EQUITY MARKETS and

Stock Valuation CH - 7
A share of common stock is more difficult to value in practice
than a bond, for at least three reasons:
First, with common stock, not even the promised cash flows
are known in advance.
Second, the life of the investment is essentially forever
because common stock has no maturity.
Third, there is no way to easily observe the rate of return that
the market requires.
Present value = ($10 + 70)/1.25 = $64
P0 = (D1 + P1)/(1 + R)= D1/(1+R)^n

(C) 2007 Prentice Hall, Inc. 1-1

 Some Special Cases
The cases we consider are the following: (1) the dividend has a zero growth rate,
(2) the dividend grows at a constant rate, and (3) the dividend grows at a
nonconstant rate. Finally, we examine stock pricing using comparable.
Zero growth
Po = D (Dividend) / R (Discount Ratio/Required return)
$10/20%=$50
Constant growth
Dt = D0 (1 + g)t
Po = Do* (1 + g)/(R − g)
Do =2.3 ; R=13% g - 5%
Po=2.3*1.05/(0.13-0.05)= 30.19
dividend growth model - A model that determines the current price of a stock
as its dividend next period divided by the discount rate less the dividend growth
rate
We can actually use the dividend growth model to get the stock price at any point in time,
not just today. In general, the price of the stock as of Time t is: (f ex 5 year)
Pt =Dt ×(1+g)/R−g=Dt +1/R−g
D5=2.3*1.05^5=2.93
P5=2.93*1.05/0.13-0.05=38.53
1-2
 Some Special Cases
Nonconstant Growth
D5 =0.5;R=20% g -10%- first dividend pay at 5 th years and than cont gowth at 10 %
P4=0.5/(0.2-0.1)=5$
PO=5/1.2^4=2.41
The problem of nonconstant growth is only slightly more complicated if the dividends are not
zero for the first several years
Growth rate - 5%
R – 10%

P3= D3×(1 + g)/(R − g)=$2.50 ×1.05/(.10 −.05)=$52.50

P0=D1/(1+R)^1 +D2/(1+R)^2+D3/(1+R)^3+P3/(1+R)^3=$1/1.10+2/1.10^2+2.50/1.10^3+52.50/1.10^3
=$.91 +1.65 +1.88 +39.44 =$43.88
(C) 2007 Prentice Hall, Inc. 1-3
 Components of the Required
Return and dividend yield
P0= D1/(R − g)
R = D1/P0+ g
D1/P0, is called the dividend yield - Dividend yield A stock’s expected cash
dividend divided by its current price
g - Capital gains yield - the rate at which the value of the investment grows

The dividend growth model calculates the total return as:

R = Dividend yield + Capital gains yield
R = $1/20+10%=15%

(C) 2007 Prentice Hall, Inc. 1-4

 SOME FEATURES OF COMMON AND
PREFERRED STOCK

common stock Equity without priority for dividends or in bankruptcy

Shareholder Rights/cumulative voting
straight voting - A procedure in which a shareholder may cast all votes for each member of the
board of directors.
Proxy Voting - A proxies the grant of authority by a shareholder to someone
else to vote that shareholder’s shares
Classes of Stock – A/B
Other Rights- The value of a share of common stock in a corporation is directly
related to the general rights of shareholders
Dividends
Preferred stock - it has preference over common stock in the payment of
dividends and in the distribution of corporation assets in the event of liquidation ,
BUT sometimes have no voting privileges
THE STOCK MARKETS - primary market and a secondary market
Dealers and Brokers
(C) 2007 Prentice Hall, Inc. 1-5