Chapter 8

Stock Valuation
Prepared By :DR. Wael Shams EL-Din
Key Concepts
❑ What is Preferred Stock
❑ Value of Preferred Stock
❑ Common Stock
❑ Value of common stock
✓The Holding Period is one year
✓The Holding Period is more than one year
✓The Holding Period is unknown
 Type of Stocks

Preferred Stocks Common Stocks

Preferred Stock
Preferred stock is a Hybrid; it is similar to bonds
in some respects and to common stock in others.
Preferred stock has a par value and a fixed
amount of dividends that must be paid before
dividends can be paid on the common stock.
Despite Preferred Stock has a fixed payment like
bonds however a failure to make this payment
will not lead to bankruptcy.

The holder of the Preferred Stocks does not have

the voting right like the holder of the common
stock.
Value of Preferred Stock
The Value of Preferred Stock depend
on 2 factors:-
 The amount of annual dividends ( which is
fixed amount according to fixed rate)

 The required rate of return which is function

of ( RFR + Risk premium)

Value (PS)= Dividends

RRR
Example (1)
A preferred stock $10 par value, 10%
dividend (this amount is fixed) what is the
value of the share if the required rate of
return is equal 11%.
Answer
Value = Dividends
RRR
Value PS = 10X10% = 1 = $ 9.09
0.11 0.11
Example (2)
Fee Founders Has Preferred Stock Outstanding
Which Pays A Dividend Of $5 At The End Of Each
Year. The Preferred Stock Sells For $60 A Share.
What Is the Preferred Stock’s Required Rate of
Return?
Answer
Value = Dividends
RRR
60 = $5 =
RRR
RRR = 5 X100 = 8.33%
60
Example (3)
What will be the nominal rate of return on a
Preferred Stock with a $100 par value, a
stated dividend of 8 percent of par, and a
current market price of (a) $60, (b) $80, (c)
$100, and (d) $140?
Answer
Dividend = 100x8% = $8
Value = Dividends
RRR
Required Rate of Return
A) - RRR @ $60 = 8 X 100 = 13.33%
60
B) - RRR @ $80 = 8 X 100 = 10%
80
C) - RRR @ $100 = 8 X 100 = 8%
100
D) - RRR @ $140 = 8 X 100 = 5.71 %
140
Example (4)
Ezzell Corporation issued preferred stock
with a stated dividend of 10 % of par.
Preferred stock of this type currently yields
8% & the par value is $100. Assume
dividends are paid annually.
A. What is the value of Ezzell’s preferred
stock?
B. Suppose interest rate levels rise to the point
where the preferred stock now yields 12
percent. What would be the value of Ezzell’s
preferred stock?
Answer
Dividend = 100x 10% = $ 10

Value = Dividends
RRR
P= 10 = $ 125
0.08

P= 10 = $ 83.33
0.12
Common Stocks
The Problem of a common stock is that the
amount of dividends, earning or cash flow
of return is not fixed and there is no
maturity, therefore we need to set several
assumptions related to the holding period of
the investment and cash flow that we may
receive during that period.
1) The Holding Period is one year
2) The Holding Period is more than one year
3) The Holding Period is unknown
The Holding Period is one year
The cash that may be received at
the end of the year is known as
dividend and selling price of that
stock will be at the end of same
year.
Example (5)
XYZ Company has a share that is
expecting to pay $1 dividend next
year and to be sold at $30 by the
end of that year, what is the value
of XYZ stock if the required rate of
return is 14%.
Answer
Today Dividend (D1)= $ 1
Selling Price = $ 30
---------
FV $ 31
Price (PV) = FV
1+RRR

Price (PV) = 31 = $ 27.19

1.14
The Holding Period is more
than one year
In this case we need to estimate
dividends for the next years also the
expected growth rate in that dividends
during the coming holding period and
the selling price at the end of that
period.
Example (6)
ABC’s share is expecting to pay $2
dividend next year while the dividends
of this stock will grow by 10% each
year, ABC Share is expected to be sold
at the end of 3 years for amount of $40,
what is the value of ABC stock if the
required rate of return is 14%.
Answer
Y0 Y1 Y2 Y3
Dividend 2 2.20 2.42
10% 10%

Selling Price 40

Total 2 2.20 42.42

Answer
Price (PV) = 2 + 2.20 + 42.42
1.14 1.142 1.143
Price(PV)= 1.7544+ 1.6928 + 28.6331=
Price ( PV) = $ 32.08
The Holding Period is unknown
In this case the company will be in the mature
stage then it will enjoy a constant growth rate.
Example (7)
ABC’s Share is expecting to Pay $ 3 dividends
next year while it is expected to have a constant
growth rate for 5 %, what is the value of ABC
Stock if the required rate of return is 15%.
Answer

Value = Dividends
RRR- g
P0 = D1
RRR-g
g→ Growth Rate
P= 3 = $ 30
0.15-0.05
Example (8)
ABC’s share is expecting to pay $ 2
dividends next year while it is expected to
have a constant growth rate for 10 %
annually for the coming 2 years then it will
fall to 4 % constantly, what is the value of
ABC stock if the required rate of return is
14%.
Answer
Y0 Y1 Y2 Y3 Y4

