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Chapter Across the Disciplines


7
Why This Chapter Matters To You
Accounting: You need to understand the
difference between debt and equity in
terms of tax treatment; the ownership
claims of capital providers, including
venture capitalists and stockholders; and

Stock why book value per share is not a sophisti-
cated basis for common stock valuation.
Information systems: You need to under-
Valuation stand the procedures used to issue com-
mon stock; the sources and types of infor-
mation that impact stock value; and how
such information can be used in stock val-
uation models to link proposed actions to
share price.
Management: You need to understand
the difference between debt and equity
capital; the rights and claims of stock-
holders; the process of raising funds from
venture capitalists and through initial
LEARNING GOALS public offerings; and how the market will
use various stock valuation models to
Differentiate between debt and equity value the firm™s common stock.
LG1
capital.
Marketing: You need to understand that
Discuss the rights, characteristics, the firm™s ideas for products and services
LG2
and features of both common and will greatly affect the willingness of ven-
preferred stock. ture capitalists and stockholders to con-
tribute capital to the firm and also that a
Describe the process of issuing
LG3
perceived increase in risk as a result of
common stock, including in your
discussion venture capital, going new projects may negatively affect the
public, the investment banker™s role, firm™s stock value.
and stock quotations.
Operations: You need to understand that
Understand the concept of market the amount of capital the firm has to invest
LG4
efficiency and basic common stock in plant assets and inventory will depend
valuation under the zero-growth and on the evaluations of venture capitalists
constant-growth models.
and would-be investors; the better the
prospects look for growth, the more
Discuss the free cash flow valuation
LG5
model and the use of book value, money the firm will have for operations.
liquidation value, and price/earnings
(P/E) multiples to estimate common
stock values.
Explain the relationships among
LG6
financial decisions, return, risk, and
the firm™s value.
264
265
CHAPTER 7 Stock Valuation



O wning corporate stock is a popular investment activity. Each weekday, the
news media report on the movements of stock prices in the financial mar-
kets. The price of each share of a firm™s common stock is driven by the cash flows
(dividends) owners expect to receive from owning the stock and the perceived
riskiness of those forecasted cash flows. This chapter describes the key aspects of
corporate stock and continues our discussion of the valuation process”this time,
of the valuation of stock.




Differences Between
LG1

Debt and Equity Capital
The term capital denotes the long-term funds of a firm. All items on the right-
capital
The long-term funds of a firm; all hand side of the firm™s balance sheet, excluding current liabilities, are sources of
items on the right-hand side of capital. Debt capital includes all long-term borrowing incurred by a firm, includ-
the firm™s balance sheet, exclud-
ing bonds, which were discussed in Chapter 6. Equity capital consists of long-
ing current liabilities.
term funds provided by the firm™s owners, the stockholders. A firm can obtain
debt capital equity capital either internally, by retaining earnings rather than paying them out
All long-term borrowing incurred
as dividends to its stockholders, or externally, by selling common or preferred
by a firm, including bonds.
stock. The key differences between debt and equity capital are summarized in
equity capital Table 7.1 and discussed below.
The long-term funds provided by
the firm™s owners, the stock-
holders.
Voice in Management
Unlike creditors (lenders), holders of equity capital (common and preferred
stockholders) are owners of the firm. Holders of common stock have voting
rights that permit them to select the firm™s directors and to vote on special issues.
In contrast, debtholders and preferred stockholders may receive voting privileges
only when the firm has violated its stated contractual obligations to them.



TABLE 7.1 Key Differences Between Debt and
Equity Capital

Type of capital

Characteristic 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 deduction No deduction
aIn the event that the issuer violates its stated contractual obligations to them, debthold-
ers and preferred stockholders may receive a voice in management; otherwise, only com-
mon stockholders have voting rights.
266 PART 2 Important Financial Concepts


Claims on Income and Assets
Holders of equity have claims on both income and assets that 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. After satisfying these claims, the firm™s board of directors decides
whether to distribute dividends to the owners.
The equity holders™ claims on assets also are secondary to the claims of cred-
itors. If the firm fails, its assets are sold, and the proceeds are distributed in this
order: employees and customers, the government, creditors, and (finally) equity
holders. Because equity holders are the last to receive any distribution of assets,
they expect greater returns from dividends and/or increases in stock price.
As is explained in Chapter 10, the costs of equity financing are generally
higher than debt costs. One reason is that the suppliers of equity capital take
more risk because of their subordinate claims on income and assets. Despite
being more costly, equity capital is necessary for a firm to grow. All corporations
must initially be financed with some common stock equity.



Maturity
Unlike debt, equity capital is a permanent form of financing for the firm. It does
not “mature” so repayment is not required. Because equity is liquidated only dur-
ing bankruptcy proceedings, stockholders must recognize that although a ready
market may exist for their shares, the price that can be realized may fluctuate.
This fluctuation of the market price of equity makes the overall returns to a firm™s
stockholders even more risky.



Tax Treatment
Interest payments to debtholders are treated as tax-deductible expenses by the
issuing firm, whereas dividend payments to a firm™s common and preferred stock-
holders are not tax-deductible. The tax deductibility of interest lowers the cost of
debt financing, further causing it to be lower than the cost of equity financing.


Review Question

7“1 What are the key differences between debt capital and equity capital?




Common and Preferred Stock
LG2 LG3


A firm can obtain equity, or ownership, capital by selling either common or pre-
ferred stock. All corporations initially issue common stock to raise equity capital.
Some of these firms later issue either additional common stock or preferred stock
267
CHAPTER 7 Stock Valuation


to raise more equity capital. Although both common and preferred stock are
forms of equity capital, preferred stock has some similarities to debt capital that
significantly differentiate it from common stock. Here we first consider the key
features and behaviors of both common and preferred stock and then describe
the process of issuing common stock, including the use of venture capital.



Common Stock
The true owners of business firms are the common stockholders. Common stock-
holders are sometimes referred to as residual owners because they receive what is
left”the residual”after all other claims on the firm™s income and assets have
been satisfied. They are assured of only one thing: that they cannot lose any more
than they have invested in the firm. As a result of this generally uncertain posi-
tion, common stockholders expect to be compensated with adequate dividends
and, ultimately, capital gains.


Ownership
privately owned (stock)
The common stock of a firm can be privately owned by a single individual,
All common stock of a firm
owned by a single individual. closely owned by a small group of investors (such as a family), or publicly owned
by a broad group of unrelated individual or institutional investors. Typically,
closely owned (stock)
small corporations are privately or closely owned; if their shares are traded, this
All common stock of a firm
owned by a small group of occurs infrequently and in small amounts. Large corporations, which are empha-
investors (such as a family).
sized in the following discussions, are publicly owned, and their shares are gener-
ally actively traded on the major securities exchanges described in Chapter 1.
publicly owned (stock)
Common stock of a firm owned by
a broad group of unrelated indi-
Par Value
vidual or institutional investors.

