FINA1310 CORPORATE FINANCE

Faculty of Business and Economics

University of Hong Kong

Prof. Shiyang Huang

Lecture 5: Stock Valuation

Summary and Chapter 7
• Bond value/bond price = PV of coupons + PV of par value

 1 
1 - (1 + r) t  FV
Bond Value = C  +
 r  (1 + r) t

 
• Coupon rate vs. Discount rate (interest rate)
• Fisher Effect:
(1 + R) = (1 + r)(1 + h)
• Term structure
• The relationship between time to maturity and yields,
all else equal
Relationship Between Price and Yield-
to-maturity (YTM)
When interest rates increase, what will happen to bond prices?

Coupon rate = 8% with annual coupons; Par value = $1,000; Maturity = 10 years

1500
1400
Selling at premium
1300
Bond
Price

1200
1100 P = $1000
1000
900
800
700 Selling at discount
600
0% 2% 4% 6% 8% 10% 12% 14%

Yield-to-maturity (YTM)
 Relationship between Coupon and Yield

• Par Bond: YTM = Coupon Rate

• Bond Price = Par Value

• Discount Bond: YTM > Coupon Rate

• Bond Price < Par Value

• Premium Bond: YTM < Coupon Rate

• Bond Price > Par Value
Interest Rate Risk
Interest Risk: change in price due to changes in interest rates
• Long-term bonds have more interest rate risk than short-term bonds

𝐹
𝑃= (1)
(1+𝑟)𝑇

𝑑𝑃 𝐹 𝑇
→ = − (2)
𝑑𝑟 (1+𝑟)𝑇 1+𝑟

𝑑𝑃
𝑑𝑟 𝑇
→| |= (3)
𝑃 1+𝑟
Interest Rate Risk
Interest Risk: change in price due to changes in interest rates
• High-coupon bonds have smaller interest rate risk than low-coupon bonds
• Consider a bond with two-year maturity

𝐶 𝐶+𝐹
𝑃= + （1）
(1+𝑟) (1+𝑟)2

𝑑𝑃 𝐶 1 𝐶+𝐹 2
→ =− − （2）
𝑑𝑟 (1+𝑟) 1+𝑟 (1+𝑟)2 1+𝑟

𝐹𝑟𝑎𝑐𝑡𝑖𝑜𝑛 𝑜𝑓 𝑠𝑒𝑐𝑜𝑛𝑑 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑖𝑛 𝑏𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒

𝑑𝑃 𝐶 𝐶+𝐹
1+𝑟 1 (1+𝑟)2 2
→ 𝑑𝑟
= 𝐶 𝐶+𝐹 1+𝑟 + 𝐶 𝐶+𝐹 （3）
𝑃 + + 1+𝑟
1+𝑟 2
1+𝑟 1+𝑟 1+𝑟 2

𝐹𝑟𝑎𝑐𝑡𝑖𝑜𝑛 𝑜𝑓 𝑓𝑖𝑟𝑠𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑖𝑛 𝑏𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒

Course Overview
• Introduction

• Part I: Valuation
• Time Value of Money, Discounted Cash Flow
Valuation, Bond and Stock Valuation.

• Part II: Risk and Return

• Historical Risk and Return Relationships, CAPM.

• Part III: Capital Budgeting

• Real Investment Decisions, Cost of Capital.

• Part IV: Financing Decisions

• Raising Capital, Tradeoff between Equity and Debt.
Key Takeaways

• Characteristics of Stocks
• Industry Overview
• Common Stock Valuation: Dividend Discount Model
• Special Cases of Stock Valuation
• Preferred Stock

Reading : Chapter 8
Characteristics of Stocks

What is Common Stock?

