STOCK

VALUATION

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 Common Stock Valuation
Our goal in this chapter is to examine the
methods commonly used by financial analysts
Goal to assess the economic value of common stocks.

 These methods are grouped into two

categories:
 dividend discount models
 price ratio models

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 Corporate Valuation and Stock Price

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 Stock .. Equity … Shares
• The term "stock" refers to ownership or
equity in a firm. There are two types of
equity - common stock and preferred
stock.
1.Preferred Stock
Preferred stockholders have a higher claim to
dividends or asset distribution than common
stockholders. 

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 Common Stock or Common Shareholders
• Common stock is a security that represents ownership in a
corporation.
• Holders of common stock elect the board of directors and vote
on corporate policies.
• This form of equity ownership typically yields higher rates of
return long term.
• However, in the event of liquidation, common shareholders
have rights to a company's assets only after bondholders,
preferred shareholders, and other debtholders are paid in full.
• Common stock is reported in the stockholder's equity section of
a company's balance sheet.

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 Market Price and Intrinsic Value

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 Security Analysis: Be Careful Out There
Fundamental analysis
Examination of a firm’s accounting
statements and other financial and economic
information to assess the economic value of
a company’s stock.
• The basic idea is to identify “undervalued” stocks to buy
and “overvalued” stocks to sell.
• In practice however, such stocks may in fact be correctly
priced for reasons not immediately apparent to the analyst.

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 Definitions of Terms Used in Stock Valuation
Models

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 Calculating dividends

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 Word Problem
• The Duo Growth Company just paid a
dividend of $1 per share. The dividend is
expected to grow at a rate of 25% per year
for the next three years and then to level off
to 5% per year forever. You think the
appropriate market capitalization rate is 20%
per year.

Calculate D1, D3 and D5?

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 Book’s Word Problems
• 7-1 --- Dividend Calculations

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 The Dividend Discount Model

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 The Dividend Discount Model: Constant
Growth Model

 This is the constant perpetual growth model.

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 The Dividend Discount Model
Example: Constant Perpetual Growth Model
• Consider the electric utility industry. In late 2000, the
utility company Detroit Edison (DTE) paid a $2.06
dividend. Using D(0)=$2.06, k =8%, and g=2%,
calculate a present value estimate for DTE. Compare
this with the late-2000 DTE stock price of $36.13.

$2.06  1.02 
P ( 0)   $35.02
.08  .02
 Our estimated price is a little lower than the
$36.13 stock price.
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 Dividend Discount Model – Zero Growth
• A zero growth stock is one whose future dividends are not
expected to grow at all.

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 Horizon or Terminal Value

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 The Dividend Discount Model
• The growth rate in dividends (g) can be
estimated in a number of ways.
Using the company’s historical average
growth rate.
Using an industry median or average
growth rate.
Using the sustainable growth rate.

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 The Two-Stage Dividend Growth Model
• A two-stage dividend growth model assumes
that a firm will initially grow at a rate g1 for
T years, and thereafter grow at a rate g2 < k
during a perpetual second stage of growth.

D01  g1   1  g1 
   1  g1  D01  g 2 
T T

V 0  1     
k  g1   1  k    1  k  k  g2

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 Preferred Stock Valuation
• Preferred stock is a hybrid security.
• It’s similar to bonds in some respects and to common stock in others.
• Like bonds, preferred stock has a par value, and a fixed amount of
dividends must be paid before dividends can be paid on the common
stock.
• However, if the preferred dividend is not earned, the directors can omit
(or “pass”) it without throwing the company into bankruptcy.
• So, although preferred stock has a fixed payment like bonds, a failure to
make this payment will not lead to bankruptcy.

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 Preferred Stock Valuation

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 CAPM –Capital Asset Pricing Model
• The discount rate for a stock can be estimated
using the capital asset pricing model (CAPM ).
• Discount time value risk
rate of=money premium+

= T-bill + ( stock  stock market )

rate beta risk premium
T-bill rate = return on 90-day U.S. T-bills
stock beta = risk relative to an average stock
stock market = risk premium for an average stock
risk premium

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 APT – Arbitrage Pricing Theory
• The APT can include any number of risk factors, so the required
return could be a function of two, three, four, or more factors.

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 Observations on Dividend Discount
Models
Constant Perpetual Growth Model
Simple to compute.
Not usable for firms that do not pay
dividends.
Not usable when g > k.
Is sensitive to the choice of g and k.
k and g may be difficult to estimate
accurately.
Constant perpetual growth is often an
unrealistic assumption.
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 Observations on Dividend Discount
Models
Two-Stage Dividend Growth Model
More realistic in that it accounts for two
stages of growth.
Usable when g > k in the first stage.
Not usable for firms that do not pay
dividends.
Is sensitive to the choice of g and k.
k and g may be difficult to estimate
accurately.

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 An Analysis of the McGraw-Hill Company
• Based on the CAPM,
k = 6% + (.85  9%) = 13.65%
• Retention ratio = 1 – $1.02/$2.75 = 62.9%
sustainable g = .629  25.5% = 16.04%
• Since g > k, the constant growth rate model cannot be used.

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 Chapter Review
Security Analysis: Be Careful Out There
The Dividend Discount Model
• Constant Dividend Growth Rate Model
• Constant Perpetual Growth
• Applications of the Constant Perpetual
Growth Model

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 Chapter Review
• The Two-Stage Dividend Growth Model
• Discount Rates for Dividend Discount
Models
• Observations on Dividend Discount
Models
• Capital Pricing Model
• APT

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