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Investement CH 04

Investment analysis and Portfolio Management
Chapter four
Stock and equity valuation (Tools and techniques
used by investors to find out the true value of equity)
 Firms obtain their long-term sources of equity financing by issuing common and
preferred stock.
 The payments of the firm to the holders of these securities are in the form of
 The common stockholders are the owners of the firm. It represents equity in a
corporation. They have the right to vote on important matters to the firm such as the
election of the Board of Directors. They have a residual claim against the assets and cash
flows of the firm.
 The priority of the claims against the assets of the firm belonging to debt holders,
preferred stockholders and common stockholders differ.
 The owners of the firm's debt securities have the first claim against the assets of the firm.
This means that the debt holders must receive their scheduled interest and principal
payments before any dividends can be paid to the equity holders. The preferred
stockholders have the next claim. They must be paid the full amount of their scheduled
dividends before any dividends may be distributed to the common stockholders.
4.1 Characteristics of Stock
 The term issued refers to the shares issued to the stockholders. A corporation may
re-acquire some of the stock that it has issued.
 The stock remaining in the hands of stockholders is then called outstanding stock.
 Upon request, corporations may issue stock certificates to stockholders to document
their ownership. Printed on a stock certificate is the name of the company, the name
of the stockholder, and the number of shares owned.
 The stock certificate may also indicate a dollar amount assigned to each share of
stock, called par value. Stock may be issued without par, in which case it is called
no-par stock.
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 The most important characteristics of common stock as an investment are its
residual claim and its limited liability features.
 Residual claim means stockholders are the last in line of all those who have a claim
on the assets and income of the corporation.
 Limited liability means that the most shareholders can lose in event of the failure of
the corporation is their original investment.
 Shareholders are not like owners of unincorporated businesses, whose creditors can
lay claim to the personal assets of the owner—such as houses, cars, and furniture.
 They are not personally liable for the firm’s obligations: Their liability is limited.
The major rights that accompany ownership of a share of stock are as follows:
1. The right to vote in matters concerning the corporation.
2. The right to share in distributions of earnings.
3. The right to share in assets on liquidation.
These stock rights normally vary with the class of stock.
4.2 Balance sheet methods/ techniques
Balance sheet methods are the methods which utilize the balance sheet information to
value a company. These techniques consider everything for which accounting in the books
of accounts is done.
Book Value: In this method, book value as per balance sheet is considered the value of
equity. Book value means the net worth of the company. Net worth is calculated as follows:
Net Worth = Equity Share capital + Preference Share Capital + Reserves & Surplus –
Miscellaneous Expenditure (as per B/Sheet) – Accumulated Losses.
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Liquidation Value: In this method, liquidation value is considered the value of
 Liquidation value is the value realized if the firm is liquidated today.
 A better measure of a floor for the stock price is the firm’s liquidation value per
 This represents the amount of money that could be realized by breaking up the firm,
selling its assets, repaying its debt, and distributing the remainder to the
Liquidation Value = Net Realizable Value of All Assets – Amounts paid to All Creditors
including Preference Shareholders.
Replacement Cost: Here, the value of equity is the replacement value. is a term referring to
the amount of money a business must currently spend to replace an essential asset like a
real estate property, an investment security, a lien, or another item, with one of the same or
higher value.
 It means the cost that would be incurred to create a duplicate firm is the value of the
 This concept assumes that interest in valuing a firm is the replacement cost of its
assets less its liabilities.
 This idea is popular among economists, and the ratio of market price to replacement
cost is known as Tobin’s q, after the Nobel Prize–winning economist James Tobin. In
the long run, according to this view, the ratio of market price to replacement cost
will tend toward 1, but the evidence is that this ratio can differ significantly from 1
for very long periods of time.
Equity Value = Replacement Cost of Assets – Liabilities.
 If the role of management is to increase the shareholder value, then managers can
make better decisions if they can predict the impact of those decisions on the firm's
 By observing the difference in the firm's equity value at different points in time, one
can better evaluate the effectiveness of financial decisions.
 A rudimentary way of valuing the equity of a company is simply to take its balance
sheet and subtract liabilities from assets to arrive at the equity value. However, this
book value has little resemblance to the real value of the Company. First, the
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assets are recorded at historical costs, which may be much greater than or much less
their present market values. Second, assets such as patents, trademarks, loyal
customers, and talented managers do not appear on the balance sheet but may have
a significant impact on the firm's ability to generate future profits. So while the
balance sheet method is simple, it is not accurate; there are better ways of
accomplishing the task of valuation.
Intrinsic value versus market price
 The most popular model for assessing the value of a firm as a going concern starts
from the observation that the return on a stock investment comprises cash
dividends and capital gains or losses.
 If a stock is priced “correctly,” it will offer investors a “fair” return, i.e., its expected
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Dividend discount model
 An asset’s value is determined by the present value of its future cash flows.
 A stock provides two kinds of cash flows. First, most stocks pay dividends on a regular
basis. Second, the stockholder receives the sale price when they sell the stock. In valuing
the common stock, we have made two assumptions:
o We know the dividends that will be paid in the future.
o We know how much you will be able to sell the stock for in the future.
These assumptions will define the path of the future cash flows so that we can derive a present
value formula to value the cash flows.
If we make the following assumptions, we can derive a simple model for common stock
 Your holding period is infinite (i.e., you will never sell the stock so you don’t have to
worry about forecasting a future selling price).
 The dividends will grow at a constant rate forever.
Note that the second assumption allows us to predict every future dividend, as long as we know
the most recent dividend and the growth rate.
Thus, in order to value common stocks, we need to answer an interesting question: Is the value
of a stock equal to
1. The discounted present value of the sum of next period’s dividend plus next period’s
stock price, or
2. The discounted present value of all future dividends?
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