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Chapter 08 - Valuing Stocks
CHAPTER 8 – VALUING STOCKS
Questions
LG1 1. As owners, what rights and advantages do shareholders obtain?
Shareholders are able to participate in the economic growth of publicly traded firms without having
to manage business entities directly. They have the right to residual cash flows of corporate profits
and often receive some of these cash flows through dividends. In addition, shareholders vote on
the members of the board of directors and other proposals for the company. Shareholder capital
losses are capped in that they can only lose their initial investment. Stocks are very liquid and
investors can enjoy this liquidity in both their entrance into the stock market and their exit from it.
LG1 2. Describe how being a residual claimant can be very valuable.
Residual claimant’s are able to delegate the operations of the firm to professional managers,
enjoying the possibly vast gains in value that can be created by some firms over time.
LG2 3. Obtain a current quote of McDonald’s (MCD) from the Internet. Describe what has changed
since the quote in Figure 8.1.
As of May 12, 2011, MCD’s stock price had increased in value to $80.28 per share. MCD
experienced a modest gain from September 27, 2010, reaching a peak in mid-November at
approximately $80 per share. Since that time, it dipped back to $73 per share and then climbed
back to $80 per share.
LG2 4. Get the trading statistics for the three main U.S. stock exchanges. Compare the trading activity
to that of Table 8.1.
The table below reflects trading activity on the three main U.S. stock exchanges for May 12, 2011.
Trading volume was higher this day compared to the September 28, 2010 activity reflected in
Table 8.1. Note that there are a larger number of stocks listed on the NYSE now.
8-1
ADVANCES & DECLINES

