This document provides an overview of stock valuation and the process of issuing common stock. It discusses the differences between debt and equity financing, features of common and preferred stock, and the roles of venture capital and investment bankers in taking a company public. The learning goals cover stock valuation models, approaches to valuation such as free cash flow and multiples, and how financial decisions impact risk and firm value.

1. BBA 2204 FINANCIAL MANAGEMENT
Stock Valuation
Stock Valuation
by
Stephen Ong
Visiting Fellow, Birmingham City
University Business School, UK
Visiting Professor, Shenzhen

2. Today’s Overview

3. Learning Goals
1.
2.
3.
4.
5.
6.
7-3
Differentiate between debt and equity.
Discuss the features of both common and preferred stock.
Describe the process of issuing common stock, including
venture capital, going public and the investment banker.
Understand the concept of market efficiency and basic stock
valuation using zero-growth, constant-growth, and variablegrowth models.
Discuss the free cash flow valuation model and the book
value, liquidation value, and price/earnings (P/E) multiple
approaches.
Explain the relationships among financial decisions, return,
risk, and the firm’s value.

4. Differences Between Debt and Equity
7-4
• Debt includes all borrowing incurred by a firm, including
bonds, and is repaid according to a fixed schedule of
payments.
• Equity consists of funds provided by the firm’s owners
(investors or stockholders) that are repaid subject to the
firm’s performance.
• Debt financing is obtained from creditors and equity
financing is obtained from investors who then become
part owners of the firm.
• Creditors (lenders or debtholders) have a legal right to be
repaid, whereas investors only have an expectation of
being repaid.

5. Table 7.1 Key Differences between
Debt and Equity Capital
7-5

6. Differences Between Debt and
Equity: Voice in Management
7-6
• Unlike creditors, holders of equity
(stockholders) are owners of the firm.
• Stockholders generally have voting rights
that permit them to select the firm’s
directors and vote on special issues.
• In contrast, debtholders do not receive
voting privileges but instead rely on the
firm’s contractual obligations to them to
be their voice.

7. Differences Between Debt and
Equity: Claims on Income and Assets
• Equity holders’ claims on income and assets are
secondary to the claims of creditors.
∗ Their claims on income cannot be paid until the
claims of all creditors, including both interest and
scheduled principal payments, have been satisfied.
• Because equity holders are the last to receive
distributions, they expect greater returns to
compensate them for the additional risk they
bear.
7-7

8. Matter of Fact
∗ How Are Assets Divided in Bankruptcy?
∗ According to the U.S. Securities and Exchange
Commission, in bankruptcy assets are divided up as
follows:
7-8
1. Secured Creditors – secured bank loans or secured bonds,
are paid first.
2. Unsecured Creditors – unsecured bank loans or unsecured
bonds, suppliers, or customers, have the next claim.
3. Equity holders – equity holders or the owners of the
company have the last claim on assets, and they may not
receive anything if the Secured and Unsecured Creditors’
claims are not fully rep aid.

9. Differences Between Debt and
Equity: Maturity
• Unlike debt, equity capital is a
permanent form of financing.
• Equity has no maturity date
and never has to be repaid by
the firm.
7-9

10. Differences Between Debt and
Equity: Tax Treatment
7-10
• Interest payments to debtholders are
treated as tax-deductible expenses by the
issuing firm.
• Dividend payments to a firm’s
stockholders are not tax-deductible.
• The tax deductibility of interest lowers the
corporation’s cost of debt financing,
further causing it to be lower than the cost
of equity financing.

11. Common and Preferred Stock:
Common Stock
• Common stockholders, who are sometimes referred to as
residual owners or residual claimants, are the true
owners of the firm.
• As residual owners, common stockholders receive what
is left—the residual—after all other claims on the firms
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.
• Because of this uncertain position, common stockholders
expect to be compensated with adequate dividends and
ultimately, capital gains.
7-11

12. Common Stock: Ownership
• The common stock of a firm can be privately owned by an
private investors, closely owned by an individual investor
or a small group of investors, or publicly owned by a
broad group of investors.
• The shares of privately owned firms, which are typically
small corporations, are generally not traded; if the shares
are traded, the transactions are among private investors
and often require the firm’s consent.
• Large corporations are publicly owned, and their shares
are generally actively traded in the broker or dealer
markets .
7-12

