Shares

Chapter 7
Stock
Valuation
Chapter Outline
7.1 Stock Basics

7.2 The Mechanics of Stock Trades
7.3 The Dividend-Discount Model
7.4 Estimating Dividends in the Dividend-Discount
Model
7.5 Limitations of the Dividend-Discount Model
7.6 Share Repurchases and the Total Payout Model
7.7 Putting It All Together
Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-2

Learning Objectives
• Describe the basics of common stock, preferred
stock, and stock quotes
• Compare how trades are executed on the NYSE and
NASDAQ
• Value a stock as the present value of its expected
future dividends
• Understand the tradeoff between dividends and
growth in stock valuation
• Appreciate the limitations of valuing a stock based
on expected dividends
• Value a stock as the present value of the company’s
total payout

7.1 Stock Basics
• Stock Market Reporting: Stock Quotes

– Common Stock
– Ticker Symbol

Figure 7.1
Stock Price
Quote for Nike
(NKE)

7.1 Stock Basics
• Common Stock
– Shareholder Voting
• Straight Voting
• Cumulative Voting
• Classes of Stock
– Shareholder Rights
• Annual Meeting
• Proxy
– Proxy Contest

7.1 Stock Basics
• Preferred Stock
– Cumulative versus Non-Cumulative Preferred
Stock
– Preferred Stock: Equity or Debt?

7.2 The Mechanics of Stock Trades
• Market Order
• Limit Order
• Round Lot
• Super Display Book System
• Floor Broker
• Dealer

• A One Year Investor

– Two potential sources of cash flows from owning
a stock:
• Dividends
• Selling Shares

• A One Year Investor

– Since the cash flows are not risk-less, they must
be discounted at the equity cost of capital
(Eq. 7.1)

• Dividend Yields, Capital Gains, and Total

Returns
– Dividend Yield
– Capital Gain
• Capital Gains Rate
– Total Return
(Eq. 7.2)

• Dividend Yields, Capital Gains, and Total

Returns
– The expected total return of the stock should
equal the expected return of other investments
available in the market with equivalent risk

Example 7.1 Stock Prices and
Returns
Problem:
• Suppose you expect Longs Drug Stores to pay an annual
dividend of $0.56 per share in the coming year and to trade
$45.50 per share at the end of the year. If investments with
equivalent risk to Longs’ stock have an expected return of
6.80%, what is the most you would pay today for Longs’
stock? What dividend yield and capital gain rate would you
expect at this price?

Returns
Solution:
Plan:
• We can use Eq. 7.1 to solve for the beginning price we would
pay now (P0) given our expectations about dividends
(Div1=$0.56) and future price (P1=$45.50) and the return we
need to expect to earn to be willing to invest (rE=0.068).
• We can then use Eq. 7.2 to calculate the dividend yield and
capital gain rate
Div1  P1
P0  (Eq. 7.1)
1  rE
Returns
Execute:
Div1  P1 $0.56  $45.50
P0    $43.13
1  rE 1.0680
• Referring to Eq. 7.2 we see that at this price, Longs’ dividend
yield is Div1/P0 = 0.56/43.13 = 1.30%. The expected capital
gain is $45.50 - $43.13 = $2.37 per share, for a capital gain
rate of 2.37/43.13 = 5.50%.

Returns
Evaluate:
• At a price of $43.13, Longs’ expected total return is 1.30% +
5.50% = 6.80%, which is equal to its equity cost of capital
(the return being paid by investments with equivalent risk to
Longs’). This amount is the most we would be willing to pay
for Longs’ stock. If we paid more, our expected return would
be less than 6.8% and we would rather invest elsewhere.

Example 7.1a Stock Prices and
Returns
Problem:
• Suppose you expect Koch Industries to pay an annual
equivalent risk to Koch’s stock have an expected return of
8.9%, what is the most you would pay today for Koch’s stock?
What dividend yield and capital gain rate would you expect at
this price?

Returns
Solution:
Plan:
need to expect to earn to be willing to invest (rE=0.089).
capital gain.
Div1  P1
P0  (Eq. 7.1)
1  rE
Returns
Execute:
Div1  P1 $2.31  $82.75
P0    $78.11
1  rE 1.089
• Referring to Eq. 7.2 we see that at this price, Koch’s dividend
yield is Div1/P0 = 2.31/78.11 = 2.96%. The expected capital
gain is $82.75 - $78.11 = $4.64 per share, for a capital gain
rate of 4.64/78.11 = 5.94%.