NYSE AMEX NASDAQ
Advancing Issues 2,485 (61%) 394 (58%) 1,714 (63%)
Declining Issues 1,505 (37%) 236 (35%) 903 (33%)
Unchanged Issues 103 (3%) 50 (7%) 94 (3%)
Total Issues 4,093 680 2,711
New Highs 198 33 112
New Lows 64 7 53
Up Volume 2,297,900,752 (55%) 602,484,998 (54%) 1,266,472,255 (57%)
Down Volume 1,863,514,957 (44%) 406,452,447 (36%) 940,707,584 (42%)
Unchanged Volume 38,458,632 (1%) 104,670,260 (9%) 16,369,286 (1%)
Total Volume 4,199,874,341 1,113,607,705 2,223,549,125
LG3 5. Why might the Standard & Poor’s 500 Index be a better measure of stock market performance
than the Dow Jones Industrial Average? Why is the DJIA more popular than the S&P 500?
The S&P 500 is a broad market index that includes stocks of the 500 largest US firms from ten
sectors of the economy. It captures 80 percent of the overall stock market capitalization and is a
good proxy for what is occurring in the overall stock market. The DJIA has been used for a longer
period, since the mid-1880’s, and represents the activity of the 30 largest corporations in the US,
covering 30 percent of the stock market. Its popularity arises from it being the first index used by
the media.
LG3 6. Explain how it is possible for the DJIA to increase one day while the Nasdaq Composite
decreases during the same day.
The components of the DJIA and the Nasdaq Composite index are mostly different companies.
The DJIA includes the 30 industry leaders across all sectors of the economy. The
8-2
Nasdaq is comprised of predominantly technology related firms and emits a noisy signal of
technology performance on any given day.
LG4 7. Which is higher, the ask quote or the bid quote? Why?
The market maker’s ask price is the lowest price offered for stock sale and the bid price is the
highest price a market maker will pay for stock purchase. Thus, the ask price is higher than the
bid price. The difference is the bid-ask spread and it represents the gain a market maker achieves
by taking the risk position and providing the needed liquidity for the stock in question.
LG4 8. Illustrate through examples how trading commission costs impact an investor’s return.
Assume an investor wishes to purchase a stock at a strike price of $90. Two scenarios to consider,
at their extremes, would be the purchase of 10 shares versus the purchase of 100 shares. The costs
to purchase through a discount broker, assuming the broker charges $20 per trade would be $920
($900 + $20) and $9020, respectively. The commission for the trades in percentages would be
2.22 percent and 0.22 percent, respectively. For the investor who owns only 10 shares, the price
would have to rise by $2 per share to recoup the commission cost. It would only have to rise $0.20
for the investor who owns 100 shares. It is evident that the percentage of trading commissions is
lower on larger volume trades and the effect would be even more pronounced if the trades had
been placed through a retail broker.
LG4 9. Describe the difference in the timing of trade execution and the certainty of trade price between
market orders and limit orders.
Market makers fill market orders immediately at the current stock price. This provides the liquidity
an investor needs to buy and sell stocks quickly. However, the price at which the stock will fill
cannot be guaranteed. With limit orders, the market maker will only fill the order when the stated
price is reached. This means that you can count on the execution only after your target buy or sell
price is reached, but you cannot guarantee your trade will execute with a limit order.
LG5 10. What are the differences between common stock and preferred stock?
Common stock dividends change over time, hopefully increasing in the long-term. Preferred stock
pays a constant dividend. Preferred stockholders have higher precedence for payment in the event
of firm liquidation from bankruptcy. However, preferred stockholders do not have voting rights
that common stockholders enjoy. Preferred stock prices fluctuate with market interest rates and
behave like corporate bond prices. Common stock price changes with the value of the company’s
underlying business.
LG5 11. How important is growth to a stock’s value? Illustrate with examples.
8-3
Consider two firms with a common next period dividend of $1, a common market discount rate of
8 percent, but differing growth rates of 3 percent and 5 percent, respectively. The implied current
prices of these stocks are $20 [= $1 / (0.08 - 0.03)] and $33.33 [= $1 / (0.08 - 0.05)] respectively.
The firm with higher growth prospects (5 percent) is valued more highly than the firm with lower
growth rate prospects (3 percent).
LG5 12. Under what conditions would the constant growth rate model not be appropriate?
When the growth rate exceeds the discount rate, the constant growth rate model cannot be
employed. It is also not appropriate when the growth rate cannot reasonably be expected to be
constant into the future.
LG5 13. The expected return derived from the constant growth rate model relies on dividend yield and
capital gain. Where do these two parts of the return come from?
Rearranging the terms and solving for the i from the constant growth model yields the expected
return model. The components are the dividend yield and the capital gain. The dividend yield
reflects the percentage return from current firm operations. The capital gain captures the firm’s
future growth prospects. Both components are important from an investor point of view, with
dividends providing income to an investor over the stock holding period and the capital gain being
realized at the time of stock sale.
LG6 14. Describe, in words, how to use the variable growth rate technique to value a stock.
When the firm is growing at a very fast pace in its infancy, the expected growth rate will initially
be very large. This rate should be used for the high growth period, but a terminal growth rate
should be employed for valuation when the firm matures. Essentially, a firm cannot grow faster
than the general economy indefinitely and must be capped in the long term by its mature growth
rate.
LG6 15. Can the variable growth rate model be used to value a firm that has a negative growth rate in
Stage 1 and a stable and positive growth rate in Stage 2? Explain.
In this case, the firm would be contracting over a short period and then reaching a stable, positive
growth rate. Insofar as the initial rate during contraction does not dominate the later mature growth
rate, this is possible. It would suggest that a firm’s dividends in the short term decrease, followed
by a positive growth dividend stream in the longer term.
LG7 16. Explain why using the P/E relative value approach may be useful for companies that do not
pay dividends.
Since dividends are non-existent, the forecast stock price is simply a function of current price and
the discount rate. In isolation, it is hard to determine if the firm is under- or overvalued
8-4
based on this information only. Using the P/E relative value approach, the trailing P/E can be
calculated and compared to a firm’s competitors.
LG7 17. How is a firm’s changing P/E ratio reflected in the stock price? Give examples.
The P/E ratio multiplied by a firm’s earnings result in the stock price. For example, if a firm is
experiencing high growth and all other factors are held constant, this will lead to a higher P/E ratio
reflecting the growth prospects. Stock prices can change simply because the market changes the
P/E ratio appropriate for that stock.
LG7 18. Differentiate the characteristics of growth stocks and value stocks?
Taken in tandem, P/E ratios and growth rates illustrate the type of stock a firm is characterized as,
growth or income. Firms with high P/E and high growth rates are growth stocks. A comparison
across an industry of P/E ratios can be an aid to investors in selecting the best growth stock to
purchase. By contrast, firms with low P/E ratios and low growth rates tend to be value stocks.
LG7 19. What’s the relationship between the P/E ratio and a firm’s growth rate?
The price of a stock can be modeled with the constant growth rate equation. Note that the
denominator is (i – g). So the price relative to earnings is impacted by the growth rate of the firm.
A high growth rate will cause a high price and P/E. Thus, high growth firms should have high P/E
ratios while low growth rate firms should have low P/E ratios.
LG7 20. Describe the process for using the P/E ratio to estimate a future stock price.
Using current earnings and an expected growth rate for these earnings, the current P/E ratio can be
multiplied by the estimate of future earnings to produce a price estimate for the future stock value.
That is, the current P/E ratio acts as a guide for the stock’s future price. This approach should be
employed cautiously by comparing the P/E ratios to similar firms to ensure that the firm you have
selected has a reasonable P/E ratio.
Problems
Basic Problems
LG3 8-1 Stock Index Performance On March 5, 2013, the Dow Jones Industrial Average
set a new high. The index closed at 14,253.77, which was up 125.95 that day. What was the return
(in percent) of the stock market that day?
FV = PV × (1 + i)
14,253.77 = (14,253.77 - 125.95) × (1 + i)
i = (14,253.77 / 14,127.82) - 1 = 0.89%
or
N=1, PV=-14,127.82, PMT=0, FV=14,253.77, CPT I==0.8915
8-5
LG3 8-2 Stock Index Performance On March 9, 2009, the Dow Jones Industrial Average reached a
new low. The index closed at 6,547.05, which was down 79.89 that day. What was the return (in
percent) of the stock market that day?
FV = PV × (1 + i)
6,547.05 = (6,547.05 + 79.89) × (1 + i)
i = (6,547.05 / 6,626.94) - 1 = -1.21%
or
N=1, PV=-6,626.94, PMT=0, FV=6,547.05, CPT I==-1.2055
LG4 8-3 Buying Stock with Commissions At your discount brokerage firm, it costs $7.95 per stock
trade. How much money do you need to buy 200 shares of Pfizer, Inc. (PFE), which trades at
$31.40?
($31.40/share × 200 shares) + $7.95 = $6,287.95
LG4 8-4 Buying Stock with Commissions At your discount brokerage firm, it costs $9.50 per stock
trade. How much money do you need to buy 300 shares of Time Warner, Inc. (TWX), which trades
at $22.62?
($22.62/share × 300 shares) + $9.50 = $6,795.50
LG4 8-5 Selling Stock with Commissions At your full-service brokerage firm, it costs $140 per stock
trade. How much money do you receive after selling 200 shares of Nokia Corporation (NOK),
which trades at $20.13?
($20.13/share × 200 shares) - $140 = $3,886.00
LG4 8-6 Selling Stock with Commissions At your full-service brokerage firm, it costs $135 per stock
trade. How much money do you receive after selling 250 shares of International Business
Machines (IBM), which trades at $96.17?
($96.17/share × 250 shares) - $135 = $23,907.50
LG4 8-7 Buying Stock with a Market Order You would like to buy shares of Sirius Satellite Radio
(SIRI). The current ask and bid quotes are $3.96 and $3.93, respectively. You place a market buy-
order for 500 shares that executes at these quoted prices. How much money did it cost to buy these
shares?
($3.96/share × 500 shares) = $1,980.00
LG4 8-8 Buying Stock with a Market Order You would like to buy shares of Coldwater Creek, Inc.
(CWTR). The current ask and bid quotes are $20.70 and $20.66, respectively. You place a market
buy-order for 200 shares that executes at these quoted prices. How much money did it cost to buy
these shares?
8-6
($20.70/share × 200 shares) = $4,140.00
LG4 8-9 Selling Stock with a Limit Order You would like to sell 200 shares of Xenith Bankshares
(XBKS). The current ask and bid quotes are $4.66 and $4.62, respectively. You place a limit sell-
order at $4.65. If the trade executes, how much money do you receive from the buyer?
($4.65/share × 200 shares) = $930.00
LG4 8-10 Selling Stock with a Limit Order You would like to sell 100 shares of Echo Global
Logistics, Inc. (ECHO). The current ask and bid quotes are $15.33 and $15.28, respectively. You
place a limit sell-order at $15.31. If the trade executes, how much money do you receive from the
buyer?
($15.31/share ×100 shares) = $1,531.00
LG5 8-11 Value of a Preferred Stock A preferred stock from Duquesne Light Company (DQUPRA)
pays $3.55 in annual dividends. If the required return on the preferred stock is 6.7 percent, what’s
the value of the stock?
Use equation 8-6, noting that for preferred stock, the growth rate g equals zero:
D0 (1 + g ) $3.55
Constant growth model = P0 = = = $52 .99
i−g 0.067 − 0
LG5 8-12 Value of a Preferred Stock A preferred stock from Hecla Mining Co. (HLPRB) pays $3.50
in annual dividends. If the required return on the preferred stock is 6.8 percent, what is the value
of the stock?
Use equation 8-6, noting that for preferred stock, the growth rate g equals zero:
D0 (1 + g ) $3.50
Constant growth model = P0 = = = $51 .47
i−g 0.068 − 0
LG7 8-13 P/E Ratio and Stock Price Ultra Petroleum (UPL) has earnings per share of $1.56 and a P/E
ratio of 32.48. What’s the stock price?
Use equation 8-10:
( E) × E
Pn = P
n
n = 32.48 × $1.56 = $50.67
LG7 8-14 P/E Ratio and Stock Price JP Morgan Chase Co. (JPM) has earnings per share of $3.53 and
a P/E ratio of 13.81. What is the price of the stock?
8-7
Use equation 8-10:
( E) × E
Pn = P
n
n = 13.81 × $3.53 = $48.75
intermediate problems
LG5 8-15 Value of Dividends and Future Price A firm is expected to pay a dividend of $1.35
next year and $1.50 the following year. Financial analysts believe the stock will be at their price
target of $68 in two years. Compute the value of this stock with a required return of 10 percent.
D1 D2 + P2 $1.35 $1.50 + $68.00

