STOCK VALUATION

6-1
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 6.1 THE PRESENT VALUE OF
COMMON STOCKS
• The value of any asset is the present value
of its expected future cash flows
• Stock ownership produces cash flows
from:
• Dividends
• Capital Gains
• Valuation of Different Types of Stocks
• Zero Growth
• Constant Growth
• Differential Growth
6-2
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 CASE 1: ZERO GROWTH
• Assume that dividends will remain at the
same level forever
D iv 1  D iv 2  D iv 3  
· Since future cash flows are constant, the value of a zero
growth stock is the present value of a perpetuity:

Div 1 Div 2 Div 3

P0    
(1  R ) (1  R )
1 2
(1  R ) 3

Div
P0 
R
6-3
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 ZERO GROWTH EXAMPLE

• Suppose Big Deal Company will pay an annual

dividend of $2.00 per common share that will
never increase or decrease.
• The market rate of return is 8.5%.
• What is the maximum amount you should be
willing to pay for a common share of Big Deal
Corporation?

• Formula for Zero Growth Model: P = Div / R

• Solution: P = $2.00 / .085

P = $23.53
6-4
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 CASE 2: CONSTANT GROWTH
Assume that dividends will grow at a constant rate, g,
forever, i.e.,
D iv 1  D iv 0 (1  g )
D iv 2  D iv 1 (1  g )  D iv 0 (1  g ) 2
D iv 3  D iv 2 (1  g )  D iv 0 (1  g ) 3
..
.
Since future cash flows grow at a constant rate forever,
the value of a constant growth stock is the present value
of a growing perpetuity:
Div 1
P0 
Rg
6-5
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 CONSTANT GROWTH EXAMPLE

• Suppose Big D, Inc., just paid a dividend of $.50.

It is expected to increase its dividend by 2% per
year. If the market requires a return of 15% on
assets of this risk level, how much should the
stock be selling for?
• P0 = .50(1+.02) / (.15 - .02) = $3.92

6-6
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 A WORD ABOUT DIVIDENDS IN THE
CONSTANT GROWTH MODEL
• It is critical to understand that in the constant
growth model, calculations are based on the next
dividend
• If a situation only provides information on the
last dividend it must be increased by the growth
rate to arrive at the next dividend
• If a situation provides the value of the next
dividend, then the data necessary for the
calculation is known and need not be derived.
• An analyst must discriminate whether they have
information about the next or last dividend and
proceed with calculation accordingly

6-7
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 CASE 3: DIFFERENTIAL GROWTH

• Assume that dividends will grow at

different rates in the foreseeable
future and then will grow at a
constant rate thereafter.
• To value a Differential Growth Stock,
we need to:
• Estimate future dividends in the foreseeable future.
• Estimate the future stock price when the stock becomes
a Constant Growth Stock (case 2).
• Compute the total present value of the estimated future
dividends and future stock price at the appropriate
discount rate.

6-8
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 CASE 3: DIFFERENTIAL GROWTH
(DIVIDENDS)
· Assume that dividends will grow at rate g1 for N
years and grow at rate g2 thereafter
Div 1  Div 0 (1  g 1 )
D iv 2  D iv 1 (1  g 1 )  D iv 0 (1  g 1 ) 2
..
.
D iv N  D iv N 1 (1  g 1 )  D iv 0 (1  g 1 ) N

D iv N 1  D iv N (1  g 2 )  D iv 0 (1  g 1 ) N (1  g 2 )
.
..

6-9
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 CASE 3: DIFFERENTIAL GROWTH
(DIVIDENDS CONTINUED)
Dividends will grow at rate g1 for N years and grow
at rate g2 thereafter
D iv 0 (1  g 1 ) D iv 0 (1  g 1 ) 2
…
0 1 2
Div N (1  g 2 )
D iv 0 (1  g 1 ) N  Div 0 (1  g 1 ) N (1  g 2 )
… …
N N+1
6-10
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 CASE 3: DIFFERENTIAL GROWTH
(FORMULA LOGIC)
We can value this as the sum of:
 a T-year annuity growing at rate g1

C  (1  g 1 ) T 
PA  1  T 
R  g1  (1  R ) 
 plus the discounted value of a perpetuity growing at
rate g2 that starts in year T+1
 Div T 1 
 
 R  g2 
PB 
(1  R )T
6-11
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 CASE 3: FORMULA FOR
DIFFERENTIAL GROWTH

Consolidating gives:

 Div T 1 
 
C  (1  g1 ) T   R  g 2 
P 1  T 

R  g1  (1  R )  (1  R ) T

Or, we can “cash flow” it out.

6-12
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 A DIFFERENTIAL GROWTH EXAMPLE

A common stock just paid a dividend of

$2. The dividend is expected to grow at
8% for 3 years, then it will grow at 4%
in perpetuity.
What is the stock worth? The discount
rate is 12%.