13. Common Stock: Par Value
• The par value of common stock is an arbitrary value
established for legal purposes in the firm’s corporate
charter, and can be used to find the total number of
shares outstanding by dividing it into the book value of
common stock.
• When a firm sells news shares of common stock, the
par value of the shares sold is recorded in the capital
section of the balance sheet as part of common stock.
• At any time the total number of shares of common
stock outstanding can be found by dividing the book
value of common stock by the par value.
7-13

14. Common Stock: Preemptive
Rights
• A preemptive right allows common stockholders to
maintain their proportionate ownership in the
corporation when new shares are issued, thus protecting
them from dilution of their ownership.
• Dilution of ownership is a reduction in each previous
shareholder’s fractional ownership resulting from the
issuance of additional shares of common stock.
• Dilution of earnings is a reduction in each previous
shareholder’s fractional claim on the firm’s earnings
resulting from the issuance of additional shares of
common stock.
7-14

15. Common Stock: Preemptive Rights
(cont.)
• Rights are financial instruments that allow
stockholders to purchase additional shares at a
price below the market price, in direct proportion
to their number of owned shares.
• 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 capital may be less
costly than a public offering of stock.
7-15

16. Common Stock: Authorized,
Outstanding, and Issued Shares
• Authorized shares are the shares of common stock that
a firm’s corporate charter allows it to issue.
• Outstanding shares are issued shares of common stock
held by investors, this includes private and public
investors.
• Treasury stock are issued shares of common stock held
by the firm; often these shares have been repurchased by
the firm.
• Issued shares are shares of common stock that have
been put into circulation.
Issued shares = outstanding shares + treasury stock
7-16

17. Common Stock: Authorized,
Outstanding, and Issued Shares (cont.)
∗Golden Enterprises, a producer of medical
pumps, has the following stockholder’s equity
account on December 31st.
7-17

18. Common Stock: Voting Rights
• Generally, each share of common stock entitles its
holder to one vote in the election of directors and on
special issues.
• Votes are generally assignable and may be cast at the
annual stockholders’ meeting.
• A proxy statement is a statement transferring the votes
of a stockholder to another party.
7-18
∗ Because most small stockholders do not attend the annual
meeting to vote, they may sign a proxy statement transferring
their votes to another party.
∗ Existing management generally receives the stockholders’
proxies, because it is able to solicit them at company expense.

19. Common Stock: Voting Rights
(cont.)
• A proxy battle is an attempt by a nonmanagement group
to gain control of the management of a firm by soliciting
a sufficient number of proxy votes.
• Supervoting shares is stock that carries with it multiple
votes per share rather than the single vote per share
typically given on regular shares of common stock.
• Nonvoting common stock is common stock that carries
no voting rights; issued when the firm wishes to raise
capital through the sale of common stock but does not
want to give up its voting control.
7-19

20. Common Stock: Dividends
• The payment of dividends to the firm’s shareholders
is at the discretion of the company’s board of
directors.
• Dividends may be paid in cash, stock, or
merchandise.
• 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
any past due dividends owed to preferred
stockholders must be paid.
7-20

21. Common Stock:
International Stock Issues
• The international market for common stock is not as large
as that for international debt.
• However, cross-border issuance and trading of common
stock have increased dramatically during the past 30 years.
• Stock Issued in Foreign Markets
7-21
∗ A growing number of firms are beginning to list their stocks on
foreign markets.
∗ Issuing stock internationally both broadens the company’s
ownership base and helps it to integrate itself in the local business
environment.
∗ Locally traded stock can facilitate corporate acquisitions, because
shares can be used as an acceptable method of payment.

