FIN 3701 Chapter 4 :Preferred and Common Stocks 1 FIN3701

FIN 3701 Chapter 4 :Preferred and Common Stocks

Stock Valuation Assumption University of Thailand “Genius is 90% perspiration and 10% inspiration” FIN3701 Chapter 4 T. Edison Corporate Preferred and

Finance Common Stocks Warren Buffet Source: http://www.quotespin.com

Dr. Chainarin Srinutchasart

Source: http://bgr.com

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Objectives Principles Applied in This Chapter • In this chapter, you will learn • Principle 1: Money Has a Time Value. • Features of preferred stock • Principle 2: There is a Risk-Reward Tradeoff. • Determining preferred stock values • Principle 3: Cash Flows are the Source of • Features of common stock Value. • Determining common stock values • Principle 4: Market Prices Reflect Information. • Principle 5: Individuals Respond to Incentives.

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Corporate Finance addresses The Balance-Sheet Model of the the following 3 questions: Firm The Capital Structure Decision (Ch. 12, 15, 18) 1. What long-term investments should the firm (Financing Decision) engage in? 2. How can the firm raise money for the Current Liabilities required investments? (Alternatives: Bonds, Current Assets How can the Long-Term Debt This ch. Stocks, Preferred Stocks=what is the firm raise the money appropriate price?) Fixed Assets for the required 3. How much short-term cash flow does a 1 Tangible investments? Shareholders’ company need to pay its bills? and how to 2 Intangible Equity raise it

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1 FIN 3701 Chapter 4 :Preferred and Common Stocks

Debt vs. Equity Preferred Stock

“Raising the capital: Tools”

Fixed Claim Residual Claim Tax Deductible Not Tax Deductible High Priority in Financial Trouble Lowest Priority in Financial Trouble Fixed Maturity Infinite No Management Control Management Control

Debt Hybrid Securities Equity Bank Debt Convertible Debt Owner's Equity Commercial Paper Preferred Stock Venture Capital Corporate Bonds Option-linked Bonds Common Stock Warrants

What we will cover for this chapter 7 Source: http://i0.sinaimg.cn 8

Preferred Stock Preferred Stock

A hybrid security: • Usually sold for $25, $50, or $100 per share. • It’s like common stock - no fixed maturity. • Dividends are fixed either as a dollar amount • Technically, it’s part of equity capital. or as a percentage of par value. • It’s like debt - preferred dividends are fixed. • Example: In 1988, Xerox issued $75 million of 8.25% preferred stock at $50 per share. • Missing a preferred dividend does not constitute default, but preferred dividends • $4.125 is the fixed, annual dividend per are cumulative. (and preferred dividends share. need to be paid before common stock’s dividends)

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When to issue a preferred stock? Preferred Stock Features

• The company already has too high level of • Firms may have multiple classes of debt. preferreds, each with different features. • Priority: lower than debt, higher than • And they don’t want to dilute the ownership common stock. (Claim of EBIT) interest of common stock holders. • **Cumulative feature: all past unpaid preferred stock dividends must be paid before any common stock dividends are declared.

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2 FIN 3701 Chapter 4 :Preferred and Common Stocks

Preferred Stock Features Preferred Stock Valuation • PIK Preferred: Pay-in-kind preferred stocks • A preferred stock can usually be valued pay additional preferred shares to investors like a perpetuity: rather than cash dividends. • Retirement: Most preferreds are callable, and many include a sinking fund provision to set cash aside for the purpose of retiring preferred shares.

Source: http://www.palmbeachperfumes.com

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Type of Value Security Valuation

• Book value: value of an asset as shown on a • In general, the intrinsic value of an asset = firm’s balance sheet; historical cost. the present value of the stream of expected • Market value: observed value of an asset in cash flows discounted at an appropriate the marketplace; determined by supply and required rate of return. demand. • Intrinsic value: economic or fair value of an • Can the intrinsic value of an asset differ asset; the present value of the asset’s from its market value? expected future cash flows.

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Valuation Preferred Stock Valuation • Discount the Preferred stock’s cash flows n (Dividend) at the investor’s required rate of $Ct return. V = S(1 + k)t t = 1

• Ct = cash flow to be received at time t. • k = the investor’s required rate of return. • V = the intrinsic value of the asset.

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3 FIN 3701 Chapter 4 :Preferred and Common Stocks

Preferred Stock Valuation Mathematically, • Discount the preferred stock’s cash flows at 1 the investor’s required rate of return. 1 – (1 + i)n • The DIV payment stream (perpetuity). (PVIFA i, n ) = i

We said that a perpetuity is an annuity where n = infinity. What happens to this formula when n gets very, very large?

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When n gets very large, So, Preferred Stock Valuation • A preferred stock can usually be valued like 1 this becomes zero. a perpetuity: 1 – (1 + i)n i D Vps = 1 ps So we’re left with PVIFA = k i

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Example: Expected Rate of Return on Preferred • Xerox preferred pays an 8.25% dividend on a $50 par value. • Just adjust the valuation model: • Suppose our required rate of return on Xerox preferred is 9.5%. D 4.125 kps = Vps = = $43.42 Po .095

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4 FIN 3701 Chapter 4 :Preferred and Common Stocks

Example Example • If we know the preferred stock price is $40, • If we know the preferred stock price is $40, and the preferred dividend is $4.125, the and the preferred dividend (Annually) is expected return is: $4.125, the expected return is:

D 4.125 k ps = = = Po 40

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Example • If we know the preferred stock price is $40, and the preferred dividend is $4.125, the expected return is:

Common Stocks D 4.125 k ps = = = .1031 Po 40

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Common Stock Debt vs. Equity

“Raising the capital: Tools”

