Chapter 7

Valuing Stocks

Prepared by
Humayun Qadri
MacEwan University © 2020 McGraw-Hill Education Limited
Learning Objectives
After studying this chapter, you should be able to:
 LO1 Understand the stock trading reports on the Internet
or in the financial pages of the newspaper.
 LO2 Calculate the present value of a stock given forecasts
of future dividends and show how growth opportunities are
reflected in stock prices and price-earnings ratios.
 LO3 Apply valuation models to an entire business.
 LO4 Understand what professionals mean when they say
that “there are no free lunches on Bay Street.”
 LO5 Understand why stock prices sometimes behave
differently than what financial theories say.

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7.1 Stocks and Stock Markets
Some Definitions:
 Common Stock or common equity or common shares:
Ownership shares in a corporation.

 Primary Market: Market for the sale of new securities issued by

corporations. Two types of primary market issues:

 Initial Public Offering (IPO): First offering of stock to the

general public.

 Seasoned Issue (SEO): Sale of additional stock by a public

company.

 Secondary Market: Market in which already-issued securities

are traded among investors.
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Reading Stock Market Listings
 Market capitalization (market cap): The total value of the
outstanding shares of stock of a corporation.

 Large-cap or small-cap firms: This is a convenient way to

summarize the size of the company.

 Price-earnings multiple or P/E Ratio: Price per share divided

by earnings per share.

 Dividend Yield: A stock’s cash dividend divided by its current

price.

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7.2 Market Values, Book Values, and
Liquidation Values
 Book value of equity: Net worth of the firm according to the
balance sheet. It does not capture the total market value of a
business.

 Liquidation Value: Net proceeds that would be realized by

selling the firm’s assets and paying off its creditors. It does
not capture the value of a successful “going concern”.

 Market Value Balance Sheet: Financial statement that uses

market value of assets and liabilities.

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Market Values, Book Values, and
Liquidation Values
 Stocks virtually never sell at book or liquidation values.

 Investors buy shares on the basis of present and future

earning power.

 Market value is the amount investors are willing to pay for

the shares of the firm. This depends on the earning power of
today’s assets and the expected profitability of future
investments.

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Market Values, Book Values, and
Liquidation Values
 The difference between a firm’s actual market value and its
liquidation or book value is often referred to as “going
concern value”, which refers to three factors:
 Extra earning power
 Intangible assets
 Value of future investments

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7.3 Valuing Common Stocks
Valuation by Comparables
 This is a common first approach to estimating market value.

Price-earnings and price-to-book value ratios are the most

popular rules of thumb for judging the value of a common
stock.

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Valuing Common Stocks (Table 7.5)
Price-to-book-value ratios and P/E ratios for selected companies and their competitors
(on March 7, 2019)
Price/Book Ratio Price-Earnings Ratio
Industry Industry
Firm Firm
Average Average
TD 1.8 1.8 12.3 11.8
Husky .8 1.2 10 29.5
Canadian Pacific 5.8 5.2 20.2 19.7
Enbridge 1.6 1.9 33.5 24.7
Barrick Gold 2.9 1.4 N/A N/A
Constellation Software 20.8 7.3 47.5 141.9
BlackBerry 2 1.5 N/A N/A
Telus 2.8 3.4 17.8 20.1
Iamgold .6 1.4 N/A N/A
Loblaws 2 2.7 34.9 22.4
SNC-Lavalin 1.7 1.9 N/A N/A
Source: © March, 2019. Morningstar, Inc. All rights reserved. Reproduced with permission.*

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Valuing Common Stocks
Price and Intrinsic Value
 Intrinsic value is the present value of expected future cash
flows from a stock or other security – it indicates the “fair”
price for a stock.
V0 = Intrinsic value of the share
P1 = Predicted stock price in one year

𝐷𝑖𝑣1= Expected dividend over the year

r = discount rate for the stock’s expected cash flows

v0

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Price and Intrinsic Value
 Expected Return: For a one year period is the expected
dividend plus the increase (or decrease) in price, divided by
the price at the beginning of the year.
𝐷𝑖 𝑣 1 + 𝑃 1 − 𝑃 0
Expected Return=𝑟=
𝑃0
𝐷𝑖 𝑣 1 𝑃 1 − 𝑃 0
Expected Return=𝑟= +
𝑃0 𝑃0

Dividen Capital Gains

d Yield Yield

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Price and Intrinsic Value
 Example: Assume that Blue Sky Corp’s shares are selling for
$75 now. They are expected to produce $3 in cash dividends
over the next year and the expected selling price is $81 after a
year. What is the expected return from Blue Sky’s shares?

