Financial Management:: Stock Valuation

Financial Management:
Principles & Applications

Thirteenth Edition, Global Edition
Chapter 10
Stock Valuation
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Ltd. All Reserved
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Learning Objectives
1. Identify the basic characteristics and features of
common stock and use the discounted cash flow
model to value common shares.
2. Use the price/earnings (P/E) ratio to value
common stock.
3. Identify the basic characteristics and features of
preferred stock and value preferred shares.
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

Principles Applied in This Chapter
• Principle 1: Money Has a Time Value.
• Principle 2: There is a Risk-Reward Tradeoff.
• Principle 3: Cash Flows are the Source of Value.
• Principle 4: Market Prices Reflect Information.
• Principle 5: Individuals Respond to Incentives.

10.1 COMMON STOCK

Common Stock
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. The firm’s
management team then carries out the day-to-day
management of the firm.

Characteristics of Common Stock
Common stock does not have a maturity date but
exists as long as the firm does. Nor does common
stock have an upper or lower limit on its dividend
payments. In the event of bankruptcy, the common
stockholders – as owners of corporation – have the
most junior claim.

Claim on Income
• Common stockholders have the right to the firm’s
income that remains after bondholders and
preferred stockholders have been paid. The
common stockholders will either receive cash
payments in the form of dividends or, any increase
in value that results from the reinvested earnings.
• The right to residual income means the potential
return is unlimited. However, it also means that
there may be little or nothing left after paying the
bondholders and preferred shareholders.
Claim on Assets
Just as common stock has residual claim on
income, it also has a residual claim on assets in
case of liquidation. Unfortunately, when bankruptcy
does occur, the claims of the common stockholders
generally go unsatisfied. This residual claim on
assets adds to the risk of common stock.

Voting Rights
• The common stockholders elect the board of directors
and are in general the only security holders given a
vote. Common stockholders also must approve any
changes in the corporate charter. A typical charter
change might involve the authorization to issue new
stock or perhaps engage in a merger.
• Vote for directors and charter changes occurs at the
corporation’s annual meeting. Some shareholders
vote in person, but the majority generally vote by
proxy.

Agency Costs and Common Stock
• In theory, common stockholders elect the board of
directors and the board of directors pick the
management team. In reality, board members are
nominated by the management. As a result,
management effectively elects the board. This
may lead to agency problems.

Valuing Common Stock Using the
Discounted Dividend Model
As with bonds, a common stock’s value is equal to
the present value of all future cash flows that the
stockholder expects to receive from owning the
share of stock. However, unlike bonds, the common
stock does not offer its owners a promised interest
payment, maturity payment, or dividend.

Three Step Procedure for Valuing
Common Stock (1 of 2)
Step 1: Estimate the amount and timing of the
receipt of the future cash flows the common stock is
expected to provide.
Step 2: Evaluate the riskiness of the common
stock’s future dividends to determine the stock’s
required rate of return.

Three Step Procedure for Valuing
Common Stock (2 of 2)
Step 3: Calculate the present value of the expected
dividends by discounting them back to the present
at the stock’s required rate of return.
The three steps show that the value of a common
stock is equal to the present value of all future
dividends.

The Constant Dividend Growth Rate
Model
If a firm’s cash dividend grow by a constant rate,
then the common stock can be valued as follows:
 Dividend 
Dividend in Year 0  1+ 
 Growth Rate  Dividend in Year 1
Vcs = =
Stockholder's Required Dividend Stockholder's Required Dividend
 
Rate of Return Growth Rate Rate of Return Growth Rate

CHECKPOINT 10.1: CHECK YOURSELF
Valuing Common Stock

The Problem
What is the value of a share of common stock that
paid $6 dividend at the end of last year and is
expected to pay a cash dividend every year from
now to infinity, with that dividend growing at a rate
of 5 percent per year, if the investor’s required rate
of return is 12 percent on that stock?