Returns
Evaluate:
• At a price of $78.11, Koch’s expected total return is 2.96% +
5.94% = 8.90%, which is equal to its equity cost of capital
Koch’s). This amount is the most we would be willing to pay
for Koch’s stock. If we paid more, our expected return would
be less than 8.9% and we would rather invest elsewhere.

Example 7.1b Stock Prices and
Returns
Problem:
• Suppose you expect Harford Industries to pay an annual
equivalent risk to Harford’s stock have an expected return of
12.5%, what is the most you would pay today for Harford’s
stock? What dividend yield and capital gain rate would you
expect at this price?

Returns
Solution:
Plan:
need to expect to earn to be willing to invest (rE=12.5%).
capital gain.
Div1  P1
P0  (Eq. 7.1)
1  rE
Returns
Execute:
Div1  P1 $5.35  $63.32

P0    $61.04
1  rE 1.125
• Referring to Eq. 7.2 we see that at this price, Harford’s
dividend yield is Div1/P0 = 5.35/61.04 = 8.76%. The
expected capital gain is $63.32 - $61.04 = $2.28 per share,
for a capital gain rate of 2.28/61.04 = 3.74%.

Returns
Evaluate:
• At a price of $61.04 Harford’s expected total return is 8.76%
+ 3.74% = 12.50%, which is equal to its equity cost of capital
Harford’s). This amount is the most we would be willing to
pay for Harford’s stock. If we paid more, our expected return
would be less than 12.50% and we would rather invest
elsewhere.

• A Multiyear Investor
– Suppose we planned to hold the stock for two
years
• Then we would receive dividends in both year 1 and
year 2 before selling the stock, as shown in the
following timeline:

• A Multiyear Investor
– The formula for the stock price for a two-year
investor is the same as that for a sequence of
two one-year investments
Div1 Div2  P2
P0   (Eq. 7.3)
1  rE  1  rE 
2

• Dividend-Discount Model Equation
Div1 Div2 DivN PN

P0     N (Eq. 7.4)
1  rE  1  rE  2
 1  rE   1  rE 
N
– The price of the stock is equal to the present

value of all of the expected future dividends it
will pay, along with the cash flow from the sale in
year N

• Dividend-Discount Model Equation

– Alternatively, rather than having a stopping point
where we sell the shares, we can rewrite the
equation to show that the dividends go on into
the future
Div1 Div2 Div3

P0     (Eq. 7.5)
1  rE  1  rE  2
 1  rE 
3

7.4 Estimating Dividends in the
Dividend-Discount Model
• Constant Dividend Growth

– Assumes that dividends will grow at a constant
rate, g, forever
– The value of the firm depends on the dividend
level of next year, divided by the equity cost of
capital adjusted by the growth rate
Div1
P0  (Eq. 7.6)
rE  g

Example 7.2 Valuing a Firm with
Constant Dividend Growth
Problem:
• Consolidated Edison, Inc. (Con Edison), is a regulated utility
company that services the New York City area. Suppose Con
Edison plans to pay $2.30 per share in dividends in the
coming year. If its equity cost of capital is 7% and dividends
are expected to grow by 2% per year in the future, estimate
the value of Con Edison’s stock.

Solution:
Plan:
• Because the dividends are expected to grow perpetually at a
constant rate, we can use Eq. 7.6 to value Con Edison. The
next dividend (Div1) is expected to be $2.30, the growth rate
(g) is 2% and the equity cost of capital (rE) is 7%.

Execute:
Div1 $2.30
P0    $46.00
rE  g 0.07  0.02

Evaluate:
• You would be willing to pay 20 times this year’s dividend of
$2.30 to own Con Edison stock because you are buying claim
to this year’s dividend and to an infinite growing series of
future dividends.

Example 7.2a Valuing a Firm with
Problem:
• Suppose Target Corporation plans to pay $0.68 per share in
dividends in the coming year. If its equity cost of capital is
10% and dividends are expected to grow by 8.4% per year in
the future, estimate the value of Target’s stock.

