MGT 326 Ch 7 Stock Valuation (bdh2e)
Ver. 1.2 Fall 2013
STOCK (EQUITY)
Learning Objectives:
Understand Fundamental Stock Concepts, Terms & Characteristics
Define the Stock Investor's Rqd ROR
Compute Stock Realized & Expected Total Yield
Compute the Theoretical Value of a Zero Dividend Growth Stock (Div.
Discount Model)
Compute the Theoretical Value of a Constant Dividend Growth Stock
(DDM)
Compute the Theoretical Value of a Non-constant Dividend Growth Stock
(DDM)
Explain When to Use the Above Pricing Models wrt the Corporate Life
Cycle
Explain How Firms Meet the Cost of Stock
Understand the Relationship Between NI Growth, Divi. Growth & Stock
Price Growth
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2e created Sum ‘11 v1.1 Spr ‘12
MGT 326 Ch 7 Stock Valuation (bdh2e)
Common Stock Basics:
Shares of stock are initially sold by a firm; proceeds usually used
to buy capital assets (plant, machinery, equipment, etc.)
Large quantities of stock are usually only issued once by a firm
Small quantities may be issued later (stock options, convertible
bonds, warrants, etc.)
A share of stock is ownership in a company (see below)
The publicly traded stock from a particular company has a unique
symbol (the “ticker” symbol) Ex: Apple Inc.: AAPL
Common Stock Financial Considerations:
May or may not pay a dividend
May or may not be publicly traded in a market (i.e. NYSE)
Usually gains or loses value over time (capital gains/losses).
Price (perceived value) based on many company specific factors to
include:
Recent and expected earnings
Recent or pending litigation
Product/service reliability (ex: auto recall)
Financial health/stability (ex: ability to service debt)
Quality of management
Integrity of financial reporting
Legal Rights & Privileges of Common Stock Holders
Control of the firm:
A stock owner has voting rights; the right to vote on key
company issues such as electing the board of directors
each share of stock has one vote
states regulate (by law) frequency and conduct of voting
stockholders who cannot attend voting sessions can vote by
proxy
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MGT 326 Ch 7 Stock Valuation (bdh2e)
Legal Rights & Privileges of Common Stock Holders
Stockholders are entitled to all of a firm’s Net Income
The Market for Common Stock
Closely Held or Private Stock: Stock from small privately owned
firms
small companies often don’t have much stock outstanding
what stock there is, is usually held by senior
management or private owners
this stock is often not publicly traded
Publicly Held Stock: Stock from large firms
most large firms have financed themselves over years
(decades) through one or more stock issues
stock from these firms is usually (but not always) publicly
traded and has been so for a long time
in essence, the “public” owns these firms
Types of Stock Market Transactions:
primary vs. secondary markets (Ch 2)
Initial Public Offering (IPO) Market:
an IPO occurs when a firm decides to issue stock to the
public for the first time
many firms have had non-publicly traded stock (private
stock) for years prior to going public (i.e. Microsoft 1986)
investment banks “underwrite” the IPO
IPOs occur in the primary market and, in effect, are OTC
transactions almost always limited to large investor firms;
this is why you & I can’t get a piece of the action
there are initiatives to end this situation
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MGT 326 Ch 7 Stock Valuation (bdh2e)
What makes stocks valuable (why anyone would want to buy them):
A way to rearrange cash flows (hopefully in a positive, profitable
way) in the form of an investment:
stock ownership entitles holders to dividends, however…..
dividends (on common stock) are not guaranteed
a firm’s management may decide to retain all earnings for
various reasons & purposes
stock value may appreciate over time; opportunity for capital
gain by selling the stock at a price higher than you paid for it
thus the expected cash flows from stock consists of two parts:
expected dividends & expected capital gains
A chance to own a piece of a firm
this isn’t a big deal for most individual investors
this is a very big deal for corporations wishing to acquire other
firms
Why firms care about the price of their outstanding stock:
Stock prices reflect public perception of and confidence in the firm’s
future prospects
They want to avoid hostile take-over
Question: How do we determine the fair market value of a stock?
Answer: One way is to find the PV of all dividends expected to be
paid in the future and sum them because……
The value of any financial asset is determined by discounting all
future cash flows to the present (i.e. find the PV @ t = 0) and
adding them up!!!!
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MGT 326 Ch 7 Stock Valuation (bdh2e)
Common Stock Valuation (continued)
Some Terms & Concepts:
D0: The most recent dividend paid (usually just before t = 0). This
is not a future or present cash flow; it has already occurred.