Unlike bonds, which always have a par value, common stock may be sold with or
par value (stock)
A relatively useless value for a without a par value. The par value of a common stock is a relatively useless value
stock established for legal pur-
established for legal purposes in the firm™s corporate charter. It is generally quite
poses in the firm™s corporate
low, about $1.
charter.
Firms often issue stock with no par value, in which case they may assign the
preemptive right
stock a value or record it on the books at the price at which it is sold. A low par
Allows common stockholders to
value may be advantageous in states where certain corporate taxes are based on
maintain their proportionate
the par value of stock; if a stock has no par value, the tax may be based on an
ownership in the corporation
arbitrarily determined per-share figure.
when new shares are issued.

dilution of ownership
Occurs when a new stock issue
Preemptive Rights
results in each present share-
holder having a claim on a The preemptive right allows common stockholders to maintain their proportion-
smaller part of the firm™s
ate ownership in the corporation when new shares are issued. It allows existing
earnings than previously.
shareholders to maintain voting control and protects them against the dilution of
rights their ownership. Dilution of ownership usually results in the dilution of earnings,
Financial instruments that permit
because each present shareholder has a claim on a smaller part of the firm™s earn-
stockholders to purchase addi-
ings than previously.
tional shares at a price below the
In a rights offering, the firm grants rights to its shareholders. These financial
market price, in direct proportion
instruments permit stockholders to purchase additional shares at a price below
to their number of owned shares.
268 PART 2 Important Financial Concepts


the market price, in direct proportion to their number of owned shares. Rights
are used primarily by smaller corporations whose shares are either closely owned
or publicly owned and not actively traded. In these situations, rights are an
important financing tool without which shareholders would run the risk of losing
their proportionate control of the corporation.
From the firm™s viewpoint, the use of rights offerings to raise new equity cap-
ital may be less costly and may generate more interest than a public offering of
stock. An example may help to clarify the use of rights.

Dominic Company, a regional advertising firm, currently has 100,000 shares of
EXAMPLE
common stock outstanding and is contemplating a rights offering of an addi-
tional 10,000 shares. Each existing shareholder will receive one right per share,
and each right will entitle the shareholder to purchase one-tenth of a share of new
common stock (10,000 100,000), so 10 rights will be required to purchase one
share of the stock. The holder of 1,000 shares (1 percent) of the outstanding com-
mon stock will receive 1,000 rights, each permitting the purchase of one-tenth of
a share of new common stock, for a total of 100 new shares. If the shareholder
exercises the rights, he or she will end up with a total of 1,100 share of common
stock, or 1 percent of the total number of shares then outstanding (110,000).
authorized shares
Thus, the shareholder maintains the same proportion of ownership he or she had
The number of shares of
prior to the rights offering.
common stock that a firm™s
corporate charter allows it
to issue.
Authorized, Outstanding, and Issued Shares
outstanding shares
The number of shares of common
A firm™s corporate charter indicates how many authorized shares it can issue.
stock held by the public.
The firm cannot sell more shares than the charter authorizes without obtaining
treasury stock approval through a shareholder vote. To avoid later having to amend the
The number of shares of out-
charter, firms generally attempt to authorize more shares than they initially plan
standing stock that have been
to issue.
repurchased by the firm.
Authorized shares become outstanding shares when they are held by the pub-
issued shares lic. If the firm repurchases any of its outstanding shares, these shares are recorded
The number of shares of common
as treasury stock and are no longer considered to be outstanding shares. Issued
stock that have been put into
shares are the shares of common stock that have been put into circulation; they
circulation; the sum of outstand-
represent the sum of outstanding shares and treasury stock.
ing shares and treasury stock.


Golden Enterprises, a producer of medical pumps, has the following stockhold-
EXAMPLE
ers™ equity account on December 31:

Stockholders™ Equity
Common stock”$0.80 par value:
Authorized 35,000,000 shares;
issued 15,000,000 shares $ 12,000,000
Paid-in capital in excess of par 63,000,000
Retained earnings 31,000,000
$106,000,000
Less: Cost of treasury stock (1,000,000 shares) 4,000,000
Total stockholders™ equity $102,000,000
269
CHAPTER 7 Stock Valuation


How many shares of additional common stock can Golden sell without gain-
ing approval from its shareholders? The firm has 35 million authorized shares, 15
million issued shares, and 1 million shares of treasury stock. Thus 14 million
shares are outstanding (15 million issued shares 1 million shares of treasury
stock), and Golden can issue 21 million additional shares (35 million authorized
shares 14 million outstanding shares) without seeking shareholder approval.
This total includes the treasury shares currently held, which the firm can reissue
to the public without obtaining shareholder approval.


Voting Rights
Generally, each share of common stock entitles its holder to one vote in the elec-
tion of directors and on special issues. Votes are generally assignable and may be
cast at the annual stockholders™ meeting.
In recent years, many firms have issued two or more classes of common
stock; they differ mainly in having unequal voting rights. A firm can use different
classes of stock as a defense against a hostile takeover in which an outside group,
without management support, tries to gain voting control of the firm by buying
its shares in the marketplace. Supervoting shares of stock give each owner multi-
supervoting shares
Stock that carries with it ple votes. When supervoting shares are issued to “insiders,” an outside group,
multiple votes per share rather whose shares have only one vote each typically cannot obtain enough votes to
than the single vote per share
gain control of the firm. At other times, a class of nonvoting common stock is
typically given on regular shares
issued when the firm wishes to raise capital through the sale of common stock but
of common stock.
does not want to give up its voting control.
nonvoting common stock
When different classes of common stock are issued on the basis of unequal
Common stock that carries no
voting rights, class A common is typically”but not universally”designated as
voting rights; issued when the
nonvoting, and class B common has voting rights. Generally, higher classes of
firm wishes to raise capital
shares (class A, for example) are given preference in the distribution of earnings
through the sale of common
stock but does not want to give (dividends) and assets; lower-class shares, in exchange, receive voting rights.
up its voting control.
Treasury stock, which is held within the corporation, generally does not have
voting rights, does not earn dividends, and does not have a claim on assets in
liquidation.
Because most small stockholders do not attend the annual meeting to vote, they
may sign a proxy statement giving their votes to another party. The solicitation of
proxy statement
A statement giving the votes of a proxies from shareholders is closely controlled by the Securities and Exchange
stockholder to another party.
Commission to ensure that proxies are not being solicited on the basis of false or
misleading information. Existing management generally receives the stockholders™
proxy battle
proxies, because it is able to solicit them at company expense.
The attempt by a nonmanagement
group to gain control of the man- Occasionally, when the firm is widely owned, outsiders may wage a proxy
agement of a firm by soliciting a
battle to unseat the existing management and gain control. To win a corporate
sufficient number of proxy votes.
election, votes from a majority of the shares voted are required. However, the
odds of a nonmanagement group winning a proxy battle are generally slim.


