FINA5533 – Finance Essentials

Week 4
Stock and Stock valuation
Learning Objectives

1. Value a share as the present value of its expected future

dividends.
2. Understand the trade-off between dividends and growth in
share valuation.

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h
eU
n Introduction
iv
er
s
i  A lot of time and effort goes into share valuation – analysts and
ty
o
f investors attempt to profit by identifying mispriced (under or over-
W
es valued) securities.
et
r
n
A  We look at a variety of models and approaches that, theoretically,
u
s should give the same answer.
tr
a
l
ia
9
 However, all methods are based on assumptions and, in practice, what
-
3 we hope for is a common range of values

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Equity Valuation

Valuation Models:
1. Dividend Discount and Total Payout model
2. Comparable
3. Discounted Cash Flow model (DCF)
In this lecture we only focus on Dividend Discount Models

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Dividend Discount
Model

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2. Dividend Discount Model: Stock Prices and Returns

 A One-Year Investor
• Projected Cash Flows in one year
– Dividend
– Sale of Stock
Timeline for One-Year Investor

Price we pay for the stock today The cash flows we expect in 1 year

 Since the cash flows are risky, we must discount them at the equity cost of
capital (rE) - the rate that investors want for investments in that risk-class.

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Stock Prices and Returns

 A One-Year Investor

𝐷𝑖𝑣 1+ 𝑃 𝐷𝑖𝑣𝑡+1+𝑃𝑡+1
𝑃0 = 1 1+𝑟 𝑃1 =
1+𝑟

 If the current stock price were less than this amount, expect
investors to rush in and buy it, driving up the stock’s price.

 If the stock price exceeded this amount, selling it would cause

the stock price to quickly fall.

 Dividend and rE are estimates which makes the price uncertain.

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Dividend Yields, Capital Gains and Total Returns

 Dividend yield
• The dividend yield is the percentage return the investor expects
to earn from the dividend paid by the share.

 Capital gain
• Capital gain is the difference between the expected sale price and
the original purchase price for the share.

 Total return
• The sum of the dividend yield and the capital gain rate is called the
total return of theshare.
• The total return is the expected return the investor will earn for a
one-year investment in the share.

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Equity Cost of Capital

Total Return = Dividend Yield + Capital Gain Rate

Dividend Yield Capital Gain

 The expected total return of the stock should equal the

expected return of other investments available in the
market with equivalent risk.

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Example: Dividend Discount Model

 Suppose you expect Benson Toys to pay an annual dividend of

$0.56 per share in the coming year and to trade $45.50 per share
at the end of the year. If investments with equivalent risk to
Benson’s shares have an expected return of 6.80%, what is the
most you would pay today for one Benson’s share? What
dividend yield and capital gain rate would you expect at this
price?

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Solution

𝐷𝑖𝑣1 + 𝑃1 $0.56 + $45.50

𝑃0 = = = $43.13
1 + 𝑟𝐸 1.068

Dividend Yield
𝐷𝑖𝑣1 $0.56
𝐷𝑖𝑣. 𝑦𝑖𝑒𝑙𝑑 = = = 1.30%
𝑃𝑜 $43.13
Capital Gains
𝑃1 − 𝑃0 $45.50 − $43.13
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐺𝑎𝑖𝑛𝑠 = = = 5.5%
𝑃𝑜 $43.13
Total Return
1.3% + 5.5% = 6.8%

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A Multi-Year Investor

 What is the price if we plan on holding the stock for two years?

= P1
1
P1 + Div1 ×
(1 + 𝑟𝐸 )

= P0
1
×
(1 + 𝑟𝐸 )

Div1 Div2  P2
P0  
1  rE (1  rE ) 2
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A Multi-Year Investor

 What is the price if we plan on holding the stock for three years?

-P0 Div1 Div2 P3 + Div3

= P2
× 1
P2 + Div2 (1 + 𝑟𝐸)

= P1
× 1
P1 + Div1 (1 + 𝑟𝐸)

= P0 1
×
(1 + 𝑟𝐸 )

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A Multi-Year Investor

 What is the price if we plan on holding the stock for N

years?
Div1 Div2 DivN PN
P0     
1  rE (1  rE ) 2
(1  rE ) N (1  rE ) N

 This is known as the Dividend Discount Model.

