Tayyab Mubeen

Stock Valuation
 Cash Flows for
Stockholders
• If you buy a share of stock, you can
receive cash in two ways
– The company pays dividends
– You sell your shares, either to another
investor in the market or back to the
company
• As with bonds, the price of the stock
is the present value of these
expected cash flows
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 One-Period Example
• 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?
– Compute the PV of the expected cash flows
– Price = (14 + 2) / (1.2) = $13.33
– Or FV = 16; I/Y = 20; N = 1; CPT PV = -13.33

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 Two-Period Example
• 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?
– PV = 2 / (1.2) + (2.10 + 14.70) / (1.2)2 =
13.33

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 Three-Period Example
• 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?
– PV = 2 / 1.2 + 2.10 / (1.2)2 + (2.205 +
15.435) / (1.2)3 = 13.33

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 Developing The Model
• You could continue to push back the
year in which you will sell the stock
• You would find that the price of the
stock is really just the present value
of all expected future dividends
• So, how can we estimate all future
dividend payments?

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 Estimating Dividends:
Special Cases
• Constant dividend
– The firm will pay a constant dividend forever
– This is like preferred stock
– 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
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 Zero Growth
• If dividends are expected at regular intervals
forever, then this is a perpetuity and the present
value of expected future dividends can be found
using the perpetuity formula
– P0 = D / R
• Suppose stock is expected to pay a $0.50
dividend every quarter and the required return is
10% with quarterly compounding. What is the
price?
– P0 = .50 / (.1 / 4) = $20

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 Dividend Growth Model
• Dividends are expected to grow at a
constant percent per period.
– P0 = D1 /(1+R) + D2 /(1+R)2 + D3 /(1+R)3 + …
– P0 = D0(1+g)/(1+R) + D0(1+g)2/(1+R)2 +
D0(1+g)3/(1+R)3 + …
• With a little algebra and some series work,
this reduces to:
D1
P0 
R -g

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 DGM – Example 1
• Suppose TB Pirates, 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 / (.2 - .05) = $13.33
– Why isn’t the $2 in the numerator
multiplied by (1.05) in this example?

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Example 8.3 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

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 Nonconstant Growth
Problem Statement
• 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 have to find the PV of
all expected future dividends.

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 Nonconstant 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

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 Quick Quiz – Part I
• What is the value of a stock that is
expected to pay a constant dividend
of $2 per year if the required return is
15%?
• What if the company starts
increasing dividends by 3% per year,
beginning with the next dividend?
The required return stays at 15%.

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Features of Common Stock
• Voting Rights
• Other Rights
– Share proportionally in declared dividends
– Share proportionally in remaining assets
during liquidation
– Preemptive right – first shot at new stock
issue to maintain proportional ownership if
desired

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 Dividend Characteristics
• Dividends are not a liability of the firm until a
dividend has been declared by the Board
• Consequently, a firm cannot go bankrupt for not
declaring dividends
• Dividends and Taxes
– Dividend payments are not considered a business
expense; therefore, they are not tax deductible
– The taxation of dividends received by individuals
depends on the holding period
– Dividends received by corporations have a
minimum 70% exclusion from taxable income

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Features of Preferred Stock
• Dividends
– Stated dividend that must be paid before
dividends can be paid to common stockholders
– Dividends are not a liability of the firm, and
preferred dividends can be deferred indefinitely
– Most preferred dividends are cumulative – any
missed preferred dividends have to be paid
before common dividends can be paid
• Preferred stock generally does not carry
voting rights

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