Dividends
The payment of dividends to the firm™s shareholders is at the discretion of the
corporation™s board of directors. Most corporations pay dividends quarterly.
Dividends may be paid in cash, stock, or merchandise. Cash dividends are the
most common, merchandise dividends the least.
270 PART 2 Important Financial Concepts


Common stockholders are not promised a dividend, but they come to expect
certain payments on the basis of the historical dividend pattern of the firm. Before
dividends are paid to common stockholders, the claims of the government, all
creditors, and preferred stockholders must be satisfied. Because of the importance
of the dividend decision to the growth and valuation of the firm, dividends are
discussed in greater detail in Chapter 12.


International Stock Issues
Although the international market for common stock is not so large as the inter-
national market for bonds, cross-border issuance and trading of common stock
have increased dramatically in the past 20 years.
Some corporations issue stock in foreign markets. For example, the stock of
General Electric trades in Frankfurt, London, Paris, and Tokyo; the stocks of
AOL Time Warner and Microsoft trade in Frankfurt; and the stock of McDon-
ald™s trades in Frankfurt and Paris. The London, Frankfurt, and Tokyo markets
are the most popular. Issuing stock internationally broadens the ownership base
and also helps a company to integrate itself into the local business scene. A listing
on a foreign stock exchange both increases local business press coverage and
serves as effective corporate advertising. Having locally traded stock can also
facilitate corporate acquisitions, because shares can be used as an acceptable
method of payment.
Foreign corporations have also discovered the benefits of trading their stock
in the United States. The disclosure and reporting requirements mandated by the
U.S. Securities and Exchange Commission have historically discouraged all but
the largest foreign firms from directly listing their shares on the New York Stock
Exchange or the American Stock Exchange. For example, in 1993, Daimler-Benz
(now Daimler Chrysler) became the first large German company to be listed on
American depositary
the NYSE.
receipts (ADRs)
Alternatively, most foreign companies tap the U.S. market through American
Claims issued by U.S. banks
representing ownership of depositary receipts (ADRs). These are claims issued by U.S. banks representing
shares of a foreign company™s
ownership of shares of a foreign company™s stock held on deposit by the U.S.
stock held on deposit by the U.S.
bank in the foreign market. Because ADRs are issued, in dollars, by a U.S. bank
bank in the foreign market and
to U.S. investors, they are subject to U.S. securities laws. Yet they still give
issued in dollars to U.S.
investors the opportunity to diversify their portfolios internationally.
investors.



Preferred Stock
Preferred stock gives its holders certain privileges that make them senior to com-
mon stockholders. Preferred stockholders are promised a fixed periodic dividend,
par-value preferred stock
Preferred stock with a stated which is stated either as a percentage or as a dollar amount. How the dividend is
face value that is used with the
specified depends on whether the preferred stock has a par value, which, as in
specified dividend percentage to
common stock, is a relatively useless stated value established for legal purposes.
determine the annual dollar
Par-value preferred stock has a stated face value, and its annual dividend is speci-
dividend.
fied as a percentage of this value. No-par preferred stock has no stated face value,
no-par preferred stock
but its annual dividend is stated in dollars. Preferred stock is most often issued by
Preferred stock with no stated
public utilities, by acquiring firms in merger transactions, and by firms that are
face value but with a stated
experiencing losses and need additional financing.
annual dollar dividend.
271
CHAPTER 7 Stock Valuation


Basic Rights of Preferred Stockholders
The basic rights of preferred stockholders are somewhat more favorable than
the rights of common stockholders. Preferred stock is often considered quasi-
debt because, much like interest on debt, it specifies a fixed periodic payment
(dividend). Of course, as ownership, preferred stock is unlike debt in that it has
no maturity date. Because they have a fixed claim on the firm™s income that
takes precedence over the claim of common stockholders, preferred stock-
holders are exposed to less risk. They are consequently not normally given a
voting right.
Preferred stockholders have preference over common stockholders in the dis-
tribution of earnings. If the stated preferred stock dividend is “passed” (not paid)
by the board of directors, the payment of dividends to common stockholders is
prohibited. It is this preference in dividend distribution that makes common
stockholders the true risk takers.
Preferred stockholders are also usually given preference over common stock-
holders in the liquidation of assets in a legally bankrupt firm, although they must
“stand in line” behind creditors. The amount of the claim of preferred stockhold-
ers in liquidation is normally equal to the par or stated value of the preferred stock.


Features of Preferred Stock
A number of features are generally included as part of a preferred stock issue.
These features, along with the stock™s par value, the amount of dividend pay-
ments, the dividend payment dates, and any restrictive covenants, are specified in
an agreement similar to a bond indenture.

Restrictive Covenants The restrictive covenants in a preferred stock issue
are aimed at ensuring the firm™s continued existence and regular payment of the
dividend. These covenants include provisions about passing dividends, the sale of
senior securities, mergers, sales of assets, minimum liquidity requirements, and
repurchases of common stock. The violation of preferred stock covenants usually
permits preferred stockholders either to obtain representation on the firm™s
board of directors or to force the retirement of their stock at or above its par or
stated value.
cumulative preferred stock
Preferred stock for which all
passed (unpaid) dividends in Cumulation Most preferred stock is cumulative with respect to any divi-
arrears, along with the current
dends passed. That is, all dividends in arrears, along with the current dividend,
dividend, must be paid before
must be paid before dividends can be paid to common stockholders. If preferred
dividends can be paid to common
stock is noncumulative, passed (unpaid) dividends do not accumulate. In this
stockholders.
case, only the current dividend must be paid before dividends can be paid to com-
noncumulative preferred stock
mon stockholders. Because the common stockholders can receive dividends only
Preferred stock for which passed
after the dividend claims of preferred stockholders have been satisfied, it is in the
(unpaid) dividends do not
firm™s best interest to pay preferred dividends when they are due.1
accumulate.




1. Most preferred stock is cumulative, because it is difficult to sell noncumulative stock. Common stockholders obvi-
ously prefer issuance of noncumulative preferred stock, because it does not place them in quite so risky a position.
But it is often in the best interest of the firm to sell cumulative preferred stock because of its lower cost.
272 PART 2 Important Financial Concepts


Utley Corporation, a manufacturer of specialty automobiles, currently has out-
EXAMPLE
standing an issue of $6 preferred stock on which quarterly dividends of $1.50 are
to be paid. Because of a cash shortage, the last two quarterly dividends were
passed. The directors of the company have been receiving a large number of com-
plaints from common stockholders, who have, of course, not received any divi-
dends in the past two quarters either. If the preferred stock is cumulative, the
company will have to pay its preferred stockholders $4.50 per share ($3.00 of
dividends in arrears plus the current $1.50 dividend) prior to paying dividends to
its common stockholders. If the preferred stock is noncumulative, the firm must
pay only the current $1.50 dividend to its preferred stockholders prior to paying
dividends to its common stockholders.

