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Financial Management ­ MGT201
VU
Lesson 16
INTRODUCTION TO STOCKS AND STOCK VALUATION
Learning Objectives:
After going through this lecture, you would be able to have an understanding of the following
topics
·  Introduction to Stocks
·  Stock Valuation
In previous lectures, we have discussed about one kind of direct claim security which is bonds.
Bonds are long term debt instruments. Now, we will take in detail about another kind of security which
is known as Stocks or Shares.
Stocks:
These are equity paper representing ownership. Shareholders are part owners of the company. If
you look at the balance sheet when the company issues shares to raise money such shares should be
shown on the liability side of the balance sheet of the company. Shareholders are called owners of the
company these are shown under the equity section .However, the shares that are purchased by the
company are shown on the asset side of the company under the head of marketable securities .Generally,
when we are talking about the issuance of the shares we refer to shares as liability. Basically, the share
is a legal contractual piece of paper it shows the name of the company. It shows the par or face value of
the share and it also assures that the shareholder is the part owner of the company.
Remember that Shares are distinguished from the bonds because shares represent the
ownership whereas the bond is a debt instrument. Another thing about the shares is to remember that par
value is the value when they are issued the market value of the shares changes with investor's
perception about the company's future and supply and demand situation. So, do not confuse the par
value with the Market value of the shares .par value is printed on that share certificate. As we have
studied that Value of Direct Claim Security is directly tied to the value of the underlying Real Asset.
Why raise money through Equity (i.e. Shares or Stocks) rather than Debt (i.e. Bonds or
Loan)?
What are the advantages of raising money through equity?
Equity financing gives the flexibility that you do not have to made regular payments. In case of debt or
bond you have under taken a promise to pay a fixed rate of return .but in case of shares o fixed rate of
interest is paid only dividend is paid on net income according to the decisions of the board of directors
and management. You have no obligations to pay fixed dividend to common shareholders. But, if the
Company raises money using Bonds, then it will have to pay a fixed amount of interest (or mark-up)
regularly for 2 Years. If the Company does NOT pay on time, you are declared Defaulter and your
business can be closed and the Lenders (Bondholders) can sell the company's assets to recover their
money.
The value of direct claim security because derived from underlying real asset. It can be thought
of as a piece of paper that generates a certain cash flow over the period of time. Share certificate is a
piece of paper that represents some other real assets and it generates future cash flows.
1. Dividend you are received as shareholder.
2. Capital gain
For example, if there is a textile company which need to raise the amount of  Rs1 million to
invest in looms. Company can raise this amount either by equity or bonds.
In case the company decides to raise it through equity. Then it issues the share certificate amounting to
Rs 1 million and sells them to various interested investors and receives the capital in the form of equity.
Why do these share certificates carry value?
This investment for the share holders will generate the cash flow in form of income and the cash
flows in the form of capital gains .These cash flows are generated through the under lying real
assets .what are these real assets .the real assets in this example are the textile weaving looms and fabric
prepared by these looms. The cash flows are generated from the sale of this fabric. From these cash
flows the company is paying dividend (See diagram)
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Financial Management ­ MGT201
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Share Value & Cash Flows
from Underlying Real Assets
COMPANY'S REAL WORKING ASSETS
that has issued the Share ie: Weaving Looms
Capital
Budgeting NPV
Criteria
COMPANY'S OPERATING CASH FLOWS
& INCOME ie. Revenue from sale of Fabric
(Company Value)
DIVIDEND & CAPITAL GAIN CASHFLOWS
Securities Valuation
i.e. Cash pay out to Shareholders (Share Value)
or Share Pricing
Share Concept:
A Limited Company can raise money by Issuing (or selling) Equity in the form of Shares. In
Pakistan, the Par Value (or Face Value) of each share is generally Rs 10. But by in large public listed
companies' issues shares with par value of Rs.10each .keep in mind that par value of the share is value
when it was issued when it has gone into market it has different value. The Life of a Share is considered
Perpetual (or never-ending "going concern") unless of course the company closes down or goes
bankrupt.
As the financial health (cash flows and income) of the company changes with time, the Market
Value (or Price) of the Share changes (even though it's Par Value is fixed). Market Prices also change
depending on the Supply-Demand for the share and also speculation or satta.
Shares of Listed Public Limited Companies are traded in the Stock Exchange like KSE (Karachi
Stock Exchange), LSE (Lahore), ISE (Islamabad). You can buy / sell shares over the phone &/or
computer through your Broker whose agents / Jobbers are trading at the exchange. You make payments
to your Broker through a Brokerage Account at one of the banks in the Stock Exchange or through cash
soon after the trade is made.
