EQUITY VALUATION

Equity- consists of funds provided by the firm’s owners (investors or stockholders) and is repaid subject to the
firm’s performance.

DEBT SECURITIES – invest money then repaid according to repayment schedule or according to terms of the debt.

Equity Securities - Financial assets that represent ownership of a corporation.

DIFFERENCE OF DEBT AND EQUITY SECURITIES

1. Voice in management – Investment in Equity Securities generally received the voting rights. Debt
securities are not entitled to voting rights.

2. 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.
3. Maturity - Unlike debt, equity is a permanent form of financing for the firm. It does not “mature”, so
repayment is not required.
4. Tax treatment - Interest payments to debtholders are treated as tax-deductible expenses by the issuing
firm, whereas dividend payments to a firm’s stockholders are not tax deductible.
Tax-shielding- decrease in tax due because of increase in incremental expenses (most likely
interest expense)
EBIT = EARNINGS BEFORE INTEREST AND TAX

Common and Preferred Stock

Common Stock- The true owners of corporate business are the common stockholders. They are sometimes
referred to as residual owners because they received what is left after all other claims on the firm’s income and
assets have been satisfied

Privately owned (stock) – The common stock of a firm owned by private investors; this stock is not publicly traded

Publicly owned (stock) – The common stock of a firm is owned by public investors; this stock is publicly traded

Closely owned (stock) – The common stock of a firm is owned by an individual or a small group of investors (such
as a family); these are usually privately owned companies.

Widely owned (stock) – The common stock of a firm is owned by many unrelated individual or a small group of
investors (such as a family); these are usually privately owned companies.

Par value- an arbitrary value established for legal purposes in the firm’s corporate charter and which can be used to
find the total number of shares outstanding by dividing it into the book value of common stock. It is also the value
that is recorded in the equity portion of the balance sheet and any excess of selling price and par value is recorded
in additional paid-in capital.
Preemptive rights- a contractual right that allows current shareholders to buy new shares in a company before
they are offered to the public. This allows common stockholders to maintain their proportionate ownership in the
corporation, when new shares are issued, thus protecting them from dilution of their ownership.

A dilution of ownership is a reduction in each previous shareholder’s fractional ownership resulting from the
issuance of additional shares of common stock.

A dilution of earnings is the reduction in each previous shareholders’ fractional claim on the firm’s earnings
resulting from the issuance of additional shares of common stock.

Rights- 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.

Authorized, Outstanding and Issued Shares

Authorized shares- Shares of common stock that a firm’s corporate charter allows to issue. It is also the
number of shares that was registered by the company to the SEC that was allowed to issue.

Outstanding shares- issued shares of common stock held by investors, including both private and public
investors.

Treasury Shares- Issued shares of common stock held by the firm; often these shares have been
repurchased by the firm

Issued shares- Shares of common stock that have been put into circulation; the sum of outstanding
shares and treasury 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.

Treasury stock generally does not have voting rights, does not earn dividends, and does not have
a claim on assets in liquidation.

Dividends - The payment of dividends to the firm’s shareholders is at the discretion of the company’s
board of directors. Most corporations that pay dividends pay them quarterly. Dividends may be paid in
cash, stock, or merchandise. Cash dividends are the most common, merchandise dividends the least.
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.

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- preferred stock with stated face value that is used with the specified dividend
percentage to determine the annual dollar dividend. EX: 100,000 shares preferred stock @Php10 per
share par value, 10%- Dividend rate

No-par preferred stock- preferred stock with no stated face value but with a stated annual dollar
dividend.
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). However, preferred stock 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.

In liquidation, generally after deducting all claims on creditors, they have the privilege to claims first over
common stock holders.

Features of Preferred Stock – Similar to bond indenture

1. Restrictive Covenants- focus on ensuring the firm’s continued existence and regular payment of
the dividend. These includes provisions about passing dividends, the sale of senior securities,
mergers, sales of assets, minimum liquidity requirements, and repurchases of common stock.
The violation of preferred stock covenants usually permits preferred stockholders either to
obtain representation on the firm’s board of directors or to force the retirement of their stock at
or above its par or stated value.
2. Cumulation- Most preferred stock is cumulative with respect to any dividends passed.
That is, all dividends in arrears, along with the current dividend, must be paid before
dividends can be paid to common stockholders.
a) Cumulative preferred stock- Cumulative preferred stock is a type of preferred stock
with a provision that stipulates that if any dividend payments have been missed in the
past, the dividends owed must be paid out to cumulative preferred shareholders first.
b) Noncumulative preferred stock- Preferred stock for which passed (unpaid) dividends
do not accumulate.