Solution:
Plan:
constant rate, we can use Eq. 7.6 to value Target. The next
dividend (Div1) is expected to be $0.68, the growth rate (g) is
8.4% and the equity cost of capital (rE) is 10%.

Execute:
Div1 $0.68
P0    $42.50
rE  g .10  .084

Evaluate:
• You would be willing to pay 62.5 times this year’s dividend of
$0.68 to own Target stock because you are buying claim to
this year’s dividend and to an infinite growing series of future
dividends.

Example 7.2b Valuing a Firm with
Problem:
• Suppose The Walt Disney Company plans to pay $0.38 per
share in dividends in the coming year. If its equity cost of
capital is 10.6% and dividends are expected to grow by 9.5%
per year in the future, estimate the value of Disney’s stock.

Solution:
Plan:
constant rate, we can use Eq. 7.6 to value Disney. The next
dividend (Div1) is expected to be $0.38, the growth rate (g) is
9.5% and the equity cost of capital (rE) is 10.6%.

Execute:
Div1 $0.38
P0    $34.55
rE  g .106  .095

Evaluate:
• You would be willing to pay 90.9 times this year’s dividend of
$0.38 to own Disney stock because you are buying claim to
this year’s dividend and to an infinite growing series of future
dividends.

• Dividends Versus Investment and Growth

– A Simple Model of Growth
• The dividend each year is equal to the firm’s earnings
per share (EPS) multiplied by its dividend payout rate
(Eq. 7.8)


• The firm can increase its dividend in three ways:
1. It can increase its earnings
2. It can increase its dividend payout rate
3. It can decrease its number of shares outstanding


• If all increases in future earnings result exclusively from
new investment made with retained earnings, then:
Change in Earnings = New Investment  Return on New Investment (Eq. 7.9)


• New investment equals the firm’s earnings multiplied by
its retention rate, or the fraction of current earnings
that the firm retains:
New Investment  Earnings  Retention Rate (Eq. 7.10)


• Substituting Eq. 7.10 into Eq. 7.9 and dividing by
earnings gives an expression for the growth rate of
earnings:
Change in Earnings
Earnings Growth Rate =
Earnings
 Retention Rate  Return on New Investment
(Eq. 7.11)


• If the firm chooses to keep its dividend payout rate
constant, then the growth in its dividends will equal the
growth in its earnings:
g  Retention Rate  Return on New Investment (Eq. 7.12)

Example 7.3 Cutting Dividends for
Profitable Growth
Problem:
• Crane Sporting Goods expects to have earnings per share of
$6 in the coming year. Rather than reinvest these earnings
and grow, the firm plans to pay out all of its earnings as a
dividend. With these expectations of no growth, Crane’s
current share price is $60.

Profitable Growth
Problem:
• Suppose Crane could cut its dividend payout rate to 75% for
the foreseeable future and use the retained earnings to open
new stores. The return on investment in these stores is
expected to be 12%. If we assume that the risk of these new
investments is the same as the risk of its existing
investments, then the firm’s equity cost of capital is
unchanged. What effect would this new policy have on
Crane’s stock price?

Profitable Growth
Solution:
Plan:
• To figure out the effect of this policy on Crane’s stock price,
we need to know several things. First, we need to compute
its equity cost of capital. Next we must determine Crane’s
dividend and growth rate under the new policy.
• Because we know that Crane currently has a growth rate of 0
(g = 0), a dividend of $6 and a price of $60, we can use Eq.
7.7 to estimate rE.

Profitable Growth
Plan:
• Next, the new dividend will simply be 75% of the old dividend
of $6. Finally, given a retention rate of 25% and a return on
new investment of 12%, we can use Eq. 7.12 to compute the
new growth rate (g). Finally, armed with the new dividend,
Crane’s equity cost of capital, and its new growth rate, we can
use Eq. 7.6 to compute the price of Crane’s shares if it
institutes the new policy.

Profitable Growth
Execute:
• Using Eq. 7.7 to estimate rE we have
Div1
$6
rE  g  0%  0.10  0  10%
P0 $60
• In other words, to justify Crane’s stock price under its current
policy, the expected return of other stocks in the market with
equivalent risk must be 10%.

