Stock Valuation Models:

The Basic Stock Valuation Equation

Like the value of a bond, which we discussed in bond valuation Chapter,
the value of a share of common stock is equal to the present value of all
future cash flows (dividends) that it is expected to provide.

The basic valuation model for common stock is given in Equation

Although a stockholder can earn capital gains by selling stock at a price

above that originally paid, what the buyer really pays for is the right to all
future dividends.
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Three circumstances of
Dividend Discounting Model

1) No Growth in Dividend
2) Constant Growth in Dividend
3)Variable Growth in Dividend
(Differential, Supernormal)
4) Free Cash Flow Model
Stock Valuation Models:
The Zero Growth Model

• The zero dividend growth model assumes that

the stock will pay the same dividend each year,
year after year.

D1 is the next period’s Dividend.

Rs is the required rate of return.

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Stock Valuation Models:
The Zero Growth Model (cont.)

The dividend of Denham Company, an established textile

manufacturer, is expected to remain constant at $3 per
share indefinitely. What is the value of Denham’s stock if the
required return demanded by investors is 15%?

P0 = $3/0.15 = $20

• Note that the zero growth model is also the appropriate

valuation technique for valuing preferred stock.

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Stock Valuation Models:
Constant Growth Model

• The constant dividend growth model assumes

that the stock will pay dividends that grow at a
constant rate each year—year after year forever.

D1 = Dividend in next period

Rs= Required rate of return
G= Growth rate

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The Constant-Growth Model

• Mr. Haque has purchased a common stock of ABC

company. The company has paid dividend TK 36. this
year. When the growth rate is 6% and the required rate
of return is 12%, what is the value of the stock.
D1
P0 = D1 = D0 (1  g ) n
rs  g
D 1 = 36 (1  0.06)1
38.16 D1 = 38.16
P0 =
0.12  0.06

P 0 = 636 TK
Stock Valuation Models:
Constant Growth Model (cont.)

Lamar Company, a small cosmetics company, paid the

following per share dividends:

2012
2011
2010
2009
2008
2007

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Stock Valuation Models:
Constant Growth Model (cont.)
We assume that the historical annual growth rate of
dividends is an accurate estimate of the future constant
annual rate of dividend growth, g. To find the historical
annual growth rate of dividends, we must solve the following
for g:
Use missing interest rate
formula
1
 D t 1  n
g =
 D 
 1
 t 
1
 1.40  5
g =  1
 1 

g= 7%
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Stock Valuation Models:
Constant Growth Model (cont.)

Using Appendix Table A-2 and time value techniques, we

can determine that the growth in dividends is 7%.
Required rate of return is 15%
D1 = D0 (1  g ) n
P0 = $1.50/(0.15 – 0.07) = $18.75
D 1 = 1.40(1  7%)1

• Assuming the values of D1, rs, and g are

accurately estimated, Lamar Company’s stock
value is $18.75 per share.

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 Exercise

McCracken Roofing, Inc., common stock paid a dividend of $1.20 per share
this year. The company expects earnings and dividends to grow at a rate
of 5% per year for the foreseeable future.
a. What required rate of return for this stock would result in a price per
share of $28?
b. If McCracken expects both earnings and dividends to grow at an annual
rate of 10%, what required rate of return would result in a price per share
of $28?
D1 1.20  1.05
P0 = 28 =
rs  g rs  0.05
D1 1.26
( rs  g ) = ( rs  0.05) =
P0 28
D1
rs =  g rs = 0.045  0.05  0.095  (9.5%)
P0
B. 0.145 = 14.5%
Stock Valuation Models:
Variable-Growth Model

• The non-constant dividend growth or variable-growth

model assumes that the stock will pay dividends that
grow at one rate during one period, and at another rate in
another year or thereafter.

• We will use a four-step procedure to estimate the value of

a share of stock assuming that a single shift in growth
rates occurs at the end of year N.

• We will use g1 to represent the initial growth rate and g2

to represent the growth rate after the shift.
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Stock Valuation Models:
Variable-Growth Model (cont.)

Step 1. Find the value of the cash dividends at the end of

each year, Dt, during the initial growth period, years 1
though N.

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Stock Valuation Models:
Variable-Growth Model (cont.)

Step 2. Find the present value of the dividends expected

during the initial growth period.

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Stock Valuation Models:
Variable-Growth Model (cont.)

Step 3. Find the value of the stock at the end of the initial
growth period, PN = (DN+1)/(ks-g2), which is the present
value of all dividends expected from year N+1 to infinity,
assuming a constant dividend growth rate, g2.

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Stock Valuation Models:
Variable-Growth Model (cont.)

Step 4. Add the present value components found in

Steps 2 and 3 to find the value of the stock, P0, given
in following Equation

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Stock Valuation Models:
Variable-Growth Model (cont.)