Dt: the dividend a stockholder expects to receive at the end of a
some future period ( t is an index)
P0: The actual price (market value) of the stock today (t = 0)
P0: The expected, theoretical, intrinsic value of the stock at t = 0;
(Note: the symbol is the statistics way to say “expected”
Pt: The expected price of a stock at the end of some future period
( t is an index)
g: Expected growth rate of the dividend
rs: Required ROR/Yield.
This is the minimal acceptable ROR for an investor; it’s an
opportunity cost. For example, if the NYSE has been paying
8% recently then rs for any particular NYSE stock might be 8%
rs is also the “cost of stock” from the firm’s perspective (more
on this later)
rs: Actual or “realized” ROR or Yield; a historical ROR
rs: Expected and/or theoretical ROR/Yield
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MGT 326 Ch 7 Stock Valuation (bdh2e)
Expected/Theoretical Yield (rs) on a Stock (This is rE as discussed
in your text book)
Can we determine the expected ROR on a stock? Yes.
There are two ways to make a profit from stocks:
dividends
capital gains
Expected Dividend Yield = ROR from dividends = D1 / P0
Expected Capital Gains Yield = Potential ROR from Selling the
stock at some point in the future (let’s say one year from now)
= (P1 - P0)/P0
Expected Total Yield = rs = Expected Dividend Yield + Expected
Capital Gains Yield
rs = D1 / P0 + (P1 - P0)/P0
= (D1 + P1 - P0)/P0
rs is the discount rate we will use to find the theoretical value of the
stock by discounting all future cash flows to t = 0 and adding them
up
→it is the best available expected return offered in the stock
market on a stock of comparable risk
→it should compensate us for r*, inflation and the associated
level of risk for that particular stock
→it is the rate at which we expect our investment to grow to
achieve a future value
→since discounting is the opposite of compounding, we must
discount at that exact same rate in order to find the present value
→rs (rE)is also called the “Opportunity Cost of Equity” because
it is the return the investor forgoes on an alternative investment
of equivalent risk and term when the investor takes on the
alternative investment
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MGT 326 Ch 7 Stock Valuation (bdh2e)
Expected/Theoretical Yield (rs) on a Stock (continued)
Example: A firm’s stock is expected to pay a dividend of $1.25 per share at the
end of the year. The stock price was $37.75 at the beginning of the year. The
firm’s stock is expected to be at around $38.90 by the end of the year. What is
the firm’s expected annual ROR?
1) Find Dividend Yield: D1/P0 = $1.25/$37.75 = 3.3113%
2) Find Cap. Gains Yield: (P1 - P0)/P0 = (38.90 - 37.75)/37.75
= 3.0464%
3) Find rs: 3.3113% + 3.0464% = 6.3576%
Finding Realized Return (Yield) (rs) with Dividend Yield and
Capital Gains Yield
Can we determine the historical ROR on a stock? Yes.
There are two ways to make a profit from stocks:
dividends
capital gains
Thus the total realized return has two parts:
rs = Total Realized Return/Yield
= Realized Dividend Yield + Realized (or Potential) Capital Gains
Yield
rs = D0/P-1 + (P0 - P-1)/P-1
= (D0 + P0 – P-1) / P-1
Example: A firm’s last stock dividend of $0.75 per share was paid at the end
of the 2008. This was the only dividend paid in 2008. The price of that firm’s
stock at that time (P0) was $31.95. The stock price was $33.75 at the
beginning of 2008 (P-1). What was the firm’s realized 2008 ROR?
1) Find Dividend Yield: D0/P-1 = $0.75/$33.75 = 2.2222%
2) Find Capital Gains Yield: (P0 - P-1)/P-1 = (31.95 - 33.75)/33.75
= -5.3333%
3) Find rs (Total Realized Return): 2.22% - 5.33% = -3.1111%
Another Way to Find rs: Compute the average period-to-period ROR over a
given length of time (more on this in Ch
7 10)
MGT 326 Ch 7 Stock Valuation (bdh2e)
Realized ROR (rs) vs. Expected ROR (rs)
The key principle of statistics is past performance is a predictor of
future performance. Therefore:
rs is often used for rs; i.e. rs  rs
Estimates of future stock values and future dividends are just
educated guesses
There’s not much guessing about past data
Analyst feel more confident using past data than future estimates
This is the most common method for finding rs
Required ROR (rs)
Whenever we invest in something we require compensations for r*,
inflation and the associated level of risk of that investment
The same holds for stock investments
The required ROR for a particular stock is rs
There are at least two ways to come up with a value for rs:
1. Suppose your are considering buying stock in Black & Decker
Inc., a power tool manufacturing company. You do some research
and find that the average stock total yield of all power tool
manufacturing firms was 8% for the last five years. You may
choose to call 8% your required ROR (rs).