6-13
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 EXAMPLE WITH THE FORMULA

 $ 2 (1 .08) 3 (1 .04 ) 
 
$ 2  (1 .08)  (1 .08) 3   .12  .04 

P 1  3

.12  .08  (1 .12 )  (1 .12 ) 3

P  $ 54  1  .8966 
$ 32 .75 
3
(1 .12 )

P  $ 5 .5 8  $ 2 3 .3 1 P  $ 2 8 .8 9

6-14
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 EXAMPLE WITH CASH FLOWS

$ 2 (1 . 0 8 ) $ 2(1 . 08) 2 $ 2(1 . 08) 3 $ 2(1 . 08 ) 3 (1 . 04 )

…
0 1 2 3 4
$ 2 .62 The constant
$ 2 .1 6 $ 2 .3 3 $ 2 .52  growth phase
.08 beginning in year 4
can be valued as a
0 1 2 3 growing perpetuity
at time 3.
$ 2 . 16 $ 2 . 33 $ 2 . 52  $ 32 . 75
P0   2
 3
 $ 28 . 89
1 . 12 (1 . 12 ) (1 . 12 ) $ 2 . 62
P3   $ 32 . 75
. 08
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
6-15
 6.2 ESTIMATES OF PARAMETERS

• The value of a firm depends upon its growth rate,

g, and its discount rate, R.
• Where does g come from?
g = Retention ratio × Return on retained
earnings
• Example: Suppose a company has a retention
ratio of 70% and earns an ROE of 12%. What is
the Growth Rate, g?
• g = .70 X .12
• g = .084 = 8.4%

6-16
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 WHERE DOES R COME FROM?

• The discount rate can be broken into two parts:

• The dividend yield
• The growth rate (in dividends)
• AKA: Capital Gains Yield
• In practice, there is a great deal of estimation
error involved in selecting R
• Cases calling for special skepticism:
• Stocks not paying dividends
• Stocks with g expected to equal or exceed R

6-17
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 USING THE DGM TO FIND R
• Start with the DGM:
D 0 (1  g) D1
P0  
R -g R -g
Rearrange and solve for R:
D 0 (1  g) D1
R g g
P0 P0
• Note that D1 /P0 is the dividend yield and g
is the capital gains yield.

6-18
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 EXAMPLE: USING DGM TO FIND R

• Imagine that a Solar Corp.’s last dividend was

$.65 per share. Solar’s dividends are growing at a
rate of 4% and the current price per share is
$11.25. What is the market R implicit in Solar’s
price?
• R=(D1 / P0) +g
• R = [(.65 x 1.04) / 11.25] + .04
• R= .10 or 10%

6-19
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 TOTAL PAYOUT

• Dividends may not be a firm’s only cash payout

• Recently many firms have repurchased shares,
another form of payout
• Using the Dividend Growth Model, the price of a
share will be higher if considering total payout
rather than just dividends

6-20
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 EXAMPLE: TOTAL PAYOUT
VALUATION
• A firm forecasts income of $4.00 per share and will
payout 30% as dividends, 30% as a share repurchase
and will retain the rest. Its growth rate is 5% and
required return is 10%. What is the price of a share?
• Dividend Growth Model: P0 = (4.00 X .30) / (.1 - .05) =
$24.00
• Notice that the price is based on dividend ( 30% of earnings)
growth only
• Total Payout Model: P0 = (4.00 X .60) / (.1 - .05) = $48.00
• Notice that the price is based on total payout (60% of
earnings = 30% for dividends and 30% for share repurchase)
growth

6-21
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 6.3 COMPARABLES

• Comparables are used to value companies

based primarily on multiples
• Common multiples include:
• Price-to-Earnings
• Enterprise Value Ratios

6-22
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 PRICE-EARNINGS RATIO

• The price-earnings ratio is calculated as the

current stock price divided by annual EPS.
• The Wall Street Journal uses last four quarters’
earnings

Price per share

P/E ratio 
EPS

6-23
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 PRICING WITH A COMPARABLE

• Suppose your company has EPS of $1.69.

The industry average P/E ratio is 26.94.
What is the estimated price for your
company?

P / E  E  26.94 1.69  $45.53

6-24
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
6.5 SOME FEATURES OF COMMON AND
PREFERRED STOCK
• Voting rights (Cumulative vs. Straight)
• Proxy voting
• Classes of stock
• Other rights
• Share proportionally in declared dividends
• Share proportionally in remaining assets during
liquidation
• Preemptive right – first shot at new stock issue to
maintain proportional ownership if desired

6-25
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 FEATURES OF PREFERRED STOCK

• Dividends
• Stated dividend must be paid before dividends can be
paid to common stockholders
• Dividends are not a liability of the firm, and preferred
dividends can be deferred indefinitely
• Most preferred dividends are cumulative – any missed
preferred dividends have to be paid before common
dividends can be paid
• Preferred stock generally does not carry voting
rights

6-26
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 6.6 THE STOCK MARKETS

• Dealers vs. Brokers

• New York Stock Exchange (NYSE Euronext)
• Largest stock market in the world
• License Holders (members)
• Entitled to buy or sell on the exchange floor
• Designated market makers (DMMs)
• Floor brokers
• Supplemental liquidity providers (SLPs)
• Operations
• Floor activity

6-27
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 NASDAQ

• Not a physical exchange – computer-based

quotation system
• Multiple market makers
• Electronic Communications Networks
• Websites that allow investors to trade directly with one
another
• They increase liquidity and competition
• Large portion of technology stocks

6-28
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 STOCK MARKET REPORTING

Insert Costco quote information from Section 6.6 here

6-29
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 QUICK QUIZ

• What determines the price of a share of stock?

• What determines g and R in the DGM?
• Discuss the importance of the PE ratio.
• What are some of the major characteristics of
common and preferred stock?
• Discuss the nature of the various markets for
stocks.

6-30
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.