Chapter 7

Chapter 7
Stocks and
Stock Valuation
Learning Objectives
1. Explain the basic characteristics of common

stock.
2. Define the primary market and the secondary
market.
3. Calculate the value of a stock given a history of
dividend payments.
4. Explain the shortcomings of the dividend pricing
models.
5. Calculate the price of preferred stock.
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1 share = 1 vote 1 share = 10 votes Stocks Vs Bond
Standard Super voting • maturity
• no maturity
• Owner • Debt holder
• Coupon bond
Pay debt -> preferred -> common • Dividends ( periodic fixed
variable income )
Preferred stock
• Payment after debt
• Fixed div
• No voting
ar
=
3 =
n(1 M +
7.1 Characteristics of Common
Stock
• Major financing vehicle for corporations

• Provides holders with an opportunity to
share in the future cash flows of the issuer.
• Holders have ownership in the company.
• Unlike bonds, no maturity date and
variable periodic income.

7.1 (A) Ownership
• Share in the residual profits of the company.

• Claim to all its assets and cash flow once
the creditors, employees, suppliers, and
taxes are paid off.
• Voting rights
– participate in the management of the company
– elect the board of directors which selects the
management team that runs the company’s day-
to-day operations.

7.1 (B) Claim on Assets and
Cash Flow (Residual Claim)
• In case of liquidation…
Shareholders have a claim on the residual assets
and cash flow of the company.
Known as “residual” rights.

7.1 (C) Vote (Voice in
Management)
• Standard voting rights: Typically, one vote

per share provided to shareholders to vote
in board elections and other key changes to
the charter and bylaws.
• Can be altered by issuing several classes of
stock.
– Non-voting stock, which is usually for a
temporary period of time,
– Super voting rights, which provide the holders
with multiple votes per share, increasing their
influence and control over the company.

7.1 (D) No Maturity Date
• Considered to be permanent financing

• Infinite life, i.e. no maturity date
• No promised date when investment is
returned.

7.2 Stock Markets
Stocks are traded in two types of markets;

1. the primary or “first sale” market, and the
2. secondary or “after-sale” market,

7.3 Stock Valuation
• Value of a share of stock ➔the present

value of its expected future cash flow…
– Cash dividends paid (if any).
– Future selling price of the stock.
– The discount rate i.e. risk-appropriate rate of
return to be earned on the investment.
• No guaranteed cash flow information.
• No maturity date.
• Valuation is more of an “art” than a science.

7.3 Stock Valuation (continued)
Table 7.1 Differences between Bonds and

Stocks

Example 1: Stock price with known

dividends and sale price.
Agnes wants to purchase common stock of New

Frontier Inc. and hold it for 3 years. The
directors of the company just announced that
they expect to pay an annual cash dividend of
$4.00 per share for the next 5 years. Agnes
believes that she will be able to sell the stock
for $40 at the end of three years. In order to
earn 12% on this investment, how much should
Agnes pay for this stock?

Example 1 Answer
 1 
 1 − n 
Price = Future Price 
1
+ Dividend Stream   (1 + r ) 
(1+ r )n  r 
 
 
 1 
 1 − 
1  (1+ 0.12 )4 
Price = $40.00 
4
+ $4.00   
(1+ 0.12 ) 
0.12

 
 
Price = $40.00 x 0.635518 + $4.00 x 3.03734

Price = $25.42 + $12.149 = $37.57

4 variations of a dividend pricing model have

been used to value common stock
1. The constant dividend model with an infinite

horizon
2. The constant dividend model with a finite
horizon
3. The constant growth dividend model with a
finite horizon
4. The constant growth dividend model with an
infinite horizon

Dividend Valuation Model
• Where,
• = Price of stock today;
• D = Dividend for each year;
• = the required rate of return for common stock (discount
rate).
• This formula, with modifications is generally applied to
three different situations:
– No growth in dividends.
– Constant growth in dividends.
– Variable growth in dividends.

No Growth in Dividends
• The common stock pays a constant dividend as in the case of a

preferred stock.
• This is not a very popular option.
• Where,
• = Price of the common stock; = Current annual common stock
dividend (constant); = Required rate of return for common stock.
• Assuming = $1,86 and = 12%, the price of the stock would be:

Constant Growth in Dividends
• The general valuation process is shown:
• Where,
• = Price of common stock today;
• = Dividend in year 1, ;
• = Dividend in year 2, , and so on;
• g = Constant growth rate in dividends;
• = Required rate of return for common stock (discount rate).