Fixed Claim Residual Claim Tax Deductible Not Tax Deductible High Priority in Financial Trouble Lowest Priority in Financial Trouble Fixed Maturity Infinite No Management Control Management Control

Debt Hybrid Securities Equity Bank Debt Convertible Debt Owner's Equity Common stock = owner Commercial Paper Preferred Stock Venture Capital Corporate Bonds Option-linked Bonds Common Stock Bond = creditor Warrants

Preferred stock = hybrid What we will cover for this chapter Source: http://computerwoche.de 29 30

5 FIN 3701 Chapter 4 :Preferred and Common Stocks

Common Stock: Owners, Directors, Common Stock and Managers (In theory) • Is a variable-income security. • Represents ownership in a corporation. • Dividends may be increased or decreased, • Ownership implies control. depending on earnings. • Stockholders elect directors. Agency • Includes voting rights. Cost • : liability is limited to amount • Directors hire management. arises Limited liability • Since managers are “agents” of of owners’ investment. shareholders, their goal should be: • Priority: lower than debt and preferred. Maximize stock price. (That’s why we need to know how to value a stock)

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Understanding Stock Share Terms Understanding Stock Share Terms

• Authorized Shares – These shares represent the • Restricted Shares – Restricted shares refer to total number of shares of stock authorized when company stock used for employee incentive and the company was created. Only a vote by the compensation plans. Restricted stockowners need shareholders can increase this number of shares. permission of the SEC to sell. There is a waiting period after a company first goes public where However, just because a company authorized a insiders’ restricted stock is frozen. When insiders certain number of shares doesn’t mean it must want to sell their stock, they must file a form with issue all of them to the public. Most companies the SEC declaring their intention. Even insiders of retain shares for use later called unissued stock or established companies must file with the SEC shares. before selling their restricted stock. • Unissued Shares – Shares a company retains in • Float Shares – Float refers to the number of its treasury and not issued to the public or to shares actually available for trade on the open employees are unissued shares. market. You and I can buy these shares.

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Understanding Stock Share Terms Here’s a simple example with numbers to illustrate the relationship of these • Outstanding Shares – Outstanding shares different shares: includes all the shares issued by the company, which would be the restricted shares plus the float. • Authorized Shares – 100 • Treasury Shares – Previously issued stock that has been repurchased by the company. Buying • Unissued Shares – 20 treasury stock is an alternative to paying • Restricted Shares – 10 dividends. Since outstanding shares will be fewer • Float – 70 (100 – 20 – 10 = 70) after stock has been repurchased, EPS will rise. • Outstanding Shares – 80 (10 + 70 = 80)

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6 FIN 3701 Chapter 4 :Preferred and Common Stocks

Why is this Important? Why is this Important? • Look at the relationship of unissued shares • If the float of a company is very small and the and restricted shares to float for where stock attracts attention of investors it can controlling interest of the company will reside. become volatile because of supply and demand imbalances. Many companies retain a large percentage of More buyers will drive the price up, which is the authorized shares in their treasuries or in not a bad thing if you own the stock. the hands of management through restricted However, it may make the stock over priced shares. Companies do this to make sure no relative to its earnings or other fundamental other company can seize control in an measures. unfriendly takeover. They may also want to Likewise, if the stock falls out of favor, sellers have stock handy for future issue instead of may have trouble unloading their shares, using debt to buy another company or for which would tend to force the price down further and more rapidly than fundamentals another major expenditure. might indicate.

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Common Stock Characteristics Common Stock Characteristics

• Claim on Income - a stockholder has a claim Voting Rights on the firm’s residual income. • Most shareholders vote by proxy. A proxy • Claim on Assets - a stockholder has a gives a designated party the temporary residual claim on the firm’s assets in case of power of attorney to vote for the signee at liquidation. the corporation’s annual meeting. • Preemptive Rights - stockholders may share • There are two commonly used procedures proportionally in any new stock issues. for voting: majority voting and cumulative • Voting Rights - right to vote for the firm’s voting. board of directors.

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Common Stock Characteristics Example of Proxy Statement Voting Rights • Majority Voting: Each share of stock allows the shareholder one vote, and each position on the board is voted on separately. Because each member of the board is elected by a simple majority, a majority of shares has the power to elect the entire board of directors.

Source: http://img.ehowcdn.com

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7 FIN 3701 Chapter 4 :Preferred and Common Stocks

Common Stock Characteristics

Voting Rights • Cumulative Voting: Each share of stock allows the shareholders a number of votes equal to the number of directors being elected. The shareholders can use all his or Return of Common Stocks her votes for a single candidate or split them among the various candidates. The advantage of cumulative voting is that it gives minority shareholders the power to elect a director.

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Calculating the Realized Return Calculating the Realized Return from an Investment from an Investment (Cont.)

• Realized return or cash return measures the • Example: You invested in 1 share of Apple gain or loss on an investment. (AAPL) for $95 and sold a year later for $200. The company did not pay any dividend during Cash Ending Cash Distribution Beginning = + _ Return Price (Dividend) Price that period. What will be the cash return on this investment?

Source: http://theapplecollection.com

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Calculating the Realized Return Calculating the Realized Return from an Investment (Cont.) from an Investment (Cont.)

• Example: You invested in 1 share of Apple Cash Ending Cash Distribution Beginning = + _ (AAPL) for $95 and sold a year later for $200. Return Price (Dividend) Price The company did not pay any dividend during that period. What will be the cash return on • Cash Return = $200 + 0 - $95 this investment? = $105

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8 FIN 3701 Chapter 4 :Preferred and Common Stocks

Calculating the Realized Return Calculating the Realized Return from an Investment (Cont.) from an Investment (Cont.)