2. Because an investor requires at least what was earned in the past
and you may choose to use rs as rs
Note on How These Terms are Used in Common Practice:
rs, rs and rs are often used interchangeably because rs is often used for
rs and rs is often used for rs
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MGT 326 Ch 7 Stock Valuation (bdh2e)
Required ROR on Bonds (rd) vs. Required ROR on Stocks (rs)
There is no doubt about rd; it is the current market interest rate for
all bonds of the same rating and maturity
There is no definitive answer for the value of rs
Common Stock Valuation: The Dividend Discount Model
Finding the Expected (Theoretical, Fair Market) Value of a Stock (P0)
A basic assumption is: any company that issues stock is planning on
being around at least for the foreseeable future
Therefore, we don’t know when the last dividend will occur
Therefore, we will assume that the firm will exist indefinitely
Thus, we can model a stock as a perpetuity
(recall from Ch 4: PVperpetuity = PMT/ r )
“Pricing” a “zero-growth” stock; (i.e. the dividend always remains
the same, forever)
Expected Value of the Stock (Base Equation) = Vs = P0


D̂1
D̂ 2
D̂




1  rs 1 1  rs 2
1  rs 

D̂ t
 1  r 
t 1
t
s
As t in the perpetuity equation continues to infinity, the equation
converges to:
P0 = D/ rs [This is the same thing as a perpetuity (Ch 4) but with
different variables]
Example: The stock of Jihad Jim’s Travel Adventures Corp. pays an
annual dividend of $2. If the required ROR (rs) is 8%, what is the
“theoretical” or “expected” price of this stock?
P0 = D/ rs = $2 / 0.08 = $25
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MGT 326 Ch 7 Stock Valuation (bdh2e)
Common Stock Valuation (continued)
“Pricing” a “constant-growth” stock; (i.e. the dividend grows at a
constant rate, forever)
P0 = D0(1 + g) = D1
Note: rs must be > g or the model
makes no sense
rs – g
rs - g
We don’t know what D1 will be but we can estimate it
A firm’s net income usually grows from year to year (see next
page). That rate of grow is “g”
We assume that dividends grow at that same rate
We know what D0 (the last dividend paid) is
To estimate D1, we simply grow D0 one period at growth rate g;
D1= D0(1 + g)1 (i.e. FV = PV(1 + g)n)
Example: The CEO of Jihad Jim’s Travel Adventures Corp. has
decided that, since the firm is doing exceedingly well and since
future prospects look very promising, all dividends for the
foreseeable future will be increased at an annual rate of 2% (g = 2%).
The last dividend (D0) was $2. If the required ROR (rs) is 8%, what
is the “theoretical” or “expected” price of this stock?
D0
0
D1
1
D2
2
Dinfinity
D3
3
t = ? (infinity)
4
P0 = D0(1 + g) = $2(1 + 0.02) / (0.08 - 0.02) = $34.00
rs - g
Solving the above equation for rs we get:
rs = D1/P0 + g
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MGT 326 Ch 7 Stock Valuation (bdh2e)
Common Stock Valuation (continued)
Rationale for Constant Dividend Growth:
We expect a firm’s net income to grow at least as fast as inflation
or else the firm loses value
We expect all stock dividends to grow at least as fast as inflation
(disregarding any possible capital gains by selling the stock in the
future) If this were not the case, why invest in that stock?