Div  P1  P0
Expected Return r 
P0

3  81  75
Expected Return r  0.12 12%
75

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Price and Intrinsic Value
 For the same Blue Sky problem, we can also report the
expected return in this form:
Expected Return r Dividend Yield  Capital Gains Yield

Div1 P1  P0
Expected Return r  
P0 P0

3 81  75
Expected Return r   0.04  0.08 0.12 12%
75 75

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Price and Intrinsic Value
 If the price of Blue Sky was above $75, the expected return
would be lower than 12%. Investors would sell (not getting the
return required for the level of risk) which would drive the
price down.
 If the price of Blue Sky was below $75, the expected return

would be higher than 12%. Investors would buy (getting higher

return for the level of risk) which would drive the price up.
 If we identify “r” as the expected return on all securities at a

given level of risk, we can show intrinsic value as:

Div1  P1
P0 
(1  r )1

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The Dividend Discount Model
(DDM)
 The value of a stock is the present value of the dividends it will
pay over the investor’s horizon plus the present value of the
expected stock price at the end of that horizon.

Div1 Div2 DivH  PH

P0  1
 2
 ... 
(1  r ) (1  r ) (1  r ) H

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The Dividend Discount Model

Example: Blue Skies Company is expected to pay a dividend of

$3 this year (D1). Dividends are expected to grow at 8% per
year. Investor A plans to sell at the end of year 1 for $81,
Investor B will sell at the end of year 2 for $87.48, and Investor
C will sell at the end of year 3 for $94.48. What is the price of
the stock today (P0) for each investor given a 12% expected
return?

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The Dividend Discount Model

𝐴
𝐵
𝐶
The stock is worth the same regardless of the time horizon.

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The Dividend Discount Model
 If the horizon date is far away, we simply say that stock price
equals the present value of all future dividends per share.

Div1 Div2 Divt

P0  1
 2
 ... 
(1  r ) (1  r ) (1  r ) t

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7.4 Simplifying the Dividend
Discount Model
 Zero-Growth Model: If the dividend paid by the
corporation is not expected to change, then we treat
the dividend as a perpetuity. The company’s stock
would offer a perpetual stream of equal dividend
payments, D0 = D1 = D2 = ... = D∞

 Value of a no growth stock is:

Div 1
P0 
r

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Simplifying the Dividend
Discount Model
 Constant-Growth Model: If the dividend paid by the
stock is expected to grow at a constant rate, then the
cash flows are treated like perpetual flows with a
growth rate (growing perpetuity).
 The value of the stock is:

Div1
P0 
r g

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Constant-Growth Model
 Example: Calculate the price of Blue Sky shares if: next year’s
dividend (D1) will be $3, dividends will grow at 8% in
perpetuity and the discount rate is 12%.

Div1
P0 
r g

3
𝑃0= =$ 75
.1 2 −.0 8

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Calculating the expected rate of
return
 We can calculate the expected rate of return by rearranging the
constant-growth formula:
 For Blue Skies, the expected first-year dividend is $3 and the
growth rate 8%. With an initial stock price of $75, the expected
rate of return is

𝐷1
𝑟= +𝑔
𝑃0
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Non-Constant-Growth Model
 Many companies grow at rapid or irregular rates for several
years before finally settling down. There are three steps for
non-constant growth stocks:
 Step 1. Set the investment horizon (year H) as the future year after
which you expect the company’s growth to settle down to a stable
rate. Then calculate the present value of dividends from now to this
horizon year.

 Step 2. Forecast the stock price at the horizon, and discount it also
to give its present value today.

 Step 3. Finally, sum the total present value of dividends plus the
present value of the ending stock price.

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Non-Constant Growth
 Example: Blue Skies Company is estimated to grow at a rate
of 20% for the next 5 years and then at a normal rate of 8%
thereafter. Dividend at the end of the first year is expected to
be $3, how much will you be willing to pay for Blue Skies
stock? (The expected return on the stock is 12%)
 Step 1: Estimate expected dividends on Blue Skies stock over

the period of rapid growth.

D1 = 3
D2 = 3(1.20) = $3.60
D3 = 3.6(1.20) = $4.32
D4 = 4.32(1.20) = $5.18
D5 = 5.18(1.20) = $6.22

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Non-Constant Growth
 Step 2: Estimate the stock price at the horizon year, when
growth should have settled down to normal rate.
P5 = D6 / (r – g) = D5 (1 + g) / (r – g)
= $6.22 (1 + .08) / (.12 - .08) = $167.92

 Step 3. Compute the present value of dividends from now

until the horizon period and the present value of the price at
the horizon.

P0 = $110.75
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7.5 Growth Stocks and Income
Stocks
 Investors buy growth stocks primarily in the expectation of
capital gains; and income stocks principally for the cash
dividends.
 The fraction of earnings retained by the firm is called the
plowback ratio or retention ratio.
 The fraction of earnings a company pays out in dividends is
called the payout ratio.

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Growth Stocks and Income Stocks
 Calculating “g” - sustainable growth rate
 If a company earns a constant return on its equity and
plows back a constant proportion of earnings then:

g = ROE x plowback ratio

 It is the growth rate a company can sustain from reinvested

earnings without changing its leverage.