• Ownership interest in a corporation
• Payouts to common stock are dividends
• Unlike bonds, payouts to common stock are uncertain
in both magnitude and timing

Key characteristics
• Residual claimant to corporate assets (after
bondholders)
• Limited liability
• Voting rights
Comparing Debt and Equity

Debt Equity
• Not an ownership interest • Ownership interest
• No voting right for creditors • Common stockholders vote
• Interest on debt is tax for board of directors and
deductible other issues
• Unpaid debt is legal liability; • Dividends are not tax
creditors can claim asset of deductible
firm • Dividends are not liability of
• Excess debt can lead to the firm
financial distress and • An all equity firm cannot go
bankruptcy bankrupt
Key Takeaways

• Characteristics of Stocks
• Industry Overview
• Common Stock Valuation: Dividend Discount Model
• Special Cases of Stock Valuation
• Preferred Stock

Reading : Chapter 8
Primary Market Activities
U.S. Market

Source: PwC
 Secondary Market Activities
New York Stock Exchange

Value (US $ Million) Volume (million shares) Deals (million)

Year # Trading Days Total Avg Daily Total Avg Daily Total Avg Daily
2010 252 11,968,822.0 47,495.3 444,652.7 1,764.5 1,481.7 5.9
2011 252 11,686,027.0 46,373.1 383,867.5 1,523.3 1,437.6 5.7
2012 250 8,773,453.4 35,093.8 286,795.5 1,147.2 1,018.1 4.1
2013 252 8,976,288.2 35,620.2 260,657.1 1,034.4 862.2 3.4
2014 252 10,200,895.0 40,479.7 261,915.2 1,039.3 1,089.5 4.3

Source: NYSE Data Library

Stock Exchanges
• Dealers vs. Brokers
• Bid vs. Ask price
Stock Exchanges
• New York Stock Exchange (NYSE)
• Largest stock market in the world (built at 1882)
• Market Capitalization is $19.3 trillion and daily trading value
is $169 billion
• Members (1,366 members)
• Operations: to attract and process order flows
• Designated market makers(DMMs), floor brokers and
supplemental liquidity provides (SLPs)

• NASDAQ
• Not a physical exchange – computer-based quotation
system
• Multiple market makers
• Electronic Communications Networks
• Large portion of technology stocks
Key Takeaways

• Characteristics of Stocks
• Industry Overview
• Common Stock Valuation: Dividend Discount Model
• Special Cases of Stock Valuation
• Preferred Stock

Reading : Chapter 8
Common Stock Valuation

Challenges: Two Sources of Uncertainty

• Cash Flows: Not Known in Advance

• Discount Rate: Needs to be Risk-Adjusted

Value = Present Value of Expected Cash Flows

HSBC – Historical Dividends
 Common Stock Valuation
• You can receive cash flow from a share of stock in two ways:
• Dividends
• Selling the share

• Notations:
• 𝑃0 = Price Today
• 𝑃𝑡 = Expected Price at t
• 𝐷𝑡 = Expected Dividend at t
• 𝑟 = Discount Rate
 Dividends and Common Stock Valuation
Derivation:
𝐷1 +𝑃1 𝐷2 +𝑃2
• 𝑃0 = where 𝑃1 =
1+𝑟 1+𝑟

1 𝐷 𝐷2 𝑃2
• Therefore 𝑃0 = 1+𝑟 + 1+𝑟 2
+ 1+𝑟 2

• Keep repeating the above, we get

𝐷1 𝐷2 𝐷3 𝑫𝒕
• 𝑷𝟎 = + + + ⋯ = 𝜮∞
𝒕=𝟏
1+𝑟 1+𝑟 2 1+𝑟 3 𝟏+𝒓 𝒕

• The value of the stock depends only on the future cash

dividend payments

• Future selling price is not needed since it also depends on

subsequent cash dividend payments
Buy and hold a stock for a year
• Suppose you are thinking of purchasing the stock of
Moore Oil, Inc. You expect it to pay a $2 dividend in
one year, and you believe that you can sell the stock
for $14 at that time. If you require a return of 20% on
investments of this risk, what is the maximum you
would be willing to pay?
Buy and hold a stock for a year
Expect a $2 dividend in 1 year and sell the stock for $14

0 20% 1 2 3

D1=$2
+
P1=14
P0 $16 Expect to sell stock at this
PV20%,1 price

Price = (14 + 2) / (1.2) = $13.33

Buy and hold a stock for two years
• Now, what if you decide to hold the stock for two
years? In addition to the dividend in one year, you
expect a dividend of $2.10 in two years and a stock
price of $14.70 at the end of year 2. Now how much
would you be willing to pay?
Buy and hold a stock for two years
dividend of $2 at yr 1
dividend of $2.10 at yr 2
stock price of $14.70 at yr 2
0 20% 1 20% 2 3

