VALUING NONCONSTANT GROWTH STOCKS

For many companies, it is not appropriate to assume that dividends will grow at a constant rate. Firms
typically go through life cycles. During their early years, their growth is much faster than that of the
economy as a whole; then they match the economy’s growth; and finally their growth is slower than
that of the economy.9 Automobile manufacturers in the 1920s, software companies such as Microsoft in
the 1990s, and technology firms such as Cisco in the 2000s are examples of firms in the early part of the
cycle; these firms are called supernormal, or nonconstant, growth firms. In the supernormal case,
however, the expected growth rate is not a constant—it declines at the end of the supernormal growth
period.

Figure above illustrates nonconstant growth and also compares it with normal growth, zero growth, and
negative growth.

We assume that the dividend will grow at a nonconstant rate (generally a relatively high rate) for N
periods, after which it will grow at a constant rate, g. To solve for terminal value:

•N PERIODS – Horizon date or the terminal date

•STOCKS CURRENT INTRINSIC VALUE – is the value of all dividends after time 0, discounted back to time
0.

•THE INTRINSIC VALUE OF A STOCK AT TIME N – is the present value of all dividends beyond time N,
discounted by to time N.

•INTRINSIC VALUE AT TIME N – horizon value or terminal value

The horizon value is the value of all dividends beyond Time N discounted back to Time N. Discounting
the horizon value from Time N to Time 0 provides an estimate of the present value of all dividends
beyond the nonconstant growth period.

To implement the equation, we go through the following three steps.

1. Estimate the expected dividends for each year during the period of non-constant growth.

2. Find the expected price of the stock at the end of the non-constant growth period, at which point it
has become a constant growth stock.

3. Find the present values of the expected dividends during the non-constant growth period and the
present value of the expected stock price at the end of the non-constant growth period. Their sum is the
intrinsic value of the stock.
STOCK VALUATION BY THE FREE CASH FLOW APPROACH

The value of a firm is the present value of its future expected free cash flows (FCFs) discounted at the
weighted average cost of capital (WACC).

FCF (Free cash flow)- is the cash flow available for distribution to all of the firm’s investors, bondholders
as well as stockholders.

WACC ( Weighted Average Cost of Capital)- is the average rate of return required by all of the firm’s
investors, not just shareholders.

V - is the value of the entire firm’s operations, not just the value of its equity.

Illustration:

Suppose Crum Inc. had a free cash flow of $200 million at the end of the most recent year. Chapter 12
shows how to forecast financial statements and free cash flows,but for now let’s assume that Crum’s
FCFs are expected to grow at a constant rate of 5% per year forever. Chapter 9 explains how to estimate
the weighted average cost of capital, but for now let’s assume that Crum’s WACC is 9%.
If the firm had any nonoperating assets, such as short-term investments in marketable securities, then
we would add them to V to find the firm’s total value. Crum has no nonoperating assets, so its total
value is $5,250 million. To find the value of its equity, subtract the value of claims held by all groups

other than common shareholders, such as debtholders and preferred stockholders. If the value of debt
plus preferred stock is $2,000 million, then Crum’s common equity has a value of $5,250 − $2,000 =
$3,250 million.

PREFERRED STOCK

•A hybrid
•Similar to bonds in some respects and to common stocks in others
•Has a par value and a fixed amount of dividends must be paid before dividends can be on common
stocks

The dividends on preferred stocks are fixed, and if they are scheduled to go on forever, the issue is a
perpetuity whose value is found as follows:

VPS = the value of the preferred stock

Dps = is the preferred dividend

Rps = the required rate of return.

Illustration:

MicroDrive has preferred stock outstanding that pays a dividend of $10 per year. If the required rate of
return on this preferred stock is10%, then its value is $100:

STOCK MARKET EQUILIBRIUM

Equilibrium is the condition under which the expected return on a security asseen by the marginal
investor is just equal to its required return. Also, the stock’s intrinsic value must be equal to its market
price.
Recall that the required return on Stock i, can be found using the Capital Asset Pricing Model (CAPM) as
discussed in Chapter 6:

If the risk-free rate of return is 8%, the market risk premium, RPM, is 4%, and Stock has a beta of 2, then
its required rate of return is 16%:

The marginal investor will want to buy Stock i if its expected rate of return is more than 16%, will want
to sell it if the expected rate of return is less than 16%, and will be indifferent—and hence will hold but
not buy or sell it—if the expected rate of return is exactly 16%.

Now suppose a typical investor’s portfolio contains Stock i, and suppose she analyzes the stock’s
prospects and concludes that its earnings, dividends, and price can be expected to grow at a constant
rate of 5% per year. The last dividend was D0 = $2.8571, so the next expected dividend is

The investor can calculate Stock i’s expected rate of return as follows:

Because the expected rate of return, 15%, is less than the required return, 16%, the investor would want
to sell the stock, as would most other holders if this one is typical.However, few people would want to
buy at the $30 price, so the present owners would be unable to find buyers unless they cut the price of
the stock. Thus, the price would decline, and this decline would continue until the price reached $27.27,
at which point the stock would be in equilibrium, defined as the price at which the expected rate of
return, 16%, is equal to the required rate of return as seen by the marginal investor:

To summarize, in equilibrium two related conditions must hold.

1. A stock’s expected rate of return as seen by the marginal investor must equal its required rate of
return.
2. The actual market price of the stock must equal its intrinsic value as estimated by the marginal
investor.

Changes in Equilibrium Stock Prices and Market Volatility

Stock prices are not constant—as we demonstrated earlier in this chapter and elsewhere, they undergo
violent changes at times. Indeed, many stocks declined by 80% or more during 2008, and a few enjoyed
gains of up to 200% or even more. At the risk of understatement, the stock market is volatile!

To see how such changes can occur, assume that Stock i is in equilibrium, selling at a price of $27.27. If
all expectations are met exactly, during the next year the price would gradually rise by 5%, to $28.63.
However, many different events could occur to cause a change in the equilibrium price. To illustrate,
consider again the set of inputs used to develop Stock i’s price of $27.27, along with a new set of
expected inputs:
This indicates that the stock is in equilibrium at the new and higher price. As this example illustrates,
even small changes in the size of expected future dividends or in their risk, as reflected in the required
return, can cause large changes in stock prices as the price moves from one equilibrium condition to
another.

THE EFFICIENT MARKETS HYPOTHESIS

A body of theory called the Efficient Markets Hypothesis (EMH) asserts that;

(1) Stocks are always in equilibrium and

Weak-Form Efficiency

Technical analysts believe that past trends or patterns in stock prices can be used to predict future stock
prices. In contrast, those who believe in the weak form of the EMH argue that all information contained
in past price movements is fully reflected in current market prices.

Semistrong-Form Efficiency

The semi-strong form of the EMH states that current market prices reflect all publicly available
information. Therefore, if semi-strong-form efficiency exists, it would do no good to pore over annual
reports or other published data because market prices would have adjusted to any good or bad news
contained in such reports back when the news came out.

Strong-Form Efficiency

The strong form of the EMH states that current market prices reflect all pertinent information, whether
publicly available or privately held.

Is the Stock Market Efficient?

it is generally safe to assume that the market is reasonably efficient in the sense that the intrinsic price is
approximately equal to the actual market price (^P0 ≈ P0). However, major shifts can and do occur
periodically, causing most stocks to move strongly up or down.