22. Common Stock: International Stock
Issues (cont.)
∗ Foreign Stocks in U.S. Markets
∗ American depositary receipts (ADRs) are dollardenominated receipts for the stocks of foreign companies
that are held by a U.S. financial institution overseas.
∗ American depositary shares (ADSs) are securities,
backed by American depositary receipts (ADRs), that
permit U.S. investors to hold shares of non-U.S.
companies and trade them in U.S. markets.
∗ ADSs are issued in dollars to U.S. investors and are
subject to U.S. securities laws.
∗ ADSs give investors the opportunity to diversify their
portfolios internationally.
7-22

23. Preferred Stock
• Preferred stock gives its holders certain privileges
that make them senior to common stockholders.
• Preferred stockholders are promised a fixed
periodic dividend, which is stated either as a
percentage or as a dollar amount.
• Par-value preferred stock is preferred stock with
a stated face value that is used with the specified
dividend percentage to determine the annual dollar
dividend.
• No-par preferred stock is preferred stock with no
stated face value but with a stated annual dollar
dividend.
7-23

24. Preferred Stock: Basic Rights of
Preferred Stockholders
• Preferred stock is often considered quasi-debt because,
much like interest on debt, it specifies a fixed periodic
payment (dividend).
• Preferred stock is unlike debt in that it has no maturity
date.
• Because they have a fixed claim on the firm’s income that
takes precedence over the claim of common stockholders,
preferred stockholders are exposed to less risk.
• Preferred stockholders are not normally given a voting
right, although preferred stockholders are sometimes
allowed to elect one member of the board of directors.
7-24

25. Preferred Stock:
Features of Preferred Stock
• Restrictive covenants including provisions about
passing dividends, the sale of senior securities,
mergers, sales of assets, minimum liquidity
requirements, and repurchases of common stock.
• Cumulative preferred stock is preferred stock for
which all passed (unpaid) dividends in arrears,
along with the current dividend, must be paid
before dividends can be paid to common
stockholders.
• Noncumulative preferred stock is preferred stock
for which passed (unpaid) dividends do not
accumulate.
7-25

26. Preferred Stock: Features of Preferred
Stock (cont.)
• A callable feature is a feature of callable
preferred stock that allows the issuer to
retire the shares within a certain period time
and at a specified price.
• A conversion feature is a feature of
convertible preferred stock that allows
holders to change each share into a stated
number of shares of common stock.
7-26

27. Issuing Common Stock
• Initial financing for most firms typically comes
from a firm’s original founders in the form of a
common
stock investment.
• Early stage debt or equity investors are unlikely
to make an investment in a firm unless the
founders also have a personal stake in the
business.
• Initial non-founder financing usually comes first
from private equity investors.
• After establishing itself, a firm will often “go
public” by issuing shares of stock to a much
broader group.
7-27

28. Issuing Common Stock:
Venture Capital
• Venture capital is privately raised external equity
capital used to fund early-stage firms with attractive
growth prospects.
• Venture capitalists (VCs) are providers of venture
capital; typically, formal businesses that maintain
strong oversight over the firms they invest in and that
have clearly defined exit strategies.
• Angel capitalists (angels) are wealthy individual
investors who do not operate as a business but invest in
promising early-stage companies in exchange for a
portion of the firm’s equity.
7-28

29. Table 7.2 Organization of Institutional
Venture Capital Investors
7-29

30. Venture Capital:
Deal Structure and Pricing
• Venture capital investments are made under legal
contracts that clearly allocate responsibilities and
ownership interests between existing owners
(founders) and the VC fund or limited partnership
• Terms depend on factors related to the (a)
original founders, (b) business structure, (c) stage
of development, and (d) other market and timing
issues.
• Specific financial terms depend upon (a) the
value of the enterprise, (b) the amount of funding
required, and (c) the perceived risk of the
investment.
7-30

31. Venture Capital: Deal Structure
and Pricing (cont.)
• To control the VC’s risk, various covenants are
included in agreements and the actual funding
provided may be staggered based on the
achievement of measurable milestones.
• The contract will also have a defined exit
strategy.
• The amount of equity to which the VC is
entitled depends on (a) the value of the firm, (b)
the terms of the contract, (c) the exit terms, and
(d) minimum compound annual rate of return
required by the VC on its investment.
7-31

32. Going Public
∗When a firm wishes to sell its stock in the
primary market, it has three alternatives.
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 shareholders.
3. A private placement, in which the firm sells new
securities directly to an investor or a group of
investors.
∗Here we focus on the initial public offering
(IPO), which is the first public sale of a firm’s
stock.
7-32

33. Going Public (cont.)
• IPOs are typically made by small, fast-growing
companies that either:
∗ require additional capital to continue expanding, or
∗ have met a milestone for going public that was
established in a contract to obtain VC funding.
• The firm must obtain approval of current
shareholders, and hire an investment bank to
underwrite the offering.
• The investment banker is responsible for
promoting the stock and facilitating the sale of
the company’s IPO shares.
7-33