Shares of Private Limited Companies (which are not listed) can also be bought and sold
privately and the Corporate Law Authority and Registrar Joint Stock Companies need to be informed.
Types of Equity:
There are two types of equity
1. Common Stock
2. Preferred Stock
Common Stock:
It is the most common kind of equity as compared to preferred stock. Common Shareholders are
Owners who have Voting Rights in management decisions. Common Shareholders are owners who
receive a Dividend (share of the Profit or Net Income proportionate to their shareholding) which varies
depending on the Net Income for that year and the decision of the Board of Directors regarding how
much to Retain and Reinvest. Cash flows associated with common shares will be used to calculate the
expected price of share then we compare it market value of stock. There are 2 kinds of cash flow
associated with the stocks
1. Dividend you received as shareholder: In case of common stocks, these are unpredictable
and changing as to bond valuation where the coupon receipts are generally constant and
regular in time interval. Therefore we can use annuity formula. But when we are talking
about common shares dividends are not fixed. That's make the valuation of common stock
different from bond valuation
2. Capital gains
Preferred Stock:
This kind of Equity is rare. Preferred Shareholders get a preference (or priority) over the
Common Shareholders in recovering their money if the company goes bankrupt. Although
Preferred Shareholders are owners, they may not get voting rights. It is also known as Hybrid
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Financial Management ­ MGT201
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Equity. As it is a Mix of Bond and Share. Preferred Shareholders receive a Fixed Regular
Dividend (similar to the Coupon for a Bondholder).
Share Price Valuation - Preferred Stock:
Perpetual Investment with Fixed Regular Dividends:
Perpetual Investment means you are considering buying this Stock and keeping it forever!
PV = Po* = DIV 1 / r PE
Where r PE = Minimum Required Rate of Return on Preferred Stock Equity for the individual investor,
PV = Present Market Value (or Estimated Present Price) which depends on DIV 1 = Forecasted Future
Dividend in the next period (ie. Year 1 and all other years since DIV 1=DIV2= DIV3=...) Basically, it
is a Perpetuity Formula.
Finite Investment:
Finite Investment means you plan to buy this Stock and then sell it in a few days or years (n). Formula
similar to Bond.
PV = Po* =
DIVt / (1+ rPE) t + Pn / (1+ rPE) n .
t=year. Sum from t = 1 to n.  Pn = Final Expected Selling Price
PV (Share Price) = Dividend Value + Capital Gain /Loss.
The Dividend Value derived from Dividend Cash Stream and Capital Gain /Loss from Difference
between Buying & Selling Price.
Example:
Company ABC Preferred Stock is traded in the Lahore Stock Exchange and has a Market Price of
Rs 13. The Company has fixed the Dividend to be Rs 2 per share. The Par Value of each share is
Rs 10. You expect the Price to be Rs 13 after 2 years. As the investor, you expect a Minimum
Required Return of 10% because you can earn that much from a bank deposit account almost risk
free. BUT, Stocks are generally more risky investments than bank deposits SO you will only invest
in risky stock IF the expected return is higher than 10% - lets say 15%. Calculate the Fair (or
Expected) Price of the Preferred Stock.
NOTE: We will discuss RISK in detail later in course
Perpetual Investment in Preferred Stock
­  PV = DIV 1 / r PE = Rs 2 / 15% = 2 / 0.15 = Rs 13.33
The Fair (or Intrinsic Value) of the Share to You is Rs 13.33. The Market Value is Rs 13. So, the Share
is worth more to You than its price in the market. It is undervalued and you will gain value by buying it.
Finite Investment in Preferred Stock:
­  PV =
DIVt / (1+ rPE) t + Pn / (1+ rPE) n.  n = 2 years
= 2 / (1.15) + 2 / (1.15)2 + 13 / (1.15)2 = Rs 13.08
In this example, Perpetual Investment in Preferred Stock is worth more than Finite Investment in
Preferred Stock because Present Value of the Infinite Stream of Rs 2 Dividends is more than the Present
Value of the expected future Selling Price (Rs 13).
Share Price Valuation - Common Stock
Finite (Limited Life) Investment in Common Stock
It is more common. Need to account for Cash Flows from Variable Dividends and Estimated
Selling Price (Pn).
Note that Pn depends on DIVn+1. Price at any point in time will always depend on Dividend in the
following year! Formula is similar to Bond Valuation Equation.