Profitable Growth
Execute:
• Next, we consider the consequences of the new policy. If
Crane reduces its dividend payout rate to 75%, then from Eq.
7.8 its dividend this coming year will fall to Div1 = EPS1 x
75% = $6 x 75% = $4.50.
• At the same time, because the firm will now retain 25% of its
earnings to invest in new stores, from Eq. 7.12 its growth rate
will increase to:
g  Retention Rate  Return on New Investment  25%  12%  3%

Profitable Growth
Execute:
• Assuming Crane can continue to grow at this rate, we can
compute its share price under the new policy using the
constant dividend growth model of Eq. 7.6
Div1 $4.50
P0    $64.29
rE  g 0.10  0.03

Profitable Growth
Evaluate:
• Crane’s share price should rise from $60 to $64.29 if the
company cuts its dividend in order to increase its investment
and growth, implying that the investment has positive NPV.
By using its earnings to invest in projects that offer a rate of
return (12%) greater than its equity cost of capital (10%),
Crane has created value for its shareholders.

Example 7.3a Cutting Dividends for
Profitable Growth
Problem:
• Pittsburgh & West Virginia Railroad (PW) expects to have
earnings per share of $0.48 in the coming year. Rather than
reinvest these earnings and grow, the firm plans to pay out all
of its earnings as a dividend. With these expectations of no
growth, PW’s current share price is $10.

Profitable Growth
Problem:
• Suppose PW could cut its dividend payout rate to 67% for the
foreseeable future and use the retained earnings to expand.
The return on investment in the expansion is expected to be
11%. If we assume that the risk of these new investments is
the same as the risk of its existing investments, then the
firm’s equity cost of capital is unchanged. What effect would
this new policy have on PW’s stock price?

Profitable Growth
Solution:
Plan:
• To figure out the effect of this policy on PW’s stock price, we
need to know several things. First, we need to compute its
equity cost of capital. Next we must determine PW’s dividend
and growth rate under the new policy.
• Because we know that PW currently has a growth rate of 0 (g
= 0), a dividend of $0.48 and a price of $10, we can use Eq.
7.7 to estimate rE.

Profitable Growth
Plan:
of $0.48. Finally, given a retention rate of 33% and a return
on new investment of 11%, we can use Eq. 7.12 to compute
the new growth rate (g). Finally, armed with the new
dividend, PW’s equity cost of capital, and its new growth rate,
we can use Eq. 7.6 to compute the price of PW’s shares if it
institutes the new policy.

Profitable Growth
Execute:
Div1 $0.48
rE  g  0  4.8%  0%  4.8%
P0 $10
• In other words, to justify PW’s stock price under its current
policy, the expected return of other stocks in the market with
equivalent risk must be 4.8%.

Profitable Growth
Execute:
• Next, we consider the consequences of the new policy. If PW
reduces its dividend payout rate to 67%, then from Eq. 7.8 its
dividend this coming year will fall to Div1 = EPS1 x 67% =
$0.48 x 67% = $0.32.
will increase to
g  Retention Rate  Return on New Investment  33% 11%  3.63%

Profitable Growth
Execute:
• Assuming PW can continue to grow at this rate, we can
Div1 $0.32
P0    $27.35
rE  g .048  .0363

Profitable Growth
Evaluate:
• PW’s share price should rise from $10 to $27.35 if the
return (11%) greater than its equity cost of capital (4.8%),
PW has created value for its shareholders.

Example 7.3b Cutting Dividends for
Profitable Growth
Problem:
• Lengefeld Manufacturing expects to have earnings per share
of $1.80 in the coming year. Rather than reinvest these
earnings and grow, the firm plans to pay out all of its
earnings as a dividend. With these expectations of no
growth, Lengefeld’s current share price is $24.

Profitable Growth
Problem:
• Suppose Lengefeld could cut its dividend payout rate to 50%
for the foreseeable future and use the retained earnings to
open an additional factory. The return on investment in the
new factory is expected to be 15%. If we assume that the
risk of the new factory is the same as the risk of its existing
factories, then the firm’s equity cost of capital is unchanged.
What effect would this new policy have on Lengefeld’s stock
price?