• We can also calculate the rate of return as a • Example: You invested in 1 share of share percentage. It is simply the cash return Apple (AAPL) for $95 and sold a year later for divided by the beginning stock price. $200. The company did not pay any dividend during that period. What will be the rate of Cash Ending Cash Distribution _ Beginning return on this investment? Return Price + (Dividend) Price Rate of = = Return Beginning Beginning Price Price

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Calculating the Realized Return from an Investment (Cont.)

Cash Ending Cash Distribution _ Beginning Return Price + (Dividend) Price Rate of = = Return Beginning Beginning Price Price

• Rate of Return = ($200 + 0 - $95) ÷ 95 = 110.53% • Next table has additional examples on measuring an investor’s realized rate of return from investing in common stock.

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What drives the stock price?

What is the reasonable price for a common stock? Source: http://www.orientalwatchsite.com Valuation techniques “the future cash flows expected by market players” Source: http://www.jobonomics.com

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9 FIN 3701 Chapter 4 :Preferred and Common Stocks

Basic Security Valuation Basic Common Stock Valuation (Single Holding Period) • In general, the intrinsic value of an asset = the present value of the stream of • You expect XYZ stock to pay a $5.50 expected cash flows discounted at an dividend at the end of the year. The stock appropriate required rate of return. price is expected to be $120 at that time. • If you require a 15% rate of return, what would you pay for the stock now? ? 5.50 + 120

Source: http://sombomull.blogspot.com 0 1

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Basic Common Stock Valuation Basic Common Stock Valuation (Single Holding Period) (Single Holding Period)

Solution: Financial Calculator solution: Price or Vcs = (5.50/1.15) + (120/1.15) P/Y =1, I = 15, n=1, FV= 125.50 = 4.783 + 104.348 solve: PV = -109.13 or: = $109.13 P/Y =1, I = 15, n=1, FV= 120, PMT = 5.50 solve: PV = -109.13

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Valuation of Common Stock Valuation of Common Stock (actual approaches to value the stock) (actual approaches to value the stock)

1. Discounted Cash Flow Techniques (DCF) 2. Relative valuation techniques • PV of Dividends (DDM) • Price-earnings ratio (P/E) • PV of Free Cash Flow to Equity (FCFE) • Price-cash flow ratios (P/CF) • PV of Free Cash Flow to Firm (FCFF) • Price-book value ratios (P/BV) • PV of Free Cash Flow to Firm (FCFF) by • Price-sales ratio (P/S) using the percent of sales method

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10 FIN 3701 Chapter 4 :Preferred and Common Stocks

When is a company going to pay Dividend Discount Model it’s dividend (mostly)? (DDM) Product Life Cycle Curve Intrinsic Valuation Decline Introduction Growth Maturity SALES

Source: http://wikimedia.org

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Intrinsic Valuation Stock Value = PV of Dividends Dividend Discount Method • The price of a stock reflects the present value  D of the stock's future dividends Price t • t = period   t t1 (1 rs) • Dt = dividend in period t • k or r = discount rate cs s  D Price t   t What is a constant growth stock? t1 (1 rs) D D D D ˆ 1 2 3  P0  1  2  3  . . .   One whose dividends are expected to 1 rs  1 rs  1 rs  1 rs  grow forever at a constant rate, g.

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How to get “g” Example >>Internal Growth (growing what?) • Let’s assume that the return on equity (ROE) • Use retained earnings to finance new for AA company is 16 percent. investments. • If AA’s management decides to pay all the • Why not debts? Or issuing new stocks? profits out in dividends to its stockholders, the firm will experience no growth internally (right?). • It might become larger by borrowing more money or issuing new stocks (growth externally), but internal growth will come only through the retention of profits (Net Income). Source: http://biomassmagazine.com

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11 FIN 3701 Chapter 4 :Preferred and Common Stocks

Example (Cont.) How to find growth rate (g) • If, however, AA retains all the profits, the g = ROE x retention rate or stockholders’ investment in the firm would g = ROE x (1 – dividend payout ratio) grow by the amount of profits retained, or by Where 16 percent. ROE = net income / total equity(BV) • If, however, management kept only 50 percent of the profits for investment, the Therefore, if only 25 percent of the profits common shareholders’ investment would were retained by AA, we would expect the increase only by half of the 16 percent return common stockholders’ investment in the firm on equity, or by 8 percent. and the value of the stock price to increase or grow by only g= 16% x 0.25 = 4%

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For a constant growth stock, What happens if g > rs? **The most recent 1 dividend     D1 D1 D0 1 g Pˆ  requires r  g.   2 0 s D2 D01 g rs  g t Dt  Dt 1 g • If rs< g, get negative stock price, which is If g is constant, then nonsense. (Gordon’s Growth Model): Preferred • We can’t use model unless (1) g  rs and Stock; g =0 D 1 g D (2) g is expected to be constant forever. ˆ 0   1 P0   rs  g rs  g

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D0 was $2.00 and g is a constant 6%. What’s the stock’s intrinsic value? Find the expected dividends for the next D0 = 2.00, rs = 13%, g = 6%. 3 years, and their PVs. rs = 13%. Constant growth model (Gordon Growth Model): 0 1 2 3 4 g=6% D 1 g D ˆ 0  1 D0=2.00 2.12 2.2472 2.3820 P0   rs  g rs  g 13% 1.8761 1.7599 $2.12 $2.12 = = = $30.29. 1.6508 0.13 - 0.06 0.07

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12 FIN 3701 Chapter 4 :Preferred and Common Stocks

For a stock you have two sources of profit What is the stock’s intrinsic value one ^ (loss): price increase (decrease), and year from now, P1? dividends. Thus, (P1 - P0) + Dividend kt = actual return = D will have been paid, so expected dividends P0 1 (3) are D , D , D and so on. Thus, P1 - P0 Dividend 2 3 4 + P0 P0 D = capital gains yield + dividend yield Pˆ  2 1 Where, rs  g • P1 = value of asset at the end of the period • P0 = value of asset at the beginning or current = $2.2427 = $32.10 of the period 0.07 • k1 = actual return over period "t" • P1 - P0 = capital gain (loss) • yield = return 73 74

Find the expected dividend yield and capital Find the total return during gains (CG) yield during the first year. the first year.

