Lecture 3

Stock Valuation
Contact: Natt Koowattanatianchai
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9-1
Outline
1 The Present Value of Common Stocks
2 Different growth assumptions

9-2
References
 Ross, S., Westerfield, R. and Jaffe, J.
(2013), Corporate Finance (10th Edition),
McGraw Hill/Irvin. (Chapter 9)
 Moyer, R.C., McGuigan, J.R., and Rao,
R.P. (2015), Contemporary Financial
Management (13th Edition), Cengage
Learning. (Chapter 7)

9-3
The PV of Common Stocks
 The value of any asset is the present value of its
expected future cash flows.
 Stock ownership produces cash flows from:
 Dividends
 Capital Gains
 Valuation of Different Types of Stocks
 Zero Growth
 Constant Growth
 Differential Growth

9-4
Case 1: Zero Growth
 Assume that dividends will remain at the same level
forever
Div1  Div 2  Div 3  
 Since future cash flows are constant, the value of a zero
growth stock is the present value of a perpetuity:

Div1 Div 2 Div 3

P0    
(1  R) (1  R) (1  R)
1 2 3

Div
P0 
R
9-5
Case 2: Constant Growth
Assume that dividends will grow at a constant rate, g,
forever, i.e.,
Div1  Div 0 (1  g )
Div 2  Div1 (1  g )  Div 0 (1  g ) 2
Div 3  Div 2 (1  g )  Div 0 (1  g )3
..
.
Since future cash flows grow at a constant rate forever,
the value of a constant growth stock is the present value
of a growing perpetuity:
Div1
P0 
Rg 9-6
Constant Growth Example
 Suppose Big D, Inc., just paid a dividend of
$.50. It is expected to increase its dividend by
2% per year. If the market requires a return of
15% on assets of this risk level, how much
should the stock be selling for?
 P0 = .50(1+.02) / (.15 - .02) = $3.92

9-7
Case 3: Differential Growth
 Assume that dividends will grow at different
rates in the foreseeable future and then will
grow at a constant rate thereafter.
 To value a Differential Growth Stock, we need
to:
 Estimate future dividends in the foreseeable future.
 Estimate the future stock price when the stock
becomes a Constant Growth Stock (case 2).
 Compute the total present value of the estimated
future dividends and future stock price at the
appropriate discount rate. 9-8
Case 3: Differential Growth
 Assume that dividends will grow at rate g1 for N
years and grow at rate g2 thereafter.
Div1  Div 0 (1  g1 )
Div 2  Div1 (1  g1 )  Div 0 (1  g1 ) 2
.
..
Div N  Div N 1 (1  g1 )  Div 0 (1  g1 ) N

Div N 1  Div N (1  g 2 )  Div 0 (1  g1 ) N (1  g 2 )

..
.
9-9
Case 3: Differential Growth
Dividends will grow at rate g1 for N years and grow
at rate g2 thereafter

Div 0 (1  g1 ) Div 0 (1  g1 ) 2
…
0 1 2
Div N (1  g 2 )
Div 0 (1  g1 ) N  Div 0 (1  g1 ) N (1  g 2 )
… …
N N+1 9-10
Case 3: Differential Growth
We can value this as the sum of:
 a T-year annuity growing at rate g1

C  (1  g1 ) 
T
PA  1  T 
R  g1  (1  R) 
 plus the discounted value of a perpetuity growing at
rate g2 that starts in year T+1
 Div T 1 
 
 R  g2 
PB 
(1  R ) T
9-11
Case 3: Differential Growth
Consolidating gives:

 Div T 1 
 
C  (1  g1 )T   R  g 2 
P 1  T 

R  g1  (1  R)  (1  R) T

Or, we can “cash flow” it out.

9-12
A Differential Growth Example
A common stock just paid a dividend of $2. The
dividend is expected to grow at 8% for 3 years,
then it will grow at 4% in perpetuity.
What is the stock worth? The discount rate is 12%.

9-13
With the Formula
 $2(1.08)3 (1.04) 
 
$2  (1.08)  (1.08) 3   .12  .04 

P 1  3

.12  .08  (1.12)  (1.12) 3

P  $54  1  .8966 
$32.75
3
(1.12)

P  $5.58  $23.31 P  $28.89

9-14
 With Cash Flows
$2(1.08) $2(1.08) 2 $2(1.08)3 $2(1.08)3 (1.04)
…
0 1 2 3 4
$2.62 The constant
$2.16 $2.33 $2.52  growth phase
.12  .04 beginning in year 4
can be valued as a
0 1 2 3 growing perpetuity
at time 3.
$2.16 $2.33 $2.52  $32.75
P0   2
 3
 $28.89
1.12 (1.12) (1.12) $2.62
P3   $32.75
.08 9-15
Questions?