Profitable Growth
Solution:
Plan:
• To figure out the effect of this policy on Lengefeld’s stock
price, we need to know several things. First, we need to
compute its equity cost of capital. Next we must determine
Lengefeld’s dividend and growth rate under the new policy.
• Because we know that Lengefeld currently has a growth rate
of 0 (g = 0), a dividend of $2.00 and a price of $24, we can
use Eq. 7.7 to estimate rE.

Profitable Growth
Plan (cont'd):
of $2.00. Finally, given a retention rate of 50% and a return
on new investment of 15%, we can use Eq. 7.12 to compute
the new growth rate (g). Finally, armed with the new
dividend, Lengefeld’s equity cost of capital, and its new
growth rate, we can use Eq. 7.6 to compute the price of
Lengefeld’s shares if it institutes the new policy.

Profitable Growth
Execute:
Div1 $2.00
rE  g  0%  0.0833  0  8.33%
P0 $24
• In other words, to justify Lengefeld’s stock price under its
current policy, the expected return of other stocks in the
market with equivalent risk must be 8.33%.

Profitable Growth
Execute:
• Next, we consider the consequences of the new policy. If
Lengefeld reduces its dividend payout rate to 50%, then from
Eq. 7.8 its dividend this coming year will fall to Div1 = EPS1 x
50% = $2.00 x 50% = $1.00.
will increase to:
g  Retention Rate  Return on New Investment  50%  15%  7.5%

Profitable Growth
Execute:
• Assuming Lengefeld can continue to grow at this rate, we can
Div1 $1.00
P0    $120.48
rE  g 0.0833  0.075

Profitable Growth
Evaluate:
• Lengefeld’s share price should rise from $24 to $120.48 if the
return (15%) greater than its equity cost of capital (8.33%),
Lengefeld has created value for its shareholders.

Example 7.4 Unprofitable Growth
Problem:
• Suppose Crane Supporting Goods decides to cut its dividend
payout rate to 75% to invest in new stores, as in Example
7.3. But now suppose that the return on these new
investments is 8%, rather than 12%. Give its expected
earnings per share this year of $6 and its equity cost of
capital of 10% (we again assume that the risk of the new
investments is the same as its existing investments), what
will happen to Crane’s current share price in this case?

Solution:
Plan:
• We will follow the steps in Example 7.3, except that in this
case, we assume a return on new investments of 8% when
computing the new growth rate (g) instead of 12% as in
Example 7.3.

Execute:
• Just as in Example 7.3, Crane’s dividend will fall to $6 x 75%
= $4.50. Its growth rate under the new policy, given the
lower return on new investment, will now be g = 25% x 8% =
2%. The new share price is therefore
Div1
$4.50
P0    $56.25
rE  g .10  .02

Evaluate:
• Even though Crane will grow under the new policy, the return
on its new investments is too low. The company’s share price
will fall if it cuts its dividend to make new investments with a
return of only 8%. By reinvesting its earnings at a rate (8%)
that is lower than its equity cost of capital (10%), Crane has
reduced shareholder value.

Example 7.4a Unprofitable Growth
Problem:
• Suppose Pittsburgh & West Virginia Railroad decides to cut its
dividend payout rate to 67% to invest in new stores, as in
Example 7.3a. But now suppose that the return on these new
earnings per share this year of $0.48 and its equity cost of
capital of 4.8% (we again assume that the risk of the new
will happen to PW’s current share price in this case?

Solution:
Plan:
• We will follow the steps in Example 7.3a, except that in this
Example 7.3a.

Execute:
• Just as in Example 7.3a, PW’s dividend will fall to $0.48 x
67% = $0.32. Its growth rate under the new policy, given
the lower return on new investment, will now be g = 33% x
4% = 1.32%. The new share price is therefore
Div1 $0.32
P0    $9.20
rE  g .048  .0132

Evaluate:
• Even though PW will grow under the new policy, the return on
its new investments is too low. The company’s share price
will fall if it cuts its dividend to make new investments with a
return of only 4%. By reinvesting its earnings at a rate (4%)
that is lower than its equity cost of capital (4.8%), PW has
reduced shareholder value.

Example 7.4b Unprofitable Growth
Problem:
• Suppose Lengefeld Manufacturing decides to cut its dividend
payout rate to 50% to invest in new stores, as in Example
7.3b. But now suppose that the return on these new
earnings per share this year of $2 and its equity cost of
capital of 8.33% (we again assume that the risk of the new
will happen to Lengefeld’s current share price in this case?

