Topic 6: Stock valuation

Topic Learning Outcomes

After this topic, you should be able to:
1. Differentiate between debt and equity.
2. Discuss the rights, characteristics, and features of both common and preferred stock.
3. Describe the process of issuing common stock, including venture capital, going public and the investment
bankers, and interpreting stock quotations.
4. Discuss the concept of market efficiency and basic common stock valuation using zero growth, constant growth,
and variable growth models.
5. Discuss the free cash flow valuation model and the book value, liquidation value, and price/earnings (P/E)
multiple approaches.
6. Explain the relationship among financial decisions, return, risk, and the firm’s value.

Be Engaged
Read:
Converge ICT plans P35.9-B IPO

Riding on strong demand for connectivity especially with the lockdowns prompted by the coronavirus pandemic, fiber
internet and other digital services provider Converge ICT Solutions Inc. filed an application at the Securities and
Exchange Commission (SEC) for an initial public offering (IPO) worth as much as P35.9 billion.
The SEC announced on Friday that it had received the registration statement of Converge ICT’s IPO of up to 1.496 billion
primary and secondary common shares at a maximum offer price of P24 a share.

Converge ICT, led by Pampanga-based businessman Dennis Anthony Uy, plans to sell shares and list on the main board
of the Philippine Stock Exchange by October this year, subject to regulatory approvals.
The offer consists of 1.3 billion common shares consisting of 425.68 million primary shares and 885.61 million secondary
shares together with an offer of up to 195.19 million option shares.
About 70 percent of the firm shares will be offered for sale to foreign investors.

The stock debut will bring about a quarter of the company’s shares to public hands.
Proceeds from the primary offering will be used for the company’s capital expenditure requirements to accelerate its
nationwide fiber network rollout and other general corporate purposes.
Morgan Stanley and UBS AG are the joint global coordinators and joint bookrunners, while BPI Capital is the sole local
coordinator, joint local underwriter and joint bookrunner. BDO Capital is a joint local underwriter and book runner.
Converge ICT operates the fastest-growing end-to-end finer network in the Philippines with over 30,000 kilometers of
fiber as of end-March serving about 4.1 million homes.
The company’s residential business captured over 50 percent of the market for new subscriptions from Jan. 1, 2018, to
March 31, according to the prospectus.
“We believe that the Philippine fixed broadband market is currently at an inflection point, with Converge in particular,
serving as a catalyst for market growth as it continues to lead efforts to address current unserved demand,” the
prospectus said.

Source: https://business.inquirer.net/301656/converge-ict-plans-p35-9-b-ipo#ixzz6SPjamXux

Think:
1. Are familiar with the company on the above article? Are you availing is services?
2. What is your first impression when you hear “stock market”? Do you think this is only for really rich people?
3. What do you think is the objective of people who buys shares of a company? What do these shares have that
make it so attractive?
Let’s Discuss
1. Differences between Debt and Equity
2. Legal rights and privileges of common stockholders
3. Common and Preferred
4. Common Stock Valuation
5. Changes in Expected Dividend and Dividend
6. Constant growth stocks
7. Expected rate of return on a constant
8. Valuing the entire corporation
9. Stock market equilibrium

Debt vs Equity

Debt
• debt financing is obtained from creditors
• Includes all borrowing incurred by a firm, such as bonds that is repaid in accordance with a fixed schedule of
payments
• Creditors (lenders or debtholders)
o have a legal right to be repaid
Equity
• equity financing is obtained from investors – part owners of the firm
• investors have only an expectation of being repaid unlike creditors who are entitled for periodic payments
• payment to equity holders are subject to the firm’s performance.

