Chapter 7

Valuing Stocks

Financial Management (MGCM10018)

Preview
• This chapters introduces valuations techniques
for equity (stocks).
▫ The dividend discount model provides an
excellent measure of a stock’s intrinsic value.

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Outline
• Stocks and the Stock Market
• Market Values, Book Values, and Liquidation
Values
• Valuing Common Stocks
• Simplifying the Dividend Discount Model
• Valuing a Business
• No Free Lunches on Wall Street
• Market Anomalies and Behavioral Finance

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Stocks and the Stock Market (7.1)

• Corporations sell shares of common stock to the

public for the first time is called initial public
offering (IPO).
▫ Common stock: ownership shares in a publicly
held corporation.
▫ The corporations can continue to sell additional
shares, and this is called primary offering in the
primary market.
▫ The stocks then are traded between investors in
the secondary markets.
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Stock Market
• The two principal stock exchanges in the U.S.
are the New York Stock Exchange & NASDAQ.
▫ In Taiwan, it is the 台灣證劵交易所 (Taiwan Stock
Exchange, TWSE).
▫ There are many computer networks called
electronic communication networks (ECNs) that
connect traders with each other.

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Stock Market (continued)
• Investors often trade the stock through their
brokers.
▫ They can place either market order or limit order
when trading the stocks.
▫ Stocks are quoted with bid and ask prices.
 Bid price: the prices at which investors are willing to
buy shares.
 Ask price: the prices at which current shareholders
are willing to sell their shares.
 The difference between the two is called bid-ask
spread.
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Example
• Shannon sells 100 shares of Google stock from
her portfolio for $500 per share to help pay for
her son Domenic’s college education.
▫ How much does Google receive from the sale of its
shares?
▫ Does this transaction occur on the primary or
secondary market?

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Stock price quotes (FedEx, NYSE)

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Trading information on FedEx

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Stock Market (continued)
• Investors use a number of methods to determine
the quality of a company’s shares.
▫ For examples, the market cap (market
capitalization) of FedEx was $26.34 billion.
 Traders often refer to large-cap or small-cap firms.
▫ The P/E (price-earnings) ratio is 22.24.
 The ratio of stock price to earnings per share.
▫ The dividend yield is 0.48.
 It tells how much dividend income shareholders will
receive for every $100 invested in the stock.
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Example
• You are considering investing in a firm whose
shares are currently selling for $50 per share
with 1,000,000 shares outstanding. Expected
dividends are $2/share and earnings are
$6/share.
▫ What is the firm’s Market Cap? P/E Ratio? Dividend
Yield?

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Market Values, Book Values, and
Liquidation Values (7.2)
• There are 3 ways to value a firm.
▫ Market Value: the value of the firm as determined
by investors who would be willing to purchase the
company.
▫ Book Value: net worth of the firm according to the
balance sheet.
▫ Liquidation Value: net proceeds that could be
realized by selling the firm’s assets and paying off
its creditors.

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Market Values, Book Values, and
Liquidation Values (continued)
• Market value is simply the price × number of
outstanding shares.
• Book value is based on firm’s equity in balance
sheet.

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Market values vs. Book values, August 2010

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Market Values, Book Values, and
Liquidation Values (continued)
• The difference between a company’s actual value
and its book or liquidation value is called its
going-concern value with below 3 factors.
▫ Extra earning power.
▫ Intangible assets.
▫ Value of future investments.

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Valuing Common Stocks (7.3)

• Valuation by comparables.
▫ First identify a sample of similar firms.
▫ Then examine how much investors are prepared to
pay for each dollar of assets or earnings.
▫ Market-to-book and P/E ratios are the most
popular rules of thumbs for valuing common
stocks.

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Valuation by Comparables

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Valuing Common Stocks (continued)

• Intrinsic value is the present value of future cash

payoffs from a stock or other security.
▫ The future payoffs include dividend and selling
price.
DIV1 + P1
V0 =
1+ r
 V0: the intrinsic value of the share.
 DIV1: the expected dividend per share over the year.
 P1: the predicted stock price in 1 year.
 r: discount rate
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Example

What is the intrinsic value of a share of stock if

expected dividends are $2/share and the expected
price in 1 year is $35/share? Assume a discount
rate of 10%.