Step 1: Picture the Problem
With a perpetuity, a timeline goes on for ever with the
growing cash flow occurring every period.
i = 12%
Years 0 1 2… Blank
…
Cash flow $6 $6(1.05) $6(1.05)2 Blank Blank
Value of common
stock = Present
Value of Expected
Dividends. The growing
dividends go on
forever

Step 2: Decide on a Solution Strategy
• The value of a share of stock can be viewed as a
the present value of a growing perpetuity.
• Here we know the expected dividends, the growth
rate, and investor’s required rate of return.
• We can use equation 10-2 to determine the value
of a share of common stock.

Step 3: Solve (1 of 2)
• We need to first determine D1, the dividend next
period.
• Since dividends at the end of last year was $6 and
dividends are expected to grow at a rate of 5%,
dividends for next period will be:
• D1 = D0 (1+g) = $6 (1.05) = $6.30

Step 3: Solve (2 of 2)
Expected Rate Risk-Free Rate Common Stock  Expected Rate of Return Risk-Free Rate 
    
of Return of Interest Beta Coefficient  on the Market Portfolio of Interest 
• Vcs = $6.30 ÷ (0.12−0.05)

= $6.30 ÷ 0.07
= $90

Step 4: Analyze
Equation 10-2 is based on the assumption that
dividends will grow at a constant rate for ever. While
not a realistic assumption, it enables us to
determine the value of common stock easily and
also helps us to identify the factors that move the
stock prices.

What Causes Stock Prices to Go Up and
Down? (1 of 2)
Equation 10-2 indicates that there are three
variables that drive share value:
– The most recent dividend (D0),
– Investor’s required rate of return (rcs ), and
– Expected rate of growth in future dividends (g).

What Causes Stock Prices to Go Up and
Down? (2 of 2)
Since most recent dividend (D0) has already been
paid, it cannot affect price. Thus the other two
variables, rcs and g, can vary and lead to changes in
stock prices.

Determinants of the Investor’s Required
Rate of Return (1 of 3)
The investor’s required rate of return is determined
by two key factors:
1.The level of interest rates in the economy;
2.The risk of the firm’s stock.

Determinants of the Investor’s Required
Rate of Return (2 of 3)
CAPM suggests that if risk-free rate and/or
systematic risk (beta) rises, the investor’s required
rate of return will rise and the stock price will fall.
Expected Rate Risk-Free Rate Common Stock  Expected Rate of Return Risk-Free Rate 
    
of Return of Interest Beta Coefficient  on the Market Portfolio of Interest 

Determinants of the Growth Rate of Future
Dividends (3 of 3)
The growth rate of future dividends (g) can also
change and lead to a change in the stock price. The
two key determinants of a firm’s growth
opportunities relate to:
– the return on equity (ROE), and
– the retention ratio (b)

Figure 10.3 (1 of 2)
A Quick Reference Guide for the Growth Rate in

Earnings and Dividends
The rate of growth a firm can expect in its future
dividends is a function of how much of the firm’s
earnings are reinvested in the firm (i.e., the
dividend retention ratio, b), and the rate of return
the firm is expected to earn on the reinvested
earnings (ROE).
g  (1  D1 /E1 )  ROE

Figure 10.3 (2 of 2)
Important Definitions and Concepts:

• g = the expected annual rate of growth in dividends.
• D1/E1 = the dividend payout ratio, reflecting the ratio of
cash dividends to be paid next period divided by the firm’s
earnings.
• b = (1 − D1/E1), which is the proportion of firm earnings or
net income that is retained and reinvested in the firm.
• ROE = the return on equity earned when the firm reinvests
a portion of its earnings back into the firm.
• Equation (10–3) requires that the retention ratio, b, and
ROE remain constant for all future periods.
10.2 THE COMPARABLES APPROACH
TO VALUING COMMON STOCK

The Comparables Approach to Valuing
Common Stock
This method estimates the value of the firm’s stock
as a multiple of some measure of firm’s
performance. The most common performance is
metric is earnings per share, which means that the
values are determined from the price/earnings ratio,
or the earnings multiplier, of comparable firms.

Defining the P/E Ratio Valuation Model
Value of
 Appropriate   Estimated Earnings  P
Common Stock,      E1
 Price/Earnings Ratio   per Share for Year 1 E1
Vcs
• Vcs = the value of common stock of the firm.