Legal Rights and Privileges of Common Stockholders

1. Control of the Firm
• the right to elect its directors, who in turn elect the officers who manage the business
2. The Preemptive Right
• To purchase on a pro rata basis any additional shares sold by the firm
• A provision in the corporate charter or bylaws that gives common stockholders the right to purchase on
a pro rata basis new issues of common stock (or convertible securities).
Common vs Preferred Stock
Summary Table for differences of Common and Preferred Stock:
Feature Preferred Common

Ownership of Company Yes Yes

Voting Rights No Yes

Dividends Fixed Varies

Order Paid if Company Defaults First Second

Price of Security Is Based on: Earnings Earnings

Common Stock
• true owners of a corporate business are the common or the ordinary stockholders.
• sometimes referred to as residual owners since they receive what is left after all other claims on the firm’s
income and assets have been satisfied – debt and preferred stockholder.
• They are assured that they cannot lose any more than they have invested in the firm.

Preemptive Rights
• A right that allows common stockholders to maintain their proportionate ownership in the corporation when
new shares are issued

Authorized, Outstanding, and Issued Shares

a. authorized shares
• Shares of common stock that a firm allows it to issue.
b. outstanding shares
• Issued shares of common stock held by investors.
c. treasury stock
• Issued shares of common stock held by the firm or repurchased by the corporation.
d. issued shares
• Shares of common stock that have been put into circulation
• the sum of outstanding shares and treasury stock.

Preferred Stock
• “hybrid” – similar to a bond in some respects and to common stock in others.
• It has a par value and a fixed dividend that must be paid before dividends can be paid on the common stock.
• a preferred stock entitles its owners to regular, fixed dividend payments
• most often issued by public utilities, by financial institutions, by acquiring firms in merger transactions, and by
young firms receiving investment funds from venture capital firms
• Dividends
o Like the dividends on common stock, preferred dividends are not tax deductible for the firm that pays
them.

Types of preferred stock

a. par-value preferred stock

• has a stated face value that is used with the specified percentage of dividend.
b. no-par preferred stock
• no stated face value but with a stated annual dividend amount.
 c. cumulative preferred stock
• all unpaid dividends in arrears, including the current dividend, must be paid before dividends can be paid to
common stockholders.
d. noncumulative preferred stock
• unpaid dividends do not accumulate, only current dividends are paid when declared
e. callable feature preferred stock
• allows the issuer to retire the shares at a specified price within a certain period of time and.
f. conversion feature preferred stock
• allows holders to convert each share into a stated number of common stock.

Value of the preferred stock (assuming same dividend payments last forever)

𝐷𝑝
𝑉𝑝 =
𝑟𝑝

Where: Vp = value of the preferred stock; Dp = preferred dividend; rp = required rate of return on the preferred
stock

Example:
Mixed Foods discussed that its preferred should pay a dividend of P10 per year. If its required return was 7%,
what would be the preferred value?

Solution:
𝐷𝑝
𝑉𝑝 =
𝑟𝑝
10
𝑉𝑝 =
7%
𝑉𝑝 = 𝟏𝟒. 𝟐𝟗

Stock Valuation
• Process of determining the stock’s intrinsic or true value.
• A fundamental step in determining if a stock is overvalued or undervalued

Methods of Stock Valuation

1. Non-discounting Techniques – these involves primarily on information based on financial statements and
fundamental market information.

a. Book Value or Net Asset Value Approach

i. This method has an objective of determining the Net Asset Value per Share that represents the
equity or the value of each ordinary shares

ii. Formula:

𝑇𝑜𝑡𝑎𝑙 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝐸𝑞𝑢𝑖𝑡𝑦

Book Value or Net Asset Value =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑆ℎ𝑎𝑟𝑒𝑠
 iii. Example:

At year-end of 2019, Lock Company’s balance sheet shows total assets of P5,000,000, total liabilities of
P4,000,000, and 100,000 ordinary shares outstanding. Compute for the net asset value

Solution:
5,000,000 − 4,000,000
𝟏𝟎 =
100,000

b. Price-Earning Relative Valuation Approach

i. This approach utilizes the Price-Earnings ratio or the Price-Earnings Multiple of a similar or
comparable company.
ii. Formula

𝐶𝑜𝑟𝑝𝑜𝑟𝑎𝑡𝑒 𝑉𝑎𝑙𝑢𝑒 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 ∗ 𝑃𝑟𝑖𝑐𝑒𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑅𝑎𝑡𝑖𝑜 𝑜𝑓 𝐶𝑜𝑚𝑝𝑎𝑟𝑎𝑏𝑙𝑒 𝐹𝑖𝑟𝑚𝑠

