Lecture Common Stock Valuation

Stock
Stock Valuation
Valuation
Lecture
Lecture
4-1
Learning Goals
1. Differentiate between debt and equity.
2. Discuss the rights, characteristics, and features of both
common and preferred stock.
3. Describe the process of issuing common stock, including
venture capital, going public and the investment banker’s, and
interpreting stock quotations.
4. Understand the concept of market efficiency and basic
common stock valuation using zero growth, constant growth,
and variable growth models.
5. Discuss the free cash flow valuation model and the book value,
liquidation value, and price/earnings (P/E) multiple
approaches.
6. Explain the relationship among financial decisions, return, risk,
and the firm’s value.
Copyright © 2009 Pearson Prentice Hall. All
rights reserved. 4-2
7-2
Key Differences b/w Bonds and Stocks
Points of Difference Stocks Bonds
Voice in Management Yes No
Voting Rights Yes No
Maturity Not Defined Defined
Fixed Interest
Return Dividend
Payment
Claims on Assets/ Income on
Less Preference Preference
Liquidation
4-3
Types of Stock
Stock
Preferred Stock Common Stock
Stock with fixed dividend Residual income with voting

but no voting rights rights & is a risky Investment
4-4
Characteristics of Preferred Stock
Preferred Stock is a type of stock that

promises a (usually) fixed dividend, but at
the discretion of the board of directors.
•Hybrid or Quasi security
•Characteristics of both bonds and stocks
4-5
Characteristics of Preferred Stock
•No voting rights

•Preference over common stock in the
payment of dividends
•Preference over common stock in claims
on assets.
4-6
Characteristics of Common Stock
Common stock represents a residual ownership
position in the corporation.
•Voting rights (Proxy and Proxy Fight)
•Less preference in case of distribution of
income
•Less preference in case of claims on
assets.
•Dividends on the discretion of the BODs. 4-7
Stock Valuation
Value of any asset is the present value of cash

flows expected from it
• Capital Gain
• Dividend Gain
4-8
Preferred Stock Valuation
Formula:
Vp = Dp / rp
P for preferred stock

Vp= Value / Price of P. Stock
Dp = Dividend on P. Stock
rp = Required rate of return on P. Stock
4-9
Preferred Stock Valuation
Stock PS has an 8%, Rs.1000 par value

issue outstanding. The appropriate
discount rate is 10%. What is the value of
the preferred stock?
4-10
Preferred Stock Example
• Company pays a dividend on preferred stock
at Rs. 10 per share. If the required rate of
return on P. stock is 10%
4-11
Common Stock Valuation
What cash flows will a shareholder receive

when owning shares of common stock?
(1) Future dividends

(2) Future sale of the common
stock shares
4-12
Dividend Valuation Model
Basic dividend valuation model accounts for the PV

of all future dividends.
Div1 Div2 Div¥
P0 = + + ... +
(1 + rs)1 (1 + rs)2 (1 + rs)¥
Divt
¥ Divt: Cash dividend
=S
t=1
(1 + rs)t at time t
rs: Equity investor’s
required return 4-13
Adjusted Dividend Valuation
Model
The basic dividend valuation model adjusted for
the future stock sale.
Div1 Div2 Divn + Pricen
P0 = + + ... +
(1 + rs)1 (1 + rs)2 (1 + rs)n
n: The year in which the firm’s

shares are expected to be sold.
Pricen: The expected share price in year n.
4-14
Dividend Growth Model
Do = Just Paid dividend

D1 = Dividend for the 1st year
rs = Required rate of return
P0 =Price or value of stock today
Where;
D1 = D0 (1 + g)
D2 = D1 (1 + g)
4-15
Dividend Growth Model
Company recently issued a dividend of Rs. 5/ share,

if it is expected to grow at 10% find the dividend for
the next 2 years.
4-16
Dividend Growth Pattern
Assumptions
The dividend valuation model requires the forecast
of all future dividends. Following dividend growth
rate assumptions simplify the valuation process.
•Constant Growth
•No Growth
•Growth Phases
4-17
Constant Growth Model
The constant growth model assumes that

dividends will grow forever at the rate g.
D0(1+g) D0(1+g)2 ¥
D0(1+g)
P0 = + + ... +
(1 + rs)1 (1 + rs)2 (1 + rs)¥
D1
P 0=
(rs - g)
4-18
P0 = Price / Value of the stock