1.667 D1 = $2 D2=$2.10
+
P2=$14.70
11.667 $16.80
P0 = $13.33

PV = 2 / (1.2) 1+ (2.10 + 14.70) / (1.2)2 = $13.33

Buy and hold a stock for three years
• Finally, what if you decide to hold the stock for three
years?
• In addition to the dividends at the end of years 1 and
2, you expect to receive a dividend of $2.205 at the
end of year 3 and the stock price is expected to be
$15.435. Now how much would you be willing to
pay?
Buy and hold a stock for three years
dividend of $2 at yr 1
dividend of $2.10 at yr 2
dividend of $2.205 at yr 3
stock price of $15.435 at yr 3
0 20% 1 20% 2 20% 3

1.667 D1 = $2
D3= $2.205
D2= $2.10
1.458
P3=$15.435

10.208 $17.64

P0 = $13.33

PV = 2 / 1.21 + 2.10 / (1.2)2 + (2.205 + 15.435) / (1.2)3 = $13.33

Zero-Dividend Company?
• Some growth companies do not currently pay dividends

• Even if a firm has never paid dividends in the past, the fact
that it has a positive stock price means investors expect
the firm to pay dividends in the future

• If the firm will never pay any dividend to investors, it is

valueless to investors

• Example 1: Facebook (no dividend, but current stock price

$133.53)
http://www.nasdaq.com/symbol/fb/dividend-history
Zero-Dividend Company?

• Example 1: Facebook (no dividend, but current stock price

$133.53)
http://www.nasdaq.com/symbol/fb/dividend-history
Zero-Dividend Company?
• Example: Microsoft

• Wall Street Journal Article: Microsoft, Awash in Cash,

Declares Its First Dividend

• History
• Founded at April, 1975
• IPO: 1986
• Subsequent rise in its share price, created three billionaires
and an estimated 12,000 millionaires among Microsoft
employees
• However, the first time Microsoft paid dividend was Feb 19th
2003.
Microsoft – Recent Dividend Payment
Key Takeaways

• Characteristics of Stocks
• Industry Overview
• Common Stock Valuation: Dividend Discount Model
• Special Cases of Stock Valuation
• Preferred Stock

Reading : Chapter 8
Special Cases

• Constant Dividend
• Constant dividend forever

• Constant Dividend Growth

• Dividend grows at constant rate forever

• Nonconstant Dividend Growth

• Inconsistent growth first, but settles down to constant
growth
Constant Dividend Model
• Assumption: 𝐷𝑡 = 𝐷

D D D D D
… …

t=0 1 2 T T+1 T+2

𝑫 𝑫
𝑷𝟎 = 𝜮∞
𝒕=𝟏 𝒕
=
𝟏+𝒓 𝒓
Example: Constant Dividends
Suppose Stock X is expected to pay a $0.5 dividend every
quarter and the required rate of return is 10% (APR with
quarterly compounding). What is the price of Stock X?

P0 = .50 / (.1 / 4) = $20

0.5 0.5 0.5 0.5 0.5

… …

t=0 1 2 T T+1 T+2

Constant Dividend Growth Model
𝑡−1
Assumption: 𝐷𝑡 = 𝐷𝑡−1 1 + 𝑔 = 𝐷1 1 + 𝑔

𝑫𝟏 𝑫𝟏 (𝟏 + 𝒈) 𝑻−𝟏
𝑫𝟏 𝟏 + 𝒈
… …

t=0 1 2 T T+1 T+2

𝒕−𝟏
∞ 𝑫𝟏 𝟏 + 𝒈 𝑫𝟏
𝑷𝟎 = 𝜮𝒕=𝟏 𝒕
= ,𝒓 > 𝒈
𝟏+𝒓 𝒓−𝒈

Known as “Gordon Growth Model”

Example: Constant Dividend Growth
Suppose Y, Inc., just paid a dividend of $0.50 per share. It is
expected to increase its dividend by 2% per year. If the
market requires a return of 15% on assets of this risk, how
much should the stock of Y be selling for?

g = 2%, r = 15%
Constant Dividend Growth Model – Example 1
Suppose Big D, Inc., just paid a dividend of $0.50 per share. It is
expected to increase its dividend by 2% per year. If the market
requires a return of 15% on assets of this risk, how much should
the stock be selling for?

