Corporate Finance (B02030) Ton Duc Thang University

Module 4
THE VALUE OF COMMON STOCKS

How Common Stocks Are Traded

Common stocks or shares represent ownership in a publicly-held corporation. Sale of new shares
by corporations occurs in the primary market. Previously issued shares are traded among investors
in the secondary market. The Ho Chi Minh Stock Market and Hanoi Stock Market are examples of a
secondary market.

How Common Stocks Are Valued

The valuation of common stocks is based on the same present value principles applied earlier to the
valuation of bonds. However, stock valuation is more difficult than bond valuation because the cash
flows are uncertain, the life is forever and the required rate of return is unobservable.

The dividend discount model, or discounted cash flow model, states that share value equals the
present value of all expected future dividends. The current stock price is computed as follows:

P0 = D1 / (1 + r) + D2 / (1 + r)2 + D3 / (1 + r)3 + … + Dt / (1 + r)t + Pt / (1 + r)t

where P0 is the price of a share today, D is the expected future dividend, r is the expected return (or
discount rate or equity cost of capital), and Pt is the price of a share at a future date.

One-Period Example: Suppose you are thinking of purchasing the stock of Moore Oil, Inc. 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?

P0 = ($14 + $2) / (1.2) = $13.33

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?

P0 = $2 / (1.2) + ($2.10 + $14.70) / (1.2)2 = $13.33

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?

P0 = $2 / 1.2 + $2.10 / (1.2)2 + ($2.205 + $15.435) / (1.2)3 = $13.33

Some Special Cases in Stock Valuation

Because of the difficulties associated with the estimation of future dividends, we find it useful to make
one of three simplifying assumptions regarding the pattern of future payments. They are: (1) zero
growth in dividends, or constant dividends; (2) constant rate of growth in dividends; and, (3) a
nonconstant rate of growth in dividends.

The Dividend Discount Model with No Growth. A stock with constant dividends is a perpetuity.
Previously we noted that the present value of a perpetuity, PV, equals C/r. Since, for a zero-growth
stock, D = C, the value of a share of stock which pays a constant dividend is P0 = D / r.
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Corporate Finance (B02030) Ton Duc Thang University

Example: Suppose a stock is expected to pay a $2 dividend each period, forever, and the required
return is 10%. What is the stock worth?

P0 = 2 / 0.1 = $20

Dividend Growth Model. A growing perpetuity is a series of cash flows, occurring at regular
intervals, which grows perpetually at a constant rate. The series of dividend payments for a share of
common stock can be considered a growing perpetuity as long as the dividend payment increases at
the same rate each year. Let Dt be the dividend paid in year t, and let g be the annual growth rate in
dividends. The dividend at any future date is Dt = D0 x (1 + g)t.

Example: If the current dividend is $2 and the expected growth rate is 5%, what is D1? D5?

D1 = $2(1 + 0.05) = $2.10

D5 = $2(1 + 0.05)5 = $2.55

It can be shown algebraically that, as long as r is greater than g, the present value of an infinite
stream of cash flows which are changing at constant rate is equal to

P0 = (D0 x (1 + g)) / (r – g) = D1 / (r – g).

Example: Consider the stock given above. If the required return is 10%, what is the expected price
today? In 4 years?

P0 = 2.10 / (0.1 – 0.05) = $42

P4 = 2.55 / (0.1 – 0.05) = $51

Nonconstant Growth. The assumption of nonconstant growth is more realistic for many firms. The
hallmark of this model is the assumption that dividends change at different rates in different periods,
until, at a specified future date, the growth rate settles at some constant equilibrium rate. Fortunately,
no new formulas are required to value such a stock. In order to use the nonconstant or supernormal
growth model we simply:

1. Compute the FV of each dividend in the nonconstant growth period, using the assumed growth
rate.

2. Compute the present value of the abovementioned dividends discounted at r.

3. Use the constant-growth model to compute the present value of all of the remaining dividends
which, by assumption, are expected to grow at a constant rate forever.

4. Sum the present values obtained in steps 2 and 4; this is the present value of all future dividends,
which is P0.

Example: 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?

D1 = $1(1.2) = $1.20
D2 = $1.20(1.15) = $1.38
D3 = $1.38(1.05) = $1.449
P2 = D3 / (r – g) = $1.449 / (0.2 – 0.05) = $9.66
P0 = $1.20 / (1.2) + ($1.38 + $9.66) / (1.2)2 = $8.67

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Corporate Finance (B02030) Ton Duc Thang University

Components of the Required Return

Required return or expected return is the percentage yield that an investor forecasts from a specific
investment over a set period of time. It is sometimes called the market capitalization rate or cost of
equity capital. Given a constant growth rate, we can obtain the components of return by solving the
constant-growth formula for r:

r = D1 / P0 + g.

Thus, the rate of return for a constant growth stock consists of two components: the dividend yield
and the capital gains yield.

The dividend yield can be thought of as the rate of return for a stock whose dividend is constant. An
investor who purchased a share of common stock for a price P0, and who received a constant
dividend of D1, would be receiving a perpetuity whose yield is equal to D1 / P0.

The capital gains yield represents the expected annual increase in the price of the stock. Given the
assumption that annual cash flows are growing at a constant rate forever, it is not surprising that the
capital gains yield is the same as the dividend growth rate g.

