Chapter 3 – Stock Valuation

What are stocks?

Stocks are a type of security that signifies ownership in a corporation and represents a claim on
part of the corporation's assets and earnings. Common stockholders are the owners of the firm.
They elect the firm’s board of directors who in turn appoint the firm’s top management team.
They have the right to the firm’s income that remains after bondholders and preferred
stockholders have been paid. In general, common shareholders are the only security holders
given the right to vote.

Common stockholders either receive cash payments in the form of dividends or the firm’s
management reinvests the earnings in the firm.

Stock Valuation
A fundamental assertion of finance holds that a security’s value is based on the present value of
its future cash flows. Common stock’s value is equal to the present value of all future cash flows
that stockholders expect to receive from owning the shares of stock.

– One measure of cash flows to shareholders is dividends

– Other measures exist which lead to other models

Constant Dividend Growth Rate Model

If the firm’s cash dividend is constant, then the common stock can be valued as follows:

D
P 0=
r

P0= Value of a share of common stock at year 0

D = Constant cash dividend
r = the common stockholder’s required rate of return

Practice Problem 1

A stock recently paid a dividend equal to $2.5. The dividend is expected to remain the same.
What would be the price of the stock if the required rate of return is 7.5%?

1
Constant Dividend Growth Rate Model
If the firm’s cash dividend grows by a constant rate each year, then the common stock can be
valued as follows:

Dn +1
P n=
r −g

Where;

Pn= Value of a share of common stock at year n

Dn +1= Expected cash dividend at year n + 1
g = Annual dividend growth rate
r = the common stockholder’s required rate of return

Dn +1 can be calculated using the following equation:

n+1
Dn +1=D0 (1+ g)

Where;

D0 = Cash dividend at year 0

Practice Problem 2

A stock recently paid a dividend equal to $2.5. The dividend is expected to grow annually by 3%.
If the required rate of return is 8.5%, what is the price of the stock today? What would the price
of the stock be after 12 years?