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How to Value a Stock
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Let s assume that corporate management does not believe that the stock of the company is overvalued. More likely, most management believes that its company s stock is too cheap. Under share repurchase programs, companies buy their own stock in the open market and reduce the number of shares outstanding. Share repurchases benefit the remaining stockholders by reducing the supply of the outstanding stock and increasing the stock s price. Some investors prefer to buy stock of a company that pays out free cash flows through a share repurchase program. These investors expect to see a stock s price grow steadily over time, like our hypothetical UVW Growth Company, rather than to receive quarterly dividend payments. Investors in higher tax brackets find it painful to pay taxes on dividends that they receive. Also, if investors don t currently need the dividends for spending purposes, they are forced to decide where they want to reinvest those dividends and incur additional transaction costs in doing so. They can decide when to sell their shares, and then pay taxes at lower long-term capital gains tax rates. Share repurchase programs allow investors to minimize their tax payments while still allowing the corporation to maintain the philosophy of paying out excess free cash flow. Other investors buy stock in a company a utility like Consolidated Edison, for example, or our hypothetical XYZ Dividend Company for the dividend stream that it pays, along with the possibility of dividend growth. The differing dividend/stock repurchase philosophies create what is termed a clientele effect. Retirees and other investors who are interested in predictable current returns usually purchase stock in companies that pay out their free cash flow through dividends. By contrast, investors who are interested more in capital gains and the growth of a stock s price gravitate to low- or no-dividend-paying companies that pay out their free cash flow through stock repurchase programs.
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Free Cash Flow the Corporation s Investment Decision
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The investment rule underlying the free cash flow approach is simple: Invest in a project or business strategy if and only if the project generates additional free cash flow to the firm. This investment will result in an increase in shareholder value. A company should undertake projects that increase FCFF. If the project decreases the discounted free cash flow to the firm, the result is a decrease in shareholder value.
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STREETSMART GUIDE TO VALUING A STOCK
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Rather than invest in a project that reduces shareholder value, the company should pay the money to investors through share repurchases or dividend payments.
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The FCFF Approach Where Does It Work
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The stocks that the FCFF valuation approach handles well represent 95 percent of all common stock traded on U.S. and international stock markets. However, in valuing highly levered companies (such as real estate investment trusts (REITs) and financial institutions), companies with no current free cash flow (such as EntreMed), and portfolio companies (such as Berkshire Hathaway or Internet Capital Group), the FCFF approach needs some minor adjustments. Typically, the balance sheets of commercial banks and investment banks have a book value, not market value, of approximately 90 percent debt and 10 percent equity. We discuss market versus book values in 6. Also, financial institutions require very little investment in property, plant, and equipment. The bulk of their investments are in financial obligations that have characteristics that more closely resemble working capital investments. The balance sheets of financial companies are more important to their valuations than the balance sheets of industrial companies. Of particular interest is the excess of marketable current assets over current liabilities. We visit this topic in greater depth when we value Citigroup and Merrill Lynch in 8. Adjustments must be made for companies that currently have little or no free cash flow or companies that are suffering net operating losses. These adjustments involve changing NOPMs over time and estimating the probability of and potential revenues from high-risk products, whose cash flows depend upon regulatory approval or future scientific breakthroughs. The value of the shares of some companies, which have no current cash flows and whose future is highly dependent on speculative products, may be better handled using an option pricing approach, which is beyond the scope of this book. Most of this fine-tuning can be handled using the FCFF approach, and we discuss how we do it in the chapters that follow.
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