Stock Valuation

Lecture 5
Business Finance
 Stock Markets
• What’s a Stock? A share of stock represents partial ownership of a company.
There are two types of stocks:
Common Stock: Owners of common stock own a percentage of the company equal to the
proportion of the total common stock that has been issued.
Owners of common stock are entitled to voting rights within the company.
Major changed to corporate structure.
Leadership.
Preferred Stock: Represents partial ownership in a company
Does not have any voting rights.
Dividend structure varies from common stock (Fixed periodic dividends i.e. 10% of $100 Par
Value which is $10).
Greater claim to company assets than common stockholders .
If company goes bankrupt, preferred stockholders are paid off before common stockholder.
 Stock Markets
• Stock markets are set to be efficient. Why?
Because TRADERS are buying stocks based on information the company releases on
the performance of its products, its sells, its profits and so on.
Stock prices fluctuate moving toward new equilibrium because new information
comes in and the traders are making their decisions accordingly.

• Market efficiency & Stock Valuation:

The behavioural finance challenge: The effect of the investor behaviour on investment
decision & stock valuations.
 Stocks
Some companies pay a dividend associated with stock:
A dividend is a distribution of a portion of a company’s earnings.
Different classes of shareholders can have different dividends.
Can be issued as cash payments, shares of stock, or other property.
• One can receive cash flow from a stock that they bought through:
1. The payments of dividends by the company.
2. Selling your shares to investors or back to the company.

So, the price of the stock is the present value of all the excepted cash flows.
 What’s a dividend
A dividend : is a payment made from a company to the owners of stock,
either common or preferred.
For a stock that pays a dividend, we can calculate the dividend yield:
𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝑷𝒆𝒓 𝑺𝒉𝒂𝒓𝒆
𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝒚𝒊𝒆𝒍𝒅 =
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑺𝒉𝒂𝒓𝒆 𝑷𝒓𝒊𝒄𝒆

• The cash payoff to owners of common stocks comes in two forms:

1. Cash dividends.
2. Capital gain or losses.

So, how can we estimate the future dividend payments ?

 Determinants of stock prices

Determinants of stock prices: We have seen how to discount future Cash Flows. So,
the discounted-cash-flow(DCF) formula for the PV of a stock is the same as for the PV
of any other asset. Shareholders receive cash from the company in the form of
dividends.
𝑷𝑽 𝒔𝒕𝒐𝒄𝒌 = 𝑷𝑽(𝒆𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝒇𝒖𝒕𝒖𝒓𝒆 𝒅𝒆𝒗𝒊𝒅𝒆𝒏𝒅𝒔)
𝐷𝐼𝑉
1 𝐷𝐼𝑉 𝐷𝐼𝑉
𝑃0 = (1+𝑟) + (1+𝑟)2 2 + ⋯ + (1+𝑟)∞∞
∞
𝐷𝐼𝑉𝑡
𝑃0 =
(1 + 𝑟)𝑡
1
𝑃0 : The current price of a share.
𝐷𝐼𝑉1 : The expected dividend per share.
r : The rate of return that investors expect from this share over the next year.
Are dividends the only price drivers?
Investors invest for both dividends & capital gain.
 Today’s Price
Today’s Price:
Let’s suppose that:
𝑃0 : The current price of a share.
𝑃1 : The expected price at the end of a year.
𝐷𝐼𝑉1 : The expected dividend per share.
𝑃1 − 𝑃0 : Expected price appreciation.
r : The rate of return that investors expect from this share over the next year.
𝐷𝐼𝑉1 + 𝑃1 − 𝑃0
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑟 =
𝑃0
 What Determines Next year Price?
From this equation:
𝐷𝐼𝑉1 + 𝑃1 − 𝑃0
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑟 =
𝑃0
What’s the discount rate “r”?
It’s called the market capitalization rate, cost of equity, or opportunity cost of
capital, which refers to the return on other securities with the same risk.
Now, all stocks with the same risk class have to be priced to offer the same expected
rate of return.
We get:

𝐷𝐼𝑉1 + 𝑃1
𝑃0 =
1+𝑟
If this equilibrium in the efficient market did not hold, what would happen?
The share would be overpriced or under-priced.
 Today’s Price
Let’s assume that the other securities in X’s risk class all offer the same expected
return of 15%. So, $100 per share should be the only possible price.
Yet, what if:
1. X’s price was above $100?
2. X’s price was below $100?
If 𝑷𝟎 > 100 => Investors would shift their capital to other securities, which will force
the price to decrease.
If 𝑷𝟎 < 100 => Investors would rush to buy, which will force the price up to $100.
Hence, at each point in time all securities in an equivalent risk class are priced to
offer the same expected return.
 Valuation Models
• Zero-Growth Dividends Model.
• Constant-Growth Dividends Model (Gordon
Growth Dividend Model).
• Variable-Growth Dividends Model.
 Zero-Growth Dividends Model
An investor should value the stocks, based on the amount of cash that they can receive
from them.
Common stocks can generate cash through regular dividend payments.
The Dividend Discount Model (DDM) treats regular dividends from common stock like bond
coupon payments, by appropriately discounting all future dividends (𝐷1 to 𝐷∞ ) to the
present using the required rate of return on the stock, r, then summing them to determine
the value of the stock , V or the 𝑃0 .
∞
𝐷𝐼𝑉𝑡
𝑃0 =
(1 + 𝑟)𝑡
1
Estimating the value of a company is relatively easy.
However, what’s challenging is the estimating the dividends that will be paid from today
until the end of the company, which could be infinite. Which requires the estimations of the
future growth of a company.
 Zero-Growth Dividends Model
In this case, the company will continue to pay the same constant dividends forever.
This is the case of the preferred stocks.
How can we compute the price of the share?
It is computed as we computed the perpetuity.

𝐷𝐼𝑉
𝑃0 =
𝑟

So, suppose that the stock is expected to pay a $0.5 dividend every quarter and the
required return is 10 % with quarterly compounding.
DIV = $0.5
r = 0.10/4 = 0.025
𝐷𝐼𝑉 0.5
Using: 𝑃0 = 𝑟
, we get: 𝑃0 = 0.025 = $20
 Constant growth rate dividends

Now, what happens if the firm increases the dividends each period by a constant percent?
The Gordon Growth Model, or constant growth model, allows for the dividends to grow by a
constant rate, g.
This means the dividend in period 1 will be greater than the dividend in period 0 by a rate of g:
𝐷𝐼𝑉1 = 𝐷𝐼𝑉0 + 𝐷𝐼𝑉0 × 𝑔 = 1 + 𝑔 𝐷𝐼𝑉0
Period 2 will be greater than period 1 by the rate of g:
𝐷𝐼𝑉2 = 𝐷𝐼𝑉1 + 𝐷𝐼𝑉1 × 𝑔 = 1 + 𝑔 𝐷𝐼𝑉1 = (1 + 𝑔) 1 + 𝑔 𝐷𝐼𝑉0
This will give:
𝐷𝐼𝑉𝑡 = 𝐷𝐼𝑉0 1 + 𝑔 𝑡
∞ 𝐷𝐼𝑉𝑡
Using this formula 𝑃0 = , it gives:
1 (1+𝑟)𝑡
𝐷𝐼𝑉0 (1 + 𝑔) 𝐷𝐼𝑉1
𝑃0 = =
𝑟−𝑔 𝑟−𝑔
The Gordon Growth Model makes two important assumptions:
The growth rate, g, must be constant
The requires rate of return must be greater than the growth rate: r > g
1+𝑔
If r > g, then the fraction converges to 0 as the series approaches infinity.
1+𝑟
 Constant growth rate dividends

The Gordon Growth Model in its most common form:

𝐷𝐼𝑉1
𝑃0 =
𝑟−𝑔
When the market is in equilibrium, then the intrinsic value of the stock, 𝑉𝑖 will equal
the market value of the stock today, 𝑃0 .
If know that when the market is in equilibrium that 𝑉𝑖 = 𝑃0 , then we can get the
𝐷𝐼𝑉
expected rate of return from the equation 𝑃0 = 𝑟−𝑔1:
𝐷𝐼𝑉1
𝑟= +g
𝑃0
Thus, the expected rate of return, is equal to the dividend yield plus the growth rate:
r = Expected Dividend Yield + Expected Growth Rate
 Valuing Non-Constant Growth Stocks