Example: Northwest Natural Gas stock was selling for $42.45 per share at the start of the year.
Dividend payments for the next year were expected to be $1.68 a share. What is the expected return,
assuming no growth?

r = $1.68 / $42.45 = 4%

Example: Northwest Natural Gas stock was selling for $42.45 per share at the start of the year.
Dividend payments for the next year were expected to be $1.68 a share. What is the expected return,
assuming a growth rate of 6.1%?

r = $1.68 / $42.45 + 0.061 = 10.1%

For companies which have a regular pay out of dividends and reinvestment of remaining earnings,
the growth rate can be approximated as: g = return on equity x plow back ratio, where the plow back
(or retention) ratio is the fraction of earnings reinvested in the business.

Example: A company forecasts to pay a $8.33 dividend next year. It decided to plowback 40% of the
earnings at the firm’s current return on equity of 25%. What is the growth rate?

g = 0.25 x 0.40 = 10%

Exercises

1. A company is expected to pay an end-of-year dividend of $5 a share. After the dividend, its stock
is expected to sell at $110. If the market capitalization rate is 8%, what is the current stock price?
$106.48

2. Suppose Acap Corporation will pay a dividend of $2.80 per share at the end of this year and $3
per share next year. You expect Acap’s stock price to be $52 in two years. If Acap’s equity cost of
capital is 10%:

a. What price would you be willing to pay for a share of Acap stock today, if you planned to hold
the stock for two years? $48.00

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b. Suppose instead you plan to hold the stock for one year. What price would you expect to be
able to sell a share of Acap stock for in one year? $50.00

3. A security analyst has forecast the dividends of Hodges Enterprises for the next three years. His
forecast is: D1 = $1.50; D2 = $1.75; D3 = $2.20. He has also forecast a price in three years of
$48.50. The rate of return for similar-risk common stock is 14%. What is the value of Hodges
common stock? $36.88

4. TTK Corp. common stock pays a $10 annual dividend per share. (a) What is the price of a share
of TTK common stock if similar-risk common stock yields 8%? (b) What is the price if comparable
common stock yields 11%? (a) $125, (b) $90.91

5. White Wedding Corporation will pay a $2.65 per share dividend next year. The company pledges
to increase its dividend by 4.75 percent per year, indefinitely. If you require a return of 11 percent
on your investment, how much will you pay for the company’s stock today? $42.40

6. The Starr Co. just paid a dividend of $2.15 per share on its stock. The dividends are expected to
grow at a constant rate of 5 percent per year, indefinitely. If investors require a return of 11
percent on the stock, what is the current price? $37.63

7. Hilliard, Inc., just paid a $2 annual dividend on its common stock. The dividend is expected to
increase at 8% per year indefinitely. If the required rate of return is 16%, what is the stock's
value? $27

8. The dividend paid this year on a share of common stock is $10. If dividends grow at a 6% rate for
the foreseeable future, and the required return is 10%, what is the value of the stock today? $265

9. A company pays a current dividend of $1.20 per share on its common stock. The annual dividend
will increase by 3%, 4% and 5%, respectively, over the next three years, and by 6% per year
thereafter. The appropriate discount rate is 12%. What is P0? $20.08.

10. Pettway Corporation's next annual dividend is expected to be $4. The growth rate in dividends
over the following three years is forecasted at 15%. After that, Pettway's growth rate is expected
to equal the industry average of 5%. If the required return is 18%, what is the current value of the
stock?

11. Universal Laser, Inc., just paid a dividend of $3.10 on its stock. The growth rate in dividends is
expected to be a constant 6 percent per year, indefinitely. Investors require a 15 percent return on
the stock for the first three years, a 13 percent return for the next three years, and then an 11
percent return thereafter. What is the current share price for the stock? $93.23

12. Gillette Corporation will pay an annual dividend of $0.65 one year from now. Analysts expect this
dividend to grow at 12% per year thereafter until the fifth year. After then, growth will level off at
2% per year. According to the dividend-discount model, what is the value of a share of Gillette
stock if the firm’s equity cost of capital is 8%? $15.07

13. Colgate-Palmolive Company has just paid an annual dividend of $0.96. Analysts are predicting an
11% per year growth rate in earnings over the next five years. After then, Colgate’s earnings are
expected to grow at the current industry average of 5.2% per year. If Colgate’s equity cost of
capital is 8.5% per year and its dividend payout ratio remains constant, what price does the
dividend-discount model predict Colgate stock should sell for? $39.43

14. Siblings, Inc., is expected to maintain a constant 6.4 percent growth rate in its dividends,
indefinitely. If the company has a dividend yield of 4.3 percent, what is the required return on the
company’s stock? 10.70%

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15. A share of common stock with a $12 annual dividend is selling for $75. What is the required rate
of return for the common stock? 16%

16. The current year's dividend for a share of common stock is $2 and the current price of the stock is
$30. Dividends are expected to grow at 5% forever. What is the rate of return for this stock? 12%

17. The next dividend payment by ECY, Inc., will be $3.20 per share. The dividends are anticipated to
maintain a growth rate of 6 percent, forever. If ECY stock currently sells for $63.50 per share,
what is the required return? 11.04%

18. The newspaper reported last week that Bennington Enterprises earned $34 million this year. The
report also stated that the firm’s return on equity is 16 percent. Bennington retains 80 percent of
its earnings. What is the firm’s earnings growth rate? 12.80%