CHAPTER 8

Stocks and Their Valuation

 Features of common stock

 Determining common stock values
 Preferred stock

8-1
Facts about common stock
 Represents ownership
 Ownership implies control
 Stockholders elect directors
 Directors elect management
 Management’s 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
 Computing the Price of Common Stock:
The One-Period Valuation Model

 Basic Principle of Finance

 Value of Investment = Present Value of
Future Cash Flows

 Just taking PV using the expected

dividend and price over the next year.


8-5
Computing the Price of Common Stock:
The One-Period Valuation Model

What is the price for a stock with an

expected dividend and price next year of
$0.16 and $60, respectively? Use a 12%
discount rate
Answer:

8-6
 Dividend growth model
 Value of a stock is the present value of the
future dividends expected to be generated by
the stock.

^ D1 D2 D3 D
P0  1
 2
 3
 ...  
(1  k s ) (1  k s ) (1  k s ) (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
 If D0 = $2 and g is a constant 6%,
find the expected dividend stream for
the next 3 years, and their PVs.

0 1 2 3
g = 6%

D0 = 2.00 2.12 2.247 2.382

1.8761
ks = 13%
1.7599
1.6509

8-9
What is the stock’s market value?
 Using the constant growth model:

D1 $2.12
P0  
k s - g 0.13 - 0.06
$2.12

0.07
 $30.29

8-10
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  
k s - g 0.13 - 0.06
 $32.10

 Could also find expected P1 as:

^
P1  P0 (1.06)  $32.10
8-11
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%
8-12
What would the expected price
today be, if g = 0?
 The dividend stream would be a
perpetuity.

0 1 2 3
ks = 13%
...
2.00 2.00 2.00
^ PMT $2.00
P0    $15.38
k 0.13

8-13
Supernormal growth:
What if g = 30% for 3 years before
achieving long-run growth of 6%?
 Can no longer use just the constant growth
model to find stock value.
 However, the growth does become
constant after 3 years.

8-14
 Valuing common stock with
nonconstant growth

0 k = 13% 1 2 3 4
s
...
g = 30% g = 30% g = 30% g = 6%
D0 = 2.00 2.600 3.380 4.394 4.658
2.301
2.647
3.045
4.658
46.114 P3   $66.54
^ 0.13  0.06
54.107 = P0
8-15
 Nonconstant growth:
What if g = 0% for 3 years before long-
run growth of 6%?

0 k = 13% 1 2 3 4
s
...
g = 0% g = 0% g = 0% g = 6%
D0 = 2.00 2.00 2.00 2.00 2.12
1.77
1.57
1.39
2.12
20.99 P3   $30.29
^ 0.13  0.06
25.72 = P0
8-16
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.

^ D1 D0 ( 1  g )
P0  
ks - g ks - g
$2.00 (0.94) $1.88
   $9.89
0.13 - (-0.06) 0.19

8-17
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.

8-18
If preferred stock with an annual
dividend of $5 sells for $50, what is the
preferred stock’s expected return?

Vp = D / kp
$50 = $5 / kp

kp = $5 / $50
= 0.10 = 10%

8-19
8-20