D1 = Dividend for the 1st year
rs = Required rate of return
g = growth rate
P1
P13
P27
4-19
Example
Stock CG has an expected growth rate of 8%. Each
share of stock just received an annual Rs.3.24 dividend
per share. The appropriate discount rate is 15%. What
is the value of the common stock?
4-20
Zero Growth Model
The zero growth model assumes that dividends will

grow forever at the rate g = 0.
D1 D2 D¥
P0 = + + ... +
(1 + rs)1 (1 + rs)2 (1 + rs)¥
D1
P0 = rs
4-21
Zero Growth
Model Example
Stock ZG has an expected growth rate of 0%. Each
share of stock just received an annual Rs.3.24 dividend
per share. The appropriate discount rate is 15%. What
is the value of the common stock?
4-22
Variable Growth Model
The variable growth model assumes that

dividends for each share will grow at two or
more different growth rates.
n D0(1+g1) t ¥ Dn(1+g2)t
P0 =S + S
(1 + rs) t=n+1 (1 + rs)
t t
t=1
4-23
Note that the second phase of the variable

growth model assumes that dividends will grow
at a constant rate g2.
Formula:
4-24
Stock GP has an expected growth rate of 16%
for the first 3 years and 8% thereafter. Each
share of stock just received an annual Rs.3.24
dividend per share. The appropriate discount
rate is 15%. What is the value of the common
stock under this scenario?
4-25
Stock GP has two phases of growth. The first, 16%, starts at time
t=0 for 3 years and is followed by 8% thereafter starting at time
t=3. We should view the time line as two separate time lines in
the valuation.
4-26
0 1 2 3 Growth Phase
#1 plus the infinitely
long Phase #2
D1 D2 D3
0 1 2 3 4 5 6 
D4 D5 D6
Note that we can value Phase #2 using the Constant
Growth Model
4-27
D4 We can use this model because

P3 =
dividends grow at a constant 8%
rs-g
rate beginning at the end of Year 3.
0 1 2 3 4 5 6 
D4 D5 D6
Note that we can now replace all dividends from Year 4 to

infinity with the value at time t=3
4-28
4-29
4-30
4-31
Summary
• Dividend Growth Model
• Constant growth Model
• Zero growth Model
• Variable growth Model
4-32
P7-1
a. Maximum shares available for sale
Authorized shares 2,000,000
Less: Shares outstanding 1,400,000
Available shares 600,000
b. $ Total shares needed shares =48,000,000/$60
=800,000
The firm requires an additional 200,000 authorized shares
to raise the necessary funds at $60 per share.
c. Aspin must amend its corporate charter to authorize
the issuance of additional shares.
4-33
7-11: Newman Manufacturing is considering a cash purchase of the stock of
Grips Tool. During the year just completed, Grips earned $4.25 per share and
paid cash dividends of (D0=$2.55) per share .Grips’ earnings and dividends are
expected to grow at 25% per year for the next 3 years, after which they are
expected to grow at 10% per year to infinity.
What is the maximum price per share that Newman should pay for
Grips if it has a required return of 15% on investments with risk
characteristics similar to those of Grips?
4-34
P7–13: Common stock value—Variable growth Lawrence
Industries’ most recent annual dividend was $1.80 per share ,
and the firm’s required return is 11%.
Find the market value of Lawrence’s shares when:
a. Dividends are expected to grow at 8% annually for 3 years,
followed by a 5% constant annual growth rate in years 4 to
infinity.
b. Dividends are expected to grow at 8% annually for 3 years,
followed by a 0%constant annual growth rate in years 4 to
infinity.
c. Dividends are expected to grow at 8% annually for 3 years,
followed by a 10%constant annual growth rate in years 4 to
infinity
4-35
P7-2:
[a]. $8.80 per year or $2.20 per quarter
[b]. $2.20 For a noncumulative preferred only the
latest dividend has to be paid before dividends
can be paid on common stock.
[c]. $8.80 For cumulative preferred all dividends in
arrears must be paid before dividends can be paid
on common stock. In this case the board must pay
the three dividends missed plus the current
dividend.
4-36
P7-4:
I P.S = 5 C.S
Po =20
Pp=$100
4-37
P7-5:
Do = $2.40
g =0
a]. rs=12%, Po=?
Po= Do/rs
= 2.40/0.12
= $20
b]. Po= 2.40/0.20
= $12
4-38
Stock Valuation Models:
Free Cash Flow Model
• The free cash flow model is based on the same
premise as the dividend valuation models except that
we value the firm’s free cash flows rather than
dividends.
4-39
7-39
Free Cash Flow Model (cont.)
• The free cash flow valuation model estimates the
value of the entire company and uses the cost of
capital as the discount rate.
• As a result, the value of the firm’s debt and preferred
stock must be subtracted from the value of the
company to estimate the value of equity.