• Note that the above equation holds for any horizon N.

Thus all investors (with the same beliefs) will attach the
same value to the stock, independent of their investment
horizons.

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The Dividend-Discount Model

We have a choice of 3 different assumptions. Dividends can:

1. Remain constant over time;

2. Have a constant growth rate; or

3. Have a mixed growth rate pattern

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 The ‘general’ Dividend-Discount Model

 If ‘n’ is very large, then the present value of the sale price (Pt)
will approach zero.

 Therefore, the expected price of any stock can be expressed as

the present value of the expected future dividends it will pay.


Div1 Div2 Div3 Divn
P0     
1  rE (1  rE ) 2
(1  rE ) 3
n 1 (1  rE )n

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Dividend Discount Model with Constant Dividend Growth

• The simplest forecast for the firm’s future dividends states

that they will grow at a constant rate, g, forever.

• Constant Dividend Growth Model

The value of the firm depends
on:
1. The current dividend level,
Div1
P0  2. The cost of equity, and
rE  g
3. The growth rate.

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Simplest Assumption - Constant Dividend Growth

 For another interpretation of the following formula

Capital Gain

Div1
rE   g
P0

Dividend Yield

 We can see that g equals the expected capital gain rate. In other
words, with constant expected dividend growth, the expected
growth rate of the share price matches the growth rate of the
dividends.

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Example – annual dividend

 Problem
• AT&T plans to pay $1.44 per share in dividends in the coming year.
• Its equity cost of capital is 8%.
• Dividends are expected to grow by 4% per year
in the future.
• Estimate the value of AT&T’s stock.

 Solution

Div1 $1.44
P0    $36.00
rE  g .08 .04

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Example - 6 monthly dividend

NAB pays dividends 6-monthly and plans to pay $0.90 per share in
dividends in 6 months. Dividends are expected to grow by 4% per
year in the future (EAR). The discount rate for NAB is 10% per
year (EAR). Estimate the value of NAB stock.

Calculate the discount and growth rate for a 6-month period

– The next dividend payment is $0.90 per share and is due in 6 months
– the dividend growth rate for 6 months is 1.04 0.5 𝑜𝑟 1.980%
– the discount rate for 6 months is: 1.10 0.5 𝑜𝑟 4.881%

𝐷𝑖𝑣1 0.90
𝑃0 = = = $31.03
𝑟𝐸 − 𝑔 0.04881 − .01980

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Dividends Versus Investment and Growth

We have looked at price per share when dividends:

1. Remain constant over time; 

2. Have a constant growth rate; or 

3. Have a mixed growth rate pattern

Before we look at (3) we will have a look at the decision to pay

dividends to shareholders and the decision to grow the company.

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Payout Ratio

New Projects

Dividend
Payout = 25%
Shareholders
Retention ratio
= 75%

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Dividends Versus Investment and Growth

A Simple Model of Growth

 Dividend Payout Ratio
• The fraction of earnings paid as dividends each
year

 Retention Rate
• Fraction of current earnings that the firm
retains
• Retention rate = 1 – payout ratio
BHP example:
0.75 = 1 – 0.25
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Dividends Versus Investment and Growth

The firm can increase its dividend in three ways:

1. It can increase its earnings.

2. It can increase its dividend payout rate.

3. It can decrease its number of shares outstanding.

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Dividends Versus Investment and Growth

To increase dividends, let’s focus on the options:

1. Increase earnings; and
2. Increase the dividend payout ratio

The firm retains more of its earnings, it can use those earnings to
invest in new projects and increase future earnings and dividends.

or

The firm can release the companies earnings to its shareholders in

the form of dividends.

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A Simple Model of Growth

 New Investment
• Earnings x Retention rate (i.e., how much money the company keeps)

 Change in earnings (i.e., what the company will earn on its new investment)
• New Investment x Return on New Investment (ROE)
• (Earnings x Retention rate) x Return on New Investment

 Earnings Growth Rate (g) (i.e., how much will earnings grow based on new investment?)
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠
• g=
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠
(Earnings x Retention rate) x Return on New Investment
• =
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠
• 𝑔 = 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 × 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑁𝑒𝑤 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

ROE  rE
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Dividends Versus Investment and Growth
If EPS (earnings per share) is expected to be $1.00 and the
dividend payout ratio = 100% such that g = 0% and the current
share price = $20. What is rE?