It may seem unreasonable to assume that a company will grow at a constant rate of g
forever.
Companies often go through “life-cycles”
• Early years where they grow faster than the economy.
• Mature years where they match economic growth.
• Depending on market and industry conditions, they may enter a phase where
growth is slower than the economy.
For many firms, near-term growth unsustainably high. For this reason a two-stage DCF
formula is used. Thus, in the case of the non-constant growth companies the Gordon
Growth Model is extended into a Multistage Growth Model.
After N years, companies usually face increased competition, and the dividend will
settle into its long-term growth rate:
 Valuing Non-Constant Growth Stocks
From the Gordon Growth Model, once a firm hits is long-term constant growth rate,
we know how to calculate the value of that stream of dividend payments from:
𝐷𝐼𝑉
𝑃0 = 𝑟−𝑔1 .
𝐷𝐼𝑉𝑁+1
𝐷𝐼𝑉1 𝐷𝐼𝑉2 𝐷𝐼𝑉3 𝑟 −𝑔
𝑃0 = + + ⋯ + +
(1 + 𝑟) (1 + 𝑟)2 (1 + 𝑟)3 (1 + 𝑟)𝑁
𝐷𝐼𝑉1 𝐷𝐼𝑉2 𝐷𝐼𝑉3 1 𝐷𝐼𝑉𝑁+1
= + + ⋯+ + ×
(1 + 𝑟) (1 + 𝑟)2 (1 + 𝑟)3 (1 + 𝑟)𝑁 𝑟 −𝑔
PV (first stage dividends) PV (second stage dividends)
 Valuing Non-Constant Growth Stocks
Table 4.6 projects the earnings and dividends for Phoenix Corp. In year 1 he
corporation has to reinvest all its earnings, leaving no cash for dividends. As
profitability increases in years 2 & 3, an increasing dividend can be paid? Finally,
starting from year 4, Phoenix settles into steady-state-growth, with equity, earnings
and dividends at 4%. The cost of the equity is 10%. What’s the worth of the Phoenix
shares?
𝐷𝐼𝑉1 𝐷𝐼𝑉2 𝐷𝐼𝑉3 1 𝐷𝐼𝑉𝑁+1
𝑃0 = + + ⋯ + + ×
(1 + 𝑟) (1 + 𝑟)2 (1 + 𝑟)3 (1 + 𝑟)𝑁 𝑟 −𝑔

0 0.31 0.65 1 0.67

𝑃0 = + + + × = $9.13
(1 + 0.1) (1 + 0.1)2 (1 + 0.1)3 (1 + 0.1)3 0.1 − 0.04
 Valuing Non-Constant Growth Stocks
Table 4.6 projects the earnings and dividends for Phoenix Corp. In year 1 he
corporation has to reinvest all its earnings, leaving no cash for dividends. As
profitability increases in years 2 & 3, an increasing dividend can be paid? Finally,
starting from year 4, Phoenix settles into steady-state-growth, with equity, earnings
and dividends at 4%. The cost of the equity is 10%. What’s the worth of the Phoenix
shares?
 The link between Stock Price & Earnings per Share

Investors separate growth stocks & income stocks. The growth stocks are bought for
the expectation of Capital gains, and they are interested in the future growth of
earnings rather than in next year’s dividends. Income stocks are bought for cash
dividends.
Now, let’s suppose that there is a company that does not grow at all. It does not
reinvest any earnings and provides a constant stream of dividends. These stocks would
look like the “perpetual bond” that we have seen in the pervious chapter. The return
on a perpetuity is equal to the yearly cash flow divided by the present value (PV).
So, the expected return on the share would be the yearly dividend divided by the share
price (dividend yield).
Excepted return = dividend yield = earnings-price ratio
𝑫𝑰𝑽𝟏 𝑬𝑷𝑺𝟏
Excepted return = 𝑷𝟎
= 𝑷𝟎
Thus,
𝑫𝑰𝑽𝟏 𝑬𝑷𝑺𝟏
𝑷𝟎 = =
𝒓 𝒓
 The link between Stock Price & Earnings per Share

The expected return for growing firms can also equal the earnings-price ratio. The key
is whether those earnings are reinvested to provide a return equal to market
capitalization rate.
Let’s suppose that the same company suddenly heard of an opportunity to invest $10
a share next year. This would mean that there will be no dividends at t=1. Yet, the
company is expecting that in each year the project would earn $1 per share, and
hence the dividend could be increased to $11 a share. Let’s assume that this
investment opportunity has about the same risk as the existing business. Then, we can
discount its cash flow at the 10% rate to find its net present value at year.
𝟏
NPV per share at year 𝟏 = −𝟏𝟎 + 𝟎.𝟏 = 𝟎
Hence, this investment opportunity will make no contribution to the company’s
value.
In this case, the market capitalization rate = the earnings-price ratio, and this is valid
only when NPV=0 .
 Long-term earnings per share

Long-term earnings per share (EPS) growth depends on several factors:

1. Economy-wide factors (recessions and inflation).
2. Industry-wide factors (technological innovation).
3. Firm-specific factors (management, brand identity, monopoly power, etc.).
So all else equal, higher dividends must be associated with either with declining
earnings growth due to lack of reinvestment, or with increasing debt level.
 Stock Price

In general, the stock price can be thought as the capitalized value of average earnings
under a no-growth policy, plus the net present value of growth opportunities (PVGO).
𝐄𝐏𝐒𝟏
𝐏𝟎 = + PVGO
𝐫
 Sources
Introduction to Business Finance: Techniques & Tools. Jeffrey S. Smith, Ph.D.
Department of Economics and Business Virginia Military Institute
Brealey, Stewart C. Myers, and Franklin Allen, Principles of Corporate Finance, 13th
edition (McGraw‐Hill Irwin, 2020).
Lecture Notes of:
https://timmurrayecon.com/wp-content/uploads/2022/07/Business-Finance-Lecture-
Notes-June-2022.pdf