CHAPTER 8

Stocks and Their Valuation

Features of common stock

Determining common stock
values
Efficient markets
Preferred stock
8-1

Facts about common stock

Represents ownership
Ownership implies control
Stockholders elect directors
Directors elect management
Managements goal: Maximize the
stock price
8-2

Types of stock market

transactions

Secondary market
Primary market
Initial public offering market
(going public)

8-3

Different approaches for

valuing common stock

Dividend growth model

Corporate value model
Using the multiples of
comparable firms

8-4

Terms used in stock

valuation
Dt = Dividend expected to receive
at the end of year t.
Po = Actual market price of the stock
today
^

P t = Expected price of the stock at

the end of year t
^

P 0 =Intrinsic or theoretical value

8-5

Terms used in stock

valuation

g= Expected growth rate in dividends.

Ks= Required rate of return
^ = Expected rate of return
Ks

= Actual or realized rate of return

Ks
D1/P0 =Dividend Yield during the coming year
(P1-P0)/P0 = Capital Gain Yield.
8-6

Dividend growth model

Value of a stock is the present value of
the future dividends expected to be
generated by the stock.

P0

D1

(1 k s )1

D2

(1 k s ) 2

D3

(1 k s ) 3

...

(1 k s )

8-7

Constant growth stock

A stock whose dividends are expected

to grow forever at a constant rate, g.
D1 = D0 (1+g)1
D2 = D0 (1+g)2
Dt = D0 (1+g)t

If g is constant, the dividend growth

formula converges to:
D0 (1 g)
D1
P0

ks - g
ks - g
^

8-8

What happens if g > ks?

If g > ks, the constant growth

formula leads to a negative stock
price, which does not make sense.
The constant growth model can
only be used if:

ks > g

g is expected to be constant forever

8-9

If kRF = 7%, kM = 12%, and = 1.2,

what is the required rate of return
on the firms stock?
Use the CAPM to calculate the
required rate of return (ks):
ks = kRF + (kM kRF)
= 7% + (12% - 7%)1.2
= 13%
8-10

If D0 = $2 and g is a constant 6%,

find the expected dividend
stream for the next 3 years, and
their PVs.
0

g = 6%

D0 = 2.00
1.8761
1.7599

2.12

2.247

3
2.382

ks = 13%

1.6509
8-11

What is the stocks market

value?

Using the constant growth model:

D1
$2.12
P0

ks - g 0.13- 0.06
$2.12

0.07
$30.29

8-12

What is the expected market

price of the stock, one year
from now?

D1 will have been paid out already.

So, P1 is the present value (as of
year 1) of D2, D3, D4, etc.
^
D2
$2.247
P1

ks - g 0.13- 0.06
$32.10

Could also find expected P1 as:

^

P1 P0 (1.06) $32.10
8-13

What is the expected dividend

yield, capital gains yield, and total
return during the first year?

Dividend yield
= D1 / P0 = $2.12 / $30.29 = 7.0%

Capital gains yield

= (P1 P0) / P0
= ($32.10 - $30.29) / $30.29 = 6.0%

Total return (ks)

= Dividend Yield + Capital Gains Yield
= 7.0% + 6.0% = 13.0%
8-14

What would the expected

price today be, if g = 0?

The dividend stream would be a

perpetuity.
ks = 13%

...
2.00

2.00

2.00

PMT $2.00
P0

$15.38
k
0.13
^

8-15

Self testing:1

Cook company is expected to pay a

$0.50 per share dividend at the end of
the year. The dividend is expected to
grow at a constant rate of 7% per
year. The required rate of return on
the stock,Ks, is 15%. What is the
value per share of the companys
stock?
8-16

Self testing:2

Dozier Corporations share currently

sell for $20 per share. The stock just
paid a dividend of $1 per share. The
dividend is expected to grow at a
constant rate of 10% a year. What
stock price is expected 1 year from
now? What is the required rate of
return on the companys stock?
8-17

Supernormal/Nonconstant growth:
What if D0 = $2 & g = 30% for 3
years before achieving long-run
growth
6%? use just the constant
Can noof
longer

growth model to find stock value.

However, the growth does become
constant after 3 years.

8-18

Valuing common stock with

nonconstant growth
0 k = 13% 1
s
g = 30%

D0 = 2.00

2
g = 30%

2.600

3
g = 30%

3.380

...

g = 6%

4.394

4.658

2.301
2.647
3.045
46.114
54.107

= P0

P 3

4.658
0.13 0.06

$66.54
8-19

Find expected dividend and capital

gains yields during the first and
fourth years.

