8

Stock Valuation

1
 Key Concepts and Skills
 Understand how stock prices depend on future
dividends and dividend growth
 Be able to compute stock prices using the
dividend growth model
 Understand how corporate directors are elected
 Understand how stock markets work
 Understand how stock prices are quoted

2
 Chapter Outline
 Common Stock Valuation
 Some Features of Common and Preferred
Stocks
 The Stock Markets

3
Cash Flows for Stockholders
 If you buy a share of stock, you can
receive cash in two ways
 The company pays dividends
 You sell your shares, either to another
investor in the market or back to the
company
 As with bonds, the price of the stock is
the present value of these expected cash
flows
4
 One-Period Example
 Suppose you are thinking of purchasing the
stock of Moore Oil, Inc. and you expect it to
pay a $2 dividend in one year and you believe
that you can sell the stock for $14 at that time.
If you require a return of 20% on investments
of this risk, what is the maximum you would be
willing to pay?
 Compute the PV of the expected cash flows
 Price = (14 + 2) / (1.2) = $13.33
 Or FV = 16; I/Y = 20; N = 1; CPT PV = -13.33

5
 Two-Period Example
 Now what if you decide to hold the stock
for two years? In addition to the dividend
in one year, you expect a dividend of
$2.10 in two years and a stock price of
$14.70 at the end of year 2. Now how
much would you be willing to pay?
 PV = 2 / (1.2) + (2.10 + 14.70) / (1.2) 2 =
13.33

6
 Three-Period Example
 Finally, what if you decide to hold the stock for
three years? In addition to the dividends at the
end of years 1 and 2, you expect to receive a
dividend of $2.205 at the end of year 3 and the
stock price is expected to be $15.435. Now
how much would you be willing to pay?
 PV = 2 / 1.2 + 2.10 / (1.2)2 + (2.205 + 15.435) /
(1.2)3 = 13.33

7
 Developing The Model
 You could continue to push back the year
in which you will sell the stock
 You would find that the price of the stock
is really just the present value of all
expected future dividends
 So, how can we estimate all future
dividend payments?

8
 Estimating Dividends: Special
Cases
 Constant dividend
 The firm will pay a constant dividend forever
 This is like preferred stock
 The price is computed using the perpetuity formula
 Constant dividend growth
 The firm will increase the dividend by a constant percent
every period
 Supernormal growth
 Dividend growth is not consistent initially, but settles
down to constant growth eventually

9
 Zero Growth
 If dividends are expected at regular intervals forever,
then this is a perpetuity and the present value of
expected future dividends can be found using the
perpetuity formula
 P0 = D / R
 Suppose stock is expected to pay a $0.50 dividend every
quarter and the required return is 10% with quarterly
compounding. What is the price?
 P0 = .50 / (.1 / 4) = $20

10
 Dividend Growth Model
 Dividends are expected to grow at a constant
percent per period.
 P0 = D1 /(1+R) + D2 /(1+R)2 + D3 /(1+R)3 + …
 P0 = D0(1+g)/(1+R) + D0(1+g)2/(1+R)2 +
D0(1+g)3/(1+R)3 + …
 With a little algebra and some series work, this
reduces to:

D 0 (1  g) D1
P0  
R -g R -g
11
 DGM – Example 1
 Suppose Big D, Inc. just paid a dividend of $.50.
It is expected to increase its dividend by 2% per
year. If the market requires a return of 15% on
assets of this risk, how much should the stock
be selling for?
 P0 = .50(1+.02) / (.15 - .02) = $3.92

12
 DGM – Example 2
 Suppose TB Pirates, Inc. is expected to
pay a $2 dividend in one year. If the
dividend is expected to grow at 5% per
year and the required return is 20%, what
is the price?
 P0 = 2 / (.2 - .05) = $13.33
 Why isn’t the $2 in the numerator multiplied by
(1.05) in this example?

13
 Stock Price Sensitivity to
Dividend Growth, g
250
D1 = $2; R = 20%
200
Stock Price

150

100

50

0
0 0.05 0.1 0.15 0.2
Growth Rate

14
 Stock Price Sensitivity to
Required Return, R
250
D1 = $2; g = 5%
200
Stock Price

150

100

50

0
0 0.05 0.1 0.15 0.2 0.25 0.3
Growth Rate

15
 Example 8.3 Gordon Growth
Company - I
 Gordon Growth Company is expected to pay a
dividend of $4 next period and dividends are
expected to grow at 6% per year. The required
return is 16%.
 What is the current price?
 P0 = 4 / (.16 - .06) = $40
 Remember that we already have the dividend
expected next year, so we don’t multiply the dividend
by 1+g