𝐷𝑖𝑣1
• D1=$1; 𝑃0 = ; then
𝑟𝐸 −
$1 $1
• $20 = 𝑟𝐸 = = 0.05 𝑜𝑟 5%
𝑟𝐸 − $20
0
If the dividend payout ratio = 60% and return on new investment
= 5%. What is the share price?
• g = (1-0.6) x 0.05 = 0.02; and Div1=$0.6;
Retention ratio Return on new investment

Why is the share price the same, even when

the company invested its some earnings?
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Dividends Versus Investment and Growth

 If DPR to 60%. Return on new investment = 4%. What is price?

• g = (1-0.6) x 0.04 = 0.016; and Div1 = $0.60
• 𝑃0 =
$0.60
0.05−0.016
= $17.64 why price fall?

 If DPR to 60%. Return on new investment = 6%. What is price?

• g = (1-0.6) x 0.06 = 0.024; and Div1 = $0.60
• 𝑃0 =
$0.60
0.05−0.024
= $23.08 why price rise?

 Cutting the firm’s dividend to increase investment will raise

the stock price if, and only if, the new investments have a
positive NPV (i.e. rnew investment> rE).

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Dividend Discount with Changing Growth Rates

 We cannot use the constant dividend growth model to value a

stock if the growth rate is not constant.
• For example, young firms often have very high initial
earnings growth rates.
• During this period of high growth, these firms often retain
100% of their earnings to exploit profitable investment
opportunities.
• As they mature, their growth slows. At some point, their
earnings exceed their investment needs and they begin to pay
dividends.

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 Changing Growth Rates

 Dividend-Discount Model with Constant Long-Term Growth

DivN  1
PN 
rE  g

Div1 Div2 DivN 1  DivN  1 

P0      
1  rE (1  rE ) 2 … (1  rE ) N (1  rE ) N  rE  g 

 This is a little bit like the DCF. We had a forecast period, and then a terminal
value that captured the remaining value of the firm.
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Example

 Phranque is a small but growing app writer, specializing in developing

new iPhone apps. It does not expect to pay dividends for 2 years
though its earnings are growing rapidly (25% per annum) with current
earnings of $0.50 per share.

 It expects competition to increase considerably by Year 3 during which

it expects earnings to grow at just 3% and this lower growth rate is
expected to continue into the future.

 The company is expected to start paying dividends at the end of the

3rd year. A dividends payout ratio of 0.50 is predicted. The
appropriate discount rate for this firm is 12% per annum.

 What is the price of a Phranque share given thesedetails?

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Solution

 First write out the earnings over the next 3 years and then to
calculate the dividends and calculate the value of the stock by
discounting the present value of dividend perpetuity starting at
year 3.
now 1 2 3
earnings 0.5 0.625 0.78125 0.804688
payout ratio 0.5 0.5 0.5 0.5
dividends 0 0 0 0.402344

𝐷𝑖𝑣1 1 0.402344 1
𝑃𝑟𝑖𝑐𝑒 = × 2
= × 2
= $3.56
𝑟𝐸 − 𝑔 1 + 𝑟𝐸 0.12 − 0.03 1.12

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Dividends as Signals

Corporate boards typically set dividend payouts that are

comfortably covered by earnings.

 In good times: A greater amount of earnings is retained

 In bad times: Dividends are often constant even if they exceed

free cash flow.

Why would a company keep dividends constant, even when they

exceed FCF?
 Maybe portray long-term confidence in the business.

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Limitations of the Dividend-Discount Model

 There is a tremendous amount of uncertainty associated

with forecasting a firm’s dividend growth rate and future
dividends.

 Small changes in the assumed dividend growth rate can lead

to large changes in the estimated stock price.

 Many companies do not pay dividends for a very long time,

thus the dividend-discount model must be modified.