Use equation 8-3: P0 = + = + = $58.67
1 + i (1 + i ) 2 1 + 0.10 (1 + 0.10) 2
LG5 8-16 Value of Dividends and Future Price A firm is expected to pay a dividend of $2.05 next
year and $2.35 the following year. Financial analysts believe the stock will be at their price target
of $110 in two years. Compute the value of this stock with a required return of 12 percent.
D1 D2 + P2 $2.05 $2.35 + $110.00

Use equation 8-3: P0 = + = + = $91.40
1 + i (1 + i )2
1 + 0.12 (1 + 0.12)2
LG5 8-17 Dividend Growth Annual dividends of ATTA Corp grew from $0.96 in 2005 to $1.76 in
2017. What was the annual growth rate?
Use equation 4-2:
Future value in 12 years = $1.76 = $0.96 × (1 + g ) ⇒ g = 5.18%

12
or
N=12, PV=-0.96, PMT=0, FV=1.76, CPT I==5.18
LG5 8-18 Dividend Growth Annual dividends of Generic Electrical grew from $0.66 in 2012 to $1.03
in 2017. What was the annual growth rate?
Use equation 4-2:
Future value in 5 years = $1.03 = $0.66 × (1 + g ) ⇒ g = 9.31%

5
or
N=5, PV=-0.66, PMT=0, FV=1.03, CPT I==9.31
LG5 8-19 Value a Constant Growth Stock Financial analysts forecast Safeco Corp.’s (SAF) growth
rate for the future to be 8 percent. Safeco’s recent dividend was $0.88. What is the value of Safeco
stock when the required return is 12 percent?
Use equation 8-6:
8-8
D0 (1 + g ) $0.88(1 + 0.08)
Constant growth model = P0 = = = $23.76
i−g 0.12 − 0.08
LG5 8-20 Value a Constant Growth Stock Financial analysts forecast Limited Brands’ (LTD) growth
rate for the future to be 12.5 percent. LTD’s recent dividend was $0.60. What is the value of
Limited Brands’ stock when the required return is 14.5 percent?
Use equation 8-6:

D0 (1 + g ) $0.60(1 + 0.125)
Constant growth model = P0 = = = $33.75
i−g 0.145 − 0.125
LG5 8-21 Expected Return Ecolap, Inc. (ECL) recently paid a $0.46 dividend. The dividend is
expected to grow at a 14.5 percent rate. At a current stock price of $44.12, what is the return
shareholders are expecting?
First convert D0 to D1: $0.46 × (1 + 0.145) = $0.5267.
Then use equation 8-7:
D1
Expected return = i = + g = ($0.5267 / $44.12) + 0.145 = 15.69%
P0
LG5 8-22 Expected Return Paychex Inc. (PAYX) recently paid an $0.84 dividend. The dividend is
expected to grow at a 15 percent rate. At a current stock price of $40.11, what is the return
shareholders are expecting?
First convert D0 to D1: $0.84 × (1 + 0.15) = $0.966.
Then use equation 8-7:
D1
Expected return = i = + g = ($0.966 / $40.11) + 0.15 = 17.41%
P0
LG6 8-23 Dividend Initiation and Stock Value A firm does not pay a dividend. It is expected to pay
its first dividend of $0.20 per share in three years. This dividend will grow at 11 percent
indefinitely. Using a 12 percent discount rate, compute the value of this stock.
First compute the year 2 value of the stock using equation 8-6 and then discount this back two
years to get the present value of the stock price:
D3
Constant growth model = P2 = = $0.20 /(0.12 − 0.11) = $20.00
i−g
P0 = ($20 / 1.12 2 ) = $15.94
LG6 8-24 Dividend Initiation and Stock Value A firm does not pay a dividend. It is expected to pay
its first dividend of $0.25 per share in two years. This dividend will grow at 10 percent indefinitely.
Using an 11.5 percent discount rate, compute the value of this stock.
8-9
First compute the year 1 value of the stock using equation 8-6 and then discount this back one year
to get the present value of the stock price:
D2
Constant growth model = P1 = = $0.25 /(0.115 − 0.10) = $16.67
i−g
P0 = ($16.67 / 1.115) = $14.95
LG7 8-25 P/E Ratio Model and Future Price Kellogg Co. (K) recently earned a profit of $2.52 per
share and has a P/E ratio of 13.5. The dividend has been growing at a 5 percent rate over the past
few years. If this growth rate continues, what would be the stock price in five years if the P/E ratio
remained unchanged? What would the price be if the P/E ratio declined to 12 in five years?
Under these two scenarios, the future price estimates using equation 8-10 are:
( E ) × E × (1 + g )
P5 = P
n
0
n
= 13.5 × $2.52 × (1 + 0.05) = $43.42
5
( E ) × E × (1 + g )
P5 = P
n
0
n
= 12 × $2.52 × (1 + 0.05) = $38.59
5
LG7 8-26 P/E Ratio Model and Future Price New York Times Co. (NYT) recently earned a profit of
$1.21 per share and has a P/E ratio of 19.59. The dividend has been growing at a 7.25 percent rate
over the past six years. If this growth rate continues, what would be the stock price in five years if
the P/E ratio remained unchanged? What would the price be if the P/E ratio increased to 22 in five
years?
Under these two scenarios, the future price estimates using equation 8-10 are:
( E ) × E × (1 + g )
P5 = P
n
0
n
= 19.59 × $1.21× (1 + 0.0725) = $33.64
5
( E ) × E × (1 + g )
P5 = P
n
0
n
= 22 × $1.21× (1 + 0.0725) = $37.77
5
advanced problems
LG5 8-27 Value of Future Cash Flows A firm recently paid a $0.45 annual dividend. The
dividend is expected to increase by 10 percent in each of the next four years. In the fourth year,
the stock price is expected to be $80. If the required return for this stock is 13.5 percent, what is
its current value?
Find the dividends in the next four years:

D1 = $0.45 × (1 + 0.10) = $0.495
D2 = $0.495 × (1 + 0.10) = $0.5445
D3 = $0.5445 × (1 + 0.10) = $0.5990
D4 = $0.5990 × (1 + 0.10) = $0.6588
8-10
Then use equation 8-3 as:
D1 D2 D3 D +P
P0 = + + + 4 44
1 + i (1 + i ) (1 + i )
2 3
(1 + i )
= $0.495 / 1.135 + $0.5445 / 1.1352 + $0.5990 / 1.1353 + ($0.6588 + $80) / 1.1354 = $49.87
LG5 8-28 Value of Future Cash Flows A firm recently paid a $0.60 annual dividend. The dividend is
expected to increase by 12 percent in each of the next four years. In the fourth year, the stock price
is expected to be $110. If the required return for this stock is 14.5 percent, what is its current value?

