Stock Valuation
Estimating the present value of a share of common stock with the Dividend Discount Model.
Problem 1:
We are fairly certain The ABC Company will pay $4, $4.50, and $5 in dividends at the end of years 1, 2, and 3
respectively. We expect the stock share to sell for $70.00 at the end of year 3. An investment with comparable risk is earning
8%. What is the value today of one share of The ABC Company?
Given:
Definition Notation: Inputs:
The expected upcoming (end of period 1) dividend D1 $4.00
The expected upcoming (end of period 2) dividend D2 $4.50
The expected upcoming (end of period 3) dividend D3 $5.00
The required rate of return on the firm's common stock r 0.08
The expected future stock price at the Horizon time PH $70.00
The present value of the stock share (market price) P0 ?
Finance Concept: P0 = PV of expected future dividends
P0 = D1/(1+r)1 + D2/(1+r)2 +…+ (DivH +PH) / (1+r)H
Where H is the horizon or specific investment time period.
In Words: The Present Value of a stock share depends on the stream of expected dividends.
This is the generalized stock valuation model which is also how we value bonds.
Excel Solution Using a Table:
Today Year 1 Year 2 Year 3
a Interest Rate - <= $I$20
b Time 0 1 2 3
c Stock Price at year 3 - 0 0 <= PH
d Dividends -
e Total Cash Flows - <= sum rows c and d
f PV interest factor -
g Present Value $67.10
1. It is easier to enter the known inputs before you enter the formulas.
Enter the interest rates, the dividends for years 1 through 3, the stock price at year 3.
In row e find the Total Cash Flows by adding row c to row d.
2. Now we are ready to calculate the PV Interest Factor for each cash flow in row f . PVIF = 1/(1+r)t
In cell F39 enter the formula: = 1/(1+F34)^1 and copy to cells G39 and H39
You must change the exponents on cells G39 to ^2 and H39 to ^3.
3. Next we find the PV of each cash flow in row g.
In cell F40 enter the PV formula CF* PVIF: =F38*F39 and copy to cells G40 and H40.
4. Lastly, we sum the PVs to get the PV of the annuity in cell E40.
In cell E40 enter the formula: = sum(F40:H40)
5. Your answer should be: The value of the stock today is $67.10.
Problem 2: Constant Dividends
We now think The ABC Company will pay a constant, non-growing dividend of $5.50 forever. An investment with
comparable risk is earning 8%. What is the value today of one share of The ABC Company?
Under the assumptiuon of no growth, the stock's dividend stream is a simple perpetuity.
Given:
Definition Notation: Inputs:
The expected constant dividend Dt 5.5
The required rate of return on the firm's common stock r 0.08
The present value of the stock share (market price) P0 ?
Finance Concept: Under the assumption of no growth, the stock's dividend stream is a simple perpetuity.
Numerical Solution: P0 = Dt/r
P0 = 5.5/0.08
P0 = $68.75
In Words: The Present Value of a stock share with expected constant dividends of $5.50, and a required return
of 8% is $68.75.
Test your skills:
1 What is the estimated stock price whose dividends are expected to be $0.75 forever with a
required return of 10% ? $ 7.50 Use the formula P0 = Dt/r.
2 What is the estimated stock price whose dividends are expected to be $0.75 forever with a
required return of 20% ? $ 3.75 Use the formula P0 = Dt/r.
Problem 3: Growing Dividends
LMN Company's dividends have historically grown at 2% per year. We expect this trend to continue. LMN Company
paid a $4.00 dividend this year. If investments with similar risk earn 8%, how much is a share of LMN Company worth today?
Given:
Definition Notation: Inputs:
The current, already paid (end of period 0) dividend D0 $4.00
The required rate of return on the firm's common stock r 0.08
The expected annual growth rate in dividends g 0.02
The expected upcoming (end of period 1) dividend D1 ?
The present value of the stock share P0 ?
Finance Concept: P0 = D1/ (r - g)
D1 = D0 (1+g)
Numerical Solution:
D1 = D0 (1+g)
D1 = 4 (1+.02)
D1 = 4.08
P0 = D1/(r - g)
P0 = 4.08 / (.08-.02)
P0 = 4.08 /.06
P0 = $68.
In Words: The Present Value of a stock share with a current dividend of $4.00 and a constant growth rate
of 2% and a required return of 8%, is valued at $68 today.
Test your skills:
1 What would you pay tod1ay for a stock that is expected to make a $4.00 dividend in one year if the
expected dividend growth rate is 3% and you require a 15% return on your investment?
D1 $ 1.50 Fill in the known inputs in cells E124:E126
g 3%
r 15%
Formula: P0 = D1/(r - g)
P0 = $ 12.50 In cell E130 write the formula by clicking on the cells or
by typing in the values. Remember the ( ) and / and - .
2 What would you pay today for a stock whose most recent dividend is $1, dividends are expected
to grow at 9% indefinitely and the required return is 9.1%?
D1 = D0 *(1+g)
D0 $ 1.00
g 7%
D1 $ 1.07 We first find next year's dividend, D1.
Formula: P0 = D1/(r - g)
D1 $ 1.07
g 0.07
r 0.091
P0 = $ 50.95 Then we find today's price.
ars 1, 2, and 3
parable risk is earning
f . PVIF = 1/(1+r)t
cells G40 and H40.
An investment with
s a simple perpetuity.
nd a required return
tinue. LMN Company
ompany worth today?
ant growth rate
in one year if the
clicking on the cells or
er the ( ) and / and - .
ds are expected