D 0 (1 + g) D1
P0 = =
R -g R -g

P0 = 0.50 * (1+.02) / (.15 - .02) = $3.92

Constant Dividend Growth Model – Example 2

Suppose TB, Inc., is expected to pay a $2 dividend in one year.

If the dividend is expected to grow at 5% per year and the
required return is 20%, what is the price?

P0 = 2 / (.20 - .05) = $13.33

Why isn’t the $2 in the numerator multiplied by (1.05) in this

example?
Stock Price Sensitivity to Dividend Growth

250
D1 = $2; R = 20%
200
Stock Price

150

100

50

0
0 0.05 0.1 0.15 0.2
Growth Rate
Stock Price Sensitivity to Required Return

250
D1 = $2; g = 5%
200
Stock Price

150

100

50

0
0 0.05 0.1 0.15 0.2 0.25 0.3
Required return
Growth Rate
Example: Gordon Growth Company
Gordon Growth Company is expected to pay a dividend of $4
next period, and dividends are expected to grow at 6% per
year. The required return is 16%. What is the current price?

What is the price expected to be in year 4?

Gordon Growth Company - I

• Gordon Growth Company is expected to pay a dividend

of $4 next period, and dividends are expected to grow

at 6% per year. The required return is 16%.

• What is the current price?

P0 = 4 / (.16 - .06) = $40

Remember that we already have the dividend expected next year, so we

don’t multiply the dividend by 1+g
Gordon Growth Company - II

• What is the price expected to be in year 4?

P4 = D5 / (R – g)
P4 = 4(1+.06)4 / (.16 - .06) = 50.50

• The price is assumed to grow at the same rate as the

dividends
Gordon Growth Company Summary

𝑫𝟏
Under Constant Dividend Growth Model 𝑷𝟎 =
𝒓−𝒈
• Price is proportional to size of next-period dividends
• Price grows at the same rate as the dividends

𝐷1 1+𝑔 𝑡 𝐷1 1+𝑔 𝑡+1

𝑃𝑡 = and 𝑃𝑡+1 =
𝑟−𝑔 𝑟−𝑔
𝑃𝑡+1
⇒ =1+𝑔
𝑃𝑡
Constant Dividend Growth Model
Gordon Growth Model
D 0 (1 + g) D1
P0 = =
R -g R -g
• Offers a convenient expression for the discount rate:
D 0 (1 + g) D1
R= +g= +g
P0 P0
Dividend Capital
Yield Gain Yield
Example of Inferring Cost of Capital
Determine the cost of capital of Company Z.
𝐷
“Dividend yield” 1 is 5.2%. Analysts forecast the long-
𝑃0
run growth rate of Company Z is 4.9%.
𝐷1
𝑅= + 𝑔 = 5.2% + 4.9% = 10.1%
𝑃0
Example of Inferring Growth Rate
The dividend of Company W is expected to be $3 next year.
Company W’s stock is selling for $100 in the market right
now. Expected return is 12%.
What is the market assuming about the long-term growth rate
in dividends?
𝐷1
𝑔=𝑅− = 12% − 3/100 = 9%
𝑃0
Finding the Required Return - Example
• Suppose a firm’s stock is selling for $10.50. It just paid
a $1 dividend, and dividends are expected to grow at
5% per year. What is the required return?

• What is the dividend yield?

• What is the capital gains yield?

Finding the Required Return - Example
• Suppose a firm’s stock is selling for $10.50. It just paid
a $1 dividend, and dividends are expected to grow at
5% per year. What is the required return?
R = [1(1.05)/10.50] + .05 = 15%

• What is the dividend yield?