• Total return = Dividend yield + D1 $2.12 Dividend yield = = = 7.0%. Capital gains yield. P0 $30.29 • Total return = 7% + 6% = 13%. • Total return = 13% = r . ^ s P1 - P0 $32.10 - $30.29 • For constant growth stock: CG Yield = = P0 $30.29 Capital gains yield = 6% = g. = 6.0%.

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What would P0 be if g = 0? Rearrange model to rate of return form: The dividend stream would be a perpetuity.  D1 D1 Pˆ  to r s   g. 0 r  g P 0 1 2 3 s 0 rs=13%

2.00 2.00 2.00 ^ Then, rs = $2.12/$30.29 + 0.06 = 0.07 + 0.06 = 13%. ^ D $2.00 P0 = = = $15.38. r 0.13

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13 FIN 3701 Chapter 4 :Preferred and Common Stocks

Nonconstant growth followed by constant Ex2:If we have supernormal growth of growth: 30% for 3 years, then a long-run constant 0 1 2 3 4 ^ r =13% g = 6%, what is P0? r is still 13%. (D0 = 2) s g = 30% g = 30% g = 30% g = 6%

D0 = 2.00 2.60 3.38 4.394 4.6576 • Can no longer use constant growth model. 2.3009 • However, growth becomes constant after 2.6470 3 years. 3.0453 $4.6576 Pˆ   $66.5371 46.1135 3 0.13 0.06 ^ 54.1067 = P0

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Ex3:If g = -6%, would anyone buy the What are the annual dividend and stock? If so, at what price? capital gains yield?

Firm still has earnings and still pays Capital gains yield = g = -6.0%. ^ dividends, so P0 > 0: Dividend yield = 13.0% - (-6.0%) D 1 g D = 19.0%. ˆ 0  1 P0   rs  g rs  g Both yields are constant over time, with the high dividend yield (19%) offsetting the $2.00(0.94) $1.88 negative capital gains yield. = = = $9.89. 0.13 - (-0.06) 0.19

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What Causes Stock Prices to Go Up and Down? EX4: Stock value vs. changes in rs and g

D1 = $2, rs = 10%, and g = 5%: P0 = D1 / (rs-g) = $2 / (0.10 - 0.05) = $40.

What if rs or g change? • Equation indicates that there are three variables that drive share value: g g g • The most recent dividend (D ), 0 rs 4% 5% 6% • Investor’s required rate of return (rcs ), and 9% 40.00 50.00 66.67 • Expected rate of growth in future dividends 10% 33.33 40.00 50.00 (g). 11% 28.57 33.33 40.00

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14 FIN 3701 Chapter 4 :Preferred and Common Stocks

Are volatile stock prices consistent Intrinsic Valuation with rational pricing? Dividend Discount Method • Small changes in expected g and rs cause large changes in stock prices. • Limitations of the Dividend Discount Model • As new information arrives, investors • Potential errors in estimating dividends continually update their estimates of g and • Potential errors in estimating growth rate rs. • Potential errors in estimating required return • Not all firms pay dividends –Technology firms –Biomedical firms

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Valuation of Common Stock Valuation of Common Stock (actual approaches to value the stock) (actual approaches to value the stock)

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Relative Valuation Mr. S wanna buy a new house in Using the Stock Price Multiples Washington DC.

Source: http://presstv.ir

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15 FIN 3701 Chapter 4 :Preferred and Common Stocks

What about He knows what he wants How much should it be? here? How do I know?

Not a chance bro!

Source: http://s2.hubimg.com Source: http://real-estate-washingtondc.com & universityofmakeup.com 91 92

Mr. S goes around looking at the prices So.. He goes around looking at the prices paid for houses in the neighborhood paid for similar houses (in terms of the quality) in the neighborhood Is cheaper better?

$100,000

Nope! AVG the prices Coz… diff quality And his house should never be more expensive than the AVG prices for the same quality houses In the same $25,000 area>>> relative price Source: http://cebuhomeproperties.wordpress.com & http://fineartamerica.com Source: http://www.monterose.com, mrwilliamsburg.com & 2.imimg.com 93 94

What about stocks? >>So… before you compare, you got to (sector: technology, industry:personel standardize first! computer) HOW? Divided the price by a common variable such as cash flow, risk and growth rate • Current Multiples $14.3 / share $366.99 / share $25.78 / share Create multiples • Trial Multiples Unit: times (X) • Forward Multiples *** Is cheaper better? Can you even compare the prices? P/E, P/S, P/CF, P/BV Source: http:// latestlaptop.biz, theapplecollection.com & gemind.com.br 95 96

16 FIN 3701 Chapter 4 :Preferred and Common Stocks

Multiple: Forward P/E Relative Valuation

Where E is expected Price-Earnings (PE) Method earning next year

• Apply the average PE ratio of publicly traded competitors • Use expected earnings rather than historical • Equation: 7.08X 4.5X 5.57X Company’s Which one is cheapest in terms of Stock = Expected EPS x AVG industry PE ratio expected earning? Price

Source: http:// latestlaptop.biz, theapplecollection.com & gemind.com.br 97 98

Valuing Common Stock Using the Valuing Common Stock Using the P/E Ratio P/E Ratio (Cont.)