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Growth Stocks and Income Stocks
 Example: Blue Skies Company’s earnings per share is
expected to be $5. If Blue Skies Blue Skies Company decides
to plow back 40% of the earnings at the firm’s current return
on equity of 20%. Calculate the value of the stock if the
expected return on the stock is 12%.
D1 = $3.00
Plowback ratio = $2 / $5 = 40%
Growth rate = ROE x Plowback ratio = 20% x 40% = 8%
With growth, the price is:
Div1 3
P0   75
r g .12  .08

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Growth Stocks and Income Stocks
 Example: Blue Skies Company’s earnings per share is
expected to be $5. If Blue Skies decide to pays out all of its
earnings and did not plow back any of its earnings.
Plowback ratio = $0 / $5 = 0%
Payout ratio = $5 / $5 = 100%
Growth rate = ROE x Plowback ratio = 20% x 0% = 0%
Without growth, the price is:
Div 1 5
P0   41.67
r g .12  0

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Growth Stocks and Income Stocks
 Thus, growth accounts for $33.33 [=$75-$41.67] of the $75
price. In other words, the Present Value of Growth
Opportunities (PVGO) is $33.33.

 The Present Value of Growth Opportunities (PVGO): The net

present value of a firm’s future investments.

 Price-Earning Ratio or P/E Ratio: Stock price/EPS.

A higher P/E ratio usually indicates that investors think the
firm has good growth opportunities.
 Blue Skies Company without growth P/E = $41.67/$5 =
8.33
 Blue Skies Company with growth P/E = $75/$5 = 15

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7.6 Valuing a Business by
Discounted Cash Flow
 DCF models work just as well for entire businesses as for
shares of common stock. The value of a business can be
computed as the discounted value of free cash flows out to a
valuation horizon (H), plus the forecasted value of the
business at the horizon, also discounted back to present
value.

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7.7 There Are No Free Lunches on
Bay Street
It is not easy to outperform the market consistently.
There are two possible ways investors and analysts
attempt to do so:

 Technical Analysis – Attempting to identify undervalued

stocks by searching for patterns in past stock prices.
 Random Walk – Security prices change randomly, with no
predictable trends or patterns.

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There Are No Free Lunches on
Bay Street
 Fundamental Analysis – Attempting to find mispriced
securities by analyzing fundamental information, such as
accounting data and business prospects.

 Analysts look to uncover stocks for which price does not

equal intrinsic value.
 Stock price reaction to news
 Insider information

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There Are No Free Lunches on
Bay Street
 The Toronto Stock Exchange is an example of an efficient
market – competition to find mis-valued stocks is so intense
that when new information is made available, investors rush
to take advantage of it thereby eliminating any profit
opportunities.

 Efficient Market: A market where prices reflect all available

information. No free lunches.

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There Are No Free Lunches on
Bay Street
 There are three degrees of efficiency:

 Weak Form Efficiency: describes a market in which prices

already reflect all the information contained in past prices.

 Semi-Strong Form Efficiency: describes a market in which

prices reflect not just the information contained in past
prices but all publicly available information.

 Strong Form Efficiency: refers to a market in which prices

incorporate all available information. In such a market no
investor, can expect to earn superior profits.

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7.8 Market Anomalies and
Behavioral Finance
 Market Anomalies: There are always
some puzzles or apparent exceptions
of the efficient market theory:

• Earning Announcement Puzzle: Studies

found that stocks with the best earnings
news typically outperform the stocks
with the worst earnings news.

• New Issues Puzzle: Researchers found

that early gains from buying IPOs often
turn into losses.

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Market Anomalies and Behavioral
Finance
 Behavioural Finance: The dot-com bubble of the nineties led
many to believe that investors are not 100% rational all the
time. The behavioural psychology issues gained ground and
led to the development of behavioural finance.

• Attitude Toward Risk: When making risky decisions, people are

particularly loath to incur losses, even if those losses are small.

• Beliefs About Probabilities: Investors are often tempted to

project recent success into the future, but forget about the
losses from distant past. They tend to be overconfident.

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Summary
 Firms wishing to raise new capital may sell shares of common
stock, which are traded on a stock exchange. The stock
listings report: stock price, price change, trading volume,
dividend yield, and P/E ratio.

 The present value (price) of a share is equal to the stream of

expected dividends per share discounted at the required
return - Dividend Discount Model
 If dividends are expected to remain constant, the value of

the stock is equal to: P0 = Div1 / r

 If dividends are expected to grow forever at a constant
rate, g, the value of the stock is equal to: P0 = Div1 / (r-g)

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Summary

 Share value made up of 2 parts – the value of the assets in

place and the Present Value of Growth Opportunities (PVGO).

 The price-earnings (P/E) ratio reflects the markets assessment

of the firm’s growth opportunities.

 Competition between investors tends to produce an efficient

market.

 There are three degrees of efficiency: weak form, semi-strong

form and strong form.

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