Dividend yield (first year)

= $2.60 / $54.11 = 4.81%

Capital gains yield (first year)

= 13.00% - 4.81% = 8.19%

During nonconstant growth, dividend

yield and capital gains yield are not
constant, and capital gains yield g.
After t = 3, the stock has constant
growth and dividend yield = 7%, while
capital gains yield = 6%.

8-20

Nonconstant growth:
What if g = 0% for 3 years before
long-run growth of 6%?
0 k = 13% 1
s
g = 0%

D0 = 2.00

2
g = 0%

2.00

3
g = 0%

2.00

...

g = 6%

2.00

2.12

1.77
1.57
1.39
20.99
25.72

= P0

P 3

2.12
0.13 0.06

$30.29
8-21

Find expected dividend and capital

gains yields during the first and
fourth years.

Dividend yield (first year)

= $2.00 / $25.72 = 7.78%

Capital gains yield (first year)

= 13.00% - 7.78% = 5.22%

After t = 3, the stock has

constant growth and dividend
yield = 7%, while capital gains
yield = 6%.
8-22

If the stock was expected to have

negative growth (g = -6%), would
anyone buy the stock, and what is its
value?

The firm still has earnings and pays

dividends, even though they may be
declining, they still have value.

D0 ( 1 g )
D1
P0

ks - g
ks - g
^

$2.00(0.94) $1.88

$9.89
0.13- (-0.06) 0.19
8-23

Find expected annual dividend

and capital gains yields.

Capital gains yield

= g = -6.00%

Dividend yield
D1 / P0 = $1.88/$9.89 = 19.00%

Since the stock is experiencing

constant growth, dividend yield and
capital gains yield are constant.
Dividend yield is sufficiently large
(19%) to offset a negative capital gains.
8-24

Corporate value model

Also called the free cash flow

method. Suggests the value of the
entire firm equals the present
value of the firms free cash flows.
Free cash flow is the firms after-tax
operating income less the net
capital investment

FCF = NOPAT Net capital investment

8-25

Issues regarding the

corporate value model

Often preferred to the dividend growth

model, especially when considering number
of firms that dont pay dividends or when
dividends are hard to forecast.
Similar to dividend growth model, assumes
at some point free cash flow will grow at a
constant rate.
Terminal value (TVn) represents value of firm
at the point that growth becomes constant.
8-26

Given the long-run gFCF = 6%, and

WACC of 10%, use the corporate
value model to find the firms
intrinsic value.
0 k = 10%

1
-5

-4.545
8.264
15.026
398.197
416.942

2
10

20

g = 6%

...

21.20

21.20

530 =

0.10

0.06

= TV 3
8-27

What is market
equilibrium?

In equilibrium, stock prices are stable

and there is no general tendency for
people to buy versus to sell.
In equilibrium, expected returns must
equal required returns.

D1
ks
g
P0
^

ks kRF (kM kRF )

8-28

Market equilibrium

Expected returns are obtained by

estimating dividends and expected
capital gains.
Required returns are obtained by
estimating risk and applying the
CAPM.

8-29

What is the Efficient Market

Hypothesis (EMH)?

Securities are normally in

equilibrium and are fairly priced.
Investors cannot beat the market
except through good luck or better
information.
Levels of market efficiency

Weak-form efficiency
Semistrong-form efficiency
Strong-form efficiency
8-30

Weak-form efficiency

The weak form of the EMH states

that all information contained in
past price movements is fully
reflected in current market prices.

8-31

Semistrong-form efficiency

The semistrong-form of the EMH

states that current market prices
reflect all publicly available
information.

8-32

Strong-form efficiency

The strong form of the EMH states

that current market prices reflect
all related information, whether
publicly available or privately
held.

8-33

Preferred stock

Hybrid security
Like bonds, preferred stockholders
receive a fixed dividend that must
be paid before dividends are paid to
common stockholders.
However, companies can omit
preferred dividend payments
without fear of pushing the firm into
bankruptcy.
8-34

If a preferred stock with an annual

dividend of $5 sells for $50, what is
the preferred stocks expected
return?
Vp = D / kp
$50= $5 / kp
kp = $5 / $50
= 0.10 = 10%

8-35