The Heels Shoe Company sells a line of athletic The investment banker has suggested that this price shoes for children and young adults including cleats can be estimated by looking at the P/E multiples of and other specialty footwear used for various types other publicly traded firms that are in the same of sports. The company is privately owned and is general business as the Heels Shoe Company and considering the sale of a portion of its shares to the multiplying their average P/E ratio by Heels’ public. The company owners are currently in expected EPS for the coming year. Last year the discussions with an investment banker who has Heels Shoe Company had earnings of $1.65 per offered to manage the sale of shares to the public. share for the 12-month period ended in March, 2009. The critical point of their discussion is the price that Heels’ CFO estimates that company earnings for Heels might expect to receive upon the sale of its 2010 will be $1.83 a share. shares.

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Valuing Common Stock Using the Valuing Common Stock Using the P/E Ratio (Cont.) P/E Ratio (Cont.)

The investment banker suggested that estimation of • What is your estimate of the price of an appropriate P/E ratio involves looking at the P/E Heels’ shares based on the above comparable multiples for similar companies. As a preliminary P/E ratios? step they suggested that Heels’ management team consider the P/E multiples of three companies: P/E Ratio Deckers Outdoor Corp. (DECK), Nike (NKE), and Timberland Co. (TBL). The expected P/E ratios for Deckers 26.85 these firms are as follows: Nike 18.79 Timberland 22.18 Average 22.61

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17 FIN 3701 Chapter 4 :Preferred and Common Stocks

STEP 1: Picture the problem STEP 2: Decide on a solution strategy The P/E valuation method is deceptively P/E Valuation (2009) 45 $41.38 simple in that the analytics are simple. 40 The estimated price per share is simply the 35 product of the firm's estimated earnings per 30 share for the coming year multiplied by 25 $22.61 what the analyst estimates to be an 20 appropriate P/E ratio. That is, substitute 15 10 into Equation (10-4): 5 $1.83 0 Vcs = P/E1 x E1 Earnings per share x P/E multiple = Stock price

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STEP 3: Solve STEP 4: Analyze (Cont.) Substituting Equation (10-4) we estimate Also, since the sale of a privately held that Heels' share price to be $41.38: company's shares to the public can take several months, this estimate is contingent Vcs = P/E1 x E1 = 22.61 x $1.83 = $41.38 on no significant changes in the market. STEP 4: Analyze For example, if inflation worsens and the country slips into a recession, the P/E Based on the P/E ratios of these three multiples of all public companies may fall. comparable firms we estimate the offering For this reason the final offering price for a price of Heels' shares to be $41.38. firm's shares that are being sold to the public However, this estimate is contingent on is typically set the night before the offering the appropriateness of the comparable set and reflects the most recent P/E ratios of of companies to the Heels Shoe Company. comparable firms.

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Relative Valuation Decision Rule Problems with Market Multiple Methods • Market P/E > Industry P/E > Stock P/E (Undervalued) • It is often hard to find comparable firms. • Differences in earnings forecasts (differences • Market P/E < Industry P/E < Stock P/E in accounting method and window dressing). (Overvalued) • The average ratio for the sample of • Market P/E > Industry P/E < Stock P/E comparable firms often has a wide range. (Overvalued compared to the market) • 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? (you are going to use mean, mode, median or what?) 107 108

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Intrinsic vs. Relative Valuation

“Relative valuation should be thought of not as a substitute but as a complement of intrinsic valuation” How to Read the Stock Table

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Common Stock Price Quotes Common Stock Price Quotes The following is typical of what you would see if you looked The following is typical of what you would see if you looked

at www.google.com/finance. 52Wk High and at www.google.com/finance. 52Wk Low: These are the highest and Stock Price and Name and Symbol: Open, High Mkt Cap: lowest prices paid for Change from These are used to and Low: On this Market the stock over the pas (Public NYSE: DIS) Previous Day: For identify the stock. day, Disney's stock Cap refers The Walt Disney Company 52 weeks, excluding Disney, the current For example, the price opened the to the total 23.19 the latest day's trading. price is $23.19, symbol for Disney is day at $23.08, and value of all 23.08 Mkt Cap: 43.06B 12.59 Dividend: 0.35 These prices will give -0.36(-1.53%) Open: P/E: which represents a "DIS." You can also ranged between the you a sense of the Dividend and Yield: High: 23.25 52Wk High: 34.85 EP/E: - Yield: 1.51 decline of 1.53% or use the stock's a high of $23.25 company's Real-time: 12:40PM EDT direction the stock Dividend is the stock's $0.36 from the symbol when using and a low of $22.95. common Low: 22.95 52Wk Low: 15.14 Beta: 1.11 Shares: 1.86B price is taking-whether annual cash dividend, previous day's online systems to stock its price is generally while Yield is the dividend Volume: 5.02M Avg. Vol: 17.60M EPS: 1.84 Inst. Own: 67% closing price. look up information outstanding. yield, which is obtained by on the stock. going up or down and by how much. dividing the firm's annual cash dividend by the closing price of the stock The Walt Disney Company (Public NYSE: DIS) The Walt Disney Company (Public NYSE: DIS) that day.

