Chapt 7 Stock Valuation

Chap 7 Stock valuation
Wednesday, October 25, 2023 12:15 PM
Zero Growth
The case of zero growth is one we’ve already seen. A share of common
stock in a company with a constant dividend is much like a share of preferred stock. From
Chapter 5 (Example 5.7), we know that the dividend on a share of preferred stock has zero
growth and thus is constant through time. For a zero-growth share of common stock, this
implies that:
So, the value of the stock is:
Because the dividend is always the same, the stock can be viewed as an ordinary perpetuity
with a cash flow equal to D every period. The per-share value is thus given by:
P0= D/R [7.2]
where R is the required return.

For example, suppose the Paradise Prototyping Company has a policy of paying a
$10 per-share dividend every year. If this policy is to be continued indefinitely, what is the
value of a share of stock if the required return is 20 percent? The stock in this case amounts
to an ordinary perpetuity, so the stock is worth $10/.20 = $50 per share.
Constant Growth
Suppose we know that the dividend for some company always
grows at a steady rate. Call this growth rate g. If we let D0 be the dividend just paid, then the
next dividend, D is
The dividend in two periods is:
We could repeat this process to come up with the dividend at any point in the future. In
general, from our discussion of compound growth in Chapter 4, we know that the dividend
t periods into the future, D
t
, is given by:
D
An asset with cash flows that grow at a constant rate forever is called a growing perpetuity.
As we will see momentarily, there is a simple expression for determining the value of such
an asset.
The assumption of steady dividend growth might strike you as peculiar. Why would the
dividend grow at a constant rate? The reason is that, for many companies, steady growth in
dividends is an explicit goal. This subject falls under the general heading of dividend policy,
so we defer further discussion of it to a later chapter.
If the dividend grows at a steady rate, then we have replaced the problem of forecasting
an infinite number of future dividends with the problem of coming up with a single growth
rate, a considerable simplification. In this case, if we take D0 to be the dividend just paid
and g to be the constant growth rate, the value of a share of stock can be written as:
As long as the growth rate, g, is less than the discount rate, R, the present value of this series
of cash flows can be written as:
This elegant result goes by a lot of different names. We will call it the dividend
growth model. By any name, it is very easy to use. To illustrate, suppose D0 is $2.30, R is
13 percent, and g is 5 percent. The price per share in this case is:
We can actually use the dividend growth model to get the stock price at any point in time,
not just today. In general, the price of the stock as of Time t is:
In our example, suppose we are interested in the price of the stock in five years, P5. We first
need the dividend at Time 5, D5. Because the dividend just paid is $2.30 and the growth rate
is 5 percent per year, D5 is:
D5 = $2.30 × 1.055 = $2.30 × 1.2763 = $2.935
From the dividend growth model, we get that the price of the stock in five years is:
EXAMPLE 7.3 Gordon Growth Company
The next dividend for the Gordon Growth Company will be $4 per share. Investors require a 16
percent return on companies such as Gordon. Gordon’s dividend increases by 6 percent every
year.Based on the dividend growth model, what is the value of Gordon’s stock today? What is
the valuein four years? The only tricky thing here is that the next dividend, D1, is given as $4,
so we won’t multiply this by (1 + g). With this in mind, the price per share is given by:
Because we already have the dividend in one year, we know that the dividend in four years is equal
to D1 × (1 + g)3 = $4 × 1.063 = $4.764. The price in four years is therefore:
This last example illustrates that the dividend growth model makes the implicit assumption that the
stock price will grow at the same constant rate as the dividend. This really isn’t too surprising. What
it tells us is that if the cash flows on an investment grow at a constant rate through time, so does the
value of that investment
You might wonder what would happen with the dividend growth model if the growth
rate, g, were greater than the discount rate, R. It looks like we would get a negative stock
price because R − g would be less than zero. This is not what would happen.
Instead, if the constant growth rate exceeds the discount rate, then the stock price is
infinitely large. Why? If the growth rate is bigger than the discount rate, then the present
value of the dividends keeps on getting bigger and bigger. Essentially, the same is true if the
growth rate and the discount rate are equal. In both cases, the simplification that allows us
to replace the infinite stream of dividends with the dividend growth model is “illegal,” so the
answers we get from the dividend growth model are nonsense unless the growth rate is less
than the discount rate.
Finally, the expression we came up with for the constant growth case will work for any
growing perpetuity, not just dividends on common stock. If C1 is the next cash flow on a
growing perpetuity, then the present value of the cash flows is given by:
Present value = C1/(R − g) = C0(1 + g)/(R − g)
Nonconstant Growth
The last case we consider is nonconstant growth. The
main reason to consider this case is to allow for “supernormal” growth rates over some
finite length of time. As we discussed earlier, the growth rate cannot exceed the required return indefinitely, but
it certainly could do so for some number of years. To
avoid the problem of having to forecast and discount an infinite number of dividends,
we will require that the dividends start growing at a constant rate sometime in the
future.
For a simple example of nonconstant growth, consider the case of a company that is
currently not paying dividends. You predict that, in five years, the company will pay a dividend for the first
time. The dividend will be $.50 per share. You expect that this dividend
will then grow at a rate of 10 percent per year indefinitely. The required return on companies such as this one
is 20 percent. What is the price of the stock today?
To see what the stock is worth today, we first find out what it will be worth once dividends are paid. We can
then calculate the present value of that future price to get today’s
price. The first dividend will be paid in five years, and the dividend will grow steadily
from then on. Using the dividend growth model, we can say that the price in four years
will be:
If the stock will be worth $5 in four years, then we can get the current value by discounting this price
back four years at 20 percent:
The stock is therefore worth $2.41 today.

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Chap 7 Stock valuation

Wednesday, October 25, 2023 12:15 PM

So, the value of the stock is:

where R is the required return.

The dividend in two periods is:

EXAMPLE 7.3 Gordon Growth Company

The stock is therefore worth $2.41 today.

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