Chapter 10

Stocks and Their Valuation

 Features of Common Stock

 Determining Common Stock Values
 Preferred Stock

10-1
Facts about Common Stock

 Represents ownership
 Ownership implies control
 Stockholders elect directors
 Directors elect management
 Management’s goal: Maximize the stock price

10-2
Intrinsic Value and Stock Price

 Outside investors, corporate insiders, and

analysts use a variety of approaches to
estimate a stock’s intrinsic value (P0).
 In equilibrium we assume that a stock’s price
equals its intrinsic value.
 Outsiders estimate intrinsic value to help
determine which stocks are attractive to buy
and/or sell.
 Stocks with a price below (above) its intrinsic
value are undervalued (overvalued).

10-3
 Determinants of Intrinsic Value and
Stock Prices
Managerial Actions, the Economic
Environment, Taxes, and the Political Climate

“True” Investor “True” “Perceived” “Perceived”

Returns Risk Investor Returns Risk

Stock’s Stock’s
Intrinsic Value Market Price

Market Equilibrium:
Intrinsic Value = Stock Price
10-4
Different Approaches for Estimating the
Intrinsic Value of a Common Stock

 Discounted dividend model

 Corporate valuation model
 Using the multiples of comparable firms

10-5
Discounted Dividend Model

 Value of a stock is the present value of the

future dividends expected to be generated by
the stock.

D1 D2 D3 D
Pˆ0 = + + + ... +
(1+rs )1
(1+rs ) 2
(1+rs ) 3
(1+rs )

10-6
Constant Growth Stock

 A stock whose dividends are expected to

grow forever at a constant rate, g.
D1 = D0(1 + g)1
D2 = D0(1 + g)2
Dt = D0(1 + g)t
 If g is constant, the discounted dividend
formula converges to:
ˆP = D0 (1+ g) = D1
0
rs  g rs  g
10-7
Future Dividends and Their Present
Values

$ D t  D0 (1  g) t

0.25 Dt
PVDt 
( 1  r )t

P0   PVDt

0 Years (t)
10-8
What happens if g > rs?

 If g > rs, the constant growth formula leads

to a negative stock price, which does not
make sense.
 The constant growth model can only be used
if:
 rs > g.
 g is expected to be constant forever.

10-9
Use the SML to Calculate the Required
Rate of Return (rs)

 If rRF = 7%, rM = 12%, and b = 1.2, what is

the required rate of return on the firm’s stock?
rs = rRF + (rM – rRF)b
= 7% + (12% – 7%)1.2
= 13%

10-10
Find the Expected Dividend Stream for
the Next 3 Years and Their PVs

D0 = $2 and g is a constant 6%.

0 1 2 3
g = 6%

D0 = 2.00 2.12 2.247 2.382

1.8761
rs = 13%
1.7599
1.6509

10-11
What is the stock’s intrinsic value?

Using the constant growth model:

D1 $2.12
P̂0  
rs  g 0.13  0.06
$2.12

0.07
 $30.29

10-12
What is the expected market price of the
stock, one year from now?

 D1 will have been paid out already. So, P1 is

the present value (as of Year 1) of D2, D3, D4,
etc.
D2 $2.247
P̂1  
rs  g 0.13  0.06
 $32.10

 Could also find expected P1 as:

P̂1  P0 (1.06)  $32.10

10-13
Find Expected Dividend Yield, Capital Gains
Yield, and Total Return During First Year

 Dividend yield
= D1/P0 = $2.12/$30.29 = 7.0%
 Capital gains yield
= (P1 – P0)/P0
= ($32.10 – $30.29)/$30.29 = 6.0%
 Total return (rs)
= Dividend yield + Capital gains yield
= 7.0% + 6.0% = 13.0%
10-14
What would the expected price
today be, if g = 0?
The dividend stream would be a perpetuity.

0 1 2 3
rs = 13%

2.00 2.00 2.00

PMT $2.00
P̂0    $15.38
r 0.13

10-15
Supernormal Growth: What if g = 30% for 3
years before achieving long-run growth of 6%?

 Can no longer use just the constant growth

model to find stock value.
 However, the growth does become constant
after 3 years.

10-16
 Valuing Common Stock with
Nonconstant Growth

0 r = 13% 1 2 3 4
s

g = 30% g = 30% g = 30% g = 6%

D0 = 2.00 2.600 3.380 4.394 4.658
2.301
2.647
3.045
4.658
46.114 P̂3   $66.54
0.13  0.06
54.107 = P̂0
10-17
Find Expected Dividend and Capital Gains
Yields during the First and Fourth Years

 Dividend yield (first year)

= $2.60/$54.11 = 4.81%
 Capital gains yield (first year)
= 13.00% – 4.81% = 8.19%
 During nonconstant growth, dividend yield
and capital gains yield are not constant, and
capital gains yield ≠ g.
 After t = 3, the stock has constant growth
and dividend yield = 7%, while capital gains
yield = 6%.
10-18
 Nonconstant Growth: What if g = 0% for
3 years before long-run growth of 6%?