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Sensitivity Analysis: Dividend Discount Model

$0.72
𝑃0 =
𝑟𝐸 − 𝑔

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Share Repurchases and the Total Payout Model

 Share repurchases: the firm uses excess cash to buy back its own
share. Consequences:

1. The more cash the firm uses to repurchase shares, the less
cash it has available to pay dividends.

2. By repurchasing shares, the firm decreases its share count,

which increases its earnings and dividends on a per-share basis.

 In the dividend-discount model, a share is valued from the

perspective of a single shareholder, discounting the dividends
the shareholder will receive

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Share Repurchases and the Total Payout Model

 Total payout model

• Values all of the firm’s equity, rather than a single share.

• To use this model, discount the total payouts that the firm
makes to shareholders, which is the total amount spent on
both dividends and share repurchases.

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Example

 Titan Industries has 217 million shares outstanding and expects

earnings next year of $860 million.
 Titan plans to pay out 50% of its earnings in total, paying 30%
as a dividend and using 20% to repurchase shares.
 If Titan’s earnings are expected to grow by 7.5% per year and
these payout rates remain constant, determine Titan’s share price
assuming an equity cost of capital of 10%.

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Solution

 Based on the equity cost of capital of 10% and an expected

earnings growth rate of 7.5%, we can compute the present value
of Titan’s future payouts as a constant growth perpetuity.

 The only input missing here is Titan’s total payouts this year,
which we can calculate as 50% of its earnings.

 The present value of all of Titan’s future payouts is the value of

its total equity.

 To obtain the price of a share, we divide the total value by the

number of shares outstanding (217 million).

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Solution

 Titan will have total payouts this year of 50% x $860 million =
$430 million. Using the constant growth perpetuity formula, we
have:

 This present value represents the total value of Titan’s equity (i.e.
its market capitalisation). To compute the share price, we divide
by the current number of shares outstanding:

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Tutorial Question No.Ch. 7 Prob. 4

Telford Corporation has a current share price of $20 and is

expected to pay a dividend of $1 in one year. Its expected
share price right after paying that dividend is $22.
 a. What is Telford’s equity cost of capital?
 b. How much of Telford’s equity cost of capital is expected
to be satisfied by dividend yield and how much by capital
gain?

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Tutorial Question No. 3 – Ch 7 Prob 11

Rampart Corporation has a dividend yield of 1.5%. Its equity

cost of capital is 8%, and its dividends are expected to grow at
a constant rate.
a. What is the expected growth rate of Rampart’s dividends?
b. What is the expected growth rate of Rampart’s share price?

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Tutorial Question No. 4 – Ch 7 Prob 14

Cooperton Mining just announced it will cut its dividend from

$4 to $2.50 per share and use the extra funds to expand. Prior
to the announcement, Cooperton’s dividends were expected to
grow at a rate of 3%, and its share price was $50. With the
planned expansion, Cooperton’s dividends are expected to
grow at a rate of 5%. What share price would you expect after
the announcement? (Assume that the new expansion does not
change Cooperton’s risk.) Is the expansion a good
investment?

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Tutorial Question No. 5 – Ch 7 Prob 17

Halliford Corporation expects to have earnings this coming

year of $3 per share. Halliford plans to retain all of its
earnings for the next two years. Then, for the subsequent two
years, the firm will retain 50% of its earnings. It will retain
20% of its earnings from that point onward. Each year,
retained earnings will be invested in new projects with an
expected return of 25% per year. Any earnings that are not
retained will be paid out as dividends. (Assume that
Halliford’s share count remains constant and all earnings
growth comes from the investment of retained earnings.) If
Halliford’s equity cost of capital is 10%, what price would you
estimate for Halliford shares?

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Tutorial Question No. 6 – Ch 7 Prob 21

Maynard Steel plans to pay a dividend of $3 this year. The

company has an expected earnings growth rate of 4% per year
and an equity cost of capital of 10%. a. Assuming that
Maynard’s dividend payout rate and expected growth rate
remain constant, and that the firm does not issue or
repurchase shares, estimate its share price. b. Suppose
Maynard decides to pay a dividend of $1 this year and to use
the remaining $2 per share to repurchase shares. If Maynard’s
total payout rate remains constant, estimate its share price. c.
If Maynard maintains the dividend and total payout rate given
in part (b), at what rates are its dividends and earnings per
share expected to grow?

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