Perpetual Investment in Common Stock:
PV = DIV1/(1+rCE) +DIV2/(1+rCE)2 +..+ DIVn/(1+rCE)n + Pn/(1+rCE)n
PV = Po* = Expected or Fair Price = Present Value of Share, DIV1= Forecasted Future Dividend at
end of Year 1, DIV 2 = Expected Future Dividend at end of Year 2, ..., Pn = Expected Future Selling
Price, rCE = Minimum Required Rate of Return for Investment in the Common Stock for you (the
investor). Note that Dividends are uncertain and n = infinity
PV (Share Price) = Dividend Value + Capital Gain.
Dividend Value is derived from Dividend Cash Stream and Capital Gain / Loss from Difference
between Buying & Selling Price.
Perpetual Investment in Common Stock:
It is an idealized Case. The Final Cash Flow term (containing Pn) in the equation takes place at
Year n = infinity The last term (containing Pn) has a Present Value almost equal to Zero because the
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Financial Management ­ MGT201
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Discount Factor (1+rE)n in the denominator becomes very large when n=infinity. So, you can ignore
the Last Cash Flow terms taking place at Year n.
Simplified Formula (Pn term removed from the equation for large investment durations i.e. n =
infinity):
PV = DIV1/ (1+rE) + DIV2/ (1+rE) 2 + ... DIVn/(1+rE)n
= DIVt / (1+ rE) t. t = year. Sum from t =1 to n
This Equation is still impractical because need to forecast Dividends for every year forever!!
Example:
The Common Stock of Company ABC is being traded in the Islamabad Stock Market. Its
Market Price is Rs.13. You study Company ABC's Annual Report, Balance Sheet, Income Statement,
and Cash Flow Statement and you forecast the future Dividends to be Rs 2 in the first year and Rs 4 in
the second year. You forecast the Market Price to be Rs 13 after 2 years. The Par Value of each share is
Rs 10. The Risk Free Return is 10% pa. Your expected Minimum Required Return from the high-risk
Common Stock of ABC is 20%. Calculate the Fair (or Expected) Price of the Common Stock
Common Stock Valuation (Risky Investment: rCE= 20%)
1st year will be Rs.2 and dividend in 2nd year will be Rs.4 assume risk free rate of return is 10% and high
rate of return to be required is 20%again this 20% is higher than 10% in a country .and this 20%
minimum required rate of return is higher than the preferred stock required by that company is
15 % .this is because common stock is considered more risky than preferred stock and bank deposit in a
country .let's calculate the value of common stock for company ABC we will use our old present value
formula for finite investment :
PV=2/12+4/(1.2)2+1.3/(1.2)2
Finite Investment for 2 Years: PV = 2/1.2 + 4 / (1.2)2 + 13 / (1.2)2 = Rs 13.47
This is estimated price for 2nd year investment based on forecasted dividend let's see the long term
investment use present value formula about which we talked earlier on
Perpetual Investment: PV =??
We can not determine it because we don't have Dividend forecast data for every year forever!! We need
to use Models for approximating future Dividends Cash Flow Stream:
Zero Growth Model
Constant Growth Model
We will discuss about these in the next lecture.
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Table of Contents:
  1. INTRODUCTION TO FINANCIAL MANAGEMENT:Corporate Financing & Capital Structure,
  2. OBJECTIVES OF FINANCIAL MANAGEMENT, FINANCIAL ASSETS AND FINANCIAL MARKETS:Real Assets, Bond
  3. ANALYSIS OF FINANCIAL STATEMENTS:Basic Financial Statements, Profit & Loss account or Income Statement
  4. TIME VALUE OF MONEY:Discounting & Net Present Value (NPV), Interest Theory
  5. FINANCIAL FORECASTING AND FINANCIAL PLANNING:Planning Documents, Drawback of Percent of Sales Method