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Valuing Common Stocks (continued)

• The expected return (ER) of a stock would be.

DIV1 + P1 − P0
ER =
P0
▫ It can be decomposed into two terms:
 ER = Expected dividend yield + expected capital
gain
DIV1 P1 − P0
ER = +
P0 P0
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Example
What should be the price of a stock in one year if it
sells for $40 today, has an expected dividend per
share of $3, and an expected return of 12%?

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Dividend Discount Model
• The dividend discount model is a discounted
cash-flow model which states that today’s stock
price equals the present value of all expected
future dividends.

DIV1 DIV2 DIVH + PH

P0 = + + ... +
1 + r (1 + r )2
(1 + r )H

▫ H: time horizon
▫ DIVi = expected dividend in i period
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Dividend Discount Model (continued)

• There can be 3 cases to consider regarding

expected dividend.
▫ Constant dividend (no growth)
▫ Constant growth
▫ Nonconstant growth

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Example
A firm is currently pay $3/share in dividends in next year.
Investors expect both the stock price and the dividend to increase
at 8% per year. Assuming the stock price would be $81 in one year,
what would be the present value of stock when investing and
holding the stock for 3 years (given 12% expected return)?

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Simplifying Dividend Discount Model (7.4)

• When we have constant dividend, we know that

DIV1 = DIV2 = … = DIVt = …. The value of such
no-growth stock would be:
DIV1
P0 =
r
▫ What should the price of a share of stock be if
dividends are projected at $5/share, the discount rate
is 10%, and growth is 0%?

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Simplifying DDM (continued)

• If the dividend grows at a constant rate of g, the

price of stock would be
2
DIV1 DIV1 (1 + g ) DIV1 (1 + g )
P0 = + + + ...
1+ r (1 + r )2
(1 + r )3

DIV1
P0 =
r−g
▫ This is known as Gordon growth model.
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Example

What should the price of a share of stock be if the firm will

pay a $4 dividend in 1 year that is expected to grow at a
constant rate of 5%? Assume a discount rate of 10%.

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Example of constant growth dividend
Aqua America

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Simplifying DDM (continued)

• Note that the Gordon model provides a useful

tool to determine the expected rates of return for
a stock.
DIV1
r= +g
P0

Dividend yield Growth rate

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Example

Example: What rate of return should an investor

expect on a share of stock with a $2 expected
dividend and 8% growth rate that sells today for
$60?

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Simplifying DDM (continued)

• For nonconstant growth of dividend, the price of

stock would be

DIV1 DIV2 DIVH PH

P0= + + ... + +
1 + r (1 + r )2
(1 + r ) (1 + r )
H H

PV of dividends from PV of stock price

year 1 to horizon at horizon

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Example
A firm is expected to pay $2/share in dividends next year. Those
dividends are expected to grow by 8% for the next three years and
6% thereafter. If the discount rate is 10%, what is the current price
of this security?

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Growth Stocks & Income Stocks
• Investors buy growth stocks primarily in the
expectation of capital gains. They buy income
stocks principally for the cash dividends.
▫ People are more interested in future growth of
earnings for growth stock, rather than the
dividends.
▫ Note that a firm can determine the fraction of
earnings paid out as dividends; this is called
payout ratio.
 The fraction of earnings retained by the firm is called
plowback ratio.
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Growth Stocks & Income Stocks (continued)
• If a firm earns a constant return on its equity
and plows back a constant proportion of
earnings, then the growth rate g would also be
constant.
g = ROE × plowback ratio
▫ Suppose a firm that pays out 35% of earnings as
dividends and expects its return on equity to be
10%. What is the expected growth rate?
▫ g = 0.1 × (1 – 0.35) = 6.5%
▫ This is called sustainable growth rate.
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Growth Stocks & Income Stocks (continued)
• Plowing earnings back into new investments
may result in growth in earnings and dividends.
▫ But it does not add to the current stock price
 If that money is expected to earn only the return that
investors require.
• If the investors believe a firm has opportunity to
earn on new investment with a rate above the
required rate, additional value is generated.
▫ There is the present value of growth opportunities
(PVGO) to be added into current price.
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Valuing Growth Stocks
• The value per share of assets in place equals the
firm’s average future earnings if it does not grow.
▫ That is, EPS / r.
• Thus, the value of a growth stock would be