Solution:
Plan:
• We will follow the steps in Example 7.3b, except that in this
Example 7.3b.

Execute:
• Just as in Example 7.3b, Lengefeld’s dividend will fall to $2 x
50% = $2.00. Its growth rate under the new policy, given
the lower return on new investment, will now be g = 50% x
8% = 4%. The new share price is therefore
Div1 $1.00
P0    $23.09
rE  g .0833  .04

Evaluate:
• Even though Lengefeld will grow under the new policy, the
return on its new investments is too low. The company’s
share price will fall if it cuts its dividend to make new
investments with a return of only 8%. By reinvesting its
earnings at a rate (8%) that is lower than its equity cost of
capital (8.33%), Lengefeld has reduced shareholder value.

• Changing Growth Rates

– If the firm is expected to grow at a long-term
rate g after year N + 1, then from the constant
dividend growth model:
Div N 1
PN  (Eq. 7.13)
rE  g

Example 7.5 Valuing a Firm with Two
Different Growth Rates
Problem:
• Small Fry, Inc., has just invented a potato chip that looks and
tastes like a french fry. Given the phenomenal market
response to this product, Small Fry is reinvesting all of its
earnings to expand its operations. Earnings were $2 per
share this past year and are expected to grow at a rate of
20% per year until the end of year 4. At that point, other
companies are likely to bring out competing products.
Analysts project that at the end of year 4, Small Fry will cut
its investment and begin paying 60% of its earnings as
dividends. Its growth will also slow to a long-run rate of 4%.
If Small Fry’s equity cost of capital is 8%, what is the value of
a share today?

Solution:
Plan:
• We can use Small Fry’s projected earnings growth rate and
payout rate to forecast its future earnings and dividends.
After year 4, Small Fry’s dividends will grow at a constant 4%,
so we can use the constant dividend growth model (Eq. 7.13)
to value all dividends after that point. Finally, we can pull
everything together with the dividend-discount model (Eq.
7.4).

Execute:
• The following spreadsheet projects Small Fry’s earnings and
dividends:

Execute:
• Starting from $2.00 in year 0, EPS grows by 20% per year
until year 4, after which growth slows to 4%. Small Fry’s
dividend payout rate is zero until year 4, when competition
reduces its investment opportunities and its payout rate rises
to 60%. Multiplying EPS by the dividend payout ratio, we
project Small Fry’s future dividends in line 4.

Execute:
• After year 4, Small Fry’s dividends will grow at the constant
expected long-run rate of 4% per year. Thus we can use the
constant dividend growth model to project Small Fry’s share
price at the end of year 3. Given its equity cost of capital of
8%,
Div4 $2.49
P3    $62.25
rE  g 0.08  0.04

Execute:
• We then apply the dividend discount model (Eq. 7.4) with this
terminal value:
Div1 Div2 Div3 P3 $62.25

P0       $49.42
1  rE   1  r  1  r  1.08
2 3 3 3
1  rE E E

Evaluate:
• The dividend-discount model is flexible enough to handle any
forecasted pattern of dividends. Here the dividends were zero
for several years and then settled into a constant growth rate,
allowing us to use the constant growth rate model as a
shortcut.

Two Different Growth Rates
Problem:
• Small Fry, Inc., has just invented a potato chip that looks and
tastes like a french fry. Given the phenomenal market
response to this product, Small Fry is reinvesting all of its
earnings to expand its operations. Earnings were $5 per
share this past year and are expected to grow at a rate of
30% per year until the end of year 3. At that point, other
companies are likely to bring out competing products.
Analysts project that at the end of year 3, Small Fry will cut
its investment and begin paying 75% of its earnings as
dividends. Its growth will also slow to a long-run rate of 5%.
If Small Fry’s equity cost of capital is 9%, what is the value of
a share today?

Solution:
Plan:
• We can use Small Fry’s projected earnings growth rate and
payout rate to forecast its future earnings and dividends.
After year 3, Small Fry’s dividends will grow at a constant 5%,
so we can use the constant dividend growth model (Eq. 7.13)
to value all dividends after that point. Finally, we can pull
everything together with the dividend-discount model (Eq.
7.4).