𝐶𝑜𝑟𝑝𝑜𝑟𝑎𝑡𝑒 𝑉𝑎𝑙𝑢𝑒
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆𝑡𝑜𝑐𝑘 =
𝑁𝑜. 𝑜𝑓 𝑂𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒𝑠 𝑖𝑠𝑠𝑢𝑒𝑑 𝑎𝑛𝑑 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

iii. Example:

A stockholder of Kitty Co. plans to use the Price-Earning Relative Valuation Approach to estimate the value of
Kitty Co.’s stocks which he holds. The stockholder estimates that Kitty Co. will earn P2.60 per share next year. This
expectation is based on an analysis of the firm’s historical earnings trend and of expected economic and industry
conditions. The price-to-earnings ratio for firms in the same industry averages 7. The number of outstanding and issued
shares of Kitty Co. is 1 Million

Solution:
𝐶𝑜𝑟𝑝𝑜𝑟𝑎𝑡𝑒 𝑉𝑎𝑙𝑢𝑒 = 18,200,000 = (2.60 ∗ 1,000,000) ∗ 7
18,200,000
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆𝑡𝑜𝑐𝑘 = 18.2 =
1,000,000
Note:
If the given is EPS and not the total net income of Kitty Co., you may simply multiply the EPS with the Price/Earnings
Ratio i.e.:
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆𝑡𝑜𝑐𝑘 = 18.2 = 2.6 ∗ 7

2. Discounted Techniques – these approaches are the most common valuation techniques for common stocks.
Future cash inflows generated from the stock is considered. Appropriate discount rate is also utilized to arrive at
the present values of these cash inflows.

a. Discounted Dividend Model – This model considers the expected cash flows of investment: (1)
Dividends, and (2) Stock Price upon sale.

i. Constant Growth
1. A situation where a stock price and its dividends grows at a constant rate
2. Formula:

𝐷1
a. 𝑃0 =
𝑟−𝑔
b. Where: P0 = stock price today; D1 = dividends at the end of the year; r = cost of
equity (required rate of return); g = growth rate
 3. Example:
Welcome Bank is expected to pay P3 dividend to its stockholders at the end of the year. The dividends are
expected to grow at a constant rate of 5%. The required rate of return of the stock is 8%. Determine the stock price
today.

Solution:
3
𝑃0 = 𝟏𝟎𝟎 =
8% − 5%

ii. Non-Constant Growth

1. Also known as Supernormal growth. A situation where the dividends and the stock grow
at a different rate at the earlier part of the stock’s life. This growth will stop or terminate
at a certain point at a horizon or terminal date where the stock and dividends begin to
grow at a constant growth rate.
2. Formula:

𝐷𝑇𝐷+1
a. Get the terminal Value: 𝑇𝑉 =
𝑟−𝑔
𝐷1 𝐷2 𝐷𝑇𝐷 𝑇𝑉
b. Stock Price: 𝑃0 = + + ⋯ + (1+𝑟) 𝑇𝐷 + (1+𝑟)𝑇𝐷
(1+𝑟) (1+𝑟)2
c. Where: P0 = stock price today; D1 to DTD = dividends received during the non-
constant growth phase; r = cost of equity (required rate of return); g = growth
rate under constant growth rate phase; TD = terminal date or horizon (the end
of the non-constant growth phase)

3. Example:
The last dividend paid by Bank de Plata was P1. The growth rate is expected to be constant for 2 years at 5%,
after which the dividends are expected to grow at a rate of 10% annually forever. It is determined that the required rate
of return is 12%. What is the current price of Bank de Plata’s common stock?