34. Going Public (cont.)
• The company must file a registration statement
with the SEC.
• The prospectus is a portion of a security
registration statement that describes the key
aspects of the issue, the issuer, and its
management and financial position.
• A red herring is a preliminary prospectus made
available to prospective investors during the
waiting period between the registration
statement’s filing with the SEC and its approval.
7-34

35. Figure 7.1 Cover of a Preliminary
Prospectus for a Stock Issue
7-35

36. Going Public (cont.)
• Investment bankers and company officials
promote the company through a road show, a
series of presentations to potential investors
around the country and sometimes overseas.
• This helps investment bankers gauge the
demand for the offering which helps them to
set the initial offer price.
• After the underwriter sets the terms, the SEC
must approve the offering.
7-36

37. Going Public:
The Investment Banker’s Role
• An investment banker is a financial intermediary that
specializes in selling new security issues and advising firms
with regard to major financial transactions.
• Underwriting is the role of the investment banker in bearing
the risk of reselling, at a profit, the securities purchased from
an issuing corporation at an agreed-on price.
• This process involves purchasing the security issue from the
issuing corporation at an agreed-on price and bearing the
risk of reselling it to the public at a profit.
• The investment banker also provides the issuer with advice
about pricing and other important aspects of the issue.
7-37

38. Going Public: The Investment
Banker’s Role (cont.)
• An underwriting syndicate is a group of other
bankers formed by an investment banker to share the
financial risk associated with underwriting new
securities.
• The syndicate shares the financial risk associated
with buying the entire issue from the issuer and
reselling the new securities to the public.
• The selling group is a large number of brokerage
firms that join the originating investment banker(s);
each accepts responsibility for selling a certain
portion of a new security issue on a commission
basis.
7-38

39. Figure 7.2 The Selling Process for
a Large Security Issue
7-39

40. Going Public: The Investment
Banker’s Role (cont.)
∗Compensation for underwriting and selling services
typically comes in the form of a discount on the sale
price of the securities.
∗ For example, an investment banker may pay the issuing
firm $24 per share for stock that will be sold for $26 per
share.
∗ The investment banker may then sell the shares to
members of the selling group for $25.25 per share. In
this case, the original investment banker earns $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 purchase price).
7-40

41. Common Stock Valuation
• Common stockholders expect to be rewarded through
periodic cash dividends and an increasing share value.
• Some of these investors decide which stocks to buy and
sell based on a plan to maintain a broadly diversified
portfolio.
• Other investors have a more speculative motive for
trading.
∗ They try to spot companies whose shares are undervalued—
meaning that the true value of the shares is greater than the
current market price.
∗ These investors buy shares that they believe to be undervalued
and sell shares that they think are overvalued (i.e., the market
price is greater than the true value).
7-41

42. Common Stock Valuation:
Market Efficiency
• Economically rational buyers and sellers use their
assessment of an asset’s risk and return to determine its
value.
• In competitive markets with many active participants,
the interactions of many buyers and sellers result in an
equilibrium price—the market value—for each security.
• Because the flow of new information is almost constant,
stock prices fluctuate, continuously moving toward a
new equilibrium that reflects the most recent
information available. This general concept is known as
market efficiency.
7-42

43. Common Stock Valuation:
Market Efficiency
• The efficient-market hypothesis (EMH) is
a theory describing the behavior of an
assumed “perfect” market in which:
7-43
∗ securities are in equilibrium,
∗ security prices fully reflect all available
information and react swiftly to new
information, and
∗ because stocks are fully and fairly priced,
investors need not waste time looking for
mispriced securities.