1*(1.05) / 10.50 = 10%

• What is the capital gains yield?

g =5%
Nonconstant Dividend Growth
Multiple-Stage Growth Model

• Growth Stage: rapid expansion in sales, high profit margins,

high earnings per share
• Sometimes we observe 𝑔 > 𝑟 for a firm in growth stage, but it
will not be sustainable

• Transition Stage: growth and profit margin reduced by

competition

• Mature Stage: growth stabilizes for the remaining life of firm

→We can value the stages separately and add them together
Non constant Growth

• Suppose a firm is expected to increase dividends by 20% in

one year and by 15% in two years. After that, dividends will
increase at a rate of 5% per year indefinitely. If the last
dividend was $1 and the required return is 20%, what is the
price of the stock?

Remember that we must find the PV of ALL expected future

dividends.
Non constant Growth Example Solution
• Compute the dividends until growth levels off
D1 = 1(1.2) = $1.20
D2 = 1.20(1.15) = $1.38
D3 = 1.38(1.05) = $1.449

• Find the expected future price

P2 = D3 / (R – g) = 1.449 / (.2 - .05) = 9.66

• Find the present value of the expected future cash flows

P0 = 1.20 / (1.2) + (1.38 + 9.66) / (1.2)2 = 8.67
 Estimating Dividends: three scenarios
• Constant dividend
• The firm will pay a constant dividend forever
• The price is computed using the perpetuity formula

• Constant dividend growth

• The firm will increase the dividend by a constant percent every
period
• The price is computed using the growing perpetuity model

• Supernormal growth
• Dividend growth is not consistent initially, but settles down to
constant growth eventually
• The price is computed using a multistage model
Shiller, AER, 1981 （not required）
Other Stock Valuation Methods:
Market Multiple Method
• Also known as the peer comparison method.
• The value of a company is derived by applying a certain
multiplier to the company’s profitability parameter.
• Analysts often use the following multiples to value stocks.
P / E (Price-to-earnings) ratio
P / Sales ratio
P/Cash Flow ratio

• Example: Based on comparable firms, estimate the

appropriate P/E. Multiply this by expected earnings to
obtain an estimate of the stock price.
Market Multiple Method
• PE (price-to-earnings) ratio
• Estimated share price=Average industry PE ratio ×Projected Earning Per Share
• Price-to-Sales ratio
• Estimated share price=Average price-to-sales ratio ×Sales Per Share
• Price-to-cash flow multiple
• Estimated share price=Average price-to-cash flow multiple×cash flow per
share
Problems with Market Multiple Method

• Often hard to find comparable firms.

• The average ratio from a sample of comparable firms can
have a wide range.
• Example: The average P/E ratio of comparable firms is 20
but the range is from 10 to 50.
Key Takeaways

• Characteristics of Stocks
• Industry Overview
• Common Stock Valuation: Dividend Discount Model
• Special Cases of Stock Valuation
• Preferred Stock

Reading : Chapter 8
Preferred Stock Features
Preference in dividend payment and in the distribution of
assets in the event of liquidation

• Limited voting privilege

• Have stated dividend value
• Collect dividends before common stockholders
• Unpaid preferred stock dividends are not a liability of the firm
but may earn voting rights in return
• Preferred dividends are not tax deductible for the firm
• Have stated liquidation value
• Collect stated liquidation value before distribution of assets
to common shareholders but after payments to bondholders
Different Classes of Common Stocks
Different Classes of Common Stocks
• Purpose: the voting power remains with a certain groups
• When there is more than one class of stock, the classes are
traditionally designated as Class A and Class B
• Example: Berkshire Hathaway (ticker: BRK) has two classes
of stocks: BRKa, and BRKb
Example: Facebook (Fortune article: Facebook Investors
Approve Mark Zuckerberg’s Three-Class Share Structure)
• In June 2016, Mark Zuckerberg plans to give away 99% of
his wealth in his lifetime. Will Zuckberger control the
Facebook?
• Answer: Yes.
• Facebook proposed creating a third class of shares that
comes with no voting power for its owners
Preferred Stock – Example

If preferred stock with an annual dividend of $5 sells for $50, what is

the preferred stock’s expected return?

D
P0 =
r
D 5
r = = = 0.10 = 10%
P0 50
Table 8.1 - Stock Valuation Summary
Key Takeaways

• Characteristics of Stocks
• Industry Overview
• Common Stock Valuation: Dividend Discount Model
• Special Cases of Stock Valuation
• Preferred Stock

Reading for Next Week: Chapter 12, Chapter 13