7-40
Dewhurst Inc. wishes to value its stock using the free cash flow model.
To apply model, the firm’s CFO developed the data given in below table
Table : Dewhurst, Inc.’s Data for the Free Cash Flow Valuation Model

7-41
Step 1. Calculate the present value of the free cash flow occurring from the
end of 2012 to infinity, measured at the beginning of 2012.

7-42
Step 2. Add the PV (in 2011) of the FCF for 2012 found in Step 1 to the FCF for
2011 to get total FCF for 2011.
Total FCF2011 = $600,000 + $10,300,000 = $10,900,000
Step 3. Find the sum of the present values of the FCFs for 2007 through 2011 to
determine, VC, and the market values of debt, VD, and preferred stock, VP, given
in Table 7.5 on the following slide.

7-43
Table 7.5 Calculation of the Value of the Entire

Company for Dewhurst, Inc.

7-44
Step 4. Calculate the value of the common stock using equation 7.8.
Substituting the value of the entire company, VC, calculated in Step 3, and
the market value of the debt, VD, and preferred stock, VP, yields the value of
the common stock, VS.
VS = $8,628,620 - $3,100,000 = $4,728,620

P0 = $4,728,628 / 300,000 shares = $15.16 per share

7-45
Other Approaches to Stock Valuation: Book
Value
• Book value per share is the amount per share that
would be received if all the firm’s assets were sold for
their exact book value and if the proceeds remaining
after paying all liabilities were divided among
common stockholders.
• This method lacks sophistication and its reliance on
historical balance sheet data ignores the firm’s
earnings potential and lacks any true relationship to
the firm’s value in the marketplace.

7-46
Other Approaches to Stock Valuation:
Liquidation Value
• Liquidation value per share is the actual amount per
share of common stock to be received if al of the
firm’s assets were sold for their market values,
liabilities were paid, and any remaining funds were
divided among common stockholders.
• This measure is more realistic than book value
because it is based on current market values of the
firm’s assets.
• However, it still fails to consider the earning power of
those assets.

7-47
Other Approaches to Stock Valuation:
Price/Earnings (P/E) Multiples
• Some stocks pay no dividends—using P/E ratios are

one way to evaluate a stock under these
circumstances.
• The model may be written as:
P0 = (EPSt+1) X (Industry Average P/E)
For example, Lamar’s expected EPS is $2.60/share and the

industry average P/E multiple is 7, then P0 = $2.60 X 7 =
$18.20/share.

7-48
Decision Making
and Common Stock Value
• Valuation equations measure the stock value at a point in time

based on expected return and risk.
• Any decisions of the financial manager that affect these
variables can cause the value of the firm to change as shown in
the Figure below.
Figure 7.4 Decision Making and Stock Value

7-49
Decision Making and Common Stock Value: Changes in
Dividends or Dividend Growth
• Changes in expected dividends or dividend growth

can have a profound impact on the value of a stock.
Price Sensitivity to Changes in Dividends and Dividend Growth

(Using the Constant Growth Model)
D0 $ 2.00 $ 2.50 $ 3.00 $ 2.00 $ 2.00 $ 2.00
g 3.0% 3.0% 3.0% 3.0% 6.0% 9.0%
D1 $ 2.06 $ 2.58 $ 3.09 $ 2.06 $ 2.12 $ 2.18
kS 10.0% 10.0% 10.0% 10.0% 10.0% 10.0%
P0 $ 29.43 $ 36.79 $ 44.14 $ 29.43 $ 53.00 $ 218.00