D1 = $0.60 × (1 + 0.12) = $0.672
D2 = $0.672 × (1 + 0.12) = $0.7526
D3 = $0.7526 × (1 + 0.12) = $0.8430
D4 = $0.8430 × (1 + 0.12) = $0.9441
Now use equation 8-3:
D1 D2 D3 D +P
P0 = + + + 4 44
1 + i (1 + i ) (1 + i )
2 3
(1 + i )
= $0.672 / 1.145 + $0.7526 / 1.1452 + $0.8430 / 1.1453 + ($0.9441 + $110) / 1.1454 = $66.27
LG5 8-29 Constant Growth Stock Valuation Waller Co. paid a $0.286 dividend per share in 2006,
which grew to $0.55 in 2012. This growth is expected to continue. What is the value of this stock
at the beginning of 2013 when the required return is 13.7 percent?
First calculate the growth rate from 2000 to 2012:
FV = PV × (1 + g)12
$0.55 = $0.137 × (1 + g)12
g = ($0.55 / $0.137)1/12 - 1 = 0.1280
Now, use this growth rate in equation 8-6 to obtain the present value of the stock:
D0 (1 + g )
Constant growth model = P0 = = ($0.55 × 1.1228) /(0.137 − 0.1280) = $68.93
i−g
LG5 8-30 Constant Growth Stock Valuation Campbell Supper Co. paid a $0.632 dividend per share
in 2013, which grew to $0.76 in 2016. This growth is expected to continue. What is the value of
this stock at the beginning of 2017 when the required return is 8.7 percent?
First calculate the growth rate from 2013 to 2016:
8-11
FV = PV × (1 + g)3
$0.76 = $0.632 × (1 + g)3
g = ($0.76 / $0.632)1/3 - 1 = 0.0634
Now, use this growth rate in equation 8-6 to obtain the present value of the stock:
D0 (1 + g )
i−g
LG5 8-31 Changes in Growth and Stock Valuation Consider a firm that had been priced using a 10
percent growth rate and a 12 percent required return. The firm recently paid a $1.20 dividend. The
firm has just announced that because of a new joint venture, it will likely grow at a 10.5 percent
rate. How much should the stock price change (in dollars and percentage)?
Use equation 8-6 to calculate the firm’s value prior to the venture:
D0 (1 + g )
Constant growth model = P0 = = ($1.20 × 1.10) /( 0.12 − 0.10) = $66.00
i−g
If the firm’s growth rate changes to 10.5 percent, then the new stock price is:
D0 (1 + g )
Constant growth model = P0 = = ($1.20 ×1.105) /(0.12 − 0.105) = $88.40
i−g
The dollar amount of this change is $88.40 - $66.00 = $22.40 or 33.94 percent for the 0.5 percent
increase in the growth rate.
LG5 8-32 Changes in Growth and Stock Valuation Consider a firm that had been priced using an
11.5 percent growth rate and a 13.5 percent required return. The firm recently paid a $1.50
dividend. The firm has just announced that because of a new joint venture, it will likely grow at a
12 percent rate. How much should the stock price change (in dollars and percentage)?
Use equation 8-6 to calculate the firm’s value prior to the venture:
D0 (1 + g )
i−g
If the firm’s growth rate changes to 12 percent, then the new stock price is:
D0 (1 + g )
Constant growth model = P0 = = ($1.50 ×1.12) /(0.135 − 0.12) = $112.00
i−g
The dollar amount of this change is $112.00 - $83.625 = $28.38 or 33.93 percent for the 0.5 percent
increase in the growth rate.
8-12
LG6 8-33 Variable Growth A fast growing firm recently paid a dividend of $0.35 per share. The
dividend is expected to increase at a 20 percent rate for the next three years. Afterwards, a more
stable 12 percent growth rate can be assumed. If a 13 percent discount rate is appropriate for this
stock, what is its value?
Use equation 8-8:
D0 (1 + g1 ) (1 + g 2 )
3
D0 (1 + g1 ) +
3
D0 (1 + g1 ) D0 (1 + g1 ) i − g2
2
P0 = + +
1+ i (1 + i )2 (1 + i )3
$0.35(1 + 0.20) (1 + 0.12 )

3
$0.35(1 + 0.20 ) +
3
$0.35(1 + 0.20 ) $0.35(1 + 0.20 )
2
P0 = + + 0.13 − 0.12
1 + 0.13 (1 + 0.13)2 (1 + 0.13)3
P0 = $0.372 + $0.395 + $47.36 = $48.13
LG6 8-34 Variable Growth A fastgrowing firm recently paid a dividend of $0.40 per share. The
dividend is expected to increase at a 25 percent rate for the next four years. Afterwards, a more
stable 11 percent growth rate can be assumed. If a 12.5 percent discount rate is appropriate for this
stock, what is its value?
Use equation 8-8:
D0 (1 + g1 ) (1 + g 2 )
4
D0 (1 + g1 ) +
4
D0 (1 + g1 ) D0 (1 + g1 ) D (1 + g1 ) i − g2
2 3
P0 = + + 0 +
1+ i (1 + i )2
(1 + i )3 (1 + i )4
$0.40(1.25) (1 + 0.11)
4
$0.40(1.25) +
4
$0.40(1 + 0.25 ) $0.40(1.25 ) $0.40(1.25)
2 3
P0 = + + + 0.125 − 0.11
1 + 0.125 (1.125 )2 (1.125)3 (1.125 )4
= $0.444 + $0.494 + $0.549 + $45.725 = $47.21
LG5 8-35 P/E Model and Cash Flow Valuation Suppose that a firm’s recent earnings per
LG7 share and dividend per share are $2.50 and $1.30, respectively. Both are expected to grow at 8
percent. However, the firm’s current P/E ratio of 22 seems high for this growth rate. The P/E ratio
is expected to fall to 18 within five years. Compute a value for this stock by first estimating the
dividends over the next five years and the stock price in five years. Then discount these cash flows
using a 10 percent required rate.

D1 = $1.30 × (1 + 0.08) = $1.404
D2 = $1.404 × (1 + 0.08) = $1.516
D3 = $1.516 × (1 + 0.08) = $1.638
D4 = $1.638 × (1 + 0.08) = $1.769
D5 = $1.769 × (1 + 0.08) = $1.910
8-13
Next, use equation 8-10 to calculate the stock price in year 5:
( E ) × E = (P E ) × E
P5 = P
5
5
5
0 × (1 + g ) = 18 × $2.50 × (1.08) 5 = $66.12
5
Now find the present value of these cash flows using a 10 percent discount rate to get P0:
D1 D2 D3 D4 D +P
P0 = + + + + 5 55
1 + i (1 + i ) (1 + i ) (1 + i )
2 3 4
(1 + i )
= $1.404 / 1.10 + $1.516 / 1.10 2 + $1.638 / 1.103 + $1.769 / 1.10 4 + ($1.910 + $66.12) / 1.105 = $47.21
LG5 8-36 P/E Model and Cash Flow Valuation Suppose that a firm’s recent earnings per
LG7 share and dividend per share are $2.75 and $1.60, respectively. Both are expected to grow at 9
percent. However, the firm’s current P/E ratio of 23 seems high for this growth rate. The P/E ratio
is expected to fall to 19 within five years. Compute a value for this stock by first estimating the
dividends over the next five years and the stock price in five years. Then discount these cash flows
using an 11 percent required rate.