Other Features Preferred stock is generally callable”the issuer can retire
outstanding stock within a certain period of time at a specified price. The call
option generally cannot be exercised until a specified date. The call price is nor-
mally set above the initial issuance price, but it may decrease as time passes.
Making preferred stock callable provides the issuer with a way to bring the
fixed-payment commitment of the preferred issue to an end if conditions in the
conversion feature
(preferred stock) financial markets make it desirable to do so.
A feature of convertible pre- Preferred stock quite often contains a conversion feature that allows holders
ferred stock that allows holders
of convertible preferred stock to change each share into a stated number of shares
to change each share into a
of common stock. Sometimes the number of shares of common stock that the
stated number of shares of
preferred stock can be exchanged for changes according to a prespecified formula.
common stock.



Issuing Common Stock
Because of the high risk associated with a business startup, a firm™s initial financ-
ing typically comes from its founders in the form of a common stock investment.
Until the founders have made an equity investment, it is highly unlikely that oth-
ers will contribute either equity or debt capital. Early-stage investors in the firm™s
equity, as well as lenders who provide debt capital, want to be assured that they
are taking no more risk than the founding owner(s). In addition, they want con-
firmation that the founders are confident enough in their vision for the firm that
they are willing to risk their own money.
The initial nonfounder financing for business startups with attractive growth
prospects comes from private equity investors. Then, as the firm establishes the
viability of its product or service offering and begins to generate revenues, cash
flow, and profits, it will often “go public” by issuing shares of common stock to a
much broader group of investors.
Before we consider the initial public sales of equity, let™s review some of the
venture capital
key aspects of early-stage equity financing in firms that have attractive growth
Privately raised external equity
capital used to fund early-stage prospects.
firms with attractive growth
prospects.
Venture Capital
venture capitalists (VCs)
Providers of venture capital; The initial external equity financing privately raised by firms, typically early-
typically, formal businesses stage firms with attractive growth prospects, is called venture capital. Those who
that maintain strong oversight
provide venture capital are known as venture capitalists (VCs). They typically are
over the firms they invest in and
formal business entities that maintain strong oversight over the firms they invest
that have clearly defined exit
in and that have clearly defined exit strategies. Less visible early-stage investors
strategies.
273
CHAPTER 7 Stock Valuation


TABLE 7.2 Organization of Institutional Venture Capital
Investors

Organization Description

Small business investment Corporations chartered by the federal government that can
companies (SBICs) borrow at attractive rates from the U.S. Treasury and use
the funds to make venture capital investments in private
companies.
Financial VC funds Subsidiaries of financial institutions, particularly banks, set
up to help young firms grow and, it is hoped, become major
customers of the institution.
Corporate VC funds Firms, sometimes subsidiaries, established by nonfinancial
firms, typically to gain access to new technologies that the
corporation can access to further its own growth.
VC limited partnerships Limited partnerships organized by professional VC firms, who
serve as the general partner and organize, invest, and manage
the partnership using the limited partners™ funds; the profes-
sional VCs ultimately liquidate the partnership and distribute
the proceeds to all partners.




called angel capitalists (or angels) tend to be investors who do not actually oper-
angel capitalists (angels)
Wealthy individual investors ate as a business; they are often wealthy individual investors who are willing to
who do not operate as a business
invest in promising early-stage companies in exchange for a portion of the firm™s
but invest in promising early-
equity. Although angels play a major role in early-stage equity financing, we will
stage companies in exchange for
focus on VCs because of their more formal structure and greater public visibility.
a portion of the firm™s equity.

Organization and Investment Stages Institutional venture capital investors
tend to be organized in one of four basic ways, as described in Table 7.2. The VC
limited partnership is by far the dominant structure. These funds have as their
sole objective to earn high returns, rather than to obtain access to the companies
in order to sell or buy other products or services.
VCs can invest in early-stage companies, later-stage companies, or buyouts
and acquisitions. Generally, about 40 to 50 percent of VC investments are
devoted to early-stage companies (for startup funding and expansion) and a simi-
lar percentage to later-stage companies (for marketing, production expansion,
and preparation for public offering); the remaining 5 to 10 percent are devoted to
the buyout or acquisition of other companies. Generally, VCs look for compound
rates of return ranging from 20 to 50 percent or more, depending on both the
development stage and the attributes of each company. Earlier-stage investments
tend to demand higher returns than later-stage financing because of the higher
risk associated with the earlier stages of a firm™s growth.

Deal Structure and Pricing Regardless of the development stage, venture
capital investments are made under a legal contract that clearly allocates respon-
sibilities and ownership interests between existing owners (founders) and the VC
fund or limited partnership. The terms of the agreement will depend on numerous
factors related to the founders; the business structure, stage of development, and
outlook; and other market and timing issues. The specific financial terms will
274 PART 2 Important Financial Concepts


depend on the value of the enterprise, the amount of funding, and the perceived
risk. To control the VC™s risk, various covenants are included in the agreement,
and the actual funding may be pegged to the achievement of measurable mile-
stones. The contract will have an explicit exit strategy for the VC that may be tied
both to measurable milestones and to time.
Each VC investment is unique. The amount of equity to which the VC is
entitled will depend on the value of the firm, the terms of the contract, the exit
terms, and the minimum compound rate of return required by the VC on its
investment. The transaction will be structured to provide the VC with a high rate
of return that is consistent with the typically high risk of such transactions. The
exit strategy of most VC investments is to take the firm public through an initial
public offering.


