Chapter 9

Stock Valuation

McGraw-Hill/Irwin Copyright © 2015 by the McGraw-Hill Companies, Asia Global Edition Inc. All rights reserved.
Key Concepts and Skills
 Understand how stock prices depend on future
dividends and dividend growth
 Be able to compute stock prices using the
dividend growth model
 Understand how growth opportunities affect
stock values
 Understand the PE ratio
 Understand how stock markets work

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Chapter Outline
9.1 The Present Value of Common Stocks
9.2 Estimates of Parameters in the Dividend
Discount Model
9.3 Growth Opportunities
9.4 Price-Earnings Ratio
9.5 The Stock Markets

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9.1 The PV of Common Stocks
 The value of any asset is the present value of its
expected future cash flows.
 Stock ownership produces cash flows from:
 Dividends
 Capital Gains
 Valuation of Different Types of Stocks
 Zero Growth
 Constant Growth
 Differential Growth

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Case 1: Zero Growth
 Assume that dividends will remain at the same level forever

Div 1  Div 2  Div 3  

 Since future cash flows are constant, the value of a zero
growth stock is the present value of a perpetuity:

Div 1 Div 2 Div 3

P0    
(1  R) (1  R ) (1  R )
1 2 3

Div
P0 
R
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Case 2: Constant Growth
Assume that dividends will grow at a constant rate, g,
forever, i.e.,
Div 1  Div 0 (1  g )
Div 2  Div 1 (1  g )  Div 0 (1  g ) 2
Div 3  Div 2 (1  g )  Div 0 (1  g ) 3
..
.
Since future cash flows grow at a constant rate forever,
the value of a constant growth stock is the present value
of a growing perpetuity:
Div 1
P0 
Rg 9-6
Constant Growth Example
 Suppose Big D, Inc., just paid a dividend of
$.50. It is expected to increase its dividend by
2% per year. If the market requires a return of
15% on assets of this risk level, how much
should the stock be selling for?
 P0 = .50(1+.02) / (.15 - .02) = $3.92

9-7
Case 3: Differential Growth
 Assume that dividends will grow at different rates
in the foreseeable future and then will grow at a
constant rate thereafter.
 To value a Differential Growth Stock, we need to:
 Estimate future dividends in the foreseeable future.
 Estimate the future stock price when the stock
becomes a Constant Growth Stock (case 2).
 Compute the total present value of the estimated
future dividends and future stock price at the
appropriate discount rate.

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Case 3: Differential Growth
 Assume that dividends will grow at rate g1 for N
years and grow at rate g2 thereafter.
Div 1  Div 0 (1  g1 )
Div 2  Div 1 (1  g1 )  Div 0 (1  g1 ) 2
..
.
Div N  Div N 1 (1  g1 )  Div 0 (1  g1 ) N

Div N 1  Div N (1  g 2 )  Div 0 (1  g1 ) N (1  g 2 )

.
..
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Case 3: Differential Growth
Dividends will grow at rate g1 for N years and grow
at rate g2 thereafter

Div 0 (1  g1 ) Div 0 (1  g1 ) 2
…
0 1 2
Div N (1  g 2 )
Div 0 (1  g1 ) N  Div 0 (1  g1 ) N (1  g 2 )
… …
N N+1 9-10
Case 3: Differential Growth
We can value this as the sum of:
 a T-year annuity growing at rate g1

C  (1  g1 ) 
T
PA  1  T 
R  g1  (1  R) 
 plus the discounted value of a perpetuity growing at
rate g2 that starts in year T+1
 Div T 1 
 
 R  g2 
PB 
(1  R ) T
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Case 3: Differential Growth
Consolidating gives:

 Div T 1 
 
C  (1  g1 )T   R  g 2 
P 1  T 

R  g1  (1  R )  (1  R ) T

Or, we can “cash flow” it out.

9-12
A Differential Growth Example
A common stock just paid a dividend of $2. The
dividend is expected to grow at 8% for 3 years,
then it will grow at 4% in perpetuity.
What is the stock worth? The discount rate is 12%.

