Essentials of Financial Management

Value of a share of common stock

Chapter 10: Stocks and Their Valuation
- Depends on the cash flows it is expected
- Common Stock
to provide, from two elements:

- Constant Growth Stocks

• Dividends received each year while a
- Valuing Nonconstant Growth Stocks
stock is held

- Corporate Valuation Model

• Price received when the stock is sold

- Preferred Stock
- Final price = Original price + Expected
capital gain

10-4 The Discounted Dividend Model

Marginal Investor
- A representative investor whose actions
reflect the beliefs of those people who are
currently trading a stock

- Determines the equilibrium stock price

after performing the analysis among
different investors

Expected Dividends as the Basis for Stock

Values

Value of Stock = PV of expected future

dividends

• Since the sale price depends on the

expected dividends, the expected cash
flows is based on expected dividends

• The value of a stock is based on the

present value of the stock’s expected
dividend stream

- Dt: the dividend a stockholder expects to

receive at the end of each year

- P0: actual market price of the stock today,

known with certainty

10-5 Constant Growth Stocks

- Constant Growth (Gordon) Model: Used to

find the calue of a constant growth stock

Dividends vs Growth
- Growth in dividends requires growth in
earnings

- In the long run, grwoth in dividends

depends primarily on the firm’s payout
ratio and its ROE

- A firm can have a high growth rate or high -

current dividend but not both

• The retention of earnings is the basis of

growth

Required Conditions for the Constant Supernormal (Nonconstant) Growth

Growth Model - The part of the firm’s life cycle in which it
1. rs > g
grows much faster than the ecnomy as a
2. Growth rate is expected to remain whole

constant

3. Expected to pay dividends in the future

Horizon (Terminal) Date
- The date when the growth rate becomes
Zero Growth Stock constant. At this date, it is no longer
- A common stock whose future dividends necessary to forecast the individual
are not expected to grow at all; g = 0
dividends

Horizon (Continuing) Value

-
- The value at the jorizon date of all
dividends expected thereafter

10-6 Valuing Nonconstant Growth Stocks

-

10-7 Enterprise-Based Approach to

Valuation

Corporate Valuation Model

- An alternative to the discounted dividend
model that is useful for firms with no
 history of dividends or the value of a Free Cash Flow Valuation

division

- First calculates the frim’s free cash flows,

then firms their present values to
determine the firm’s values

Recall: FCF represents the cash generated

from current operations minus the cash
spend on investments in assets for future
growth

Market Value of Company

Procedure:

- 1. Calculate the FCF for each nonconstant

growth year

2. Find the PV of all FCF discounted at

WACC

- WACC: the weighted average cost of all 3. Use the constant growth model for the
the firm’s capital (debt, preferred stock and terminal value

common equity)
4. Calculate the total market value or
- When the company starts to grow at a horizon value
constant rate, use the formula

5. Find the PV of the horizon value

6. Find the estimated market value by

adding both PVs

7. Subtract the market value of debt and

preferred stock to find the value of
common equity

8. Divide the equity value by the number of

shares outstanding

Corporate Valuation vs Discounted

Dividend Models
- Corporate Model: used to value divisions
and firms that do not pay dividends;
feasible when comparing only one firm in
the high growth stage

- Discounted Model: more feasible in

comparing firms with estimated growth
rates in dividends

10-8 Preferred Stock

- A hybrid between a bond and common

stock

• Similarity to bonds: a par value and a

fixed dividend that must be paid before
common stock is paid

- In contrast to bonds, skipping

payment will not lead the firm into
bankruptcy

Perpetuity
- A preferred stock with payments that last
forever

- Formula: Vp = DP ÷ rp

• Vp: value of the preferred stock

• Dp: preferred dividend

• rp: required rate of return on the

preferred

- In equilibrium, rs(h at) = rp

Expected Rate of Return

- Can be found given the preferred’s current
price and dividend

- rp(h at) = DP ÷ Vp