Going Public
When a firm wishes to sell its stock in the primary market, it has three alterna-
tives. It can make (1) a public offering, in which it offers its shares for sale to the
general public; (2) a rights offering, in which new shares are sold to existing
stockholders; or (3) a private placement, in which the firm sells new securities
directly to an investor or group of investors. Here we focus on public offerings,
particularly the initial public offering (IPO), which is the first public sale of a
initial public offering (IPO)
The first public sale of a firm™s firm™s stock. IPOs are typically made by small, rapidly growing companies that
stock.
either require additional capital to continue expanding or have met a milestone
for going public that was established in a contract signed earlier in order to
obtain VC funding.
To go public, the firm must first obtain the approval of its current sharehold-
ers, the investors who own its privately issued stock. Next, the company™s audi-
tors and lawyers must certify that all documents for the company are legitimate.
The company then finds an investment bank willing to underwrite the offering.
This underwriter is responsible for promoting the stock and facilitating the sale of
the company™s IPO shares. The underwriter often brings in other investment bank-
ing firms as participants. We™ll discuss the role of the investment banker in more
detail in the next section.
The company files a registration statement with the SEC. One portion of the
registration statement is called the prospectus. It describes the key aspects of the
prospectus
A portion of a security registra- issue, the issuer, and its management and financial position. During the waiting
tion statement that describes the period between the statement™s filing and its approval, prospective investors can
key aspects of the issue, the
receive a preliminary prospectus. This preliminary version is called a red herring,
issuer, and its management and
because a notice printed in red on the front cover indicates the tentative nature of
financial position.
the offer. The cover of the preliminary prospectus describing the 2002 stock issue
red herring
of Ribapharm, Inc. is shown in Figure 7.1. Note the red herring printed vertically
A preliminary prospectus made
on its left edge.
available to prospective
After the SEC approves the registration statement, the investment community
investors during the waiting
can begin analyzing the company™s prospects. However, from the time it files until
period between the registration
statement™s filing with the SEC at least one month after the IPO is complete, the company must observe a quiet
and its approval.
period, during which there are restrictions on what company officials may say
about the company. The purpose of the quiet period is to make sure that all poten-
tial investors have access to the same information about the company”the infor-
mation presented in the preliminary prospectus”and not to any unpublished data
that might give them an unfair advantage.
275
CHAPTER 7 Stock Valuation


FIGURE 7.1
Cover of a
Preliminary Prospectus
for a Stock Issue
Some of the key factors
related to the 2002 common
stock issue by Ribapharm,
Inc. are summarized on the
cover of the prospectus. The
type printed vertically on the
left edge is normally red,
which explains its name “red
herring.” (Source: Ribapharm,
Inc., March 21, 2002, p. 1.)




The investment bankers and company executives promote the company™s
stock offering through a road show, a series of presentations to potential investors
around the country and sometimes overseas. In addition to providing investors
with information about the new issue, road show sessions help the investment
bankers gauge the demand for the offering and set an expected pricing range. After
the underwriter sets terms and prices the issue, the SEC must approve the offering.

investment banker
The Investment Banker™s Role
Financial intermediary that
specializes in selling new
Most public offerings are made with the assistance of an investment banker. The
security issues and advising
investment banker is a financial intermediary (such as Salomon Brothers or
firms with regard to major
Goldman, Sachs) that specializes in selling new security issues and advising firms
financial transactions.
276 PART 2 Important Financial Concepts


with regard to major financial transactions. The main activity of the investment
banker is underwriting. This process involves purchasing the security issue from
underwriting
The role of the investment the issuing corporation at an agreed-on price and bearing the risk of reselling it to
banker in bearing the risk of
the public at a profit. The investment banker also provides the issuer with advice
reselling, at a profit, the securi-
about pricing and other important aspects of the issue.
ties purchased from an issuing
In the case of very large security issues, the investment banker brings in other
corporation at an agreed-on
bankers as partners to form an underwriting syndicate. The syndicate shares the
price.
financial risk associated with buying the entire issue from the issuer and reselling
underwriting syndicate
the new securities to the public. The originating investment banker and the syndi-
A group formed by an investment
cate members put together a selling group, normally made up of themselves and a
banker to share the financial risk
large number of brokerage firms. Each member of the selling group accepts the
associated with underwriting
new securities. responsibility for selling a certain portion of the issue and is paid a commission
on the securities it sells. The selling process for a large security issue is depicted in
selling group
Figure 7.2.
A large number of brokerage
firms that join the originating Compensation for underwriting and selling services typically comes in the
investment banker(s); each
form of a discount on the sale price of the securities. For example, an investment
accepts responsibility for selling
banker may pay the issuing firm $24 per share for stock that will be sold for $26
a certain portion of a new
per share. The investment banker may then sell the shares to members of the sell-
security issue on a commission
ing group for $25.25 per share. In this case, the original investment banker earns
basis.
$1.25 per share ($25.25 sale price $24 purchase price). The members of the
selling group earn 75 cents for each share they sell ($26 sale price $25.25 pur-
chase price). Although some primary security offerings are directly placed by the
issuer, the majority of new issues are sold through public offering via the mecha-
nism just described.




FIGURE 7.2
The Selling Process for Issuing
Corporation
a Large Security Issue
The investment banker hired
by the issuing corporation
Underwriting Syndicate
may form an underwriting
syndicate. The underwriting
Originating
syndicate buys the entire Investment Investment Investment Investment
Investment
security issue from the issu- Banker Banker Banker Banker
Banker
ing corporation at an agreed-
on price. The underwriter
Selling Group
then has the opportunity (and
bears the risk) of reselling the
issue to the public at a profit.
Both the originating invest-
ment banker and the other
syndicate members put
together a selling group to Purchasers of Securities
sell the issue on a commis-
sion basis to investors.
277
CHAPTER 7 Stock Valuation



Interpreting Stock Quotations
The financial manager needs to stay abreast of the market values of the firm™s out-
standing stock, whether it is traded on an organized exchange, over the counter,
or in international markets. Similarly, existing and prospective stockholders need
to monitor the prices of the securities they own because these prices represent the
current value of their investments. Price quotations, which include current price
data along with statistics on recent price behavior, are readily available for
actively traded stocks. The most up-to-date “quotes” can be obtained electroni-
cally, via a personal computer. Price information is available from stockbrokers
and is widely published in news media. Popular sources of daily security price
quotations include financial newspapers, such as the Wall Street Journal and
Investor™s Business Daily, and the business sections of daily general newspapers.
Figure 7.3 includes an excerpt from the NYSE quotations, reported in the
Wall Street Journal of March 18, 2002, for transactions through the close of
trading on Friday, March 15, 2002. We™ll look at the quotations for common
stock for McDonalds, highlighted in the figure. The quotations show that stock
prices are quoted in dollars and cents.
The first column gives the percent change in the stock™s closing price for the
calendar year to date. You can see that McDonalds™ price has increased 8.5 per-
cent ( 8.5) since the start of 2002. The next two columns, labeled “HI” and
“LO,” show the highest and lowest prices at which the stock sold during the pre-
ceding 52 weeks. McDonalds common stock, for example, traded between
$24.75 and $31.00 during the 52-week period that ended March 15, 2002.
Listed to the right of the company™s name is its stock symbol; McDonalds goes by
“MCD.” The figure listed right after the stock symbol under “DIV” is the annual
cash dividend paid on each share of stock. The dividend for McDonalds was
$0.23 per share. The next item, labeled “YLD%,” is the dividend yield, which is
found by dividing the stated dividend by the last share price. The dividend yield
for McDonalds is 0.8 percent (0.23 28.72 0.0080 0.8%).
The price/earnings (P/E) ratio, labeled “PE,” is next. It is calculated by divid-
ing the closing market price by the firm™s most recent annual earnings per share
(EPS). The price/earnings (P/E) ratio, as noted in Chapter 2, measures the amount
investors are willing to pay for each dollar of the firm™s earnings. McDonalds™ P/E
ratio was 23”the stock was trading at 23 times it earnings. The P/E ratio is
believed to reflect investor expectations concerning the firm™s future prospects:
Higher P/E ratios reflect investor optimism and confidence; lower P/E ratios
reflect investor pessimism and concern.
The daily volume, labeled “VOL 100s,” follows the P/E ratio. Here the day™s
sales are quoted in lots of 100 shares. The value 59195 for McDonalds indicates
that 5,919,500 shares of its common stock were traded on March 15, 2002. The
next column, labeled “LAST,” contains the last price at which the stock sold on
the given day. The value for McDonalds was $28.72. The final column, “NET
CHG,” indicates the change in the closing price from that on the prior trading
day. McDonalds closed up $0.57 from March 14, 2002, which means the closing
price on that day was $28.15.
Similar quotations systems are used for stocks that trade on other exchanges
such as the American Stock Exchange (AMEX) and for the over-the-counter
(OTC) exchange™s Nasdaq National Market Issues. Also note that when a stock
278 PART 2 Important Financial Concepts