23.19 Open: 23.08 Mkt Cap: 43.06B P/E: 12.59 Dividend: 0.35 23.19 -0.36(-1.53%) High: 23.25 52Wk High: 34.85 EP/E: - Yield: 1.51 Real-time: 12:40PM EDT Low: 22.95 52Wk Low: 15.14 Beta: 1.11 Shares: 1.86B -0.36(-1.53%) Volume: 5.02M Avg. Vol: 17.60M EPS: 1.84 Inst. Own: 67% Real-time: 12:40PM EDT

Vol and Avg. Vol: Vol P/E, F P/E: P/E stands for price-earnings ratio (P/E ratio, EPS: The Beta: A Shares, Inst. Own: represents the number, also called the "earning multiple"). The P/E ratio is the earnings measure of Shares represents number or volume, of shares of stock's price divided by the firm on a per-share basis per share. the relation- of shares outstanding stock that were traded over the previous 12 months. In effect, it states the ship between while Inst. Own identifies so far during the day, multiple that investors are willing to pay for one dollar of an the percent of the shares Stock Price and Change from Previous Day: while Avg Vol earnings. High P/Es may result as investors are willing investment's outstanding that are owned represents the average to pay more for a dollar of earnings because they returns and by institutions such as volume on a typical day. believe that earnings will grow dramatically in the future. the market's mutual funds and For Disney, the current price is $23.19, which Low P/Es are generally interpreted as an indication of returns and institutional ownership. poor or risky future prospects. F P/E is the forward the market's represents a decline of 1.53% or $0.36 from the price-earnings ratio, and uses estimated earnings over returns. It will next 12 months. If there is no estimate, it is not given. be discussed in detail later. previous day‘s closing price.

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Common Stock Price Quotes Common Stock Price Quotes The following is typical of what you would see if you looked The following is typical of what you would see if you looked at www.google.com/finance. at www.google.com/finance.

The Walt Disney Company (Public NYSE: DIS) The Walt Disney Company (Public NYSE: DIS) 23.19 23.19 -0.36(-1.53%) Open: 23.08 Mkt Cap: 43.06B P/E: 12.59 Dividend: 0.35 -0.36(-1.53%) Open: 23.08 Mkt Cap: 43.06B P/E: 12.59 Dividend: 0.35 Real-time: 12:40PM EDT High: 23.25 52Wk High: 34.85 EP/E: - Yield: 1.51 Real-time: 12:40PM EDT High: 23.25 52Wk High: 34.85 EP/E: - Yield: 1.51 Low: 22.95 52Wk Low: 15.14 Beta: 1.11 Shares: 1.86B Low: 22.95 52Wk Low: 15.14 Beta: 1.11 Shares: 1.86B Volume: 5.02M Avg. Vol: 17.60M EPS: 1.84 Inst. Own: 67% Volume: 5.02M Avg. Vol: 17.60M EPS: 1.84 Inst. Own: 67%

(Public NYSE: DIS) The Walt Disney Company Open: 23.08 Mkt Cap: 43.06B 23.19 High: 23.25 52Wk High: 34.85 -0.36(-1.53%) Low: 22.95 52Wk Low: 15.14 Real-time: 12:40PM EDT Volume: 5.02M Avg. Vol: 17.60M

Name and Symbol: These are used to identify : On this day, Disney's the stock. For example, the symbol for Disney is Open, High and Low stock price opened the day at $23.08, and "DIS." You can also use the stock's symbol when ranged between a high of $23.25 and a low of using online systems to look up information on $22.95. the stock. 113 114

19 FIN 3701 Chapter 4 :Preferred and Common Stocks

Open: 23.08 Mkt Cap: 43.06B Open: 23.08 Mkt Cap: 43.06B High: 23.25 52Wk High: 34.85 High: 23.25 52Wk High: 34.85 Low: 22.95 52Wk Low: 15.14 Low: 22.95 52Wk Low: 15.14 Volume: 5.02M Avg. Vol: 17.60M Volume: 5.02M Avg. Vol: 17.60M 52Wk High and 52Wk Low: These are the highest Mkt Cap: Market Cap refers to the total value and lowest prices paid for the stock over the pas 52 weeks, excluding the latest day's trading. These of all the company's common stock outstanding. prices will give you a sense of the direction the stock price is taking-whether its price is generally going up or down and by how much. 115 116

Common Stock Price Quotes The following is typical of what you would see if you looked P/E: 12.59 Dividend: 0.35 at www.google.com/finance. EP/E: - Yield: 1.51 Beta: 1.11 Shares: 1.86B

The Walt Disney Company (Public NYSE: DIS) EPS: 1.84 Inst. Own: 67% 23.19 -0.36(-1.53%) Open: 23.08 Mkt Cap: 43.06B P/E: 12.59 Dividend: 0.35 Real-time: 12:40PM EDT High: 23.25 52Wk High: 34.85 EP/E: - Yield: 1.51 Low: 22.95 52Wk Low: 15.14 Beta: 1.11 Shares: 1.86B P/E, F P/E: P/E stands for price-earnings ratio (P/E Volume: 5.02M Avg. Vol: 17.60M EPS: 1.84 Inst. Own: 67% ratio, also called the "earning multiple"). The P/E ratio is the stock's price divided by the firm on a 23.08 43.06B per-share basis over the previous 12 months. In Open: Mkt Cap: effect, it states the multiple that investors are willing High: 23.25 52Wk High: 34.85 to pay for one dollar of earnings. High P/Es may Low: 22.95 52Wk Low: 15.14 result as investors are willing to pay more for a Volume: 5.02M Avg. Vol: 17.60M dollar of earnings because they believe that earnings will grow dramatically in the future. Low P/Es are generally interpreted as an indication of Vol and Avg. Vol: Vol represents the number, or poor or risky future prospects. F P/E is the forward volume, of shares of stock that were traded so far price-earnings ratio, and uses estimated earnings during the day, while Avg Vol represents the over next 12 months. If there is no estimate, it is not average volume on a typical day. given.

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P/E: 12.59 Dividend: 0.35 P/E: 12.59 Dividend: 0.35 EP/E: - Yield: 1.51 EP/E: - Yield: 1.51 Beta: 1.11 Shares: 1.86B Beta: 1.11 Shares: 1.86B EPS: 1.84 Inst. Own: 67% EPS: 1.84 Inst. Own: 67%

Beta: A measure of the relationship between an investment's returns and the market's returns EPS: The earnings per share. and the market's returns. It will be discussed in detail later.

