Stocks and Stock Valuation

A) Introduction
Stocks represent ownership in a specific company. IBM stock (shares). Public
companies: Traded on Stock Exchange.
Two kinds
a. Common stock- voting rights.
b. Preferred stock- do not have voting rights. However, they have stated dividend.
(hybrid security) since it combines the features of a fixed-income asset, and equity.
Note, preferred is ranked first before common.
Bond, preferred, and common.
B) Valuation model for stock
Few points to discuss regarding the valuation of stocks.
a. Cash flows from the stock are uncertain.
b. The discount rate used is problematic. (we will discuss at a point of time the discount
rate, Risk/Return analysis).
c. Maturity of the stock is infinite.
Suppose you buy a stock today for P 0 and hold it for one period, at which you sell it for
P 1 . Also over the period, you get a dividend which is D 1
0 is now ....... the now time.
01
P 0  P 1 , D 1
Given a rate of return on this stock R, how much are you willing to pay for it today?
You will pay the present value of Cash Flows.
P 0 . . . . . . . . . . . . . D 1 and P 1
D1 P1
P 0  1R  1R
Suppose you hold the stock for two periods, where you get, D 1 in period 1, D 2 in period
2, and P 2 as a selling price in period 2.
012
P 0  D 1  P 2 , D 2
How much you are willing to pay for this stock?
P 0 . . . . . . . D 1 . . . . . . . . D 2 and P 2
D1 D2 P2
P 0  1R  1R 2
 1R 2

Now, extend this to period 3, D 1 . . . . D 2 ......D 3 and P 3

0123
P 0  D 1  D 2  P 3 , D 3
D1 D2 D3 P3
P 0  1R  1R 2
 1R 3
 1R 3

Extending this formula for inifinite number of periods, we get the following formula:
D1 D2 D3
P 0  1R  1R 2
 1R 3
. . . . . . . . . . . .
The final component related to the price becomes small, as we go far in the future.
The price of the stock P 0 will depend on how the dividends behave over time. We
consider three cases:
a. Zero growth in Dividends
 b. Constant growth in Dividends
c. Mixed growth model.
a. Zero growth in Dividends: when dividends are equal in each period. Zero growth.
In this case, suppose D 1  D 2  D 3 . . . . . . .  D
Therefore,
0123...........
DDD..........
D D D
P 0  1R  1R 2
 1R 3
. . . . . . . . . . . . Similar to a constant amount on a perpetuity). To
prove that, use the geometric expansion used before in the case of perpetuity.
P 0  DR
An example of that is the preferred stock.
Example: you are given a preferred stock on ABC company. The stock pays $2 dividend
per share. The required rate of return on this sock is 5%. How much are you willing to pay
per share of ABC stock?
2
P 0  0.05  $40.
(some companies issue preferred with a par value (book value), for example $100, and
the stated dividend is in percentage of the par value, 5% of par).
b. Constant growth model
0123...........
NowD 1 D 2 D 3 ..........
D 0  g D 1 gD 2 gD 3 g.........
The dividends are growing at a constant rate over time, infinitely.
Suppose dividends are growing at g and the Just-paid dividend is D 0 (it is the now
dividend, known). In this case, we can determine the future dividends of D 1 , D 2 , D 3 . . . . . . .
D 1  D 0 1  g
D 2  D 1 1  g  D 0 1  g 2
D 3  D 2 1  g  D 0 1  g 2 1  g  D 0 1  g 3
.............
D1 D2 D3
P 0  1R  1R 2
 1R 3
. . . . . . . . . . . . 
D 0 1g D 0 1g 2 D 0 1g 3
 1R
 1R 2
 1R 3
. . . . . . . . . .
D 0 1g 1g 1g 2 1g 3
 1R
1  1R  1R 2  1R 3 . . . . . . . . . . . . . 
2 3
We know [1  x  x  x . . . . . . . .   1/1  x
1g
x  1R
D 0 1g 1 D 0 1g D 0 1g
P0  1R
 1g
 1R
 1R
Rg
 Rg
1 1R