D1 = $1.60 × (1 + 0.09) = $1.744
D2 = $1.744 × (1 + 0.09) = $1.901
D3 = $1.901 × (1 + 0.09) = $2.072
D4 = $2.072 × (1 + 0.09) = $2.258
D5 = $2.258 × (1 + 0.09) = $2.462
P5 = P ( E ) × E = (P E ) × E
5
5
5
0 × (1 + g ) = 19 × $2.75 × (1.09) 5 = $80.39
5
Now find the present value of these cash flows using an 11 percent discount rate to get P0:
D1 D2 D3 D4 D +P
P0 = + + + + 5 55
1 + i (1 + i ) (1 + i ) (1 + i )
2 3 4
(1 + i )
= $1.744 / 1.11 + $1.901 / 1.112 + $2.072 / 1.113 + $2.258 / 1.114 + ($2.462 + $80.39) / 1.115 = $55.29
8-37 Spreadsheet Problem Spreadsheets are especially useful for computing stock value under
different assumptions. Consider a firm that is expected to pay the following dividends:
Year 1 2 3 4 5 6
$1.20 $1.20 $1.50 $1.50 $1.75 $1.90 and grow at 5 percent thereafter
A. Using an 11 percent discount rate, what would be the value of this stock?
B. What is the value of the stock using a 10 percent discount rate? A 12 percent discount rate?
8-14
C. What would the value be using a 6 percent growth rate after Year 6 instead of the 5 percent rate
using each of these three discount rates?
D. What do you conclude about stock valuation and its assumptions?
SOLUTION:
Present
At 5 percent growth: Value
11% 10% 12%
Discount Discount Discount
Year Dividend Rate Rate Rate
1 $1.20 $1.08 $1.09 $1.07
2 $1.20 $0.97 $0.99 $0.96
3 $1.50 $1.10 $1.13 $1.07
4 $1.50 $0.99 $1.02 $0.95
5 $1.75 $1.04 $1.09 $0.99
6 $1.90 $1.02 $1.07 $0.96
Terminal Price
6 @ 11% $33.25 $17.78
6 @ 10% $39.90 $22.52
6 @ 12% $28.50 $14.44
Sum = $23.97 $28.92 $20.44
Present
At 6 percent growth: Value
11% 10% 12%
Discount Discount Discount
Year Dividend Rate Rate Rate
1 $1.20 $1.08 $1.09 $1.07
2 $1.20 $0.97 $0.99 $0.96
3 $1.50 $1.10 $1.13 $1.07
4 $1.50 $0.99 $1.02 $0.95
5 $1.75 $1.04 $1.09 $0.99
6 $1.90 $1.02 $1.07 $0.96
Terminal Price
6 @ 11% $40.28 $21.54
6 @ 10% $50.35 $28.42
6 @ 12% $33.57 $17.01
Sum = $27.73 $34.81 $23.01
8-15
a. From the table calculated in Excel, the value of the stock based on an 11 percent discount
rate would be $23.97.
b. From the table, the value of the stock based on a 10 percent discount rate would be $28.92
and based on a 12 percent discount rate would be $20.44.
c. From the table, the value of the stock that grows at 6 percent (rather than 5 percent) in year
7 and after causes a higher stock value than a future 5 percent growth.
d. Assumptions are crucially important in stock valuation. Minor changes in either the
discount rate or the growth assumption rate can have a big impact on stock valuation.
8-38 Spreadsheet Problem Design a spreadsheet similar to the one below to compute the value
of a variable growth rate firm over a five-year horizon.
A. What is the value of the stock if the current dividend is $1.30, the first stage growth is
18%, the second stage growth is 9%, and the discount rate is 11%?
B. What is the value of the stock if the current dividend is $1.30, the first stage growth is
2%, the second stage growth is 8%, and the discount rate is 9.5%?
C. What is the value of the stock if the current dividend is $2.50, the first stage growth is
15%, the second stage growth is 7%, and the discount rate is 10%?
SOLUTION
A.
B.
8-16
C.
research it
Stock Screener
Investors can choose from many thousands of stocks. The large number to choose from can be
quite daunting to new investors. Fortunately, some good stock screeners are available for free on
the Internet that will find only the kinds of companies the investor is looking for. Looking for small
value companies? A stock screen at Yahoo! Finance will show all the stocks that meet the three
criteria of (1) market capitalization between $250 million and $1 billion, (2) P/E ratio less than or
equal to 10, and (3) a quick ratio greater or equal to 1.0. In September of 2010, 127 firms met all
three of these criteria. Yahoo! Finance provides 18 screens like this one to choose from. Pick one
of these pre-set screens. Discuss the kinds of stocks the screen will find and report on those
companies.(http://screener.finance.yahoo.com/presetscreens.html)
SOLUTION: Consider the preset screen for Large Cap Value. The stock screener description is
as follows:
Stocks with market capitalizations greater than or equal to $5 billion with a price-earnings ratio
less than or equal to 15 and a quick ratio of greater than or equal to 1.0.
Selecting this prescreen yields many of the big, mature firms you would expect, such as
ExxonMobil (XOM), Pfizer, Inc. (PFE), Goldman Sachs (GS) and Fedex Corp (FDX). These are
mature firms in their industry that command very large capitalizations ($417 billion for XOM) and
are favored investments for larger institutional investors. These firms tend to be leaders in their
industry and offer an attractive stream of dividends for their investors.
integrated minicase: Valuing Carnival Corporation
8-17
Carnival Corp. (CCL) provides cruises to major vacation destinations. Carnival operates 99 cruise
ships in North America, Europe, Australia, and Asia. The company also operates hotels,
sightseeing motor coaches and rail cars, and luxury day boats. These activities generated earnings
per share of $2.69 for 2015. The stock price at the end of 2015 was $54.48. The previous stock
prices and dividends are shown in the following table.
8-18
2008 2009 2010 2011 2012 2013 2014 2015