16
Example 8.3 – Gordon Growth
Company - II
 What is the price expected to be in year 4?

P4 = D4(1 + g) / (R – g) = D5 / (R – g)

P4 = 4(1+.06)4 / (.16 - .06) = 50.50
 What is the implied return given the change in price
during the four year period?
 50.50 = 40(1+return)4; return = 6%
 PV = -40; FV = 50.50; N = 4; CPT I/Y = 6%
 The price grows at the same rate as the dividends

17
Nonconstant Growth Problem
Statement
 Suppose a firm is expected to increase
dividends by 20% in one year and by 15% in
two years. After that dividends will increase at
a rate of 5% per year indefinitely. If the last
dividend was $1 and the required return is
20%, what is the price of the stock?
 Remember that we have to find the PV of all
expected future dividends.

18
Nonconstant Growth – Example
Solution
 Compute the dividends until growth levels off

D1 = 1(1.2) = $1.20

D2 = 1.20(1.15) = $1.38

D3 = 1.38(1.05) = $1.449
 Find the expected future price

P2 = D3 / (R – g) = 1.449 / (.2 - .05) = 9.66
 Find the present value of the expected future cash
flows

P0 = 1.20 / (1.2) + (1.38 + 9.66) / (1.2)2 = 8.67

19
 Quick Quiz – Part I
 What is the value of a stock that is
expected to pay a constant dividend of $2
per year if the required return is 15%?
 What if the company starts increasing
dividends by 3% per year, beginning with
the next dividend? The required return
stays at 15%.

20
 Using the DGM to Find R
 Start with the DGM:

D 0 (1  g) D1
P0  
R -g R -g
rearrange and solve for R
D 0 (1  g) D1
R g g
P0 P0

21
Finding the Required Return -
Example
 Suppose a firm’s stock is selling for $10.50.
They just paid a $1 dividend and dividends are
expected to grow at 5% per year. What is the
required return?
 R = [1(1.05)/10.50] + .05 = 15%
 What is the dividend yield?
 1(1.05) / 10.50 = 10%
 What is the capital gains yield?
 g =5%

22
Table 8.1 - Summary of Stock
Valuation

23
 Features of Common Stock
 Voting Rights
 Proxy voting
 Classes of stock
 Other Rights
 Share proportionally in declared dividends
 Share proportionally in remaining assets during
liquidation
 Preemptive right – first shot at new stock issue to
maintain proportional ownership if desired

24
 Dividend Characteristics
 Dividends are not a liability of the firm until a dividend
has been declared by the Board
 Consequently, a firm cannot go bankrupt for not
declaring dividends
 Dividends and Taxes
 Dividend payments are not considered a business
expense; therefore, they are not tax deductible
 The taxation of dividends received by individuals
depends on the holding period
 Dividends received by corporations have a minimum
70% exclusion from taxable income

25
 Features of Preferred Stock
 Dividends
 Stated dividend that must be paid before dividends
can be paid to common stockholders
 Dividends are not a liability of the firm and preferred
dividends can be deferred indefinitely
 Most preferred dividends are cumulative – any
missed preferred dividends have to be paid before
common dividends can be paid
 Preferred stock generally does not carry voting
rights

26
 Stock Market
 Dealers vs. Brokers
 New York Stock Exchange (NYSE)
 Largest stock market in the world
 Members
• Own seats on the exchange
• Commission brokers
• Specialists
• Floor brokers
• Floor traders
 Operations
 Floor activity

27
 NASDAQ
 Not a physical exchange – computer-based quotation
system
 Multiple market makers
 Electronic Communications Networks
 Three levels of information
 Level 1 – median quotes, registered representatives
 Level 2 – view quotes, brokers & dealers
 Level 3 – view and update quotes, dealers only
 Large portion of technology stocks

28
 Work the Web Example
 Electronic Communications Networks provide
trading in NASDAQ securities
 INET allows the public to view the “order book”
in real time
 Click on the web surfer and visit The Island!

29
 Reading Stock Quotes
 Sample Quote
55.93 44.40 38.60 HarleyDav .84f 1.50 16 24726 54.25 1.18
 What information is provided in the stock
quote?
 Click on the web surfer to go to Bloomberg
for current stock quotes.

30
 Quick Quiz – Part II
 You observe a stock price of $18.75. You expect
a dividend growth rate of 5% and the most
recent dividend was $1.50. What is the required
return?
 What are some of the major characteristics of
common stock?
 What are some of the major characteristics of
preferred stock?

31
 8

End of Chapter

32
 Comprehensive Problem
 XYZ stock currently sells for $50 per
share. The next expected annual
dividend is $2, and the growth rate is 6%.
What is the expected rate of return on
this stock?
 If the required rate of return on this stock
were 12%, what would the stock price be,
and what would the dividend yield be?

33