CHAPTER 8

Stocks and Their Valuation

 Features of common stock

 Determining common stock values
 Preferred stock

8-1
Facts about common stock
 Represents ownership
 Ownership implies control
 Stockholders elect directors
 Directors hire management
 Management’s goal: Maximize the
stock price

8-2
Social/Ethical Question
 Should management be equally concerned
about employees, customers, suppliers,
and “the public,” or just the stockholders?
 In an enterprise economy, management
should work for stockholders subject to
constraints (environmental, fair hiring,
etc.) and competition.

8-3
Types of stock market
transactions
 Secondary market
 Primary market
 Initial public offering market
(“going public”)

8-4
Different approaches for
valuing common stock
 Dividend growth model
 Corporate value model
 Using the multiples of comparable
firms

8-5
 Terms
2018 2019 2020

0 1 2
D0 D1 D2
D0= last dividend received or paid Or the most
recent dividend received or paid Or divided
paid at year 0.
D1 = Expected dividend at the end of current
year or expected dividend at the end of year 1
8-6
 Terms
Po= Price at year 0 or current market price
P1 = Expected price at the end of current
year or expected price at the end of year 1
i= interest rate which required or expected
by the investor or current market rate
g= growth rate

8-7
Types of Stock
Based on growth rate
1.Constant growth Stock

2.Zero growth stock

3.Non constant growth stocks

8-8
g=8% (constant)

8-9
When growth is constant

8-10
Zero growth(Preferred Stocks)

0 1 2
D0 = 2
D1 = D0(1+g)1
D1 = 2(1+0)1
D1 = 2
It means that when growth is zero,
dividend remains constant. 8-11
Non Constant growth

8-12
Price is the present value of all
future cashflows

0 1 2 3 …..
P0 D1 D2 D3 D

8-13
 Dividend growth model
 Value of a stock is the present value of the
future dividends expected to be generated by
the stock.

^ D1 D2 D3 D
P0  1
 2
 3
 ...  
(1  k s ) (1  k s ) (1  k s ) (1  k s )

8-14
Constant growth stock

8-15
Constant growth stock

8-16
Po = D0 (1+g)1
(1+i) 1

1- (1+g)
(1+i)
1+I – 1-g
(1+i)
P0 = D0 (1+g)1
i–g
P0 = D1
i-g 8-17
 Constant growth stock
 If g is constant, the dividend growth formula
converges to:

^ D 0 (1  g) D1
P0  
ks - g ks - g

 It is known as Gordon constant growth

model.
8-18
Constant growth Stock
^ D 0 (1  g) D1
P0  
ks - g ks - g

P0 = D1
i = D1 +g
i-g P0

8-19
 D1/Po is termed as dividend Yield.

8-20
Zero growth Stock
P0 = D0 (1+g)1
i-g
If g = 0 then

P0 = PD
i
i= PD
P0 8-21
 9-1
=1 (1+012) 3
Do = 1.5 = 1.404
g=12% (for first three years)
D4=D3(1+g)1
gn= 5%
D4=1.404(1+0.05)1
D1=D0(1+g)1
D4=1.474
= 1 (1+0.12) 1
= 1.12 D5=D4(1+g)1
D2=D0(1+g)2 D5=1.474(1+0.05)1
=1 (1+0.12) 2 D5=1.548
= 1.254
D3=D0(1+g)3

8-22
9-2
 D1= 1.8 P0 = 1.8
 g-=4% 0.10 – 0.04
 i=10%
P0 = 30
 P0 =?
P0 = D1
i-g
8-23
 P 1 = D2
Po = 38
i–g
Do = 2 D2 = Do (1+g)2
g = 5% D2 = 2 (1+0.05)2
P1 = ? D2 = 2.205
i=? i = D1 + g
P0
P0 = D1 i = 2(1.05)1 + 0.05
i-g 38
i = 10.52% 8-24
Po = 38 P1 = D2
Do = 2 i–g
g = 5%
P1 = 2.205
P1 = ?
i=? 0.1052 – 0.05
D2 = Do (1+g)2 P1 = 39.95
D2 = 2 (1+0.05)2
D2 = 2.205