• P/E1 = the price earnings ratio for the firm based
on the current price per share divided by earnings
for end of year 1.
• E1 = estimated earnings per share of common
stock for the end of year 1.
Valuing Common Stock
Using the P/E Ratio

The Problem
After some careful analysis and reflection on the
valuation of the Heals’ shares the company CFO
suggested that the earnings projection are too
conservative and earnings for the coming year
could easily jump to $2.00. What does this do for
your estimate of the value of Heals’ shares?

EPS P/E Stock Price

= $2.00 Multiple

• The common stock value can be computed by
multiplying the firm’s estimated earnings per share
for the coming year by what the analyst estimates
to be an appropriate P/E ratio.
• We can use equation 10-4 to estimate the value of
common stock.

Step 3: Solve
Value of
 Appropriate   Estimated Earnings  P
Common Stock,      E1
 Price/Earnings Ratio   per Share for Year 1 E1
V cs
Vcs  18.20  $2
 $36.40

Step 4: Analyze
• We estimated the value of Heales’ shares based
on the P/E ratios of three comparable firms.
However, this estimate is contingent on the
appropriateness of the comparable set of
companies to the Heals Shoe Company.
• Furthermore, if the market conditions change by
the time the shares are sold in the market, the
price estimate will not be appropriate.

What Determines the P/E Ratio for a
Stock? (1 of 2)
Using Equation 10-5a and 10-5b, there are two
fundamental determinants of a firm’s P/E ratio:
1. Growth Rate in Dividends (higher the growth rate, the
higher the P/E ratio), and
2. Investor-Required Rates of Return (higher the
required rate, the lower the P/E ratio)

What Determines the P/E Ratio for a
Stock? (2 of 2)
What causes the growth rate in dividends (and earnings) and
the investor’s required rate of return to go up and down?
These are the real determinants of the P/E ratio:
• Firm factors impacting the investor’s required rate of return
• Economic or macro factors impacting the investor’s
required rate of return
• Firm factors impacting the growth rate. The growth rate in
dividends is determined by two variables – dividend policy
and the profitability of the firm’s investment opportunities.

10.3 PREFERRED STOCK

Features of Preferred Stock (1 of 3)
• Dividend: In general, size of preferred stock
dividend is fixed, and it is either stated as a dollar
amount or as a percentage of the preferred
stock’s par value.
• Multiple Classes: A company can issue more
than one class of preferred stock, and each class
can have different characteristics.

• Claims on Assets and Income: The claims of preferred
stockholders have priority over those of common
stockholders for payment of dividends and in settlement of
claims at bankruptcy. However, the claims of preferred
stockholders have lower priority than those of the firm’s
debt holders. Most preferred stock carry a cumulative
feature i.e. all past unpaid dividends must be paid before
any common stock dividends can be declared. Thus, in
terms of risk, preferred stock is safer than common stock
but riskier than the firm’s debt.

Preferred Stock as a Hybrid Security:
– Like common stocks, preferred stocks has no fixed
maturity date. Also, like common stocks, nonpayment
of dividends does not bring on bankruptcy, and
dividends are not deductible for tax purposes.
– Like debt, preferred stocks have a fixed dividend
amount. Also, most preferred stocks are periodically
retired even though there is no stated maturity date.

Valuing Preferred Stock (1 of 2)
Because preferred stocks are perpetuities
(nonmaturing), and because the cash dividend is
the same every period, the dividend stream is a
level perpetuity and can be valued using the
present value of perpetuity equation introduced in
chapter 6.

Valuing Preferred Stock (2 of 2)
Value of Annual Preferred Stock Dividend

Preferred Stock Market's Required Yield on Preferred Stock
•Vps = the value of a share of preferred stock

•Dps = the annual preferred stock dividend
• rps = the market yield or the rate of return on the
preferred stock’s promised dividend

Estimating the Market’s Required Yield
Estimating the Market Yield: We can use equation
10-6 to solve for the market’s required yield.
rps = Dps ÷Vps

Dealing with Reality: Promised versus
Expected Returns for Preferred Stock (1 of 2)
Preferred stock dividends are promised dividends
that are paid only if the firm earns sufficient income
to pay them. For valuing the preferred stock, we
simply discount the promised dividends back to the
present using the market’s required yield or
promised rate of return for similar shares of
preferred stock in the financial market place.

