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Cost of Preferred Stock and Stock Outstanding ConEd
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ConEd has an issue of preferred stock that is listed on the NYSE, pays a quarterly dividend of $1.25 ($5 per year), and was trading on August 27, 2002 at a price of $76.20 per share for a yield of 6.56 percent. From ConEd s balance sheet (Exhibit 6-1), we find that it has $249.6 million face value of total preferred stock outstanding.
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The inputs for ConEd (discussed above) result in an after-tax weighted average cost of capital for ConEd of 4.84 percent. We show the calculation of the WACC in the weighted average cost of capital screen in Exhibit 6-5.
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EXHIBIT 6-5
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Recall that Cisco does not have debt or preferred stock outstanding, which makes the calculation of Cisco s WACC relatively easy. Cisco s WACC is its cost of equity, which we calculate under the cost of equity section above, to be 10.04 percent. Cisco is a high-tech firm in a quickly changing industry where obsolescence is a major concern. Cisco s WACC is considerably higher than the WACC for ConEd, a regulated company in the stodgy utility industry. As can be seen by these two examples, the discounting mechanism is the way that the capital asset pricing model introduces risk differences into valuing a stock.
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Valuation Inputs Relating to Cost of Capital and Market Capitalization Cisco
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Our initial inputs for the ValuePro 2002 software relating to Cisco s cost of capital and market capitalization are: Stock Price ($) Shares Outstanding (mil) 10-Year Treasury Yield (%) Bond Spread to Treasury (%) Preferred Stock Yield (%) Equity Risk Premium (%) Company Beta Value of Debt Outstanding ($mil) Value of Preferred Stock Outstanding ($mil) $14.45 7447 million 4.25% 0% 0% 3.0% 1.93 0 0
Balance Sheet Items in the Valuation Process: Our Recommendation
The majority of the intrinsic stock value for most companies comes from discounting the expected future operating profits. Therefore, the bulk of the company s value depends on future revenue and earnings metrics that are captured primarily by the income and cash flow statements of the corporation. Nevertheless, the corporation s balance sheet is important and has its role in the valuation equation, particu-
STREETSMART GUIDE TO VALUING A STOCK
larly for financial companies, such as Citigroup and Merrill Lynch, and portfolio companies (companies whose value is derived from a portfolio of operating companies), such as ICGE and Berkshire Hathaway (Warren sorry to mention ICGE and your company in the same dependent clause). A balance sheet captures a picture of the financial health of a company on one particular day in time. The top portion of the balance sheet lists the company s assets what the company owns. Current assets are assets that are expected to be realized in cash or sold or consumed within one year. Examples of current assets are cash, shortterm investments, inventories, accounts receivable, and prepaid expenses. Long-term assets are assets that will not be completely consumed during a year. Examples are long-term investments, PP&E, intangible assets such as goodwill and patents, and deferred charges. The bottom portion of the balance sheet lists the company s liabilities what the company owes, and the shareholders equity. Current liabilities are obligations of the company that are expected to be paid by the firm within the year. Examples of current liabilities include accounts payable, current maturity of long-term debt, accrued expenses, and the current portion of deferred income taxes. Long-term liabilities are obligations of the firm that are not required to be paid by the firm within the current year. Examples of long-term liabilities are long-term debt, lease agreements, warranty obligations, and other funding commitments. Equity is ownership, the shareholders residual interest in the firm what s left over after subtracting liabilities from assets. Shareholders equity consists of common and preferred stock, paid in capital in excess of par; treasury stock; and retained earnings. What role should the balance sheet play in valuation Let s assume that two similar companies, ABC and XYZ, have identical capital structures, costs of capital, and operating cash flows, and that the expected future cash flows generated by both firms are identical. We assume also that the long-term assets of the corporation, such as PP&E, goodwill, and intangibles, will be consumed through depreciation and amortization charges as the firms operate and generate business over the years. Finally, let s assume that the balance sheets of both firms are identical with one exception the amount of current assets of ABC exceeds those of XYZ by a million dollars. Should the corporate or enterprise value of ABC XYZ No! The enterprise value of ABC should exceed XYZ by $1 million. This con-
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