44. Common Stock Valuation:
Market Efficiency
• Although considerable evidence supports the
concept of market efficiency, a growing body
of academic evidence has begun to cast doubt
on the validity of this notion.
• Behavioural finance is a growing body of
research that focuses on investor behaviour
and its impact on investment decisions and
stock prices. Advocates are commonly
referred to as “behaviourists.”
7-44

45. Focus on Practice
∗Understanding Human Behaviour Helps Us Understand
Investor Behaviour
∗ Regret theory deals with the emotional reaction people
experience after realizing they have made an error in
judgment.
∗ Some investors rationalize their decision to buy certain stocks
with “everyone else is doing it.” (Herding)
Herding
∗ People have a tendency to place particular events into mental
compartments, and the difference between these compartments
sometimes impacts behavior more than the events themselves.
∗ Prospect theory suggests that people express a different degree
of emotion toward gains than losses.
∗ Anchoring is the tendency of investors to place more value on
recent information.
7-45

46. Common Stock Valuation:
Basic Common Stock Valuation Equation
∗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.
∗where
P0
Dt
∗
7-46
= value of common stock
= per-share dividend expected at the end of year
t
Rs = required return on common stock
P0 = value of common stock

47. Common Stock Valuation:
The Zero Growth Model
∗The zero dividend growth model assumes that the
stock will pay the same dividend each year, year
after year.
∗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
7-47

48. Personal Finance Example
• Chuck Swimmer estimates that the
dividend of Denham Company, an
established textile producer, is expected to
remain constant at $3 per share
indefinitely.
• If his required return on its stock is 15%,
the stock’s value is:
∗ $20 ($3 ÷ 0.15) per share
7-48

49. Common Stock Valuation:
Constant-Growth Model
∗The constant-growth model is a widely cited
dividend valuation approach that assumes that
dividends will grow at a constant rate, but a rate that is
less than the required return.
∗The Gordon model is a common name for the
constant-growth model that is widely cited in dividend
valuation.
7-49

50. Common Stock Valuation:
Constant-Growth Model (cont.)
∗Lamar Company, a small cosmetics company, paid
the following per share dividends:
7-50

51. Common Stock Valuation:
Constant-Growth Model (cont.)
∗Using a financial calculator or a spreadsheet,
we find that the historical annual growth rate
of Lamar Company dividends equals 7%.
7-51

52. Common Stock Valuation:
Variable-Growth Model
• The zero- and constant-growth common
stock models do not allow for any shift in
expected growth rates.
• The variable-growth model is a dividend
valuation approach that allows for a change
in the dividend growth rate.
• To determine the value of a share of stock
in the case of variable growth, we use a
four-step procedure.
7-52

53. Common Stock Valuation:
Variable-Growth Model (cont.)
∗Step 1. Find the value of the cash
dividends at the end of each year, Dt, during
the initial growth period, years 1 though N.
D
∗Dt = D0 × (1 + g1)t
7-53

54. Common Stock Valuation:
Variable-Growth Model (cont.)
∗Step 2. Find the present value of the
dividends expected during the initial growth
period.
7-54

55. Common Stock Valuation:
Variable-Growth Model (cont.)
∗Step 3. Find the value of the stock at the end of the
initial growth period, PN = (DN+1)/(rs – g2), which is the
present value of all dividends expected from year N
+ 1 to infinity, assuming a constant dividend growth
rate, g2.
7-55

56. Common Stock Valuation:
Variable-Growth Model (cont.)
∗Step 4. Add the present value components
found in Steps 2 and 3 to find the value of
the stock, P0.
7-56

57. Common Stock Valuation:
Variable-Growth Model (cont.)
∗The most recent annual (2012) dividend payment of
Warren Industries, a rapidly growing boat
manufacturer, was $1.50 per share. The firm’s
financial manager expects that these dividends will
increase at a 10% annual rate, g1, over the next three
years. At the end of three years (the end of 2015), the
firm’s mature product line is expected to result in a
slowing of the dividend growth rate to 5% per year,
g2, for the foreseeable future. The firm’s required
return, rs, is 15%.
7-57

58. Table 7.3 Calculation of Present Value of
Warren Industries Dividends (2013–2015)
7-58

59. Common Stock Valuation:
Variable-Growth Model (cont.)
∗Step 3. The value of the stock at the end of the
initial growth period (N = 2015) can be found by
first calculating DN+1 = D2016.
∗D2016 = D2015 × (1 + 0.05) = $2.00 × (1.05) = $2.10
∗By using D2016 = $2.10, a 15% required return, and a
5% dividend growth rate, we can calculate the value
of the stock at the end of 2015 as follows:
∗P2015 = D2016 / (rs – g2) = $2.10 / (.15 – .05) = $21.00
7-59