FIGURE 7.3
YTD 52 WEEKS YLD VOL NET
Stock Quotations % CHG HI LO STOCK (SYM) DIV % PE 100S LAST CHG
Selected stock quotations
for March 15, 2002




McDonalds




Source: Wall Street Journal, March 18, 2002, p. C4.




(or bond) issue is not traded on a given day, it generally is not quoted in the
financial and business press.


Review Questions

7“2 What risks do common stockholders take that other suppliers of long-
term capital do not?
7“3 How does a rights offering protect a firm™s stockholders against the dilu-
tion of ownership?
7“4 Explain the relationships among authorized shares, outstanding shares,
treasury stock, and issued shares.
7“5 What are the advantages to both U.S.-based and foreign corporations of
issuing stock outside their home markets? What are American depositary
receipts (ADRs)?
7“6 What claims do preferred stockholders have with respect to distribution of
earnings (dividends) and assets?
279
CHAPTER 7 Stock Valuation


7“7 Explain the cumulative feature of preferred stock. What is the purpose of
a call feature in a preferred stock issue?
7“8 What is the difference between a venture capitalist (VC) and an angel cap-
italist (angel)?
7“9 Into what bodies are institutional VCs most commonly organized? How
are their deals structured and priced?
7“10 What general procedures must a private firm go through in order to go
public via an initial public offering (IPO)?
7“11 What role does an investment banker play in a public offering? Explain
the sequence of events in the issuing of stock.
7“12 Describe the key items of information included in a stock quotation. What
information does the stock™s price/earnings (P/E) ratio provide?



Common Stock Valuation
LG4 LG5


Common stockholders expect to be rewarded through periodic cash dividends
and an increasing”or at least nondeclining”share value. Like current owners,
prospective owners and security analysts frequently estimate the firm™s value.
Investors purchase the stock when they believe that it is undervalued”when its
true value is greater than its market price. They sell the stock when they feel that
it is overvalued”when its market price is greater than its true value.
In this section, we will describe specific stock valuation techniques. First,
though, we will look at the concept of an efficient market, which questions
whether the prices of actively traded stocks can differ from their true values.


Market Efficiency
Economically rational buyers and sellers use their assessment of an asset™s risk
and return to determine its value. To a buyer, the asset™s value represents the
maximum price that he or she would pay to acquire it; a seller views the asset™s
value as a minimum sale price. In competitive markets with many active partici-
pants, such as the New York Stock Exchange, the interactions of many buyers
and sellers result in an equilibrium price”the market value”for each security.
This price reflects the collective actions that buyers and sellers take on the basis of
all available information. Buyers and sellers are assumed to digest new informa-
tion immediately as it becomes available and, through their purchase and sale
activities, to create a new market equilibrium price quickly.
efficient-market hypothesis
Theory describing the behavior
The Efficient-Market Hypothesis
of an assumed “perfect” market
in which (1) securities are typi-
As noted in Chapter 1, active markets such as the New York Stock Exchange are
cally in equilibrium, (2) security
efficient”they are made up of many rational investors who react quickly and
prices fully reflect all public
objectively to new information. The efficient-market hypothesis, which is the basic
information available and react
swiftly to new information, and, theory describing the behavior of such a “perfect” market, specifically states that
(3) because stocks are fairly
priced, investors need not waste
1. Securities are typically in equilibrium, which means that they are fairly priced
time looking for mispriced
and that their expected returns equal their required returns.
securities.
280 PART 2 Important Financial Concepts


2. At any point in time, security prices fully reflect all public information avail-
able about the firm and its securities,2 and these prices react swiftly to new
information.
3. Because stocks are fully and fairly priced, investors need not waste their time
trying to find and capitalize on mispriced (undervalued or overvalued)
securities.

Not all market participants are believers in the efficient-market hypothesis.
Some feel that it is worthwhile to search for undervalued or overvalued securities
and to trade them to profit from market inefficiencies. Others argue that it is
mere luck that would allow market participants to anticipate new information
correctly and as a result earn excess returns”that is, actual returns greater than
required returns. They believe it is unlikely that market participants can over the
long run earn excess returns. Contrary to this belief, some well-known investors
such as Warren Buffett and Peter Lynch have over the long run consistently
earned excess returns on their portfolios. It is unclear whether their success is the
result of their superior ability to anticipate new information or of some form of
market inefficiency.
Throughout this text we ignore the disbelievers and continue to assume mar-
ket efficiency. This means that the terms “expected return” and “required
return” are used interchangeably, because they should be equal in an efficient
market. This also means that stock prices accurately reflect true value based on
risk and return. In other words, we will operate under the assumption that the
market price at any point in time is the best estimate of value. We™re now ready to
look closely at the mechanics of stock valuation.