Execute:
• The following spreadsheet projects Small Fry’s earnings and
dividends:
4 EPS $5.00 $6.50 $8.45 $10.99 $11.54

5 Dividends
6 Dividend Payout Ratio 0% 0% 75% 75%
7 Div $0.00 $0.00 $8.24 $8.66

Execute:
• Starting from $5.00 in year 0, EPS grows by 30% per year
until year 3, after which growth slows to 5%. Small Fry’s
dividend payout rate is zero until year 3, when competition
reduces its investment opportunities and its payout rate rises
to 75%. Multiplying EPS by the dividend payout ratio, we
project Small Fry’s future dividends in line 7.

Execute:
• From year 3 onward, Small Fry’s dividends will grow at the
expected long-run rate of 5% per year. Thus we can use the
constant dividend growth model to project Small Fry’s share
price at the end of year 3. Given its equity cost of capital of
9%,
Div3 $8.24
P2    $206.00
rE  g .09  .05

Execute:
• We then apply the dividend discount model (Eq. 7.4) with this
terminal value:
Div1 Div2 P2 $206.00

P0      $173.39
1  rE (1  rE ) 2
(1  rE ) 2
1.09 2

Evaluate:
• The dividend-discount model is flexible enough to handle any
forecasted pattern of dividends. Here the dividends were zero
for several years and then settled into a constant growth rate,
allowing us to use the constant growth rate model as a
shortcut.

• Value Drivers and the Dividend-Discount

Model
– The dividend-discount model includes an implicit
forecast of the firm’s profitability which is
discounted back at the firm’s equity cost of
capital

7.5 Limitations of the Dividend-
Discount Model
• Uncertain Dividend Forecasts

– The dividend-discount model values a stock
based on a forecast of the future dividends, but a
firm’s future dividends carry a tremendous
amount of uncertainty

Figure 7.2 NKE Stock Prices for
Different Expected Growth Rates

7.5 Limitations of the Dividend-
Discount Model
• Non-Dividend-Paying Stocks
– Many companies do not pay dividends, thus the
dividend-discount model must be modified

7.6 Share Repurchases and the Total
Payout Model
• Share Repurchases
– The firm uses excess cash to buy back its own
stock
• Two Consequences:
1. The more cash the firm uses to repurchase shares, the
less cash it has available to pay dividends
2. By repurchasing shares, the firm decreases its share
count, which increases its earnings and dividends on a
per-share basis

Payout Model
• Share Repurchases
– In the dividend-discount model, a share is valued
from the perspective of a single shareholder,
discounting the dividends the shareholder will
receive:
P0  PV  Future Dividends per Share  (Eq. 7.14)

Payout Model
• Total Payout Model

– Values all of the firm’s equity, rather than a
single share
• To use this model, discount the total payouts that the
firm makes to shareholders, which is the total amount
spent on both dividends and share repurchases
PV  Future Total Dividends and Repurchases  (Eq. 7.15)

P0 
Shares Outstanding 0

Example 7.6 Valuation with Share
Repurchases
Problem:
• Titan Industries has 217 million shares outstanding and
expects earnings at the end of this year of $860 million. Titan
plans to pay out 50% of its earnings in total, paying 30% as a
dividend and using 20% to repurchase shares. If Titan’s
earnings are expected to grow by 7.5% per year and these
payout rates remain constant, determine Titan’s share price
assuming an equity cost of capital of 10%.

Repurchases
Solution:
Plan:
• Based on the equity cost of capital of 10% and an expected
earnings growth rate of 7.5%, we can compute the present
value of Titan’s future payouts as a constant growth
perpetuity. The only input missing here is Titan’s total
payouts this year, which we can calculate as 50% of its
earnings. The present value of all of Titan’s future payouts is
the value of its total equity. To obtain the price of a share, we
divide the total value by the number of shares outstanding
(217 million).