7-50
Decision Making and Common Stock Value: Changes in
Risk and Required Return
• Changes in expected dividends or dividend growth

can have a profound impact on the value of a stock.
Price Sensitivity to Changes Risk (Required Return)

(Using the Constant Growth Model)
D0 $ 2.00 $ 2.00 $ 2.00 $ 2.00 $ 2.00 $ 2.00
g 3.0% 3.0% 3.0% 3.0% 3.0% 3.0%
D1 $ 2.06 $ 2.06 $ 2.06 $ 2.06 $ 2.06 $ 2.06
kS 5.0% 7.5% 10.0% 12.5% 15.0% 17.5%
P0 $ 103.00 $ 45.78 $ 29.43 $ 21.68 $ 17.17 $ 14.21

7-51
Summary of Key Valuation Definitions and Formulas
for Common Stock (cont.)

7-52
Summary of Key Valuation Definitions and
Formulas for Common Stock

7-53
P7–6
Common stock value: Zero growth Kelsey Drums, Inc., is a
well-established supplier of fine percussion instruments to
orchestras all over the United States. The company’s class A
common stock has paid a dividend of $5.00 per share per
year for the last 15 years. Management expects to continue
to pay at that amount for the foreseeable future. Sally Talbot
purchased 100 shares of Kelsey class A common 10 years
ago at a time when the required rate of return for the stock
was 16%. She wants to sell her shares today. The current
required rate of return for the stock is 12%. How much
capital gain or loss will Sally have on her shares?
Value of stock when purchased: $5 / 16% = $31.25
Value of stock when sold: $5.00 / 12% = $41.67
Sally’s capital gain is $10.42 per share.
Sally’s total capital gain is = 100x10.42= $1,042.00.
4-54

Lecture Common Stock Valuation

Uploaded by

Copyright:

Available Formats

You might also like

Lecture Common Stock Valuation

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Lecture Common Stock Valuation

Uploaded by

Copyright:

Available Formats

Stock

Points of Difference Stocks Bonds

Voice in Management Yes No

Voting Rights Yes No

Maturity Not Defined Defined

Preferred Stock Common Stock

Stock with fixed dividend Residual income with voting

Preferred Stock is a type of stock that

•No voting rights

Value of any asset is the present value of cash

P for preferred stock

Stock PS has an 8%, Rs.1000 par value

What cash flows will a shareholder receive

(1) Future dividends

Basic dividend valuation model accounts for the PV

n: The year in which the firm’s

Do = Just Paid dividend

Company recently issued a dividend of Rs. 5/ share,

The constant growth model assumes that

P0 = Price / Value of the stock

The zero growth model assumes that dividends will

The variable growth model assumes that

Note that the second phase of the variable

D4 We can use this model because

Note that we can now replace all dividends from Year 4 to

Copyright © 2009 Pearson Prentice Hall. All

Copyright © 2009 Pearson Prentice Hall. All

Copyright © 2009 Pearson Prentice Hall. All

Total FCF2011 = $600,000 + $10,300,000 = $10,900,000

Copyright © 2009 Pearson Prentice Hall. All

Table 7.5 Calculation of the Value of the Entire

Copyright © 2009 Pearson Prentice Hall. All

VS = $8,628,620 - $3,100,000 = $4,728,620

Copyright © 2009 Pearson Prentice Hall. All

Copyright © 2009 Pearson Prentice Hall. All

Copyright © 2009 Pearson Prentice Hall. All

• Some stocks pay no dividends—using P/E ratios are

P0 = (EPSt+1) X (Industry Average P/E)

For example, Lamar’s expected EPS is $2.60/share and the

Copyright © 2009 Pearson Prentice Hall. All

• Valuation equations measure the stock value at a point in time

Copyright © 2009 Pearson Prentice Hall. All

• Changes in expected dividends or dividend growth

Price Sensitivity to Changes in Dividends and Dividend Growth

Copyright © 2009 Pearson Prentice Hall. All

• Changes in expected dividends or dividend growth

Price Sensitivity to Changes Risk (Required Return)

Copyright © 2009 Pearson Prentice Hall. All

Copyright © 2009 Pearson Prentice Hall. All

Copyright © 2009 Pearson Prentice Hall. All

You might also like