The most recent annual (2009) dividend payment of Warren

Industries, a rapidly growing boat manufacturer, was $1.50
per share. The firm’s financial manager expects that these
dividends will increase at a 10% annual rate, g1, over the
next three years. At the end of three years (the end of
2012), the firm’s mature is expected to result in a slowing of
the dividend growth rate to 5% per year, g2, for the
foreseeable future. The firm’s required return, ks, is 15%.

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Stock Valuation Models:
Variable-Growth Model (cont.)

Steps 1 and 2. See Table 7.3 below.

Table 7.3 Calculation of Present Value of Warren

Industries Dividends (2010–2012)

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Stock Valuation Models:
Variable-Growth Model (cont.)

Step 3. The value of the stock at the end of the initial

growth period (N = 2009) can be found by first calculating
DN+1 = D2010.

D2013 = D2012 X (1 + 0.05)1 = $2.00 X (1.05)1 = $2.10

By using D2013 = $2.10, a 15% required return, and a 5%

dividend growth rate, we can calculate the value of the
stock, P2012, at the end of 2012 as follows:

P2012 = D2013 / (rs-g2) = $2.10 / (.15 - .05) = $21.00

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Stock Valuation Models:
Variable-Growth Model (cont.)

Step 3 (continued). Finally, in Step 3, the share value of $21 at the

end of 2012 must be converted into a present (end of 2009) value.

PVIFrs,N X PN = PVIF15%,3 X P2009 = 0.658 X $21.00 = $13.82

PV0 = FV / (1+i)n = 21/ (1+.15)3 = 13.82

Step 4. Adding the PV of the initial dividend stream (found in Step 2)

to the PV of the stock at the end of the initial growth period (found in
Step 3), we get:

P2009 = $4.14 + $13.82 = $17.96 per share

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Stock Valuation Models:
Variable-Growth Model (cont.)

This example can be summarized using the time line below:

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Stock Valuation Models:
Free Cash Flow Model

• The free cash flow model is based on the same premise as the
dividend valuation models except that we value the firm’s free
cash flows rather than dividends.
• free cash flow valuation Model determines the value of an
entire company as the present value of its expected free cash
flows discounted at the firm’s weighted average cost of capital,
which is its expected average future cost of funds over the long
run.

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Stock Valuation Models:
Free Cash Flow Model (cont.)

• FCF= Operating Cash Flow − Capital Expenditures​

Cash Flow From Operating Activities=$1.944 billion
Capital Expenditures=$760 million
Macy’s FCF = $1,944 − $760=$1.184 billion
• ​The free cash flow valuation model estimates the value of the
entire company and uses the cost of capital as the discount rate.
• As a result, the value of the firm’s debt (VD)and preferred
stock (VP) must be subtracted from the value of the company to
estimate the value of equity.

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Stock Valuation Models:
Free Cash Flow Model (cont.)

Dewhurst Inc. wishes to value its stock using the free cash flow model.
To apply the model, the firm’s CFO developed the data given in Table 7.4.

Table 7.4 Dewhurst, Inc.’s Data for the Free Cash Flow Valuation Model

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Stock Valuation Models:
Free Cash Flow Model (cont.)

Step 1 Calculate the present value of the free cash flow occurring
from the end of 2018 to infinity, measured at the beginning of 2018 (that
is, at the end of 2017). Because a constant rate of growth in FCF is
forecast beyond 2017, we can use the constant-growth dividend valuation
model to calculate the value of the free cash flows from the end of 2018 to
infinity

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Stock Valuation Models:
Free Cash Flow Model (cont.)

Add the present value of the FCF from 2018 to infinity, which
is measured at the end of 2017, to the 2017 FCF value to
get the total FCF in 2017.

Total FCF2017 = $600,000 + $10,300,000 = $10,900,000

Step 3. Find the sum of the present values of the FCFs for
2013 through 2017 to determine, VC, and the market values
of debt, VD, and preferred stock, VP, given in Table 7.5 on the
following slide.

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 Stock Valuation Models:
Free Cash Flow Model (cont.)
Table 7.5 Calculation of the Value of the Entire Company for Dewhurst, Inc.

(FCFt)/(1+ra)t

(FCFt)/(1+ra)t
(10,900,000)/(1+.09)5

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Stock Valuation Models:
Free Cash Flow Model (cont.)

Step 4. Calculate the value of the common stock using

equation 7.8. Substituting the value of the entire
company, VC, calculated in Step 3, and the market value
of the debt, VD, and preferred stock, VP, yields the value
of the common stock, VS.

VS = $8,628,620 - $3,100,000-$800,000 = $4,728,620

P0 = $4,728,628 / 300,000 shares = $15.16 per share
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