Solution:
1. Compute the dividends per year up to the terminal date i.e. up to year 3
a. Year 1: 5%
𝐷1 = 𝐷0 ∗ (1 + 𝑔𝑛 )
𝐷1 = 1 ∗ (1 + 5%)
𝐷1 = 1.05

b. Year 2: 5%
𝐷2 = 𝐷1 ∗ (1 + 𝑔𝑛 )
𝐷2 = 1.05 ∗ (1 + 5%)
𝐷2 = 1.1025

c. Year 3: 10%
𝐷3 = 𝐷2 ∗ (1 + 𝑔𝑐 )
𝐷3 = 1.1025 ∗ (1 + 10%)
𝐷3 = 1.21275

2. Get the Terminal Value

𝐷2+1
𝑇𝑉 =
𝑟−𝑔
1.21275
𝑇𝑉 =
12% − 10%
𝑇𝑉 = 60.6375
 3. Compute for the Stock Price
𝐷1 𝐷𝑇𝐷 𝑇𝑉
𝑃0 = + 𝑇𝐷 +
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟)𝑇𝐷
1.05 1.1025 60.6375
𝑃0 = + 2 ++
(1 + 12%) (1 + 12%) (1 + 12%)2
𝑃0 = 𝟓𝟎. 𝟏𝟓

iii. Zero or No Growth

1. This situation is a characteristic of preferred shares whose stock and its dividend does
not grow.
2. Formula:

𝐷
a. 𝑃0 = 𝑟
b. Where: P0 = stock price today; D = current dividends; r = cost of equity (required
rate of return)

3. Example:
The dividend of Runner Company, an established shoe manufacturer, is expected to remain constant at P6 per
share indefinitely. If his required return on its stock is 12%, what is the value of the stock today?

Solution:
6
𝑃0 = 𝟓𝟎 =
12%

b. Corporate Valuation or Free Cash Flow Model

i. This approach computed the market value of the company based on the present value of the
company’s free cash flows. Upon the determination of the market value of the company, long-
term debt and the preferred share capital is deducted leaving the market value of the common
shares divided by the number of outstanding common shares to determine the stock’s intrinsic
value

ii. Steps:
1. Compute the company’s free cash flow
a. 𝐹𝑟𝑒𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤(𝑜𝑟 𝐹𝐶𝐹) = [𝐸𝐵𝐼𝑇 ∗ (1 − 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒) +
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑎𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛] − [𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 +
∆𝑁𝑒𝑡 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙]

2. Get the market value of the firm based on the firm’s growth rate
a. Constant Growth firms
𝐹𝐶𝐹1
i. 𝑀𝑉𝐹𝑖𝑟𝑚 = 𝑊𝐴𝐶𝐶−𝑔

b. Non-constant growth firms

𝐹𝐶𝐹1 𝐹𝐶𝐹2 𝐹𝐶𝐹𝑇𝐷 𝑇𝑉
i. 𝑀𝑉𝐹𝑖𝑟𝑚 = (1+𝑊𝐴𝐶𝐶) + (1+𝑊𝐴𝐶𝐶) 2 + ⋯ + (1+𝑊𝐴𝐶𝐶)𝑇𝐷 + (1+𝑊𝐴𝐶𝐶)𝑇𝐷

c. Zero or no growth firms

𝐹𝐶𝐹
i. 𝑀𝑉𝐹𝑖𝑟𝑚 = 𝑊𝐴𝐶𝐶
 3. Determine the Stock price
𝑀𝑉𝐹𝑖𝑟𝑚−𝑀𝑉𝐷𝑒𝑏𝑡+𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑
a. 𝑃0 = 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘

4. Where: 𝑃0 = Stock price today; 𝑀𝑉𝐹𝑖𝑟𝑚 = Market value of the firm; 𝑀𝑉𝐷𝑒𝑏𝑡+𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 =
market value of preferred and debt; 𝐹𝐶𝐹1 = free cash flow at the end of year 1; g =
growth rate; TD = terminal date; TV = terminal value; OCS = outstanding common stock

5. Example
Knights Corp., a company with 40% tax rate, projected its EBIT for the next year at P600,000,000, projected
depreciation expense, capital expenditure and an increase in working capital for the next year of P100,000,000,
P200,000,000, and P120,000,000, respectively. Its capital structure is 60% equity and 40% debt. The cost of equity and
debt is 12% and 11.66% respectively. The company’s free cash flow is expected to grow at a constant rate of 6% a year.
Knights Corp. has 40,000,000 outstanding shares, and the market value of preferred stock and debt is P1,000,000,000.

