Financial Markets and Institutions

2021-2022

(2nd Semester)

Department of Humanities & Social Sciences IIT, Ropar

One Period Valuation model

An investor is wondering what the correct price of a share should be? He knows that his
required rate of return is 9%. He also knows that the share will give a $5 dividend in the
current period and the expected market value at the end of the period is $200. What
would the fair price for such a stock be?

Where:
– the current fair value of a stock
D1 – the dividend payment in one period from now
P1 – the stock price in one period from now
– Discount factor

= $188.07
Generalized Dividend Valuation Model -Two Period Valuation model

An investor is confident that a certain stock can be sold off for $100 if it is held on to for 2 years. He has a required rate of return of
10%.He is also confident that the company will pay a $4 dividend in the first year and a $6 dividend in the second year. However, he
is not certain about what the price of the stock should be today?

Once again, the value of the stock is only equal to the present value of all future cash flows that can be derived from that stock. In this
case, we will receive three different cash flows.

• The first cash flow is dividend 1. Let’s call it D1

• The second cash flow is dividend 2. Let’s call it D2
• Lastly, the third cash flow is the final selling price i.e. P2

Also, note that the first cash flow will be received at the end of year 1. However, the second and third cash flows will be simultaneously
received at the end of year 2.
Hence, we will discount the first dividend of $4 at 10% for 1 period only. However, second dividend plus the final sale proceeds i.e. $6
and $100 are to be received after two years, therefore they will be discounted for 2 periods.
The formula for the two period dividend discount model is:

= [D1/(1+ )]+ [D2+P2/(1+ )2 ]

= [$4/(1.1)]+ [$6+$100/(1.1)2 ]
= $3.7 + $87.6
=$91.3
Thus, from the given assumptions the value of this investment should be equal to $91.3 in present value terms
Current market price =Rs. 60, Expected dividends for next 2 years Rs.3 and Rs.3.5, Expected price at the end of 2 years
Rs.80, Investor’s required return is 16%. What’s the value of the share and should it be bought at Rs.60?

Solution:

P0 = 3/(1.16) +3.5/(1.16)2 +80/(1.16)2 =2.58 + 2.60 + 59.45 = 64.63

Decision: Since V0 > Current market price of Rs. 60, investor should buy the share.
Gordon Growth model

Given last year’s dividend = Rs. 3 per share, expected growth rate 10% p.a.,
investor’s required rate 16%. What should be the value of share to the
investor? If current market price is Rs.52, should it be bought?

Solution:

V0 = D0 (1+g)/(Ke –g)
= 3(1.10)/.16-.10
=3.30/.06
=Rs.55

The stock is undervalued.

Preferred Stock Valuation Using the No Growth Model

Consider the following example with a preferred stock. Assuming that a preferred
stock has a par value of $75, pays a 10% dividend and you have an 8% required
return, what is this stock worth to you?
Common Stock Valuation Using the Constant Growth Model

consider a stock that just paid a dividend (D 0) of $5.00 per share with dividends growing at a constant
4% per year. If my required return is 13%, what is the stock worth to me?
1. Suppose, the current dividend of a firm is $2.50, the growth rate is 5% and the
expected rate of return is 10%.

a. What should the price of this stock be using a constant DDM model?
Value = $2.50(1.05)/(.1-.05) = $52.50.

b. If the expected rate of return increases to 11%, what is the percentage price change of a
firm?
Value = $2.50(1.05)/(.11-.05) = $43.75 so percentage change is $43.75/$52.50 – 1 = -16.7%

c. If the growth rate of a firm falls to 4.5%(leave expected rate of return at 10%), what is
the percentage price change for the firm?
Value = $2.50(1.045)/(.10-.045) = $47.50 so percentage change is $47.50/$52.50 – 1 = -9.5%.
Notice how just a 10% error in your inputs can lead to drastic changes in your valuation.
1. Suppose, a company’s dividend next year is expected to be $5 with a growth
rate of 3% and a expected rate of return of 9%.

a. What should the current price of the stock be using a constant DDM model?

Value = $5/(.09-.03) = $83.33

b. What would the price of the stock be 5 years from now?

To find the price 5 years from now, we need to find the dividend in the 6th year.
Thus, D6 = D1 /(1 + g)5.
Note if given D0,
D6 = D0(1 + g)6.
D6 = 5(1.03)5 = $5.796,
so value = $5.796/(.09-.03) = $96.61.
3. If Reliance Petrol’s current dividend is $1 and the company is reducing dividends by 4% per year,
what should the price of the stock be with a expected rate of return of 8%? Use the constant DDM
model.
Negative or zero growth rates are not a problem for this model.
Simply set g = -4 in this case.
Value = $1(1 – .04)/(.08-(-.04)) = 0.96/.12 = $8.

4. Using the constant DDM model, what must be the growth rate of a stock that is selling for $50, has
a expected rate of return of 12%, and a current dividend of $2?

Value = D0(1+g)/(k-g).
Solving for g, we have g =(Value(k) – D0)/(Value + D0).
So g = (50(.12) – 2)/(50+2) = 4/52 =7.7%.

5. Using the constant DDM model, what must be the growth rate of a stock that is selling for $50, has
a expected rate of return of 12%, and whose dividend next year is expected to be $2?

Value = D1/(k-g), solving for g, we have g = (Value(k) – D 1)/Value.

So g = (50(.12) – 2)/50 = .08.
Firm Valuation with Non-constant Growth: Problem

Assume the following:

• k = 13.4% (required rate of return
• N = 3 (years of supernormal growth)
• gs = 30% (rate of growth in supernormal period)
• gn = 8% (rate of growth in normal period)
• D0 = $1.15 (last dividend paid)

Find the value of the supernormal growth stock stock?

Process:

• The value of the firm equals the present value of its expected future dividends.
• Find the present value of the dividends during the period of non-constant growth.
• Find the price of the stock at the end of the non-constant growth period and discount
this price back to the present.
• Add the two components to find the value of the stock, P0.
Step 1:
Calculate the dividends expected at the end of each year during the supernormal
period.
Dn = Dn-1(1 + gs)
D1 = $1.15(1 + .3) = $1.495
D2 = $1.495(1 + .3) = $1.9435
D3 = $1.9435(1 + .3) = $2.5265

Step 2:
Calculate the price of the stock during the normal growth period using the Gordon model.
Calculate the dividend in the fourth period.
Use the constant growth formula to find P3.
D4 = $2.5265(1+0.08 ) = $2.7286

P3 = $2.7286/(0.134 – 0.08) = $50.53

If the stockholder sold the stock in period 3, he would receive $50.53.

Total cash flow at time 3 equals D3 + P3 = $53.0576

Step 3:
Discount the cash flows found in steps 1 and 2 and sum the amounts to find the value of
the supernormal growth stock.
D1 = $1.4950/ 1.134 = $1.3183
D2 = $1.9435/1.2859 = $1.5113
D3 = $2.5265/1.4583 = $1.7325
P3 = $50.5310 /1.4583 = $34.65

Value of growth stock = $39.21