3. Other features - Preferred stock can be callable or convertible.

Callable preferred stock- allows the issuer to retire the shares within a certain period of time
and at a specified price.

Convertible preferred stock- allows holders to change each share into a stated number of shares
of common stock

ISSUING COMMON STOCK

1. Initial Public Offering (IPO)- The firs public sale of a firm’s stock. These are typically made by
small, rapidly growing companies that either require additional capital to continue expanding or
have met a milestone for going public that was established in a contract signed earlier.

2. Rights offering- new shares are sold to existing stockholders

3. Private Placement- the firm sells new securities directly to an investor or group of investors.
Common Stock Valuation
Market value- the interactions of many buyers and sellers that result in an equilibrium price. It
is the price or value where in the buyers are willing to pay and sellers are willing to sell in a
competitive market.
Market efficiency- continuous moving toward a new equilibrium that reflects the most recent
information available that results in stock price fluctuations.

Basic Common Stock Valuation Equation

Like in bond valuation, 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.

1. Zero- Growth Model - An approach to dividend valuation that assumes a constant,

nongrowing dividend stream.
In simplest approach, assumes that the dividend per share to be expected to be received
next year (D1) is the same indefinitely. (Same formula for Preferred stock)
D0 = D1 = D2 = D3 = Dt
P0 = D1 D1 = expected dividend the following period

r r = required return
Example: Elric, an investor, estimates that the dividend of Amestris company is expected to
remain constant at Php3 per share indefinitely. If his required return on its stock is 15%, the
stock’s value is computed as follows.
Stock value = D1 / r
Stock value = Php3 / 15%
Stock value = Php20 per share

2. Constant- Growth Model or Gordon growth model

3. A widely cited dividend valuation approach that will assumes that dividends will grow at
a constant rate, but a rate that is less than the required return.
Formula for value of the common stock
D1
=
P0 (r - g)
 Formula for D1: D1 = D0 (1+g)

D0 = Dividend that will be received today

D1 = Dividend expected to be received next period
g = constant rate of growth
r = required return
Example: Ishval company have the following dividend payments until the current
period:
Dividend per share paid
Year
(in Php)
2020 2.93
2019 2.66
2018 2.42
2017 2.20
2016 2.00

Assuming that the required return is 15%. What is the current value of the stock? (Round the
values in 2 decimal places)

3. Variable- Growth Model – Separate Discussion

4. Free Cash Flow Valuation Model - Separate Discussion

Other Approaches to common stock valuation

1. Book Value per share - The amount per share of common stock that would be received
if all of the firm’s assets were sold for their exact book value and the proceeds
remaining after paying all liabilities, including preferred stock, were divided among
stockholders.
Formula:
Book Value = Total assets – Total Liabilities - Preferred stock
Book Value per share = Book value / No. of outstanding of shares for common stock
Example: Armstrong company have total assets of Php 6million, total liabilities of Php
3.5million, Preferred shares of 10,000 shares with 100 par value per share, and outstanding
common stock of 100,000 shares. What is the book value per share of Armstrong company?
Book value = Php 6,000,000 – 3,500,000 – (10,000 * 100)
Book value = Php1,500,000
Book value per share = Php1,500,000 / 100,000 shares
Book value per share = Php15 per share

2. Liquidation value per share

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 and preferred stock were paid, and
any remaining money were divided among the common stockholders.

Example: Black bull company have total assets with book value of Php 5million and market value of Php
5.25million, total liabilities of Php 3million, liquidation expenses of Php500,000, Preferred shares of
10,000 shares with 100 par value per share, and outstanding common stock of 100,000 shares. What is
the liquidation value per share of Black bull company?

Share of common stock in liquidation = Php750,000

Liquidation value per share = Php750,000 / 100,000

Liquidation value per share = Php7.50 per share

 3. Price/ Earnings (P/E) Multiplies Approach
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/earning ratio for the
industry.
Formula:
Value of the firms share = P/E ratio * Earnings per share (EPS)

*Earnings per share = Net Income – Preferred Dividends

No. of outstanding common stock
Example: Novachrono company expects to have an earnings per share of Php 2.60 per share
next year and the price/earnings ratio of the same industry is 7. What is the value of firms share
of the company using the Price/ Earnings Multiplies Approach?
Solution
Value of the firm’s share = 7 * Php 2.60 per share
Value of the firm’s share = Php 18.20 per share