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20 FIN 3701 Chapter 4 :Preferred and Common Stocks

P/E: 12.59 Dividend: 0.35 P/E: 12.59 Dividend: 0.35 EP/E: - Yield: 1.51 EP/E: - Yield: 1.51 Beta: 1.11 Shares: 1.86B Beta: 1.11 Shares: 1.86B EPS: 1.84 Inst. Own: 67% EPS: 1.84 Inst. Own: 67%

Dividend and Yield: Dividend is the stock's Shares, Inst. Own: Shares represents number annual cash dividend, while Yield is the dividend of shares outstanding while Inst. Own identifies yield, which is obtained by dividing the firm's the percent of the shares outstanding that are annual cash dividend by the closing price of the owned by institutions such as mutual funds and stock that day. institutional ownership.

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Advantages of issuing a preferred stock

• Preferred dividends do not have to be paid (important during periods of financial distress). Interest on debt must be paid. Pros & Cons • Preferred stockholders cannot force the company into bankruptcy. • Preferred shareholders do not share in unusually high profits because the common stockholders are the real owners of the business.

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Advantages of issuing a preferred Advantages of issuing a preferred stock (cont.) stock (cont.)

• A growth company can generate better • The company does not have to collateralize earnings for its original owners by issuing its assets as it may have to do if bonds are preferred stock having a fixed dividend rate issued. than by issuing common stock. • The debt to equity ratio is improved (lower • Preferred stock issuance does not dilute the D/E) ownership interest of common stockholders in terms of earnings participation and voting rights.

Source: http://investments.academic.ru 125 126

21 FIN 3701 Chapter 4 :Preferred and Common Stocks

Disadvantages of issuing a To investors, a preferred stock preferred stock offers the followings:

• Preferred stock must offer a higher yield • Preferred stock usually provides a constant than corporate bonds because it carries return in the form of a fixed dividend greater risk (since preferred stock comes payment. after bonds in corporate liquidation). • Preferred stockholders come before common • Preferred dividends are not tax deductible. stockholders in the event of corporate • Preferred stock has higher flotation costs bankruptcy. than bonds.

Source: Source: http://www.teensguidetomoney.com http://www.teensguidetomoney.com 127 128

Disadvantages to investors(cont.) Financing with common stock has the following advantages (Think as CFO): • Return is limited because of the fixed dividend rate. • The company is not required to pay fixed • Prices of preferred stock fluctuate more than charges such as interest or dividends. those of bonds because there is no maturity • There is no repayment date or sinking fund date on the stock. requirement. • Preferred stockholders cannot require the • A common stock issue improves the company to pay dividends if the firm has company’s credit rating compared to a bond inadequate earnings. issue. For example, it improves the debt- equity ratio.

Source: http://img.ehowcdn.com Source: http://slimintrading.com 129 130

Financing with common stock has Debt vs. Equity disadvantages (cont.):

• Dividends are not tax deductible. Fixed Claim Residual Claim Tax Deductible Not Tax Deductible • Ownership interest is diluted. The additional High Priority in Financial Trouble Lowest Priority in Financial Trouble voting rights might vote to remove the current Fixed Maturity Infinite No Management Control Management Control ownership group from power. • Earnings and dividends must be spread over Debt Hybrid Securities Equity more shares outstanding. Bank Debt Convertible Debt Owner's Equity Commercial Paper Preferred Stock Venture Capital • The floatation costs of a common Corporate Bonds Option-linked Bonds Common Stock stock issue are higher than those for Warrants preferred stock and debt financing. Source: http://www.buzzle.com 131 132

22 FIN 3701 Chapter 4 :Preferred and Common Stocks

Summary comparison of bonds and Summary comparison of bonds and common stock common stock (Cont.) Bonds Common Stock Bonds Common Stock • Bondholders are • Stockholders are • Interest payments are • There is no tax creditors. owners. deductible on the tax deductibility for dividend • No voting rights exist. • Voting rights exist. return. payments. • There is a maturity • There is no maturity • The rate of return • The rate of return date. date. required by bondholders required by is typically lower than stockholders is typically • Bondholders have prior • Stockholders have that required by greater than that claims on profits and residual claims on stockholders. required by assets in bankruptcy. profits and assets in bondholders. • Interest payments bankruptcy. represent fixed • Dividend payments do charges. not constitute fixed charges. 133 134

Summary of Discounted Cash Flow Valuation of Bonds, Summary of Discounted Cash Flow Valuation of Bonds, Preferred Stock, and Common Stock Preferred Stock, and Common Stock(cont.)

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Summary of Discounted Cash Flow Valuation of Bonds, Summary of Discounted Cash Flow Valuation of Bonds, Preferred Stock, and Common Stock (Cont.) Preferred Stock, and Common Stock (Cont.)

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23 FIN 3701 Chapter 4 :Preferred and Common Stocks

Selecting a long-term financing method: Selecting a long-term financing method: An Introduction to Cost of Capital An Introduction to Cost of Capital (Cont.)

• The cost and risk of alternative financing • The current debt-to-equity ratio. A very high ratio, strategies. for example, indicates financial risk, so additional funds should come from equity sources. • Future trends in market conditions and their impact on future fund availability and interest • The maturity dates of present debt instruments. For example, the company should avoid having all rates. For example, if interest rates are debt come due at the same time; in an economic expected to go up, the company will be downturn, it may not have adequate funds to meet better off financing with long-term debt at the required debt payments. currently lower interest rates. If stock prices • The restrictions in loan agreements. For instance, are high, equity issuance may be preferred a restriction may place a cap on the allowable over debt. debt-equity ratio.