0 rs = 13% 1 2 3 4
g = 0% g = 0% g = 0% g = 6%
D0 = 2.00 2.00 2.00 2.00 2.12
1.77
1.57
1.39
2.12
20.99 P̂3   $30.29
0.13  0.06
25.72 = P̂0
10-19
Find Expected Dividend and Capital Gains
Yields During the First and Fourth Years

 Dividend yield (first year)

= $2.00/$25.72 = 7.78%
 Capital gains yield (first year)
= 13.00% – 7.78% = 5.22%
 After t = 3, the stock has constant growth
and dividend yield = 7%, while capital gains
yield = 6%.

10-20
If the stock was expected to have negative growth
(g = -6%), would anyone buy the stock, and what
is its value?

 Yes. Even though the dividends are declining,

the stock is still producing cash flows and
therefore has positive value.

D1 D0 (1  g)
P̂0  
rs  g rs  g
$2.00 (0.94) $1.88
   $9.89
0.13  (-0.06) 0.19

10-21
Find Expected Annual Dividend and
Capital Gains Yields

 Capital gains yield

= g = –6.00%
 Dividend yield
= 13.00% – (–6.00%) = 19.00%
 Since the stock is experiencing constant
growth, dividend yield and capital gains yield
are constant. Dividend yield is sufficiently
large (19%) to offset a negative capital gains.

10-22
Corporate Valuation Model

 Also called the free cash flow method.

Suggests the value of the entire firm equals
the present value of the firm’s free cash
flows.
 Remember, free cash flow is the firm’s after-
tax operating income less the net capital
investment.
FCF = EBIT(1 – T) – Net capital investment

10-23
Applying the Corporate Valuation Model

 Find the market value (MV) of the firm, by

finding the PV of the firm’s future FCFs.
 Subtract MV of firm’s debt and preferred
stock to get MV of common stock.
 Divide MV of common stock by the number of
shares outstanding to get intrinsic stock price
(value).

10-24
Issues Regarding the Corporate
Valuation Model
 Often preferred to the discounted dividend
model, especially when considering number
of firms that don’t pay dividends or when
dividends are hard to forecast.
 Similar to discounted dividend model,
assumes at some point free cash flow will
grow at a constant rate.
 Terminal value (TVN) represents value of firm
at the point that growth becomes constant.

10-25
Use the Corporate Valuation Model to
Find the Firm’s Intrinsic Value

Given: Long-Run gFCF = 6% and WACC = 10%

0 r = 10% 1 2 3 4
g = 6%

-5 10 20 21.20
-4.545
8.264
15.026
21.20
398.197 530   TV3
0.10  0.06
416.942
10-26
What is the firm’s intrinsic value
per share?
The firm has $40 million total in debt and preferred
stock and has 10 million shares of stock.
MV of equity = MV of firm  MV of debt
= $416.94  $40
= $376.94 million

Value per share = MV of equity / # of shares

= $376.94 /10
= $37.69
10-27
What is the firm’s intrinsic value
per share?
 The firm’s total value is calculated as follows:

 Using your financial calculator, enter the following inputs: CF0 =

0; CF1 = 3000000; CF2 = 6000000; CF3 = 10000000; CF4 =
15000000 + 321000000 = 336000000; I/YR = 12; and then solve
for NPV = $228,113,612.

10-28
What is the firm’s intrinsic value
per share?
 To find Barrett’s stock price, you need to first find the
value of its equity. The value of Barrett’s equity is
equal to the value of the total firm less the market
value of its debt and preferred stock.

Total firm value $228,113,612

Market value, debt + preferred 60,000,000
Market value of equity $168,113,612

10-29
Firm Multiples Method

 Analysts often use the following multiples to

value stocks.
 P/E
 P/CF
 P/Sales
 EXAMPLE: Based on comparable firms,
estimate the appropriate P/E. Multiply this by
expected earnings to back out an estimate of
the stock price.

10-30
Preferred Stock

 Hybrid security.
 Like bonds, preferred stockholders receive a
fixed dividend that must be paid before
dividends are paid to common stockholders.
 However, companies can omit preferred
dividend payments without fear of pushing
the firm into bankruptcy.

10-31
If preferred stock with an annual dividend of $5 sells
for $50, what is the preferred stock’s expected
return?

D
Vp =
rp
$5
$50 =
rp

ˆrp = $5
$50
= 0.10 =10%

10-32