60. Common Stock Valuation:
Variable-Growth Model (cont.)
∗Step 3 (cont.) Finally, the share value of $21
at the end of 2015 must be converted into a
present (end of 2012) value.
∗P2015 / (1 + rs)3 = $21 / (1 + 0.15)3 = $13.81
∗Step 4. Adding the PV of the initial dividend
stream (found in Step 2) to the PV of the
stock at the end of the initial growth period
(found in Step 3), we get:
∗P2012 = $4.14 + $13.82 = $17.93 per share
7-60

61. Common Stock Valuation:
Free Cash Flow Valuation Model
∗A free cash flow valuation model determines the value
of an entire company as the present value of its expected
free cash flows discounted at the firm’s weighted average
cost of capital, which is its expected average future cost of
funds over the long run.
∗where
7-61
VC = value of the entire company
FCFt = free cash flow expected at the end of year t end of year t
ra = the firm’s weighted average cost of capital

62. Common Stock Valuation:
Free Cash Flow Valuation Model (cont.)
∗Because the value of the entire company, VC,
is the market value of the entire enterprise
(that is, of all assets), to find common stock
value, VS, we must subtract the market value
of all of the firm’s debt, VD, and the market
value of preferred stock, VP, from VC.
7-62
V
∗VS = VC – VD – VP

63. Table 7.4 Dewhurst, Inc.’s Data for
the Free Cash Flow Valuation Model
7-63

64. Common Stock Valuation:
Free Cash Flow Valuation Model (cont.)
∗Step 1. Calculate the present value of the
free cash flow occurring from the end of 2018
to infinity, measured at the beginning of 2018.
7-64

65. Common Stock Valuation:
Free Cash Flow Valuation Model (cont.)
∗Step 2. Add the present value of the FCF from
2018 to infinity, which is measured at the end of
2017, to the 2017 FCF value to get the total FCF in
2017.
∗Total FCF2017 = $600,000 + $10,300,000 =
$10,900,000
∗Step 3. Find the sum of the present values of the
FCFs for 2013 through 2017 to determine the value
of the entire company, VC. This step is detailed in
Table 7.5 on the following slide.
7-65

66. Table 7.5 Calculation of the Value of the
Entire Company for Dewhurst, Inc.
7-66

67. Common Stock Valuation:
Free Cash Flow Valuation Model (cont.)
∗Step 4. Calculate the value of the common
stock.
∗VS = $8,626,426 – $3,100,000 – $800,000 =
$4,726,426
∗The value of Dewhurst’s common stock is
therefore estimated to be $4,726,426. By
dividing this total by the 300,000 shares of
common stock that the firm has outstanding,
we get a common stock value of $15.76 per
share ($4,726,426 ÷ 300,000).
7-67

68. Common Stock Valuation:
Other Approaches to Stock Valuation
• Book value per share is the amount per share of
common stock that would be received if all of the
firm’s assets were sold for their exact book
(accounting) value and the proceeds remaining after
paying all liabilities (including preferred stock) were
divided among the common stockholders.
• This method lacks sophistication and can be criticized
on the basis of its reliance on historical balance sheet
data.
• It ignores the firm’s expected earnings potential and
generally lacks any true relationship to the firm’s value
in the marketplace.
7-68

69. Common Stock Valuation: Other
Approaches to Stock Valuation (cont.)
∗At year-end 2012, Lamar Company’s
balance sheet shows total assets of $6
million, total liabilities (including preferred
stock) of $4.5 million, and 100,000 shares of
common stock outstanding. Its book value
per share therefore would be
7-69

70. Common Stock Valuation: Other
Approaches to Stock Valuation (cont.)
• Liquidation value per share is the actual amount
per share of common stock that would be received if
all of the firm’s assets were sold for their market
value, liabilities (including preferred stock) were
paid, and any remaining money were divided among
the common stockholders.
• This measure is more realistic than book value
because it is based on current market values of the
firm’s assets.
• However, it still fails to consider the earning power
of those assets.
7-70

71. Common Stock Valuation: Other
Approaches to Stock Valuation (cont.)
∗Lamar Company found upon investigation
that it could obtain only $5.25 million if it
sold its assets today. The firm’s liquidation
value per share therefore would be
7-71