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Selecting a long-term financing method: Selecting a long-term financing method An Introduction to Cost of Capital (Cont.) • The amount, nature, and stability of internally • The type and amount of collateral required generated funds. If earnings are stable, the by long-term creditors. company will be better able to meet debt • The company’s ability to change financing obligations. strategy to adjust to changing economic • The adequacy of present lines of credit to conditions. For example, a company subject meet current and future needs. to large cyclical variations should have less debt because it may not be able to meet • The inflation rate, since debt is repaid in principal and interest at the low point of the cheaper dollars. cycle. If earnings are unstable and/or there is a highly competitive environment, more emphasis should be given to equity financing.

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Selecting a long-term financing method Selecting a long-term financing method

• The earning power and liquidity position of • The uncertainty of large expenditures. the company. For example, a liquid company If huge cash outlays may be required (e.g., is able to meet debt payments. for a lawsuit or the acquisition of another • The nature and risk of assets. High-quality company), additional debt capacity should assets in terms of cash realizability allow for be available. greater debt. • The tax rate. For example, a higher tax rate • The nature of the product line. A company, makes debt more attractive because interest for example, that faces obsolescence risk in expense is tax deductible. its product line (e.g., computers) should refrain from overusing debt.

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Dividend Policy

Definition: Dividend is the distribution of value to shareholders. Dividend Policy: What happens to the value of the firm as dividend is increased, holding everything else Dividend Policy and (capital budgets, borrowing) constant. Thus, it is a trade-off between retained earnings on one hand, Stock Split and distributing cash or securities on the other.

Source: http://getpaydayloantoday.com

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Cash Dividend Stock Dividend “an offer to purchase some or all Example: $.5 for every share you hold 2 Of shareholders’ shares Stock Repurchase in a corporation. Regular, regular + “extra” , special Method The price offered is in the open market usually at a premium Dates: tender offer To the market price.” direct negotiation with major shareholders Reasons 1/15 1/26 1/30 2/25 Alternative to "extra" or special dividend. Declaration Ex-dividend Record Payment Example. A company just sold a division and Date Date Date Date cannot use the proceeds for favorable Only investors who hold the security prior to investments. the ex-divided date receive the dividend. If management believes the stock is under-valued.

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Stock Split Reference

• Example. (2-1 split), i.e., for every share you • Sheridan Titman, Arthur J. Keown, John D. Martin, own, now you own two. Financial Management: Principles and Applications(12thed). New Jersey: Pearson & • Argument for splits: To make stock "more Prentice Hall Inc, 2014. attractive" to investors?! • Value of firm is not expected to change.

Source: http://lh4.ggpht.com

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25 FIN 3701 Chapter 4 :Preferred and Common Stocks

References for images References for images • http://www.quotespin.com/54-warren-buffett/2/ • http://biomassmagazine.com/articles/5787/global-pellet-industry-on-the- • http://bgr.com/2007/06/27/google-worth-600-a-share/ rise-sustainability-key • http://i0.sinaimg.cn/cj/2014/0324/U10563P31DT20140324092425.jpg • http://previous.presstv.ir/photo/20130910/bavarsad20130910182556567 • http://www.palmbeachperfumes.com/images/Preferred%20Stock%201o .jpg z%20Cologne%20Spray.jpg • http://www.real-estate-washingtondc.com/Left-Image-Washington- • http://images.computerwoche.de/images/computerwoche/bdb/1866369/ DC.jpg 890.jpg • http://www.universityofmakeup.com/wp- • http://img.ehowcdn.com/article-new- content/uploads/Washington_DC-300x195.jpg thumbnail/ehow/images/a05/1g/ut/board-directors-rights-800x800.jpg • http://cebuhomeproperties.wordpress.com/ • http://iphone.theapplecollection.com/photos/14/med_black_and_gray_a pple_logo.jpg • http://fineartamerica.com/featured/that-very-old-house-murphy- elliott.html • http://www.jobonomics.com/1/03/how-to-prepare-for-an-interview/ • http://upload.wikimedia.org/wikipedia/commons/thumb/c/cd/Facade_of_ • http://www.monterose.com/wp-content/uploads/2014/04/Screen-Shot- New_York_Stock_Exchange.jpg/1280px- 2014-04-30-at-9.00.55-AM.png Facade_of_New_York_Stock_Exchange.jpg • http://mrwilliamsburg.com/search-homes-for-sale/ • http://sombomull.blogspot.com/2012/04/calculation-of-intrinsic- • http://2.imimg.com/data2/SE/XU/MY-3040106/real-estate-properties- value.html 500x500.jpg 151 152

References for images • http://latestlaptop.biz/dell-logo-png/ • http://www.gemind.com.br/wp-content/uploads/2011/12/novo-logo- hp.png • http://investments.academic.ru/pictures/investments/img1966782_Sertifi kat_privilegirovannoy_aktsii_American_Cities_Company.png • http://www.teensguidetomoney.com/investing/stock-types-common-- preferred/ • http://img.ehowcdn.com/article-new- thumbnail/ehow/images/a06/7j/fv/comparing-preferred-stock-common- stock-800x800.jpg • http://slimintrading.com/agenda-dag-126/4635/ • http://www.buzzle.com/articles/stock-investing/ • http://getpaydayloantoday.com/wp-content/uploads/2014/05/payday-12- 703x420.jpg • http://lh4.ggpht.com/-FdchvxWLW- w/TenS0PwOMdI/AAAAAAAAEF0/K02ACNq7kz8/stock%252520split%2 5255B1%25255D.jpg?imgmax=800 • http://s2.hubimg.com/u/2091319_f520.jpg 153