Differences between Debt and Equity by PAk31v6

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									Chapter 7 Stock Valuation


I.     Differences between Debt and Equity




       A.      How are assets distributed at bankruptcy?
               i.    Secured creditors
               ii.   Unsecured creditors
               iii.  Equity holders
                     a. Residual claimants


II.    Common Stock

       A.      Common shareholders
               i.   True owners
               ii.  Entitled to profits
               iii. Limited liability
               iv.  Highest level of risk

       B.      Private or publically owned
               i.      Private typically small corporations
               ii.     Public much larger companies
                       a. Trade in broker or dealer markets

       C.      Terminology
               i.    Par value
                     a. For accounting purposes only
                     b. No relationship to price
               ii.   Authorized shares – number of shares permitted via charter
                     a. Issued shares – sold to investors
                     b. Unissued shares – held by company
                     c. Outstanding shares – issued and currently owned by investors
                     d. Treasury stock – originally owned by an investor but the company has
                         repurchased
              iii.   Preemptive right
                     a. Before new shares are issued, current owners are given an opportunity to
                         buy their current proportional share of the company.
                               i. What does dilution mean?
                              ii. What is a stock right?
              iv.    Voting rights
                     a. Owners have a right to vote for major, company-changing events.
              v.     Dividends
                     a. Board of directors determines if a dividend is to be paid
                     b. Dividends are not guaranteed
                     c. The can be several types of dividends
                     d. Preferred dividends have precedence over common dividends
                               i. Companies can not pay a common dividend until preferred dividends
                                  are paid.

       D.     International stocks
              i.      Two ways to invest in international stocks
                      a. Domestic Stock exchange
                                i. From the NYSE etc.
                               ii. From a bank in the form of an ADR.
                      b. Intl stock exchange




III.   Preferred Stock

       A.     Senior to common stock

       B.     Fixed dividends

       C.     Par value may be a tie to dividends

       D.     Cumulative preferred
              ii.   Creates the mechanism to conserve preferred dividends if they are missed
                    (dividends in arrears)
IV.   Issuing stock

      A.     IPO
             iii.     Original owners “cashing out”
             iv.      Alternative offerings
                      a. Public
                      b. Rights offering’
                      c. Private placement
             v.       Prospectus
                      a. Must be provided for all primary market sales
             vi.      Investment banker
                      a. Middle man – marketing function
                      b. Advisement


V.    Valuation

      A.     How do shareholders get rewarded?

             1.       Dividends and price appreciation

             2.       What strategies can people follow?
                      a. Diversified
                      b. Buy and hold
                      c. Short-term aggressive (day trading)

      B.     What is market efficiency

             1.       Economically rational buyers and sellers et the price

             2.       In a competitive market no one person has the power to sway the price.

             3.       Information is almost free. The flow of info is somewhat constant.

             4.       Information and it’s influence on prices determines market efficiency.

             5.       What kind of info is there?
                      a. Public (historical and current events)
                      b. Private (insider)

             6.       EMH assumes
                      a. Prices are in equilibrium
                      b. Prices reflect all available information
                      c. Difficult to use info to make “abnormal” profits.
                      d. This hypothesis has held for many years.
     7.     Behavioral finance may be the new “theory” behind prices.

C.   Valuation models

     1.      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.
             a. The Gordon model is a common name for the constant-growth model that is
                widely cited in dividend valuation.




     2.     Preferred or zero growth stock
            A preferred stock pays a dividend of $6. The required return is 12%

                    What is the growth rate of a preferred stock dividend?

                    What is the value of the stock?

                    If the stock is selling for $59, should we buy the stock?
3.   Common stock dividend
     The most recent dividend is 2.65. Historically dividends have grown at a 5%
     growth rate. The required return for this stock is 20%.

             What is the value of the stock?

             If the stock’s price is $15, should you buy?




4.   How do you estimate the variables
     a. Dividends can be estimated by using time value and historical information.

         The Lamar company has the following dividend history.
b. The required return can be determined a couple of different ways
        i. By the current return earned on the stock. This is the expected
           return based on the current stock price.
       ii. By the Security market Line derived from the CAPM theory. The
           theory is later described in the risk and return chapter.
      iii. There are three pieces of data required:
               1. Risk free rate – proxied by the yields on 20 or 30 year
                   treasury securities.
               2. The beta of the company. This measures the risk of the
                   company. It is published in many places.
               3. The average rate of return of the stock market. If we
                   assume a long life for a stock, we can look at what history
                   has shown us. We will discuss this more in the risk and
                   return chapter. For now we will assume approx. 12%.




Lamar Company Stock Valuation




Should we buy the stock?



                4. Variable rate growth in dividends
                       a. Some companies have varying rates of dividends
                       b. Mostly due to changes in innovation etc.
                                  c. Sometimes referred to as super-normal growth
                                     stock.

                                  There is a company that expects to have above-normal
                                  growth in earnings and dividends over the next 3 years.
                                  The growth is expected to be 15% for 3 years and then
                                  returns to the historical rate of 8%. The most recent
                                  dividend was $2.00. The required return is 12%.




D.   What can you do if a dividend model won’t work?
     1.     What would cause this?
                  a. No dividends
                  b. Growth rate greater than required return
                  c. Not a corporation

     2.     Free cash flow model is a very similar model but the solution is the
     entire value of the firm.
     3.      What are the variables?




          The firm has estimated the growth of FCF to be 7% over the foreseeable future. The

          most recent FCF was $700,000. The firms WACC = 13%.

             What is the firms value?

                    700,000 * 1  .07 749,000
            VC                                 12,483,333
                        .13  .07         .06

     The firm has no preferred stock but the market value of debt is 7,500,000. The firm has

             100,000 shares.

                        What is the value of equity? Per share?

                                      VS  12,483,333  7,500,000  4,983,333




E.   Other valuation models
     1.      Book value per share
             a. Uses historical accounting values
             b. Not the best tool
                  Total Assets - Total Liabilities - PreferredStock
          BPS 
                             # of outstanding shares
                      Common Equity
             
                  # of outstanding shares
           2.       Liquidation value per share
                    a. Convert accounting values to market values
                    b. Do all assets of the firm have prices??

        Mkt Value Total Assets - Mkt Value Total Liabilitie s - Mkt Value Preferred Stock
LPS 
                                   # of outstandin g shares


           3.       Price earnings multiplier
                    a. Relies on the PE ratio for its development
                    b. Solve the PE ratio for Price.
                    c. Convert the variables to forecasts, changes the solution from price to value


                           P0 = (EPSt+1) X (Industry
                                      Average P/E)
 F.        Some interesting you tube videos
           a. Value investing
              http://www.youtube.com/watch?v=dX2L7JhpXl8&feature=player_detailpage

           b. How to read stocks
              http://www.youtube.com/watch?feature=player_detailpage&v=Lc791is6X0o

           c. A formula (untested but interesting concept)
              http://www.youtube.com/watch?v=UOWrhGmCsIA&feature=player_detailpage

								
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