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With the Formula
 $2(1.08) 3 (1.04) 
 
$2  (1.08)  (1.08) 3   .12  .04 

P 1  3

.12  .08  (1.12)  (1.12) 3

P  $54  1  .8966
$32.75
3
(1.12)

P  $5.58  $23.31 P  $28.89

9-14
 With Cash Flows
$2(1 .08) $2(1.08) 2 $2(1.08) 3 $2(1.08) 3 (1.04)
…
0 1 2 3 4
$2.62 The constant
$2.16 $2.33 $2.52  growth phase
.12  .04 beginning in year 4
can be valued as a
0 1 2 3 growing perpetuity
at time 3.
$2.16 $2.33 $2.52  $32.75
P0   2
 3
 $28.89
1.12 (1.12) (1.12) $2.62
P3   $32.75
.08 9-15
9.2 Estimates of Parameters
 The value of a firm depends upon its growth rate,
g, and its discount rate, R.
 Where does g come from?
g = Retention ratio × Return on retained
earnings

9-16
Where Does R Come From?
 The discount rate can be broken into two parts.
 The dividend yield
 The growth rate (in dividends)

 In practice, there is a great deal of estimation

error involved in estimating R.

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Using the DGM to Find R
 Start with the DGM:
D 0 (1  g) D1
P0  
R -g R -g
Rearrange and solve for R:
D 0 (1  g) D1
R g g
P0 P0

9-18
EPS
 Earnings per share (EPS) is the portion of a company’s
profit that is allocated to each outstanding share of common
stock, serving as an indicator of the company’s financial
health.
 In other words, earnings per share is the portion of a
company's net income that would be earned per share if all
the profits were paid out to its shareholders.

EPS = net income / average outstanding

common shares

9-19
9.3 Growth Opportunities
 Growth opportunities are opportunities to
invest in positive NPV projects.
 The value of a firm can be conceptualized as
the sum of the value of a firm that pays out
100% of its earnings as dividends plus the net
present value of the growth opportunities.
EPS
P  NPVGO
R
9-20
NPVGO Model: Example
Consider a firm that has forecasted EPS of $5,
a discount rate of 16%, and is currently priced
at $75 per share.
 We can calculate the value of the firm as a cash cow.
EPS $5
P0    $31.25
R .16
 So, NPVGO must be: $75 - $31.25 = $43.75

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Retention Rate and Firm Value
 An increase in the retention rate will:
 Reduce the dividend paid to shareholders
 Increase the firm’s growth rate
 These have offsetting influences on stock price
 Which one dominates?
 If ROE>R, then increased retention increases firm value since
reinvested capital earns more than the cost of capital.
Retention rate = 1 – payout ratio
The payout ratio is the amount of dividends the
company pays out divided by the net income.
This formula can be rearranged to show that the
retention ratio plus payout ratio equals 1
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9.4 Price-Earnings Ratio
 Many analysts frequently relate earnings per share to price.
 PE ratio is a tool that is used by investors to help decide
whether they should buy a stock.
 Essentially, the P/E ratio tells potential investors how
much they have to pay for every $1 of earnings.
 A low P/E ratio is attractive in the sense that one pays less
for every $1 of earnings.

Price per share

P/E ratio 
EPS
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PE and NPVGO
EPS
 Recall, P  NPVGO
R
 Dividing every term by EPS provides the following description
of the PE ratio:
1 NPVGO
PE  
R EPS
 So, a firm’s PE ratio is positively related to growth
opportunities and negatively related to risk (R)

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9.5 The Stock Markets
 Dealers vs. Brokers
 New York Stock Exchange (NYSE)
 Largest stock market in the world
 License Holders (formerly “Members”)
 Entitled to buy or sell on the exchange floor
 Commission brokers

 Specialists

 Floor brokers

 Floor traders

 Operations
 Floor activity

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NASDAQ
 Not a physical exchange – computer-based
quotation system
 Multiple market makers
 Electronic Communications Networks
 Three levels of information
 Level 1 – median quotes, registered representatives
 Level 2 – view quotes, brokers & dealers
 Level 3 – view and update quotes, dealers only
 Large portion of technology stocks
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Stock Market Reporting
52 WEEKS YLD VOL N ET
HI LO STOCKSYM DIV % PE 100s CLOSE CHG
21.89 9.41 Gap Inc GPS 0.34 3.1 8 88298 11.06 0.45
Gap pays a
dividend of 34
Gap has cents/share. Gap ended trading at
been as high $11.06, which is up 45
as $21.89 in cents from yesterday.
the last year. Given the current
price, the dividend
yield is 3.1%.

8,829,800 shares traded

Gap has been as Given the current hands in the last day’s
low as $9.41 in price, the PE ratio is trading.
the last year. 8 times earnings.
9-27
Quick Quiz
 What determines the price of a share of stock?
 What determines g and R in the DGM?

 Decompose a stock’s price into constant

growth and NPVGO values.
 Discuss the importance of the PE ratio.

 What are some of the major characteristics of

NYSE and Nasdaq?

9-28