Stock

Valuation
FIN202 – CHAPTER 9
Learning Objectives
1. List and describe the four types of secondary markets.

2. Explain why many financial analysts treat preferred stock as a special type of bond rather than as an
equity security.

3. Describe how the general dividend-valuation model values a share of stock.

4. Discuss the assumptions that are necessary to make the general dividend-valuation model easier to
use and use the model to compute the value of a firm’s stock.

5. Explain why g must be less than R in the constant-growth dividend model.

6. Explain how valuing preferred stock with a stated maturity differs from valuing preferred stock with
no maturity and calculate the price of a share of preferred stock under both conditions.
The Market for
Stocks
CHAP 9
The Market for Stocks
Stocks are equity securities - certificates of ownership in a corporation

The stock market is a place where shares of pubic listed

companies are traded
Where to
trade
Stock? Primary market Secondary market

a financial market in which new a financial market in which the

security issues are sold by owners of outstanding securities
companies directly to investors can sell them to other investors
The Market for Stocks
Four types of secondary markets – Ways buyers and sellers find each other in the stock market
Direct
search
• A buyer and seller must
find each other without
assistance. A search
among all possible
partners to locate the best
price is seldom done.
Broker Dealer
• Brokers earn a fee, a • A dealer has an advantage
commission, for bringing over a broker because a
buyers and sellers broker cannot guarantee
together. prompt execution of an
order. A dealer holds an
inventory of securities and
can provide the guarantee.
Auction
• In an auction market,
buyers and sellers
interact with each other
in a group and bargain
over price.
Equity Securities – Types
COMMON STOCK
• Is the basic ownership claim in a corporation
• Has the right to vote on matters such as
electing a board of directors, setting a capital
budget, and proposed mergers or acquisitions
• Has the right to a firm’s residual assets
after creditors, preferred stockholders, and
others with higher priority claims have been
satisfied
PREFERRED STOCK
• Represents ownership in corporation
• Does not have the right to vote
• Has priority over common stock with respect
to dividends and liquidation of assets
• Must be paid a fixed dividend before funds
are distributed to common stockholders
Stock Valuation
CHAP 9
 Valuation - Background
Present 1 2 3 ∞

Investment CF1 CF2 CF3 CF∞

Value of an investment = PV of expected future benefits

Apply DCF model

Cash Flows for Stockholders
If you own a share of stock, you can receive expected future benefits in two ways:

• The company pays dividends

 → cash income

• You sell your shares, either to → capital gains

another investor in the market
Not counted in our
or back to the company upcoming basic
formulars
Equity Valuation
Value of an investment = PV of expected future benefits

General Dividend Valuation Model

◦ Equation 9.1 is a general model for valuing a share of stock

Price of Stock = PV of expected future benefits , (in this case, it is dividend)

Where:
• P0 = the current value, or price, of the stock
• Dt = the dividend received in period t, where t = 1, 2, 3, …. , ∞
• i (or R) = the required return on the common stock or discount rate.
Valuation –
Common Stock
CHAP 9
Equity Valuation – Common
Stock
Valuation of Equity Securities
◦ Valuing common stock is more difficult than valuing bonds or preferred stock because:

Size and timing of dividends are less certain compared to coupon

payments
01
The rate of return on common stock cannot be observed
directly from the market. 02
Common stock is a true perpetuity because it has no
maturity date. 03
Equity Valuation – Simplifying
Assumptions
To make Equation 9.1 more applicable, some simplifying assumptions about the pattern
of dividends are necessary

Assumption 1: Assumption 2: Assumption 3:

Zero-growth Constant growth Multi-stage growth
• The dividend has a • The dividend has a • The dividend has a
zero growth rate constant growth mixed growth
and is always the rate. rate; i.e., the rate is
same higher in some
periods and lower in
others.
Equity Valuation – (1) Zero-growth
model
Assumption 1: Zero-Growth Dividend Model
◦ The dividend is constant: D1 = D2 = D3 = . . . = D∞
◦ Equation 9.1, the dividend-discount model, becomes
Zero-Growth Dividend Model