Thus, it is fair to conclude that an adequate model for basic stock
valuation is that for a constant growth stock in which the dividend
grows at least as fast as inflation
An average growth rate for all stock dividends is the GDP growth
rate plus inflation (i.e. g = DGDP + inflation)
Firm specific growth estimates are produced by financial services
companies and are available from many online sources
“Pricing” Stocks with Non-constant Dividend Growth:
For most firms, NI doesn’t grow at a constant rate indefinitely
Corporate life cycle: emergence, growth, maturity & decline
Dividend Growth Rates:
Supernormal Growth: “above average” dividend growth typically
occurring during the “emergence” phase of a firm’s life cycle
Normal Growth: “average” growth typically occurring during the
“growth” phase of a firm’s life cycle
Zero or Low Growth: typically occurs during the “mature” phase
of a firm’s life cycle; if the firm’s NI is growing at all, it’s just
keeping pace with inflation; dividends may or may not be growing
Negative Growth: typically occurs during the “decline” phase of a
firm’s life cycle. This doesn’t necessarily mean the firm is losing
money, just that dividends are shrinking
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MGT 326 Ch 7 Stock Valuation (bdh2e)
Common Stock Valuation (continued)
“Pricing” Stocks with Non-constant Dividend Growth: (continued)
Usually, only the supernormal growth period and the normal
growth period are considered; the other two growth phases are too far
into the future to accurately forecast
Example: A firm just recently paid a stock dividend of $1.15 (D0 =
$1.15). The firm pays only 1 dividend per year and that occurs at the
end of the year. The firm expects its dividends to grow by 30% for
the next 3 years (t=1 thru t=3). After that, dividends are expected to
grow at 8% per year for the foreseeable future. What is the
theoretical value of this firm’s stock (P0)? Assume rs is 13.4%
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MGT 326 Ch 7 Stock Valuation (bdh2e)
Common Stock Valuation (continued)
Pricing Stocks with Non-constant Dividend Growth: (continued)
Example: (continued)
Approach: break the problem down into two parts; a supernormal
growth part and a normal growth part
Dinfinity
D3
D0 = $1.15
0
D1
1
D4
D5
D6
D7
5
6
7
D2
2
3
4
t = ? (infinity)
rs = 13.4%
Note: the dividends occur at the end of each period
The solution approach is kind of like the changing interest rate
problem we looked at in Ch 4
P0 = PV0(CFs1-3) + PV0(PVt=3, CFs 4-infinity)
1) Find PV0(CFs1-3) : Compute each dividend (gSN=30%) then
discount each of the dividends (@ rs = 13.4%) back to t=0.
Note: D0 has already been paid and is thus not included in the PV
Dividend
Dt = Dt-1 (1 + 0.3)
PV(t=0)
0
$1.1500
1
$1.4950
$1.3183
2
$1.9435
$1.5113
3
$2.5266
$1.7326
PV 0(CFs 1-3) =
$4.5622
N=1, I/Y=30, PV=1.15; FV = 1.4950
N=2, I/Y=30, PV=1.15; FV = 1.9435
N=3, I/Y=30, PV=1.15; FV = 2.5266
N=1, I/Y=13.4, FV=1.4950; PV = $1.3183
N=2, I/Y=13.4, FV=1.9435; PV = $1.5113
N=3, I/Y=13.4, FV=2.5266; PV = $1.7326
$4.5622
or
I/Y=13.4, CF0=0, CF1=1.4950, CF2=1.9435, CF3=2.5266; NPV = $4.5622
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MGT 326 Ch 7 Stock Valuation (bdh2e)
Common Stock Valuation (continued)
Pricing Stocks with Non-constant Dividend Growth: (continued)
The cash flow diagram now looks like this:
Dinfinity
D4
D5
D6
D7
5
6
7
PV0,CFs1-3 = $4.5622
0
1
2
3
4
rs = 13.4%
t = ? (infinity)
PVt=3,CFs4-infinity = Vterminal = Vhorizon = P3 =?
2) Find PVt=3, CFs 4-infinity :
We will find this by viewing this portion of the problem as a stock
that has constant growth
We will find the theoretical value of a constant growth stock at t =
3 (This is called the “terminal” or “horizon” value)
This is equivalent to the PV @ t=3 of all future cash flows
Thus PVt=3, = P3 = Vhorizon = D3(1+gN)/(rs - gN)
PVt=3, CFs 4-infinity = D3(1+gN)/(rs - gN)
= 2.5266(1.08)/(0.134 - 0.08) = $50.5320
The cash flow diagram now looks like this:
PVt=3,CFs4-infinity = $50.5320
PV0,CFs1-3 = $4.5622
0
1
2
3
4
5
6
rs = 13.4%
14
7
t = ? (infinity)
MGT 326 Ch 7 Stock Valuation (bdh2e)
3) Find PV0(PVt=3, CFs 4-infinity)
Discount PVCFs 4-infinity back to t = 0
Discount 3 periods
PVt=3,CFs4-infinity = $50.5320
PV0,CFs1-3 = $4.5622
0
1
2
3
4
5
6
7
t = ? (infinity)
rs = 13.4%
PV0(PV t=3, CFs 4-infinity) = $50.5320 / (1 + 0.134)3 = $34.6519
or
N=3, I/Y=13.4, FV=50.5320; CPT,PV: = $34.6519
The cash flow diagram now looks like this:
PV0(PVt=3,CFs4-infinity) = $34.6519
PV0,CFs1-3 = $4.5622
0
1
2
3
4
5
6
7
t = ? (infinity)
rs = 13.4%
4) Find P0: P0 = $4.5622 + $34.6519 = $39.21
What’s the point of all this?