72. Common Stock Valuation: Other
Approaches to Stock Valuation (cont.)
• The price/earnings (P/E) ratio reflects the
amount investors are willing to pay for each
dollar of earnings.
• The price/earnings multiple approach is a
popular technique used to estimate the
firm’s share value; calculated by
multiplying the firm’s expected earnings per
share (EPS) by the average price/earnings
(P/E) ratio for the industry.
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73. Common Stock Valuation: Other
Approaches to Stock Valuation (cont.)
∗Lamar Company is expected to earn $2.60
per share next year (2013). Assuming a
industry average P/E ratio of 7, the firms per
share value would be
∗$2.60 × 7 = $18.20 per share
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74. Focus on Ethics
∗Psst—Have You Heard Any Good Quarterly Earnings
Forecasts Lately?
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∗ Companies used earnings guidance to lower analysts’ estimates;
when the actual numbers came in higher, their stock prices
jumped.
∗ The practice reached a fever pitch during the late 1990s when
companies that missed the consensus earnings estimate, even by
just a penny, saw their stock prices tumble.
∗ In March 2007 the CFA Centre for Financial Market Integrity
and the Business Roundtable Institute for Corporate Ethics
proposed a template for quarterly earnings reports that would, in
their view, obviate the need for earnings guidance.
∗ What are some of the real costs a company must face in
preparing quarterly earnings guidance?

75. Matter of Fact
∗ Problems with P/E Valuation
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∗ The P/E multiple approach is a fast and easy way to
estimate a stock’s value.
∗ However, P/E ratios vary widely over time.
∗ Therefore, analysts using the P/E approach in the
1980s would have come up with much lower estimates
of value than analysts using the model 20 years later.
∗ In other words, when using this approach to estimate
stock values, the estimate will depend more on
whether stock market valuations are high or low rather
than on whether the particular company is doing well
or not.

76. Figure 7.3 Decision Making and
Stock Value
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77. Decision Making and Common Stock
Value: Changes in Expected Dividends
• Assuming that economic conditions remain
stable, any management action that would cause
current and prospective stockholders to raise
their dividend expectations should increase the
firm’s value.
• Therefore, any action of the financial manager
that will increase the level of expected dividends
without changing risk (the required return)
should be undertaken, because it will positively
affect owners’ wealth.
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78. Decision Making and Common Stock
Value: Changes in Expected Dividends
(cont.)
∗Assume that Lamar Company announced a
major technological breakthrough that would
revolutionize its industry. Current and prospective
stockholders expect that although the dividend
next year, D1, will remain at $1.50, the expected
rate of growth thereafter will increase from
7% to 9%.
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79. Decision Making and Common
Stock Value: Changes in Risk
• Any measure of required return consists of two
components: a risk-free rate and a risk premium. We
expressed this relationship as in the previous chapter,
which we repeat here in terms of rs:
• Any action taken by the financial manager that increases
the risk shareholders must bear will also increase the risk
premium required by shareholders, and hence the required
return.
• Additionally, the required return can be affected by
changes in the risk free rate—even if the risk premium
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80. Decision Making and Common Stock
Value: Changes in Risk (cont.)
∗Assume that Lamar Company manager
makes a decision that, without changing
expected dividends, causes the firm’s risk
premium to increase to 7%. Assuming that
the risk-free rate remains at 9%, the new
required return on Lamar stock will be 16%
(9% + 7%).
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81. Decision Making and Common
Stock Value: Combined Effect
∗If we assume that the two changes
illustrated for Lamar Company in the
preceding examples occur
simultaneously, the key variable values
would be D1 = $1.50, rs = 0.16, and g =
0.09.
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82. Review of Learning Goals
Differentiate between debt and equity.
∗ Holders of equity capital (common and preferred stock) are owners of the
firm. Typically, only common stockholders have a voice in management.
Equity holders’ claims on income and assets are secondary to creditors’
claims, there is no maturity date, and dividends paid to stockholders are
not tax-deductible.
Discuss the features of both common and preferred stock.
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∗ The common stock of a firm can be privately owned, closely owned, or
publicly owned. It can be sold with or without a par value. Preemptive
rights allow common stockholders to avoid dilution of ownership when
new shares are issued. Some firms have two or more classes of common
stock that differ mainly in having unequal voting rights. Proxies transfer
voting rights from one party to another. The decision to pay dividends to
common stockholders is made by the firm’s board of directors.
∗ Preferred stockholders have preference over common stockholders with
respect to the distribution of earnings and assets. They do not normally
have voting privileges. Preferred stock issues may have certain restrictive
covenants, cumulative dividends, a call feature, and a conversion feature.

