BE300/BE302 Finance

Dr. Senyu (William) Wang

Lecture 5: Stock Valuation

(QMF: Chapters 16, 17 & 18)
 Stock Valuation

Learning Goals
1. Discuss the basic definitions and features of
stocks.
2. Determine the intrinsic value of a stock using the
dividend valuation model.
3. Discuss common stock ratios
 What are stocks?

• Stocks
– Corporate ownership divided into shares known as
stock
– The sum of all the outstanding shares of a
corporation known as the equity of the corporation
– Owner of a share of stock called
 Shareholder
 Or stockholder
 Or equity holder
 What are stocks?

• Stock is an equity investment that represents

ownership in a corporation
• A unique feature of this ownership is that there is no
limitation on who can own the stock.
• This feature allows free trade in the stock of a
corporation. Corporations can raise substantial
amounts of capital because they can sell ownership
shares to anonymous outside investors.
• The return on investment in stock comes from
two sources: dividends and capital gains

• Dividends are payments the corporation makes

to its shareholders

• Capital gains occur when the stock price rises

above an investor’s initial purchase price
– Capital gains may be realized or unrealized
Table 6.1 Historical Average Annual Returns on the
Standard and Poor’s 500, 1930-2014
Several interesting historical patterns:
• Big returns (or losses) come from capital gains,
rather than from dividends.
• Stocks generally earn positive returns over long
periods of time:
From 1930 to 2014, the average total return on the
S&P 500 was 11.4% per year.
Investing in stocks is clearly not without risk:
 In 2008, the S&P 500 lost roughly 36% of its value.
 From 2000 through 2009, the U.S. stock market’s
average annual return was only 1.1% per year.

The stock index, which shows the average

market performance of stocks, gives a
benchmark against which to assess current
stock returns and our own expectations.
 Basic Characteristics of Common Stock

• Reading the Quotes

– Stock quotes appear daily in the financial press and
online
– Example: Consider quotes that appear at Yahoo!
Finance
Figure 6.1 A Stock Quote for Lloyds
Banking Group
Figure 6.2 A Stock Quote for Walmart
 Basic Characteristics of Common Stock
• Couple of Points
– Market capitalization: the share price (market value per
share) times the number of shares outstanding.
– The ask and bid price.
– Bid-ask spread: difference between the bid and ask
prices for a stock.
• Cost you incur when you make a roundtrip trade (i.e.
purchase and then later sell).
– How do investors determine the price they are
willing to pay for the stock?
– EPS, PE ratio, Forward dividend & yield, what are
they?
 Stock Valuation Models
• According to the Law of One Price, the intrinsic value of
a security should equal the present value of the expected
cash flows an investor will receive from owning it.
– Intrinsic value: The underlying or inherent value of a
security

• To value a stock is to find its intrinsic value.

• To find the intrinsic value of a stock, we need to know the

expected cash flows a stock investor will receive.
– For stocks, the expected cash flows are dividends received
each year plus the future sale price of the stock.
 Stock Valuation Models
• What is the price if we plan on holding the stock for two
years?

• r is the stock’s required rate of return (calculated based

on CAPM) which is the discount rate used here to find the
present value.
 Stock Valuation Models

• What is the price if we plan on holding the stock for N

years?
 Stock Valuation Models

• What if we hold the stock forever?

Then we can let N in the above equation go to infinity and write
it as follows:

• That is, the price of any stock is equal to the present

value of the expected future dividends it will pay.
– This is known as the Dividend Valuation Model (DVM).
 Applying the Dividend Valuation Model

• Constant Dividend Growth

– The simplest forecast for the firm’s future dividends states
that they will grow at a constant rate, g, forever.
 Applying the Dividend Valuation Model

• Zero Growth
– Assumes dividends will not grow over time, i.e., g = 0.
– Value of a zero-growth stock is simply the present value of
its annual dividends.
 Applying the Dividend Valuation Model

• Changing Growth Rates

– We cannot use the constant dividend growth model to
value a stock if the dividend growth rate is not
constant.
• For example, young firms often have very high initial
earnings growth rates. During this period of high
growth, these firms often retain 100% of their
earnings to exploit profitable investment
opportunities. As they mature, their growth slows. At
some point, their earnings exceed their investment
needs, and they begin to pay dividends.
 Changing Growth Rates

DivN  1
PN 
rE  g

• Dividend Valuation Model with Constant Long-Term

Growth

Div1 Div2 DivN 1  DivN  1 

P0        
1  rE (1  rE ) 2 (1  rE ) N (1  rE ) N  rE  g 
 Example 6.1

Assume you’ve generated the following information

about the stock of Bufford’s Burger Barns: The
company’s latest dividends of $4 a share are
expected to grow to $4.32 next year, to $4.67 the
year after that, and to $5.04 in three years. After
that, you think dividends will grow at a constant 6%
rate. Use the variable growth version of the dividend
valuation model and a required return of 15% to find the
value of the stock.
 Year Future Cash Flows Present Value
1 $4.32

2 $4.67

3 $5.04+$59.36

Stock Value $49.63

The value of the stock at the end of year 3 is the present
value of all future dividends from that year onwards. Using
the constant dividend growth model
$ 5.04 ∗( 1+ 6 %)
𝑃3= =$ 59.36
15 % −6 %
 Example 6.1

The third year cash flow is the dividend of $5.04 plus

the $59.36, the stock value at the end of year 3. The
value of the stock today is simply the present value of
all the future cash flows, $49.63.
 Limitations of the Dividend Valuation
Model (DVM)

• There is a tremendous amount of uncertainty associated

with forecasting a firm’s dividend growth rate and future
dividends.
• Small changes in the assumed dividend growth rate can
lead to large changes in the estimated stock price.
 Stock Valuation Models

• Other Approaches to Stock Valuation

– The market has developed other approaches to valuing
stock in addition to the DVM.
• Free cash flow to equity method (or flow to equity
method): estimates cash flow that a firm generates for
common stockholders, whether it pays those out as
dividends or not.
• P/E approach: builds the stock valuation process
around the stock’s price-to-earnings ratio.
– Major advantage is that these approaches do not rely on
dividends as the primary input.
 Common Stock Ratios

Earnings Per Share: the amount of annual earnings

available to common stockholders, stated on a per-share
basis.
 Common-Stock Ratios
• Price-to-Earnings Ratio (P/E): used to determine how the market
is pricing the company’s common stock.

– Investors would like to find stocks with rising P/E ratios

– Watch out for P/E ratios that become too high; may be a signal
that the stock is becoming overvalued and ready to fall.
 Common Stock Ratios

Dividend yield: a measure of dividends on a relative

(percentage) basis rather than on an absolute (dollar) basis.
 Common Stock Ratios

• Payout Ratio: indicates how much of its earnings a company

pays out to stockholders in the form of dividends.

– Traditional payout ratios have been 30% to 50%; growth-oriented

companies often have low or zero payout ratios.
– A rising dividend payout ratio is often a sign that a company’s
earnings are falling.
– High payout ratios may be difficult to maintain and the stock
market does not like cuts in dividends.
 Stock Valuation Models (cont’d)

• Other Approaches to Stock Valuation

– The Price-to-Earnings (P/E) Approach
• Simpler approach.
• Favorite of professional security analysts and widely
used in practice.

• Customary to use forecasted EPS for next year (i.e.,

projected earnings one year out).
Questions?

Thank you!