𝐷 Applying 𝐷
𝑃
formula
= ¿ ¿ of perpetuity 𝑃 0 = ( 9.2)
0 𝑖
Where:
• P0 = the current value, or price, of the stock
• Dt = the dividend received in period t, where t = 1, 2, 3, …. , ∞
• i (or R) = the required return on the common stock or discount rate.
Equity Valuation – (2) Constant-
growth model
Assumption 2: Constant-Growth Dividend Model
i. Dividend expected to grow at g forever, where 𝐷𝑡 + 1= 𝐷𝑡 × ¿ ¿
ii. Stock price expected to grow at g forever
iii. Expected dividend yield is constant
iv. Expected total return, i, must be > g
Equation 9.1, the dividend-discount model, becomes Constant-Growth Dividend Model

Applying formula of 𝐷1
growing perpetuity 𝑃0= (9.4)
𝑖−𝑔
Where:
• P0 = the current value, or price, of the stock 𝐷𝑡 +1
• D1 = the dividend paid in the next period (t = 1) 𝑃𝑡= (9.5 )
• g = the constant-growth rate for dividends 𝑖 −𝑔
• i (or R) = the required return on the common stock or discount rate.
Equity Valuation – (3) Multi-stage
growth model
Assumption 3: Multi-stage Growth Dividend Model
i. In early stage of the business: the supernormal growth occurs first;
ii. Later, the constant growth occurs forever
Equation 9.1, the dividend-discount model, becomes

g%

P0 = PV (Non-constant growth dividend) + PV (Constant growth dividend)

Equity Valuation – (3) Multi-stage
growth model
Assumption 3: Multi-stage Growth Dividend Model
i. In early stage of the business: the supernormal growth occurs first;
ii. Later, the constant growth occurs forever
PV (Non-constant growth dividend)
PV (Constant growth dividend)

𝐷1 𝐷𝑡 +1
¿ ¿ 𝑃𝑡=
𝑖 −𝑔
𝑫𝟏
𝑷 𝟎=
¿ ¿
Common Stock Valuation –
Summary
Assumption 1: Zero-growth
𝐷
• The dividend has a zero growth rate and is 𝑃0= ( 9.2)
always the same
𝑅

Assumption 2: Constant growth

𝐷𝑡 + 1
𝑃𝑡= ( 9.5 )
• The dividend has a constant growth rate. 𝑅 −𝑔

Assumption 3: Multi-stage growth

𝑫𝟏
• The dividend has a mixed growth rate; i.e., the 𝑷 𝟎=
rate is higher in some periods and lower in others. ¿ ¿
Valuation –
Preferred Stock
CHAP 9
Equity Valuation – Preferred
Stock
Valuing Preferred Stock
CASE 1: Preferred stock with a fixed maturity is priced using the bond valuation model
developed in Chapter 8
◦ Equation 8.2 can be restated as the price of a share of preferred stock (PS 0)

PS0 = PV (Dividend payments) + PV (Par value)

Equity Valuation – Preferred
Stock
Perpetual Preferred Stock - Valuation
CASE 2: Perpetual preferred stock has no maturity date
◦ Dividends are fixed (g = 0) 𝐷
𝑃 𝑝𝑠 =
◦ Dividend payments go on forever 𝑖
◦ Use Equation 9.2 to value perpetual preferred stock

Perpetual Preferred Stock – Example

◦ Northwest Airlines has perpetual preferred stock that pays a 𝐷 $5
𝑃 𝑝𝑠 = = =$ 27.78
dividend of $5 per year. Investors require an 18 percent return 𝑖 0.18
on similar investments. What is the value of Northwest’s
preferred?
Thank you for your attention!
FIN202 – CHAPTER 9