The Basic Stock Valuation Equation
Like the value of a bond, which we discussed in Chapter 6, 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 stock-
holder 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. What about stocks that are
not expected to pay dividends in the foreseeable future? Such stocks have a value
attributable to a distant dividend expected to result from sale of the company or
liquidation of its assets. Therefore, from a valuation viewpoint, only dividends
are relevant.
By redefining terms, the basic valuation model in Equation 6.1 can be speci-
fied for common stock, as given in Equation 7.1:
D1 D2 D∞
...
P0 (7.1)
(1 ks )∞
(1 ks )1 (1 ks )2


2. Those market participants who have nonpublic”inside”information may have an unfair advantage that enables
them to earn an excess return. Since the mid-1980s disclosure of the insider-trading activities of a number of well-
known financiers and investors, major national attention has been focused on the “problem” of insider trading and
its resolution. Clearly, those who trade securities on the basis of inside information have an unfair and illegal advan-
tage. Empirical research has confirmed that those with inside information do indeed have an opportunity to earn an
excess return. Here we ignore this possibility, given its illegality and that given enhanced surveillance and enforce-
ment by the securities industry and the government have in recent years (it appears) significantly reduced insider
trading. We, in effect, assume that all relevant information is public and that therefore the market is efficient.
281
CHAPTER 7 Stock Valuation


where

P0 value of common stock
Dt per-share dividend expected at the end of year t
ks required return on common stock

The equation can be simplified somewhat by redefining each year™s dividend, Dt,
in terms of anticipated growth. We will consider two models here: zero-growth
and constant-growth.


Zero-Growth Model
The simplest approach to dividend valuation, the zero-growth model, assumes a
zero-growth model
constant, nongrowing dividend stream. In terms of the notation already introduced,
An approach to dividend
valuation that assumes a
...
D1 D2 D∞
constant, nongrowing dividend
stream.
When we let D1 represent the amount of the annual dividend, Equation 7.1 under
zero growth reduces to

1 1 D1
P0 D1 D1 (PVIFAks ,∞) D1 (7.2)
ks )t
1 (1 ks ks
t

The equation shows that with zero growth, the value of a share of stock would
equal the present value of a perpetuity of D1 dollars discounted at a rate ks. (Perpe-
tuities were introduced in Chapter 4; see Equation 4.17 and the related discussion.)

The dividend of Denham Company, an established textile producer, is expected
EXAMPLE
to remain constant at $3 per share indefinitely. If the required return on its stock
is 15%, the stock™s value is $20 ($3 0.15) per share.


Preferred Stock Valuation Because preferred stock typically provides its
holders with a fixed annual dividend over its assumed infinite life, Equation 7.2
can be used to find the value of preferred stock. The value of preferred stock can
be estimated by substituting the stated dividend on the preferred stock for D1 and
the required return for ks in Equation 7.2. For example, a preferred stock paying
a $5 stated annual dividend and having a required return of 13 percent would
have a value of $38.46 ($5 0.13) per share.


Constant-Growth Model
The most widely cited dividend valuation approach, the constant-growth model,
constant-growth model
A widely cited dividend assumes that dividends will grow at a constant rate, but a rate that is less than the
valuation approach that assumes
required return. (The assumption that the constant rate of growth, g, is less than
that dividends will grow at a
the required return, ks, is a necessary mathematical condition for deriving this
constant rate, but a rate that is
model.) By letting D0 represent the most recent dividend, we can rewrite Equa-
less than the required return.
tion 7.2 as follows:

D0 (1 g)∞
D0 (1 g)1 D0 (1 g)2 ...
P0 (7.3)
(1 ks )∞
(1 ks )1 (1 ks )2
282 PART 2 Important Financial Concepts


If we simplify Equation 7.3, it can be rewritten as3
D1
Gordon model P0 (7.4)
ks g
A common name for the
constant-growth model that is
The constant-growth model in Equation 7.4 is commonly called the Gordon
widely cited in dividend
model. An example will show how it works.
valuation.

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

Year Dividend per share

2003 $1.40
2002 1.29
2001 1.20
2000 1.12
1999 1.05
1998 1.00


We assume that the historical compound annual growth rate of dividends is an
accurate estimate of the future constant annual rate of dividend growth, g. Using
Appendix Table A“2 or a financial calculator, we find that the historical com-
pound annual growth rate of Lamar Company dividends equals 7%.4 The com-


3. For the interested reader, the calculations necessary to derive Equation 7.4 from Equation 7.3 follow. The first
step is to multiply each side of Equation 7.3 by (1 ks)/(1 g) and subtract Equation 7.3 from the resulting expres-
sion. This yields
D0 (1 g)∞
P0 (1 ks )
P0 D0 (1)
(1 ks)∞
1g
Because ks is assumed to be greater than g, the second term on the right side of Equation 1 should be zero. Thus
1 ks
P0 1 D0 (2)
1g
Equation 2 is simplified as follows:
(1 ks ) (1 g)
P0 D0 (3)
1g
P0 (ks g) D0 (1 g) (4)
D1
P0 (5)
ks g
Equation 5 equals Equation 7.4.
4. The technique involves solving the following equation for g:
g)5
D2003 D1998 (1
D1998 1
Input Function PVIFg,5
g)5
D2003 (1
PV
1.00
To do so, we can use financial tables or a financial calculator.
FV
1.40
Two basic steps can be followed using the present value table. First, dividing the earliest dividend (D1998
5 N $1.00) by the most recent dividend (D2003 $1.40) yields a factor for the present value of one dollar, PVIF, of 0.714
($1.00 $1.40). Although six dividends are shown, they reflect only 5 years of growth. (The number of years of
CPT
growth can also be found by subtracting the earliest year from the most recent year”that is, 2003“1998 5 years of
I growth.) By looking across the Appendix Table A“2 at the PVIF for 5 years, we find that the factor closest to 0.714
occurs at 7% (0.713). Therefore, the growth rate of the dividends, rounded to the nearest whole percent, is 7%.
Solution Alternatively, a financial calculator can be used. (Note: Most calculators require either the PV or FV value to
6.96 be input as a negative number to calculate an unknown interest or growth rate. That approach is used here.) Using
the inputs shown at the left, you should find the growth rate to be 6.96%, which we round to 7%.
283
CHAPTER 7 Stock Valuation