Dealing with Reality: Promised versus
Expected Returns for Preferred Stock (2 of 2)
Estimating the Market’s Required Yield. The
market’s required yield on a share of preferred
stock is typically estimated using the market prices
of similar shares of preferred stock that can be
observed in the financial market.

A Quick Review: Valuing Bonds, Preferred
Stock and Common Stock
• There are subtle but important difference between
how bonds and preferred stock are valued and
how common stock is valued using the discounted
cash flow method.
• Table 10-2 summarizes the application of
discounted cash flow in valuing all three types of
securities.

Table 10.2 Summary of Discounted Cash Flow Valuation of
Bonds, Preferred Stock, and Common Stock (1 of 3)
Type of Cash Flow Discount Rate Valuation Model

Security
Bond Promised interest Market’s required yield to The value of a bond is equal to the present
and principal maturity. Typically, the YTM value of the future interest and the
payments. These on a similar bond is used to repayment of the bond’s principal at maturity.
payments are set value a bond. This YTM is
forth in the contract the realized rate of return to
between the bond- the bondholder only if all
issuing company promised payments are
and the owner of made on time. Consequently,
the bond. the yield to maturity
calculated for a bond is a
promised yield and not the
expected yield.


Security
Preferred Promised Market or promised The value of a share of preferred stock is equal
stock dividends. yield on preferred stock. to the present value of the future preferred
Dividends are We typically calculate stock dividends.
defined using a this yield using market
contractually set prices and promised
dividend yield that dividends for similar
is multiplied by the shares of preferred stock.
par or face value of This yield is a promised
the preferred stock yield that will be earned
to get the preferred only if the preferred stock
stock dividend. dividends are fully paid
every period as promised.


Security
Common Expected future dividends. Investor’s expected rate of return, Value of a share of
stock No dividend is prescribed for which is the investor’s required rate common stock is equal to
common stock. Instead, of return. Because common stock the present value of the
dividends must be estimated, dividends are risky, we use expected future dividends.
so we value common stock future dividends and discount them
using expected rather than using a risk-adjusted or expected rate
promised future cash flows. of return for investing in shares of
In the constant dividend stock of firms with similar risk to the
growth rate model, dividends firm issuing the common stock being
are estimated using a valued. We can estimate this expected
constant rate of growth from rate of return using the CAPM.
year to year.

Valuing Preferred Stock
What is the present value of a share of preferred stock that pays a dividend of $12 per
share if the market’s yield on similar issues of preferred stock is 8 percent?

Preferred stocks are constant for all years and form a level
perpetuity.
rps= 8%
Years 0 1 2 3… Blank
…
Dividends Blank $12 $12 $12 Blank $12
Value of Preferred
Stock = Present
Value of promised
dividends.
The annual
$12 dividends
go on forever.

Step 3: Solve
We can determine the present value of share of
preferred stock using equation 10-6.
Value of Annual Preferred Stock Dividend

Preferred Stock Market's Required Yield on Preferred Stock
Vps = $12 ÷ 0.08 = $150

Step 4: Analyze
Since preferred stock is a level perpetuity, its value
on any future date will be the same as its present
value today as long as the promised rate of return
on the share remains the same.

Key Terms
• Constant dividend growth rate model
• Cumulative preferred stock
• Cumulative voting
• Initial public offering (IPO)
• Majority voting
• Market’s required yield
• Price/earnings ratio
• Proxy

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Financial Management:

Principles & Applications

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• Vcs = $6.30 ÷ (0.12−0.05)

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A Quick Reference Guide for the Growth Rate in

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Important Definitions and Concepts:

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• Vcs = the value of common stock of the firm.

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EPS P/E Stock Price

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•Vps = the value of a share of preferred stock

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Type of Cash Flow Discount Rate Valuation Model

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Type of Cash Flow Discount Rate Valuation Model

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Type of Cash Flow Discount Rate Valuation Model

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Vps = $12 ÷ 0.08 = $150