Professor Trainor
9-1
Preferred Stock
Preferred stock is a hybrid having some features
similar to debt and other features similar to equity.
Claim on assets and cash flow senior to common stock
As equity security, dividend payments are not tax deductible
for the corporation.
For tax reasons, straight preferred stock held mostly by
corporations.
9-4
Investment Banks’ Role in Equity
Offerings
Firms can choose an investment bank through
Smart Finance
9-7
Valuation Fundamentals:
Preferred Stock
Preferred stock is an equity security that is expected
to pay a fixed annual dividend indefinitely.
9-9
Valuation Fundamentals:
Common Stock
How is P1 determined?
PV of expected stock price P2, plus dividends
P2 is the PV of P3 plus dividends, etc...
Repeating this logic over and over, you find that
today’s price equals PV of the entire dividend
stream the stock will pay in the future:
D1 D2 D3 D4 D5
P0 ....
(1 r ) (1 r ) (1 r ) (1 r ) (1 r )
1 2 3 4 5
9-10
Constant Growth Valuation Model
Assumes dividends will grow at a constant rate
(g) that is less than the required return (r)
If dividends grow at a constant rate forever, you
can value stock as a growing perpetuity, denoting
next year’s dividend as D1:
D1
P0 Eq.4.6
rg
Commonly called the Gordon growth model
9-11
Example
Dynasty Corp. will pay a $3 dividend in one year. If investors
expect that dividend to remain constant forever, and they require a
10% return on Dynasty stock, what is the stock worth?
D1 $3
P0 $30
r 0.1
What is the stock worth if investors expect Dynasty’s dividends
to grow at 3% per year?
D1 $3
P0 $42.86
r g 0.10 0.03 9-12
Video: French
Smart Finance
9-13
Free Cash Flow to Equity
A much better model is to apply discount
models to FCFE which may more
accurately reflect a firms value.
FCFE = Net Income + depreciation –
Cap. Expend. – change in working
capital – principal debt repayments +
new debt issues.
Apply model as per usual.
9-14
Free Cash Flow to Firm
FCFF = EBIT(1-tax rate) + Dep. – Cap.
Expenditures – Change in WC – Change in
other assets.
Again, proceed as normal(replace dividends
with FCFF) but discount at firms cost of
capital.
You find value of firm. To find value of
equity, simply subtract off debt.
9-15
Firm multiples method
Analysts often use the following multiples
to value stocks.
P/E
P / CF
P / Sales
EXAMPLE: Based on comparable firms,
estimate the appropriate P/E. Multiply this
by expected earnings to back out an
estimate of the stock price.
9-16
Weaknesses of Using P/E Ratios
9-17
Video: Shiller
Smart Finance
9-18