Constant Growth Dividend Valuation
Model
• Where:
• = Price of the stock today;

• = Dividend at the end of the first year;
• = Required rate of return (discount rate);
• g = Constant growth rate in dividends.
• Based on the current example; = $2.00; = .12; g = .07.

is computed as:

7.3 (A) The Constant Dividend
Model with an Infinite Horizon
Assumes that the firm is paying the same dividend
amount in perpetuity.
i.e. Div1 = Div2 = Div3 = Div4 = Div5 = Div∞
For perpetuities,
PV = PMT/r
where r the required rate and PMT is the cash flow.
Thus, for a stock that is expected to pay the same

dividend forever,
Price = Dividend/Required rate of return

7.3 (A) The Constant Dividend Model
with an Infinite Horizon (continued)
Example 2. Quarterly dividends forever
Let’s say that the Peak Growth Company is paying a

quarterly dividend of $0.50 and has decided to pay the
same amount forever. If Joe wants to earn an annual
rate of return of 12% on this investment, how much
should he offer to buy the stock at?
Answer
Quarterly dividend = $0.50
Quarterly rate of return = Annual rate/4= 12%/4 = 3%
PV = Quarterly dividend/Quarterly rate of return
Price = 0.50/.03 = $16.67

7.3 (C) The Constant Growth Dividend
Model with an Infinite Horizon (cont’d)
QuickFix Enterprises’ Annual Dividends

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
$0.50 $0.55 $0.61 $0.67 $0.73 $0.81 $0.89 $0.98 $1.08 $1.25
Required rate of return = 14%

Compound growth rate “g” = (FV/PV) 1/n -1
Where FV = $1.25; PV = 0.50; n = 9
g = (1.25/0.50)1/9 – 1 ➔10.72%
Div1 = Div0(1+g)➔$1.25*(1.1072)➔$1.384
P0 = Div1/(r-g) ➔ $1.384/(.14-.1072)➔$42.19

7.4 Dividend Model
Shortcomings
• Need future cash flow estimates and a required rate of return,
therefore difficult to apply universally.
– Erratic dividend patterns,
– Long periods of no dividends,
– Declining dividend trends
• Need a pricing model that is more inclusive than the dividend
model, one that can estimate expected returns for stocks
without the need for a stable dividend history.

7.5 Preferred Stock
Pays constant dividend as long as the stock is outstanding.
Typically has infinite maturity, but some are convertible into

common stock at some pre-determined ratio.
Have “preferred status” over common stockholders in the case

of dividend payments and liquidation payouts.
Dividends can be cumulative or non-cumulative
To calculate the price of preferred stock, we use the PV of a

perpetuity equation, i.e. Price 0 = PMT/r
PMT = Annual dividend (dividend rate * par value); and

r = investor’s required rate of return.

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Chapter 7

1. Explain the basic characteristics of common

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-2

• Major financing vehicle for corporations

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• Share in the residual profits of the company.

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• Standard voting rights: Typically, one vote

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• Considered to be permanent financing

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Stocks are traded in two types of markets;

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• Value of a share of stock ➔the present

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-9

Table 7.1 Differences between Bonds and

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-10

Example 1: Stock price with known

Agnes wants to purchase common stock of New

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-11

Price = $40.00 x 0.635518 + $4.00 x 3.03734

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-12

4 variations of a dividend pricing model have

1. The constant dividend model with an infinite

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-13

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-14

• The common stock pays a constant dividend as in the case of a

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-15

• The general valuation process is shown:

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• = Price of the stock today;

• Based on the current example; = $2.00; = .12; g = .07.

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Thus, for a stock that is expected to pay the same

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-18

Example 2. Quarterly dividends forever

Let’s say that the Peak Growth Company is paying a

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-19

QuickFix Enterprises’ Annual Dividends

Required rate of return = 14%

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-20

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-21

Pays constant dividend as long as the stock is outstanding.

Typically has infinite maturity, but some are convertible into

Have “preferred status” over common stockholders in the case

Dividends can be cumulative or non-cumulative

To calculate the price of preferred stock, we use the PV of a

PMT = Annual dividend (dividend rate * par value); and

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-22

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