  6. PRESENT VALUE AND DISCOUNTING:Interest Rates for Discounting Calculations
  7. DISCOUNTING CASH FLOW ANALYSIS, ANNUITIES AND PERPETUITIES:Multiple Compounding
  8. CAPITAL BUDGETING AND CAPITAL BUDGETING TECHNIQUES:Techniques of capital budgeting, Pay back period
  9. NET PRESENT VALUE (NPV) AND INTERNAL RATE OF RETURN (IRR):RANKING TWO DIFFERENT INVESTMENTS
  10. PROJECT CASH FLOWS, PROJECT TIMING, COMPARING PROJECTS, AND MODIFIED INTERNAL RATE OF RETURN (MIRR)
  11. SOME SPECIAL AREAS OF CAPITAL BUDGETING:SOME SPECIAL AREAS OF CAPITAL BUDGETING, SOME SPECIAL AREAS OF CAPITAL BUDGETING
  12. CAPITAL RATIONING AND INTERPRETATION OF IRR AND NPV WITH LIMITED CAPITAL.:Types of Problems in Capital Rationing
  13. BONDS AND CLASSIFICATION OF BONDS:Textile Weaving Factory Case Study, Characteristics of bonds, Convertible Bonds
  14. BONDS’ VALUATION:Long Bond - Risk Theory, Bond Portfolio Theory, Interest Rate Tradeoff
  15. BONDS VALUATION AND YIELD ON BONDS:Present Value formula for the bond
  16. INTRODUCTION TO STOCKS AND STOCK VALUATION:Share Concept, Finite Investment
  17. COMMON STOCK PRICING AND DIVIDEND GROWTH MODELS:Preferred Stock, Perpetual Investment
  18. COMMON STOCKS – RATE OF RETURN AND EPS PRICING MODEL:Earnings per Share (EPS) Pricing Model
  19. INTRODUCTION TO RISK, RISK AND RETURN FOR A SINGLE STOCK INVESTMENT:Diversifiable Risk, Diversification
  20. RISK FOR A SINGLE STOCK INVESTMENT, PROBABILITY GRAPHS AND COEFFICIENT OF VARIATION
  21. 2- STOCK PORTFOLIO THEORY, RISK AND EXPECTED RETURN:Diversification, Definition of Terms
  22. PORTFOLIO RISK ANALYSIS AND EFFICIENT PORTFOLIO MAPS
  23. EFFICIENT PORTFOLIOS, MARKET RISK AND CAPITAL MARKET LINE (CML):Market Risk & Portfolio Theory
  24. STOCK BETA, PORTFOLIO BETA AND INTRODUCTION TO SECURITY MARKET LINE:MARKET, Calculating Portfolio Beta
  25. STOCK BETAS &RISK, SML& RETURN AND STOCK PRICES IN EFFICIENT MARKS:Interpretation of Result
  26. SML GRAPH AND CAPITAL ASSET PRICING MODEL:NPV Calculations & Capital Budgeting
  27. RISK AND PORTFOLIO THEORY, CAPM, CRITICISM OF CAPM AND APPLICATION OF RISK THEORY:Think Out of the Box
  28. INTRODUCTION TO DEBT, EFFICIENT MARKETS AND COST OF CAPITAL:Real Assets Markets, Debt vs. Equity
  29. WEIGHTED AVERAGE COST OF CAPITAL (WACC):Summary of Formulas
  30. BUSINESS RISK FACED BY FIRM, OPERATING LEVERAGE, BREAK EVEN POINT& RETURN ON EQUITY
  31. OPERATING LEVERAGE, FINANCIAL LEVERAGE, ROE, BREAK EVEN POINT AND BUSINESS RISK
  32. FINANCIAL LEVERAGE AND CAPITAL STRUCTURE:Capital Structure Theory
  33. MODIFICATIONS IN MILLAR MODIGLIANI CAPITAL STRUCTURE THEORY:Modified MM - With Bankruptcy Cost
  34. APPLICATION OF MILLER MODIGLIANI AND OTHER CAPITAL STRUCTURE THEORIES:Problem of the theory
  35. NET INCOME AND TAX SHIELD APPROACHES TO WACC:Traditionalists -Real Markets Example
  36. MANAGEMENT OF CAPITAL STRUCTURE:Practical Capital Structure Management
  37. DIVIDEND PAYOUT:Other Factors Affecting Dividend Policy, Residual Dividend Model
  38. APPLICATION OF RESIDUAL DIVIDEND MODEL:Dividend Payout Procedure, Dividend Schemes for Optimizing Share Price
  39. WORKING CAPITAL MANAGEMENT:Impact of working capital on Firm Value, Monthly Cash Budget
  40. CASH MANAGEMENT AND WORKING CAPITAL FINANCING:Inventory Management, Accounts Receivables Management:
  41. SHORT TERM FINANCING, LONG TERM FINANCING AND LEASE FINANCING:
  42. LEASE FINANCING AND TYPES OF LEASE FINANCING:Sale & Lease-Back, Lease Analyses & Calculations
  43. MERGERS AND ACQUISITIONS:Leveraged Buy-Outs (LBO’s), Mergers - Good or Bad?
  44. INTERNATIONAL FINANCE (MULTINATIONAL FINANCE):Major Issues Faced by Multinationals
  45. FINAL REVIEW OF ENTIRE COURSE ON FINANCIAL MANAGEMENT:Financial Statements and Ratios