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STREETSMART GUIDE TO VALUING A STOCK
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market, market prices of these securities are not easily observable and are harder to determine. If we re expecting a 10-percent return on a share of ConEd, and its market value is $42.53 per share, our expectation is that we will earn 10 percent per year on our $42.53 market value, or $4.25 per year between dividends and stock price appreciation. We d be disappointed if we received 10 percent on the lower $26.61 book value of the share, or $2.66 per year. Hence, professionals use market values when they look at market capitalization of common stock.
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Market versus Book Value: Our Recommendation
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In real life, as opposed to the ivory tower of academia in which some of us reside, the current quotes of market value for debt and preferred stock are often difficult to obtain. Absent credit concerns and default risk, the market values of preferred stock and debt for the most part do not stray significantly from their respective book values. In an effort to conserve time and to simplify a valuation, most market professionals use the company s reported book values for debt and preferred stock when they examine the capitalization of the corporation. Market professionals always use the market value of common stock when they examine the capitalization of the corporation. As we will see in valuation examples, the market value of common stock sometimes bears little relationship to its book value. Stock prices are readily available. In keeping with this market practice, we use book values for debt and preferred stock and market values for common stock in all of our valuation examples.
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Market Versus Book Value for ConEd
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We use the book values of ConEd s debt and preferred stock outstanding and both the book value and market value of common stock to develop ConEd s market capitalization schedule, as shown in Table 6-1 below.
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Market versus Book Value for Cisco
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Cisco, like most tech companies that have a high degree of business and operating risk, has no debt or preferred stock outstanding. According to Cisco s balance sheet (Exhibit 5-4), as of July 27, 2002, the book value of Cisco s common stock was $28,656 million and, ac-
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Estimating the Cost of Capital
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TABLE 6-1
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Consolidated Edison, Inc. Market Capitalization
12/31/2001 (millions of dollars) Book Value Total % 48.6% 2.2% 49.2% 100.0% Market Value Total $5,501.2 $249.6 $9,054.6 $14,805.4 % 37.1% 1.7% 61.2% 100.0%
Debt Preferred stock Common stock Total capitalization
$5,501.2 $249.6 $5,566.2 $11,317.0
cording to its income statement (Exhibit 5-2), it has 7301 shares outstanding in its per-share calculation-basic, and 7447 shares outstanding in its per-share calculation-diluted. We use the higher diluted number to determine Cisco s market equity. Cisco s closing stock price on August 14, 2002, the date we valued Cisco, was $14.45, resulting in total market equity for Cisco s stock of $107,609 million (see Table 6-2 below). The book equity to market equity (BE/ME) ratio for Cisco, a high-tech company that prior to 2002 had very high growth rates, is: ($28,656/$107,609) 26.6 percent, significantly lower than the 62.6percent ratio for ConEd, which no one would mistake for a growth stock.
TABLE 6-2
Cisco Systems Market Capitalization
7/27/2002 (millions of dollars) Book Value Total % 0.0% 0.0% 100.0% 100.0% Market Value Total $0.0 $0.0 $107,609.2 $107,609.2 % 0.0% 0.0% 100.0% 100.0%
Debt Preferred stock Common stock Total capitalization
$0.0 $0.0 $26,656.0 $26,656.0
STREETSMART GUIDE TO VALUING A STOCK
Estimating ConEd s WACC
Before estimating all of the component costs that make up a WACC, let s try a simple example for ConEd. Let s assume the following: The pretax cost of debt for ConEd is 5.25 percent, which represents a 1.0percent spread to Treasuries; ConEd s after-tax cost of debt (assuming a tax rate of 35 percent) is: [5.25% * (1 .35)] 3.41%; its cost of preferred stock is 6.56 percent; and the cost of common equity is 5.67 percent. ConEd s WACC on August 26, 2002, based on these assumptions, a market value weighting of common stock, and book value weightings of debt and preferred stock (see Table 6-1), was: ConEd s WACC =37.1%(3.41%) 1.7%(6.56%) 61.2%(5.67%)
4.84%
Below, we show our inputs for the ValuePro 2002 software relating to the cost of capital and market capitalization. We explain how and where these numbers come from in the pages that follow.
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