Answer:
This is how the price is estimated for an IPO of stock
This is how you can get a more accurate estimate of what any
stock should (in theory) cost in order to determine if the current
market value of a stock is way over/under valued
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MGT 326 Ch 7 Stock Valuation (bdh2e)
Common Stock Valuation (continued)
Example: The stock of Java Jim’s Gourmet Coffee Inc. is currently selling for
$65 per share. The firm pays dividends each quarter and they are expected to
grow at a rate of 16% per year for the next nine months. After this time, the
dividends are expected to grow at a constant rate of 8% per year for the
foreseeable future. The firm’s most recent dividend was $0.50. The stock's
required rate of return is 12%. What is the theoretical value of this stock?
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MGT 326 Ch 7 Stock Valuation (bdh2e)
Common Stock Valuation (continued)
What do you do if a company doesn’t pay dividends?
Answer:
Use Free Cash Flows (FCF) per share instead of dividend per share
For a definition of FCF, refer to pp 299-303
Using FCF/share for future cash flows will produce a higher P0
than if you use dividends for future cash flows
Stock Valuation Summary:
These models for stock valuation are not precise since:
g is the result of an educated guess
we assume g is stable and constant; even in the case when we
have more than one g (non-constant dividend growth), but g can
and probably will change and thus not be constant
nothing lasts forever
risk (volatility, uncertainty associated with indefinite life, etc.)
has not been addressed
These models are useful for comparative stock analysis
you can compare the theoretical values with market values to
determine if stocks are over/under valued
if you use the same model for all the stocks you evaluate, the
biases discussed above apply uniformly
Point:
Because of the uncertainty of the stock valuation parameters, (g, rs
and no specified end date) the best we can do is estimate the
theoretical value of stock
This is also why there are several methods (Discounted Free Cash
Flow model, Comparable Firm Valuation method, Total Payout
Model) to find stock theoretical value
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MGT 326 Ch 7 Stock Valuation (bdh2e)
Estimating a Future Stock Price
Example: Jihad Jim’s Travel Adventures Corp. stock currently sells for
$35, its dividends have an annual growth rate of 1.5% and its next
dividend is expected to be $1 per share. If the dividends for this stock
actually grow 1.5% per year, what is the expected value of the stock
one year from now?
P1 = P0(1 + g) = $35(1 + 0.015) = $35.53
or
N=1, I/Y=1.5, PV=35; FV = $35.53
Note: g is a periodic rate!
Example (continued): The dividends for the above stock actually grow
at 3% per year and the firm pays quarterly dividends. What is the
expected value of the stock one year from now?
P1 = P0(1 + g/m)n = $35(1 + 0.03/4)4 = $36.06
or
P/Y=4, N=4, I/Y=3, PV=35; CPT,FV = $36.06
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MGT 326 Ch 7 Stock Valuation (bdh2e)
Some Important Theoretical Relationships
Consider the formula for theoretical value of a constant growth stock:
P0 =
D1
rs – g
Solving the above equation for rs we get: rs = D1/P0 + g
Shift the
from P0 to rs and we get rs = D1/P0 + g (Eqn 1)
Now consider the formula for expected total yield:
rs = D1 / P0 + (P1 - P0)/P0
Dividend Yield
Capital Gains Yield
Substitute Eqn 1 for rs in the above equation and we get:
D1/P0 + g = D1 / P0 + (P1 - P0)/P0
Thus g = (P1 - P0)/P0 = Capital Gains Yield
What Does All This Mean?
In theory, expected dividend growth rate equals the rate at which
one should expect stock price to increase
Since we have assumed the g equals the rate at which NI increases
then:
In theory, the rate at which a stock’s price increases should equal
the rate at which that firm’s NI increases
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MGT 326 Ch 7 Stock Valuation (bdh2e)
Preferred Stock:
Definition: A security that provides a share in a company and a
scheduled payment of a fixed dividend.