In Practice
FOCUS ON e-FINANCE What™s the Value of the American Dream?
For many people, owning their own just a starting point, however, and • What will my balance sheet,
business represents the dream of must be adjusted for other factors. income statement, and cash
a lifetime. But how much should For example, food distributors flow statement look like in 5
this dream cost? To get an idea of typically sell for about 30 percent years?
how to value a small business, of annual sales. A Southeastern • Should I seek debt or equity
check out the “Business for Sale” seafood distributor was recently to finance growth?
column in Inc., a magazine that offered for $2.25 million, a discount • What impact will capital pur-
focuses on smaller emerging busi- from the $3.9 million price you™d chases have on my venture?
nesses. Each month the column get strictly on the basis of annual • How much ownership in my
describes the operations, financial sales. The reason? The new owner business should I give up for a
situation, industry outlook, price would have to buy or lease a ware- $2 million equity contribution?
rationale, and pros and cons of a house facility, freezers, and other
small business offered for sale. For equipment. Once the negotiators decide
example, columns featured in 2000 Because valuing a small busi- to move forward, however, they
and 2001 included such diverse ness is difficult, many owners usually should hire an experienced
companies as a distributor of semi- make use of reasonably priced val- valuation professional to develop a
precious stones, a software devel- uation software such as BallPark formal valuation.
oper, a Christmas tree grower, a Business Valuation and VALUware.
small chain of used-book stores, These programs offer buyers and Sources: “About Ballpark Business Valua-
and a baseball camp, with prices sellers a quick way to estimate the tion,” Bullet Proof Business Plans, down-
loaded from www.bulletproofbizplans.com/
ranging from $200,000 to $9 million. business™s value and to answer BallPark/About_/about_.html; Jill Andresky
Most valuations are based on a such questions as: Fraser, “Business for Sale: Southeastern
Seafood Distributor,” Inc. (October 1, 2000),
multiple of cash flow or annual
downloaded from www.inc.com; VALUware,
sales, with accepted guidelines for • How much cash will my busi- www.bizbooksoftware.com/VALUWARE.
different industries. That number is ness generate or consume? HTM.




pany estimates that its dividend in 2004, D1, will equal $1.50. The required
return, ks, is assumed to be 15%. By substituting these values into Equation 7.4,
we find the value of the stock to be
$1.50 $1.50
P0 $18.75 per share
0.15 0.07 0.08
Assuming that the values of D1, ks, and g are accurately estimated, Lamar Com-
pany™s stock value is $18.75 per share.


Free Cash Flow Valuation Model
As an alternative to the dividend valuation models presented above, a firm™s value
can be estimated by using its projected free cash flows (FCFs). This approach is
free cash flow valuation model
appealing when one is valuing firms that have no dividend history or are startups
A model that determines the
or when one is valuing an operating unit or division of a larger public company.
value of an entire company as the
present value of its expected free Although dividend valuation models are widely used and accepted, in these situa-
cash flows discounted at the
tions it is preferable to use a more general free cash flow valuation model.
firm™s weighted average cost of
The free cash flow valuation model is based on the same basic premise as
capital, which is its expected
dividend valuation models: The value of a share of common stock is the present
average future cost of funds over
value of all future cash flows it is expected to provide over an infinite time horizon.
the long run.
284 PART 2 Important Financial Concepts


However, in the free cash flow valuation model, instead of valuing the firm™s
expected dividends, we value the firm™s expected free cash flows, defined in Equa-
tion 3.3 (page 95). 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.
The free cash flow valuation model estimates the value of the entire company
by finding the present value of its expected free cash flows discounted at its
weighted average cost of capital, which is its expected average future cost of
funds over the long run (see Chapter 10), as specified in Equation 7.5.
FCF1 FCF2 FCF∞
... (7.5)
VC
(1 ka)∞
(1 ka)1 (1 ka)2
where
VC value of the entire company
FCFt free cash flow expected at the end of year t
ka the firm™s weighted average cost of capital
Note the similarity between Equations 7.5 and 7.1, the general stock valuation
equation.
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 sub-
tract the market value of all of the firm™s debt, VD, and the market value of pre-
ferred stock, VP, from VC.
VS VC VD VP (7.6)
Because it is difficult to forecast a firm™s free cash flow, specific annual cash
flows are typically forecast for only about 5 years, beyond which a constant
growth rate is assumed. Here we assume that the first 5 years of free cash flows
are explicitly forecast and that a constant rate of free cash flow growth occurs
beyond the end of year 5 to infinity. This model therefore requires a number of
steps to calculate and combine the forecast values of the early-year free cash
flows with those of the later-year constant-growth free cash flows. Its application
is best demonstrated with an example.

Dewhurst Inc. wishes to determine the value of its stock by using the free cash
EXAMPLE
flow valuation model. In order to apply the model, the firm™s CFO developed the
data given in Table 7.3. Application of the model can be performed in four steps.
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 (Equa-
tion 7.4) to calculate the value of the free cash flows from the end of
2009 to infinity.
FCF2009
Value of FCF2009 ∞
ka gFCF
$600,000 (1 0.03)
0.09 0.03
$618,000
$10,300,000
0.06
285
CHAPTER 7 Stock Valuation


TABLE 7.3 Dewhurst Inc.™s Data for Free Cash Flow
Valuation Model

Free cash flow

(FCFt)a
Year (t) Other data

2004 $400,000 Growth rate of FCF, beyond 2008 to infinity, gFCF 3%
2005 450,000 Weighted average cost of capital, ka 9%
2006 520,000 Market value of all debt, VD $3,100,000
2007 560,000 Market value of preferred stock, VP $800,000
2008 600,000 Number of shares of common stock outstanding 300,000
aDeveloped using Equations 3.2 and 3.3 (page 95).




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, gFCF.
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
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 7.4, using present value interest factors, PVIFs, from
Appendix Table A“2.
Step 4 Calculate the value of the common stock using Equation 7.6. Substitut-
ing 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 7.3,
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


TABLE 7.5 Calculation of the Value of the
Entire Company for Dewhurst Inc.

Present value of FCFt
FCFt PVIF 9%,t [(1) (2)]
Year (t) (1) (2) (3)

2004 $ 400,000 0.917 $ 366,800
2005 450,000 0.842 378,900
2006 520,000 0.772 401,440
2007 560,000 0.708 396,480
10,900,000a
2008 0.650 7,085,000
Value of entire company, VC $8,628,620

aThisamount is the sum of the FCF2008 of $600,000 from Table 7.3 and the
$10,300,000 value of the FCF2009 ∞ calculated in Step 1.
286 PART 2 Important Financial Concepts


stock that the firm has outstanding, we get a common stock value of
$15.76 per share ($4,728,620 300,000).

It should now be clear that the free cash flow valuation model is consistent
with the dividend valuation models presented earlier. The appeal of this approach
is its focus on the free cash flow estimates rather than on forecast dividends, which
are far more difficult to estimate, given that they are paid at the discretion of the
firm™s board. The more general nature of the free cash flow model is responsible
for its growing popularity, particularly with CFOs and other financial managers.


Other Approaches to Common Stock Valuation
Many other approaches to common stock valuation exist. The more popular
approaches include book value, liquidation value, and some type of price/earnings
multiple.


Book Value
Book value per share is simply the amount per share of common stock that
book value per share
The amount per share of common would be received if all of the firm™s assets were sold for their exact book
stock that would be received if all
(accounting) value and the proceeds remaining after paying all liabilities (includ-
of the firm™s assets were sold for
ing preferred stock) were divided among the common stockholders. This method
their exact book (accounting)
lacks sophistication and can be criticized on the basis of its reliance on historical
value and the proceeds remaining

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