8-25
Po = 30
Pd = 2.75
i=?
i = Pd / Po
i = 2.75 / 30
i = 9.16%

8-26
Pd = 10% x 100 i = Pd / Po
i = 10 / 90
Pd= 10
i = 11.1%
Po = 61 i = Pd / Po
i = Pd / Po i = 10 / 100
i = 10 / 61 i = 10%
i = Pd / Po
i = 16.4%
i = 10 / 138
i = 7.25%
8-27
Pd = 8% x 100 Po = Pd / I
Pd = 8 Po = 8 / 0.09
i = 7% Po = 88.8
Po = ?
Po = Pd / I
Po = 8 / 0.07
Po = 114.28
8-28
What happens if g > ks?
 If g > ks, the constant growth formula
leads to a negative stock price, which
does not make sense.
 The constant growth model can only be
used if:
 ks > g
 g is expected to be constant forever

8-29
If kRF = 7%, kM = 12%, and β = 1.2,
what is the required rate of return on
the firm’s stock?
 Use the SML to calculate the required
rate of return (ks):

ks = kRF + (kM – kRF)β

= 7% + (12% - 7%)1.2
= 13%

8-30
 If D0 = $2 and g is a constant 6%,
find the expected dividend stream for
the next 3 years, and their PVs.

0 1 2 3
g = 6%

D0 = 2.00 2.12 2.247 2.382

1.8761
ks = 13%
1.7599
1.6509

8-31
What is the stock’s market value?
 Using the constant growth model:

D1 $2.12
P0  
k s - g 0.13 - 0.06
$2.12

0.07
 $30.29

8-32
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
P1  
k s - g 0.13 - 0.06
 $32.10

 Could also
^
find expected P1 as:
P1  P0 (1.06)  $32.10
8-33
What is the expected dividend yield,
capital gains yield, and total return
during the 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 (ks)
= Dividend Yield + Capital Gains Yield
= 7.0% + 6.0% = 13.0%
 For constant growth stock:
Capital gains yield = 6% = g. 8-34
Ks or i for constant growth
stock
 Rearrange model to rate of return form:
 D  D
P0  1
to k s  1
 g.
ks  g P0

Then, ks = $2.12/$30.29 + 0.06

= 0.07 + 0.06 = 13%.

8-35
What would the expected price
today be, if g = 0?
 The dividend stream would be a
perpetuity.

0 1 2 3
ks = 13%
...
2.00 2.00 2.00
^ PMT $2.00
P0    $15.38
k 0.13

8-36
If the stock was expected to have
negative growth (g = -6%), would anyone
buy the stock, and what is its value?
 The firm still has earnings and pays
dividends, even though they may be
declining, they still have value.

^ D1 D0 ( 1  g )
P0  
ks - g ks - g
$2.00 (0.94) $1.88
   $9.89
0.13 - (-0.06) 0.19

8-37
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.
8-38
What is market equilibrium?
 In equilibrium, stock prices are stable and
there is no general tendency for people to
buy versus to sell.
 In equilibrium, expected returns must equal
required returns.
^
D1
ks  g  k s  k RF  (k M  k RF )
P0

8-39
Market equilibrium
 Expected returns are obtained by
estimating dividends and expected
capital gains.
 Required returns are obtained by
estimating risk and applying the CAPM.

8-40
How is market equilibrium
established?
 If expected return exceeds required
return …
 The current price (P0) is “too low” and
offers a bargain.
 Buy orders will be greater than sell
orders.
 P0 will be bid up until expected return
equals required return
8-41
Factors that affect stock price
 Required return (ks) could change
 Changing inflation could cause kRF to
change
 Market risk premium or exposure to
market risk (β) could change
 Growth rate (g) could change
 Due to economic (market) conditions
 Due to firm conditions
8-42
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.
8-43
If preferred stock with an annual
dividend of $5 sells for $50, what is the
preferred stock’s expected return?

Vp = D / kp
$50 = $5 / kp

kp = $5 / $50
= 0.10 = 10%

8-44