They are not usually offered to the general public
Similar to a coupon bond because the dividend is a fixed amount
and paid on a fixed schedule
Similar to common stock since the dividend does not have to be
paid on schedule (it can be deferred) and there is no expiration date of
the stock
Holders of preferred stock have priority over common stock
holders in the distribution of a company's funds (dividends and
bankruptcy proceeds)
Preferred Stock Dividend: Dp
Preferred Stock Required ROR: rp; this is not the same as rs; Why
not?
Vp = Dp / rp
rp = Dp / Vp
The Cost of Stock
As previously mentioned rs (required ROR, from investor’s
perspective) is also the “cost of stock” from a firm’s perspective
The cost of stock is, in essence, a management goal:
→management must run the firm such that its value continues to
improve
→this means that a firm’s mgt must try to make stock total yield
(dividends & cap. gains) match investors’ required ROR
→If not, investors buy less of the firm’s outstanding stock  the
stock falls in price due to decreased demand  the firm becomes
more vulnerable to take-over
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MGT 326 Ch 7 Stock Valuation (bdh2e)
Failure to Meet the Cost of Debt vs. Failure to Meet the Cost of
Stock
Failure to Meet the Cost of Debt is more imminent but recoverable
→if you miss an interest payment, you’re (technically) bankrupt
→this is a periodic (month to month, quarter to quarter)
possibility; thus this possibility is imminent
→however, firms can recover from bankruptcy
Failure to Meet the Cost of Stock is not imminent but unrecoverable
→if the firm fails to meet investor’s required ROR on stock,
current stock holders will sell their stock and potential new stock
investors won’t buy it
→if this continues, quarter after quarter, year after year, the stock
price will continue to fall until it becomes cheap enough for a
hostile take-over
→firms rarely recover from hostile take-overs
Price/Earnings Ratio (P/E):
Shows the dollar amount investors are willing to pay for $1of
reported (current) earnings
Must calculate Earning per Share (EPS) first
EPS = NI available to common stockholders / # of common
shares outstanding
P/E = Market price per share of common stock / EPS
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MGT 326 Ch 7 Stock Valuation (bdh2e)
Price/Earnings Ratio (P/E) (continued):
Example: A firm has 5,000,000 shares of common stock outstanding.
Its most recent quarterly earning report indicated NI of $7m. This
firms stock currently sells for $25.60. Find the P/E Ratio for this firm
a) Compute EPS: EPS = $72,000,000 / 5,000,000 shares = $1.40 per
share
b) Compute P/E Ratio: P/E = $25.60 / $1.40 = 18.29 “times
earnings”
P/E Analysis Interpretation:
Smaller is usually (but not necessarily) better.
Indicates whether a firm’s stock is undervalued or over valued
If the P/E is higher than average, the stock is overvalued
If the P/E is lower than average, the stock is undervalued
Example: Consider the following P/E Ratios:
Firm A Firm B Industry Ave.
20
40
30
Which firm’s stock is overvalued? Undervalued?
P/E is higher for firms with high growth prospects Why?
P/E is lower for firms considered to be risky Why?
One must always ask why (the stock is over/under valued)
P/E represents the markets perception of the stock’s value
Is the market seeing something that you aren't?
“Irrational Exuberance” (ref. ‘90’s tech. stock boom)
bad press / bad rep (ref. Phillip Morris)
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MGT 326 Ch 7 Stock Valuation (bdh2e)
Cost of Additional Issue of Common Stock:
Firm’s rarely issue new stock in large quantities
Viewed as a negative signal with respect to a stock’s true value
New stock issue devaluates stock currently outstanding
→dilutes ownership value
→automatically lowers EPS
A new issue of stock typically lowers the price of that firm’s stock
(supply & demand forces a new price equilibrium)
Cost of new common stock (equity): re = D1 / [P0(1 - F )]
→F = Flotation Costs: the cost (per share) to issue the new stock,
expressed as a percentage of the stock price (P0)
Other Ch 9 Topics (read them if you plan to be a Finance major)
-Dividends vs. Investment growth
-Share Repurchases and the Total Payout Model
-Discounted Free Cash Flow Model
-Valuation Based on Comparable Firms
-Valuation Multiples , Limitations of Multiples and Comparison With
Discounted Cash Flow Methods
-Information, Competition and Stock Prices
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