock for

which all passed (unpaid) dividends in arrears,

along with the current dividend, must be paid

before dividends can be paid to common

stockholders.
Noncumulative preferred stock is preferred stock
for which passed (unpaid) dividends do not
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accumulate.

Preferred Stock:
Features of Preferred Stock
A callable feature is a feature of callable

preferred stock that allows the issuer to retire

the shares within a certain period time and at a

specified price.
A conversion feature is a feature of convertible
preferred stock that allows holders to change
each share into a stated number of shares of
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common stock.

Valuing Preferred Stock

Whats the expected return of preferred stock
with Vp = $50 and annual dividend = $5?

Vp $50

$5

rp

$5
0.10 10.0%.
r p
$50
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Market Efficiency

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Market Efficiency
Economically, rational buyers and sellers use

their assessment of an assets risk and return to

determine its value.
In competitive markets with many active
participants, the interactions of many buyers and
sellers result in an equilibrium pricethe market
valuefor each security.
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Market Efficiency ( Cont.)

Because the flow of new information is almost
constant, stock prices fluctuate, continuously
moving toward a new equilibrium that reflects
the most recent information available. This
general concept is known as market efficiency.

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Market Efficiency ( Cont.)

Because the flow of new information is almost
constant, stock prices fluctuate, continuously
moving toward a new equilibrium that reflects
the most recent information available. This

general concept is known as market efficiency.

Efficient Market Hypothesis (EMH) : Securities are
normally in equilibrium and are fairly priced. One
cannot beat the market except through good luck or
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better information.

Weak-form EMH

Cant profit by looking at past trends. A

recent decline is no reason to think stocks will
go up (or down) in the future. Evidence

supports weak-form EMH, but technical

analysis is still used.

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Semistrong-Form EMH

All publicly available information is reflected

in stock prices, so it doesnt pay to pore over
annual reports looking for undervalued

stocks. Largely true.

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Strong-Form EMH

All information, even inside information, is

embedded in stock prices. Not true--insiders
can gain by trading on the basis of insider

information, but thats illegal.

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Chapter 7
Stocks, Stock Valuation, and
Stock Market Equilibrium

The End

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