Annual dividend $ 1.20 $ 0.00 $ 0.40 $1.00 $1.00 $1.50 $1.00 $1.10
Stock price at the end of $20.77 $27.06 $39.81 $28.97 $34.07 $38.29 $44.31 $54.48
the year
Carnival is a firm in the General Entertainment industry, which is in the Services sector. The
following table shows some key statistics for Carnival, the industry, and the sector.
Key Statistic Carnival

General Services Sector
Entertainment
P/E ratio 20.26 19.75 18.60
Dividend yield 2.67% 3.17% 1.57%
Next 5-year growth 18.00% 17.65% 14.72%
Use the various valuation models and relative value measures to assess whether Carnival stock is
correctly valued. Compute value estimates from multiple models. The appropriate required rate
of return is 11 percent.
It will be useful to calculate the stock price for the end of 2015 from various methods to compare
to the actual value realized at the time, $54.48 per share.
Note that the next 5 year expected growth rate is currently the higher than the discount rate, so the
constant growth rate model cannot be used.
(1) Determine the dividends to year 5 using the same growth rate at which the dividends had been
growing the last 3 years and then use a terminal P/E ratio of 20.26 to compute the future price.
Then find the PV of these cash flows. So first, determine the historical dividend growth rate:
Future value in 3 years = 1.10 = 1.00 × (1 + g ) ⇒ g = 3.2%

3
Now use this 3.2 percent growth rate to find the next five dividends:
D1 = $1.10 × (1 + 0.032) = $1.135
D2 = $1.135× (1 + 0.032) = $1.172
D3 = $1.172 × (1 + 0.032) = $1.209
D4 = $1.209× (1 + 0.032) = $1.248
D5 = $1.248 × (1 + 0.032) = $1.288
( E ) × E = (P E ) × E × (1 + g )
P5 = P
5
5
5
0
5
= 20.26 × $2.69 × (1.032)5 = $63.80
8-19
Now find the present value, P0, of these cash flows:
D1 D2 D3 D4 D +P
P0 = + + + + 5 55
1 + i (1 + i ) 2
(1 + i ) (1 + i ) (1 + i )
3 4
= $1.135 / 1.11 + $1.172 / 1.112 + $1.209 / 1.113 + $1.248 / 1.114 + ($1.288 + $63.80) / 1.115 = $42.30.
(2) Use the same procedure, but this time use the 18% expected growth rate.
Now use this 18.0 percent growth rate to find the next five dividends:
D1 = $1.10 × (1 + 0.18) = $1.298
D2 = $1.298 × (1 + 0.18) = $1.532
D3 = $1.532 × (1 + 0.18) = $1.807
D4 = $1.807 × (1 + 0.18) = $2.133
D5 = $2.133 × (1 + 0.18) = $2.517
( E ) × E = (P E ) × E × (1 + g )
P5 = P
5
5
5
0
5
= 20.26 × $2.69 × (1.18)5 = $124.680
Now find the present value, P0, of these cash flows:
D1 D2 D3 D4 D + P5
P0 = + + + + 5
1 + i (1 + i )2 (1 + i )3 (1 + i )4 (1 + i )5
= $1.298 / 1.11 + $1.532 / 1.112 + $1.807 / 1.113 + $2.133 / 1.114 + ($2.517 + $124.68) / 1.115 = $80.63
(3) Note that the expected return from equation 8-7 is:
D1
Expected return = i = + g = 2.02% + 18.0% = 20.02%
P0
This is higher than the proposed discount rate of 11 percent. This suggests that the stock is
undervalued.
The results of (2) and (3) suggest that Carnival appears undervalued. However, (1) suggests that it
is overvalued.
8-20
Another random document with
no related content on Scribd:
"I—" Fradin faltered. He started to say something but changed his
mind abruptly.
Marvak kicked over the handle of the rheostat that fed current into
the transmitter. The transformer groaned. I could see the hand of the
meter on the transmitter. It was moving forward as more and more
current flowed into that mysterious medium that transmits radio
waves.
The needle on the dial touched the red mark.
Then—it happened.
If I live to be a thousand years old I'll never be able to describe
adequately what I saw happen, what I heard happen, what I felt
happen. It had never happened before.
Something that I can only describe as a lightning flash ran through
the room. It was a sharp, tearing crash, similar to the sound you hear
when a bolt of lightning hits near you. There was a flash of brilliant
light. Thunder seemed to smash my ear drums.
Fradin leaped—but not at Marvak. He leaped at me. The next instant
he was grabbing me, shoving me across the room. And all the
tortures of hell were breaking loose around that generator.
There was a blasting, howling roar of wind. It was the coldest wind
ever. It was, I suspect, the cold of absolute zero that struck through
that laboratory.
Out of nowhere, around that transmitter, a hole seemed to appear. It
seemed to be torn in space. It was black, with a curiously liquid kind
of blackness. It appeared around the transmitter, and Marvak was at
the transmitter.
The spy seemed to freeze. A look of amazed fright appeared on his
face.
Then he seemed to fall. The transmitter seemed to fall with him.
Marvak tried to leap, but the footing seemed to fall away under him.
He fell out of sight.
For a mad instant, while Fradin kicked and hauled me away from
that transmitter, the laboratory was hideous with the blast of thunder.
Then another murderous crash came, and....
Then there was silence. Utter silence. The only sound was Fradin
fighting for his breath. I looked across the room. The transmitter was
gone. It just wasn't there any more. Under it, in the floor of the room
was a neat, round hole. All the mass of wires that had led into it were
neatly severed. Wires came from the transformer to where the hole
began, then stopped.
Marvak wasn't there. Marvak was gone.
Suddenly I turned to Fradin. "You—" I gulped. "You were afraid this
would happen. My God, man, what was it?"
"It was," he answered, "a hole in the fourth dimension."
Then I got it. He had been trying to tell that convention of radio
engineers that radio waves were transmitted through the fourth
dimension, not through the "ether." He had been able to prove his
point but he had refused because he knew that this would happen.
"But even if radio waves do pass through the fourth dimension,
nothing like this has ever happened," I stammered.
"Ordinary broadcasting stations do not put enough power through
their transmitters to open this hole," he explained. "It takes power to
do it, lots of power. I had calculated how much power it would take.
There was a red mark on the input meter of the transmitter. That red
line marked the critical point. If more power was put through the
transmitter, it would break down the fabric of space between this
dimension and the fourth dimension. I knew it would happen. That's
why I refused to make a demonstration for the benefit of my skeptical
compatriots. If I told them what I had discovered, proved I had
discovered it, some fool would be sure to try it, with disastrous
results."
"But that cold wind," I protested.
"This particular region opens out into what must be interplanetary
space in the fourth dimension. That cold wind was simply the cold of
outer space rushing through what was in effect a window."
So that was it. There was a hole in space. And space is cold.
"Marvak!" I said weakly.
"Don't mention him," Fradin shuddered. "He was catapulted into the
fourth dimension. He's frozen solid by now."
I guess the human race will never have power by radio. Probably we
will be able to get along without it. Atomic power seems to be coming
along, and it's safe.
I took Fradin to the hospital. That slug through his shoulder had cost
him a lot of blood, but he recovered all right, only to discover that the
Institute of Radio Engineers had booted him right out of their
organization, for making the preposterous claim that radio waves are
transmitted through the fourth dimension instead of through the
ether. However, he never cared two whoops in hell about that. He
knew what he knew. And he was content with that.
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Finance Applications and Theory 4th