EPS
P0 = + PVGO
r
▫ Note that PVGO never appears on a book balance
sheet but belongs on a market-value balance sheet.
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Valuing Growth Stocks (continued)

• The market-value balance sheet shows market

values of assets, liabilities, and equity.
• Example

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Example
Suppose a stock is selling today for $55/share and there are
10,000,000 shares outstanding. If earnings are projected
to be $20,000,000, how much value are investors
assigning to growth per share? Assume a discount rate of
10%.

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Valuing a Business (7.5)

• In 2015, Johnson & Johnson announced that it

had sold a medical device subsidiary for $2B.
▫ The business was not a public company.
• Here, we discount the forecast of free cash flow
(FCF) to find how much the business is worth.

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No Free Lunches on Wall Street (7.6)

• It is not easy to beat the market.

▫ In a consistent way.
• Some investors try to achieve superior returns
by spotting and exploiting patterns in stock
prices.
▫ They are known as technical analysts.
▫ It is not that simple.
 A large price rise in one period may be followed by a
further rise in next period, but it is just likely to be
followed by a fall.
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Relationship between this week’s returns and next week’s,
correlation = -0.022.

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Relationship between this month’s returns and next
month’s, correlation = -0.004.

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No Free Lunches (continued)

• Thus, the problem with technical analysis is that

stock prices appear to wander randomly.
▫ In another word, stock prices seem to follow a
random walk with no predictable trends or
patterns.

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 One of the chart shows S&P index for 5
years. Another one shows trend of a coin-
toss game.

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No Free Lunches (continued)

• Assume that a predictable trend of prices is

detected.
▫ What would happen?
▫ All investors would rush to trade the stock and
stop to do so when the prices become fair.
▫ Thus, as soon as a cycle of price becomes apparent
to investors, they immediately eliminate it by their
trading.

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Stock price would instantaneously jump if a trend is foreseeable

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No Free Lunches (continued)

• Some investors attempt to find mispriced

securities by analyzing fundamental information,
such as accounting performance and earnings
prospects.
• This is called fundamental analysis of stocks.
▫ There are fundamental analysts are paid to
uncover stocks for which price does not equal
intrinsic value.
 What happens in a market with many such talented
and competitive fundamental analysts?
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No Free Lunches (continued)

• Economists often refer to the stock market as an

efficient market.
▫ It is the market in which prices reflect all available
information.
 Thus, the competition to find misvalued stocks is
intense.
 There are weak-form efficiency, semistrong-form
efficiency, and strong-form efficiency.
▫ Even professional investors find it difficult to
outperform the market.
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Stock price change before and after the
takeover announcements

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No Free Lunches (continued)

• Efficient market hypothesis

▫ Weak-form efficiency
 Prices already reflect all the information comtained
in past prices.
▫ Semistrong-form efficiency
 Prices reflect not just past but all publicly available
information.
▫ Strong-form efficiency
 Prices impound all available information.

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Returns b/w index and mutual funds

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Market Anomalies & Behavioral
Finance (7.7)
• There are a number of market anomalies that
seem to puzzle efficient market theorists,
including:
▫ Earnings announcement puzzle
▫ The new-issue puzzle
▫ Bubbles

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Average returns in 6 months following earnings announcement

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Market Anomalies & Behavioral
Finance (continued)
• Some believe that deviations in prices from
intrinsic value can be explained by behavioral
psychology, in three broad areas.
▫ Attitudes toward risk: people generally dislike
incurring losses, yet they are more apt to take
bigger risks if they are experiencing a period of
substantial gains.
▫ Beliefs about probabilities: individuals commonly
look back to what has happened in recent periods
and assume this is representative of future
outcomes.
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Market Anomalies & Behavioral
Finance (continued)
• Some believe that deviations in prices from
intrinsic value can be explained by behavioral
psychology, in three broad areas.
▫ Sentiment: investors are people, and they are
subject to emotion. Sentiment can be interpreted
as their general level of optimism or pessimism
about the economy or firm.

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