Repurchases
Execute:
• Titan will have total payouts this year of 50%  $860 million
= $430 million. Using the constant growth perpetuity formula,
we have

Repurchases
Execute:
• This present value represents the total value of Titan’s equity
(i.e., its market capitalization). To compute the share price,
we divide by the current number of shares outstanding:

Repurchases
Evaluate:
• Using the total payout method, we did not need to know the
firm’s split between dividends and share repurchases. To
compare this method with the dividend-discount model, note
that Titan will pay a dividend of 30%  $860 million/(217
million shares) = $1.19 per share, for a dividend yield of
1.19/79.26 = 1.50%. From Eq. 7.7, Titan’s expected EPS,
dividend, and share price growth rate is g = rEDiv1/P0 =
8.50%. This growth rate exceeds the 7.50% growth rate of
earnings because Titan’s share count will decline over time
owing to its share repurchases.

Example 7.6a Valuation with Share
Repurchases
Problem:
• 3M Co. has 698 million shares outstanding and expects
earnings at the end of this year of $2.96 billion. 3M plans to
pay out 50% of its earnings in total, paying 25% as a
dividend and using 25% to repurchase shares. If 3M’s
earnings are expected to grow by 9.2% per year and these
payout rates remain constant, determine 3M’s share price
assuming an equity cost of capital of 12%.

Repurchases
Solution:
Plan:
• Based on the equity cost of capital of 12% and an expected
earnings growth rate of 9.2% we can compute the present
value of 3M’s future payouts as a constant growth perpetuity.
The only input missing here is 3M’s total payouts this year,
which we can calculate as 50% of its earnings. The present
value of all of 3M’s future payouts is the value of its total
equity. To obtain the price of a share, we divide the total
value by the number of shares outstanding (698 million).

Repurchases
Execute:
• 3M will have total payouts this year of 50% x $2.96 billion =
$1.48 billion. Using the constant growth perpetuity formula,
we have
$1.48 billion
PV (Future Total Dividends and Repurchases)   $52.86 billion
.12 - .092
• This present value represents the total value of 3M’s equity

(i.e. its market capitalization). To compute the share price,
we divide by the current number of shares outstanding:
$52.86 billion
P0   $75.73 per share
698 million shares

Repurchases
Evaluate:
• Using the total payout method, we did not need to know the
firm’s split between dividends and share repurchases. To
compare this method with the dividend-discount model, note
that 3M will pay a dividend of 25% x $2.96 billion/(698 million
shares) = $1.06 per share, for a dividend yield of
$1.06/$75.73 = 1.40%. From Eq. 7.7, 3M’s expected EPS,
dividend, and share price growth rate g = rE – Div1/P0 = 12%
– 1.4% = 10.6%. This growth rate exceeds the 9.2% growth
rate of earnings because 3M’s share count will decline over
time owing to its share repurchases.

• How would an investor decide whether to

buy or sell a stock?
– She would value the stock using her own
expectations
– If her expectations were substantially different,
she might conclude that the stock was over- or
under-priced
– Based on that conclusion, she would buy or sell
the stock

• How could a stock suddenly be worth more

or less after an earnings announcement?
– As investors digest the news, they update their
expectations and buying or selling pressure
would then drive the stock price up or down until
the buys and sells came into balance

• What should managers do to raise the stock

price further?
– The only way to raise the stock price is to make
value-increasing decisions

Chapter Quiz
1. What are some key differences between preferred

and common stock?
2. What is the role of a floor broker at the NYSE?
3. What discount rate do you use to discount the
future cash flows of a stock?
4. What are three ways that a firm can increase the
amount of its future dividend per share?
5. What are the main limitations of the dividend-
discount model?
6. How does the total payout model address part of
the dividend-discount model’s limitations?

Table 7.1 The Dividend-Discount
Model

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Chapter 7

7.1 Stock Basics

Copyright ©2015 Pearson Education, Inc. All rights reserved. 7-2

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• Stock Market Reporting: Stock Quotes

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• A One Year Investor

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• A One Year Investor

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• Dividend Yields, Capital Gains, and Total

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• Dividend Yields, Capital Gains, and Total

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Div1  P1 $5.35  $63.32

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• Dividend-Discount Model Equation

Div1 Div2 DivN PN

– The price of the stock is equal to the present

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• Dividend-Discount Model Equation

Div1 Div2 Div3

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• Constant Dividend Growth

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• Dividends Versus Investment and Growth

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• Dividends Versus Investment and Growth

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• Dividends Versus Investment and Growth

Change in Earnings = New Investment  Return on New Investment (Eq. 7.9)

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