Chapter 8

Stock Valuation

Konan Chan
Financial Management, Spring 2016

Key Concepts and Skills

Understand how stock prices depend on future
dividends and dividend growth
Be able to compute stock prices using the
dividend growth model
Understand the features of common and
preferred stocks

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Topics Covered
Dividend discount model
Constant growth dividend discount model
Valuing common stocks
Income stocks vs. growth stocks
Common stock and dividend
Preferred stock

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Dividend Discount Model (DDM)

Discount future dividends back to present where T is
time horizon for your investment
D1 D2 DT PT
P0 ...
(1 r)1 (1 r)2 (1 r)T

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Dividend Discount Model - example
Current forecasts for XYZ Company dividends are
$3, $3.24, and $3.50 over the next three years,
respectively. At the end of three years you anticipate
selling your stock at a market price of $94.48. What
is the price of the stock given a 12% expected return?

3.00 3.24 3.50 94.48

PV
(1 .12) (1 .12)
1 2
(1 .12) 3
PV $75.00
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Types of DDM
D1 D2 DT PT
P0 ...
(1 r)1 (1 r)2 (1 r)T
How to implement in reality?
Stock valuations fall into 3 categories
Constant growth rate in dividends
Zero growth rate in dividends
Supernormal (non-constant) growth rate in dividends

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Constant Growth DDM
A dividend discount model where dividends are
assume to grow at a constant rate forever
Also called Gordon Growth Model
Given any combination of variables in the equation,
you can solve for the unknown variable.

D1 D (1 g )
P0 0
rg rg

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Constant Growth DDM

D1 = D0 (1 + g)
D2 = D1 (1 + g) = D0 (1 + g)2
D1 D2 D1 D1(1 g)
P0 ... ...
(1 r)1 (1 r)2 (1 r)1 (1 r)2
Using geometric series formula

D1 1 11gr D1 1
t
D1 D0(1 g)
P0
1 r 1 1r 1 r 1r r g

1g rg
rg
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Constant Growth DDM - example
What is the value of a stock that expects to pay a
$3.00 dividend next year, and then increase the
dividend at a rate of 8% per year, indefinitely?
Assume a 12% expected return
D1 $3.00
P0 $75.00
r g .12 .08

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Same example
If the same stock is selling for $100 in the stock
market, what might the market assume about the
growth in dividends?
$3
$100 g 0.09
0.12 g
The market assumes the dividend will grow at
9% per year, indefinitely.

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 Estimate Expected Return
Given constant growth dividend discount model, we
can estimate stock return
D1 D
P0 r 1 g
rg P0
Expected return = expected dividend yield + growth
rate
Previous example:
r = $3/$75 + 8% = 12%

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Components of Expected Return

Expected Return
r = total income/ purchase price
r = [dividend income + capital gain (or loss)]/price
r = expected dividend yield + capital gain yield
= D1/ P0 + (P1 P0) / P0

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Growth in Constant Growth DDM
D1 D2 D1 D1(1 g)
P0 ... ...
(1 r) (1 r)
1 2
(1 r) (1 r)
1 2

D2 D3 D1(1 g) D1(1 g)2

P1 ... ...
(1 r)1 (1 r)2 (1 r)1 (1 r)2
P1 / P0 = 1 + g (i.e., the firm will grow
constantly)

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DDM without Growth

If we forecast no growth for the stock (i.e., dividends
keep constant forever), the stock will become a
perpetuity
D1
P0
r
This is exactly the valuation for preferred stocks
If firms pay out all earnings as dividends when firms
do not grow, then
EPS1
P0
r
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What if CGDDM Doesnt Apply?
D1
P0
rg
Any restriction on constant growth DDM?
What does it mean? How to deal with it if this
restriction exists?
Two-stage or multiple stage of growth

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Non-constant Growth Model

Two stages of growth
assume stock has period of non-constant growth in
dividend, and then eventually settles into a normal constant
growth pattern
3-step Valuation
Estimate the dividend during non-constant growth period
Estimate the PV of the constant growth dividends at the
end of non-constant growth period which is also the
beginning of the constant growth period
Get the present value of the above two values

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 Supernormal Model - Example
The growth rate for firm ABC is expected to be 20% for next two
years, and 6% thereafter. The current dividend is $1.60, and the
firms required rate of return is 10%. Whats stock worth today?

g1 = 20% g1 = 20% g = 6%

Step 1 D1=$1.6(1.2)=$1.92 D2=$1.92(1.2)=$2.304

D2 1 g $2.304(1 .06)
P2 $61.056
Step 2 rg .10 .06

D1 D P $1.92 $2.304 $61.056

Step 3 P0 2 22 $54.11
1 r (1 r ) 1.10 (1.10) 2

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Quiz (two-stage growth model)

The growth rate is 20% for the next 4 years, and no growth
thereafter. The last dividend was $1.50, and the required rate of
return is 18%. What should be the current price?
0 1 2 3 4 5

D0=$ D1=$
D2=$
D3=$
D4=$
D (1 g )
P4 4
rg

P0 $
1 r (1 r ) 2 (1 r )3 (1 r )4

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Sustainable Growth Rate
Payout ratio
Fraction of earnings paid out as dividends
Plowback (retention) ratio = 1 - payout ratio
Fraction of earnings retained by the firm
g = return on equity (ROE) * retention ratio
Steady rate at which a firm can grow
This estimation of growth rate applies to
stable firms only

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Higher or Lower Dividends?

The constant growth model suggests to pay
higher dividends
The higher D1, the higher current price P0
How about paying all earnings as dividends?
The sustainable growth rate equation suggests
that if a firm pays a lower dividend, and reinvest
the funds, the stock price MAY increase because
future dividends may be higher.

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Income Stocks vs. Growth Stocks
Our company forecasts to pay a $5.00 dividend next year, which
represents 100% of its earnings. This will provide investors with a
12% expected return. Instead, we decide to plow back 40% of the
earnings at the firms current return on equity of 20%. What is the
value of the stock before and after the plowback decision?
No growth With growth
5 g .20 .40 .08
P0 $41.67 3
.12 P0 $75.00
.12 .08
The difference between these two numbers (75.00-41.67=33.33) is
the Present Value of Growth Opportunities (PVGO), which is net
present value of a firms future investments

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Stock Valuation Using Multiples

Another common valuation approach is to multiply a
benchmark PE ratio by earnings per share (EPS) to
come up with a stock price
Pt = Benchmark PE ratio * EPSt
The benchmark PE ratio is often an industry average
or based on a companys own historical values
The price-sales ratio and price-book ratio can also be
used

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Multiples Valuation: Example
Suppose a company had earnings per share of
$3 over the past year. The industry average
PE ratio is 12.
Use this information to value this companys
stock price.
Pt = 12 x $3 = $36 per share

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Common Stock and Dividend

Voting right
Dividends are not a liability of the firm until a
dividend has been declared by the Board
Firms cannot go bankrupt for not declaring dividends
Dividends and Taxes
Dividends are not tax deductible
Dividends by individuals are taxed as ordinary
income
Dividends by corporations can exclude 70% of tax;
only 30% will be taxed

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Preferred Stock
Stated dividend that 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

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