Dividend 2 2.20 2.42 2.52

10% 10% 4% Constant Growth
Selling 25.20
Price
Total 2 2.20 27.62
Answer
P3 = D4
RRR- g
P3 = 2.52 = $ 25.20
0.14-0.04
Price (PV) = 2 + 2.20 + 27.62
1.14 1.142 1.143

Price (PV) = 1.75+ 1.69 + 18.64 = $ 22.08

Variables & Relationship that affect the
Value of common stock
P0 = D1
RRR-g
Variables
D1 →Dividend which is affected by level of earning
RRR → Required rate of return which is affected by
(Risk free rate + Risk Premium)
g→ Growth rate which is affected by payout ratio &
earning
Relationship
 There is positive relationship between
dividend and value.

 There is negative relationship between

required rate of return and value.

 Thereis a positive relationship between

growth rate and value
Growth Rate (g)
g

Retention Rate (RR) X ROE

(1- Payout Ratio) X Net Income

Equity
Example (9)
Item Amount
Sales $100 Million
Cost of Goods Sold (COGS) $ 60 Million
Book Value of ABC Share $ 10
Interest rate on Co’s Debt 8%
Tax Rate 40%
Amount Of Debt $ 10 Million
No. of outstanding Shares 9 Million Shares
Risk Free Rate 6%
Market Return 18%
Beta 1.223
Payout Ratio 40%
Example 9
From the given data, Please find the
following:-
 The Required Rate of Return
 What is the Stock Value?
Answer
P0 = D 1
RRR-g
RRR= RFR + (RM - RFR) x Beta
RRR = 6% + (18% - 6 %)X 1.223 = 20.68%
In order to get the stock value we need to
calculate g & D1
Answer
Sales 100,000,000

(-) COGS 60,000,000

EBIT 40,000,000
(-) Interest (10,000,000 X 8% ) (-) 800,000
EBT 39,200,000
(-) Tax @ 40% (-) 15,680,000
Net Income After Tax 23,520,000

Retention Rate (60%) Pay Out Ratio (40%)=9,408,000

9,408,000 ÷ 9,000,000 Shares
Dividend (D0) = $ 1.05
Answer
g = RR X ROE
ROE = Net Income X 100
Equity
ROE = 23,520,000 X100 = 26.13%
90,000,000
g = RR X ROE
g = 60% x 26.13% = 15.68%
D1 = D0 X (1+g)
D1 = 1.05 X (1.1568) = 1.21
Answer
P0 = D1
RRR-g
D1 = 1.21
RRR = 20.68%
g = 15.68%
P0 = 1.21 = 1.21 = $ 24.20
0.2068- 0.1568 0.05
Example 10
Sales Volume in Units : 10 Million
Selling Price Per Unit : $3
Variable Cost Per Unit : $1
Total Fixed Cost : $ 8,000,000
Risk Free Rate (RFR) : 6%
Market Required Rate of Return : 20%
Beta : 1.0057
Long Term Debt : $ 5,000,000 @ Interest Rate 8%
Number of Outstanding Shares : 2,500,000 Shares
Share Price (Book Value) : $ 10
Tax Rate : 35%
Payout Ratio : 50%
1. Find the Value of ABC Share
2. If Share is traded in the stock Market at $ 87, what is your decision
as investor and why?
Answer
RRR= RFR + ( RM - RFR) x Beta
RRR = 6+ (20-6)1.0057 = 20.08%
Sales = no. of units X Selling Price
Sales = 10 Million X3 = 30 Million
Variable Cost = No. of Units X Variable cost Per Unit
Variable Cost = 10 Million X 1 = 10Million
Total cost COGS= (Variable + Fixed Cost)
COGS = 10M+8M = 18M
Answer
Sales 30,000,000
(-) COGS 18,000,000
EBIT 12,000,000
(-) Interest (5,000,000 X 8% ) 400,000
EBT 11,600,000
(-) Tax @ 35% 4,060,000
Net Income After Tax 7,540,000
Answer
Net Income = 7,540,000

Retention Rate (50%) Pay Out Ratio (50%)

3,770,000 3,770,000 ÷2,500,000 Shares
Dividend D0 = 1. 51
ROE = Net Income X 100
Equity
Equity = 2,500,000 X 10 = $ 25,000,000
ROE = 7,540,000 X100 = 30.16%
25,000,000
Answer
g = RR X ROE
g = 50% x 30.16% = 15.08 %
D1 = D0 X (1+g)
D1 = 1.51 X (1.1508) = 1.74
P0 = D1
RRR-g
D1 = 1.74
RRR = 20.08 %
g = 15.08 %
Answer
P0 = 1.74 = 1.74 = $ 34.80
0.2008- 0.1508 0.05

Since the Fair value of the stock is $34.80

while it is traded at $87 (Over Price) ,
Therefore my decision as investor is to Sell
the stock and achieve capital gain .
Thank You