Compute for the following:

a. Free Cash Flow
b. Weighted Average Cost of Capital
c. Market Value of the firm
d. Stock Price

Solution:
1. Get the Free Cash flow

𝐹𝑟𝑒𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤(𝑜𝑟 𝐹𝐶𝐹) = [600,000,000 ∗ (1 − 40%) + 100,000,000] − [200,000,000 + 120,000,000]

𝐹𝑟𝑒𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤(𝑜𝑟 𝐹𝐶𝐹) = 𝟏𝟒𝟎, 𝟎𝟎𝟎, 𝟎𝟎𝟎

2. Compute for the Weighted Average Cost of Capital

𝑊𝐴𝐶𝐶 = 𝑘𝑑 (1 − 𝑇)𝑤𝑑 + 𝑘𝑒 𝑤𝑒
𝑊𝐴𝐶𝐶 = 11.66%(1 − 40%)40% + 12%(60%)
𝑊𝐴𝐶𝐶 = 𝟏𝟎%

3. Determine the Market Value of the firm. Note: The firm has a constant growth rate
𝐹𝐶𝐹1
𝑀𝑉𝐹𝑖𝑟𝑚 =
𝑊𝐴𝐶𝐶 − 𝑔
140,000,000
𝑀𝑉𝐹𝑖𝑟𝑚 =
10% − 6%
𝑀𝑉𝐹𝑖𝑟𝑚 = 𝟑, 𝟓𝟎𝟎, 𝟎𝟎𝟎, 𝟎𝟎𝟎

4. Compute for the stock price

𝑀𝑉𝐹𝑖𝑟𝑚 − 𝑀𝑉𝐷𝑒𝑏𝑡+𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑
𝑃0 =
𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘
3,500,000,000 − 1,000,000,000
𝑃0 =
40,000,000
𝑃0 = 𝟔𝟐. 𝟓𝟎
Stock market equilibrium

Equilibrium
• The condition under which the expected return on a security is just equal to its required return.
• Two conditions must hold:
1. As seen by the marginal investor, a stock’s expected rate of return must equal its required rate of return.
2. As estimated by the marginal investor, the actual market price of the stock must equal its intrinsic value.

Illustration:
The required rate of return of Stock AGI is 10% as determined by the CAPM. Suppose an investor’s portfolio
contains Stock AGI. Earnings, dividends, and price can be expected to grow at a constant rate of 3% per year. The last
dividend was P2.4271. Stock Price is P50.

Requirement:
a. Determine the Expected Rate of Return
b. Is the stock price at equilibrium level? If not, determine the price that stock would be in equilibrium.

Solution:
𝐷1
a. 𝑃0 = 𝑟−𝑔
𝐷1
𝑟= +𝑔
𝑃0
2.4271 ∗ (1.03)
𝑟= + 3%
50
𝑟 = 8%

b. No because stock’s expected rate of return is not equal to its required rate of return (10% > 8%). The expected
rate of return is less than the required return, the investor would want to sell the stock. However, few people
would want to buy at the P50 unless sellers will cut the stock price. To determine the stock price at equilibrium:

2.5
𝑃35.71 =
10% − 3%
References
• Gitman, L. J., & Zutter, C. J. (2015). Principles of Managerial Finance. Pearson Education Limited.
• Brigham, E. F., & Houston, J. F. (2019). Fundamentals of Financial Management. Cengege.
• Bagayao, I. Y., & et al. (n.d.). Financial Management Volume 1.
• Bagayao, I. S., & et al. (n.d.). Financial Management Volume 2.

Other online resources

Stock Valuation
https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/stock-valuation/
https://www.investopedia.com/articles/fundamental-analysis/11/choosing-valuation-methods.asp
https://www.youtube.com/watch?v=uajW4BWh_zY

Common vs Preferred Stock

https://www.investopedia.com/ask/answers/difference-between-preferred-stock-and-common-stock/
https://www.wallstreetmojo.com/common-stock-vs-preferred-stock/