use the geometric expansion series and then we obtain, the following:
D 0 1g D1
P 0  Rg  Rg (constant growth, or Gordon Model).
I can generalize this formula to the following:
D t1 D t 1g D 0 1g t
P t  Rg  Rg  Rg
time t.........t1, ..............
0123......tt1t2..........
 Example: Suppose you have a stock that just paid dividend of $2 per share. The
dividends are expecting to grow at a constant rate of 10% per year for ever. The required
rate of return on this stock is 12%. Can you determine the value of the stock today?
D 0  $2
Determine D 1  D 0 1  g  $21  0. 1  $2. 2
D 0 1g D1 2.2
Determine P 0  Rg  Rg  0.120.1  $110
Suppose the stock is traded in the market at $120 (that is the actual price, the stock is
overvalued). In case the price is $100 in the market (the stock is undervalued), and you
should buy it.
c. Mixed growth model
In this case, dividends will grow at different rates, say within some periods, and then
dividends will grow at a constant rate later (infinitely).
time 0123..........
D 0 ......D 1 ......D 2 .......D 3 ........
...............g 1 ........g 2 .......g 3 ........g.............
First, determine the dividends,
D 1  D 0 1  g 1 
D 2  D 1 1  g 2   D 0 1  g 1 1  g 2 
D 3  D 2 1  g 3   D 0 1  g 1 1  g 2 1  g 3 
D 4  D 3 1  g  D 0 1  g 1 1  g 2 1  g 3 1  g
D 5  D 4 1  g  D 3 1  g 2
D1 D2 D3
P 0  1R  1R 2
 1R 3
. . . . . . . . . . . . .
D 0 1g 1  D 0 1g 1 1g 2  D 0 1g 1 1g 2 1g 3  D 3 1g
 1R
 1R 2
 1R 3
 1R 4
.............
Note, since dividends are growing at a constant rate from period 3 forward (infinitely), we
can use at time 3, the constant growth model, to determine P 3
D t1 D t 1g
[Remember what I wrote P t  Rg  Rg 
D 3 1g D4
P3  Rg
 Rg
Then the price today becomes
D1 D2 D3
P 0  1R  1R 2
 1R 3
. . . . . . . . . . . . .
D 0 1g 1  D 0 1g 1 1g 2  D 0 1g 1 1g 2 1g 3  P3
 1R
 1R 2
 1R 3
 1R 3
P 3 captures all what is happening to the dividends at future dates for ever.
Example
Suppose that just-paid dividend is D 0 . Then dividends grow at a constant rate of g1 from
period 1 to 3. Then afterwards, the growth rate is g, for ever. Determine, P 0 .
time 0......1.........2..........3..........
growth D0......D1......D2.......D3........
...............g1........g1.......g1........g.............
D 1  D 0 1  g 1 
D 2  D 0 1  g 1  2
D 3  D 0 1  g 1  3
D 4  D 3 1  g  D 0 1  g 1  3 1  g
 D4
Determine P 3  Rg
D 0 1g 1  D 0 1g 1  2 D 0 1g 1  3 D4 P5
P0  1R
 1R 2
 1R 3
 1R 4
 1R 5
D 0 1g 1  D 0 1g 1  2 D 0 1g 1  3 P3
P0  1R
 1R 2
 1R 3
 1R 3
Note as long as i have a constant growth model, I can determine at any time, all the
prices:
D4 D5 D6
P 3  Rg , or P 4  Rg or P 5  Rg ...........
Example
Suppose you are given a stock, that has just-paid dividend of $1. Dividends are
expected to grow at 5%, 4%, and 6% in the first three periods, then at a constant rate of 5%
for ever after. The required rate of return on this stock is 8%. Determine the value of the
stock today P 0 ?
01234.........
$15%14%26%35%4........
We know D 0  1
D 1  D 0 1  0. 05  11. 05
D 2  D 1 1  0. 04  11. 041. 05
D 3  D 2 1  0. 06  11. 051. 041. 06
D 4  11. 051. 041. 061. 05
Then,
1.05 1.051.04 1.051.041.06 P3
P 0  1.08  1.08 2  1.08 3
 1.08 3
 $34. 987
D4 1.051.041.061.05
P3  Rg
 0.080.05
Then find the price P 0 . can you determine the price).
Look at the example in notes.
Note: given the Gordon model, we are able to determine the required rate of return on
the stock.
We know from Gordon model:
D1
P 0  Rg do a bit of changes in variables
D1 D1
Rg  P0
then R  g  P0
D1
P0
is called the dividend yield
P 1 P 0 D1
g is called the capital gains yield, the percentage change in the price. R  P0
 P0
P 0  P 1 , D 1
P 1 D 1 P 0
P0
 P 1PP
0
0
 D1
P0
P 1 P 0
P0
is the capital gain yield (that is g)
D1
P0
is the dividend yield
This rate can be used to determine the required rate of return investing in an equity, and
will be used later, as a cost of equity capital.
D1 P1
P 0  1R  1R  D1R
1 P 1
then 1  R D 1PP
0
1

D1 P1 D1 P 1 P 0 D1
So, R  P0
 P0
1  P0
 P0
 P0
g
 Year 0......Year 1.......Year 2........Year 3.......year 4.......year 5.............
1.18..........1.50...........1.75..............1.80........1.50.........150......... for ever.......
from 0 to year 1, growth rate will be
1.18(1g1)1.50
1.50(1g2)1.75
1.75(1g3)1.80
P 0 present value of future cash flows
D1 D2 D3
P 0  1R  1R 2
 1R 3
 How can you capture all the dividends paid from 3 forwards.
They can be captured by the formula similar to perpetuity.
P 3  1. 50/0. 105
D1 D2 D3
P 0  1R  1R 2
 1R 3
present value of P 3
D1 D2 D3 P3
P0  1R
 1R 2
 1R 3
 1R 3

Some problems
Problem 1
The next dividend for the Gordon growth model will be $4 per share. Investors require a
16% return on this stock. Gordon’s dividend increases by 6% every year. Based on the
constant growth model, what is the value of the stock today?What is the value of the stock
in four years?
Answer 1:
D1 $4 4
P 0  Rg  0.160.06  0.10  $40
D5
P4  Rg
012345
D1D2D3D4D5
D 5  D 1 1  g 4  41  0. 06 4  $50. 45
Problem 2:
ABC company has been growing a a phenomenal rate of 30% per year because of its
rapid expansion in sales. You believe that this growth rate will last for three more years and
will then drop to 10% per year. If the growth rate then remains at 10% indefintely, what is
the total value of the stock today? Total dividends just paid were $5 million, and the required
rate of return is 20%.
0123...........
30%30%30%10%........
D 1  $51  0. 3  $6, 500
D 2  D 1 1  0. 3  $8, 450
D 3  D 2 1  0. 3  $10, 985
D 4  D 3 1  0. 1  $10, 9851. 1
We need P 3  D 4 /R  g  $10, 9851. 1/0. 2  0. 1 
$120,835
6,500 8,450 10,985
P 0  10.2  10.2 2
 10.2 3
 $120,835
10.2 3
$87,580,000
Suppose there are 20 million shares outstanding. What is the price per share?
price per share $87,580,000/20m
$4.38
Watch the following video
https://www.youtube.com/watch?vsXpZHHpAdkw
https://www.youtube.com/watch?v3OnONipK33E
https://www.youtube.com/watch?v8o9OByCvWAg