Edition Cornett Solutions Manual

Finance Applications and Theory 4th Edition Cornett

Finance Applications and Theory 3rd Edition Cornett

Finance Applications and Theory 3rd Edition Cornett

Finance Applications and Theory 2nd Edition Cornett

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Microeconomics Theory and Applications with Calculus

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Corporate Finance Core Principles and Applications 4th

CHAPTER 8 – VALUING STOCKS

LG1 1. As owners, what rights and advantages do shareholders obtain?

LG1 2. Describe how being a residual claimant can be very valuable.

ADVANCES & DECLINES

Advancing Issues 2,485 (61%) 394 (58%) 1,714 (63%)

Declining Issues 1,505 (37%) 236 (35%) 903 (33%)

Unchanged Issues 103 (3%) 50 (7%) 94 (3%)

Total Issues 4,093 680 2,711

New Highs 198 33 112

Up Volume 2,297,900,752 (55%) 602,484,998 (54%) 1,266,472,255 (57%)

Down Volume 1,863,514,957 (44%) 406,452,447 (36%) 940,707,584 (42%)

Unchanged Volume 38,458,632 (1%) 104,670,260 (9%) 16,369,286 (1%)

Total Volume 4,199,874,341 1,113,607,705 2,223,549,125

($31.40/share × 200 shares) + $7.95 = $6,287.95

($22.62/share × 300 shares) + $9.50 = $6,795.50

($20.13/share × 200 shares) - $140 = $3,886.00

($96.17/share × 250 shares) - $135 = $23,907.50

($3.96/share × 500 shares) = $1,980.00

($20.70/share × 200 shares) = $4,140.00

($4.65/share × 200 shares) = $930.00

($15.31/share ×100 shares) = $1,531.00

Use equation 8-10:

Use equation 8-10:

D1 D2 + P2 $1.35 $1.50 + $68.00

D1 D2 + P2 $2.05 $2.35 + $110.00

Use equation 4-2:

Future value in 12 years = $1.76 = $0.96 × (1 + g ) ⇒ g = 5.18%

Use equation 4-2:

Future value in 5 years = $1.03 = $0.66 × (1 + g ) ⇒ g = 9.31%

Use equation 8-6:

Use equation 8-6:

First convert D0 to D1: $0.46 × (1 + 0.145) = $0.5267.

Then use equation 8-7:

First convert D0 to D1: $0.84 × (1 + 0.15) = $0.966.

Then use equation 8-7:

Find the dividends in the next four years:

Then use equation 8-3 as:

Find the dividends in the next four years:

Now use equation 8-3:

First calculate the growth rate from 2000 to 2012:

First calculate the growth rate from 2013 to 2016:

Use equation 8-8:

$0.35(1 + 0.20) (1 + 0.12 )

Use equation 8-8:

Find the dividends in the next four years:

Next, use equation 8-10 to calculate the stock price in year 5:

Find the dividends in the next four years:

Next, use equation 8-10 to calculate the stock price in year 5:

Sum = $23.97 $28.92 $20.44