83. Review of Learning Goals (cont.)
Describe the process of issuing common stock, including
venture capital, going public, and the investment
banker.
∗ The initial nonfounder financing for business startups with attractive
growth prospects typically comes from private equity investors. These
investors can be either angel capitalists or venture capitalists (VCs).
∗ The first public issue of a firm’s stock is called an initial public
offering (IPO). The company selects an investment banker to advise it
and to sell the securities. The lead investment banker may form a
selling syndicate with other investment bankers. The IPO process
includes getting SEC approval, promoting the offering to investors,
and pricing the issue.
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84. Review of Learning Goals (cont.)
Understand the concept of market efficiency and basic
stock valuation using zero-growth, constantgrowth, and variable-growth models.
∗ Market efficiency assumes that the quick reactions of rational investors
to new information cause the market value of common stock to adjust
upward or downward quickly.
∗ The value of a share of stock is the present value of all future dividends
it is expected to provide over an infinite time horizon. Three dividend
growth models—zero-growth, constant-growth, and variable-growth—
can be considered in common stock valuation. The most widely cited
model is the constant-growth model.
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85. Review of Learning Goals (cont.)
Discuss the free cash flow valuation model and the
book value, liquidation value, and price/earnings (P/E)
multiple approaches.
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∗ The free cash flow valuation model finds the value of the entire company
by discounting the firm’s expected free cash flow at its weighted average
cost of capital. The common stock value is found by subtracting the
market values of the firm’s debt and preferred stock from the value of the
entire company.
∗ Book value per share is the amount per share of common stock that
would be received if all of the firm’s assets were sold for their exact book
(accounting) value and the proceeds remaining after paying all liabilities
(including preferred stock) were divided among the common stockholders.
∗ Liquidation value per share is the actual amount per share of common
stock that would be received if all of the firm’s assets were sold for their
market value, liabilities (including preferred stock) were paid, and the
remaining money were divided among the common stockholders.
∗ The price/earnings (P/E) multiple approach estimates stock value by
multiplying the firm’s expected earnings per share (EPS) by the average
price/earnings (P/E) ratio for the industry.

86. Review of Learning Goals (cont.)
Explain the relationships among financial decisions,
return, risk, and the firm’s value.
∗ In a stable economy, any action of the financial
manager that increases the level of expected
dividends without changing risk should increase
share value; any action that reduces the level of
expected dividends without changing risk should
reduce share value. Similarly, any action that
increases risk (required return) will reduce share
value; any action that reduces risk will increase share
value. An assessment of the combined effect of
return and risk on stock value must be part of the
financial decision-making process.
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87. Integrative Case: Encore
International
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88. a.
b.
c.
d.
e.
f.
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Integrative Case: Encore
International
What is the firm’s current book value per share?
What is the firm’s current P/E ratio?
What is the current required return for Encore stock? What will be the new
required return for Encore stock assuming that they expand into European
and Latin American markets as planned?
If the securities analysts are correct and there is no growth in future
dividends, what will be the value per share of the Encore stock? (Note: use
the new required return on the company’s stock here)
If Jordan Ellis’s predictions are correct, what will be the value per share of
Encore stock if the firm maintains a constant annual 6% growth rate in
future dividends? (Note: Continue to use the new required return here.) If
Jordan Ellis’s predictions are correct, what will be the value per share of
Encore stock if the firm maintains a constant annual 8% growth rate in
dividends per share over the next 2 years and 6% thereafter?
Compare the current (2012) price of the stock and the stock values found in
parts a, d, and e. Discuss why these values may differ. Which valuation
method do you believe most clearly represents the true value of the Encore
stock?

89. Further Reading
∗ Gitman, Lawrence J. and Zutter ,Chad
J.(2013) Principles of Managerial
Finance, Pearson,13th Edition
∗ Brooks,Raymond (2013) Financial
Management: Core Concepts ,
Pearson, 2th edition
1 - 89

90. Questions?