The value of common stocks

Abhinav Anand (IIM Bangalore)

Common stocks

Trading
I Sales of new shares to raise equity capital is done in the
primary market
I However, most trading happens on the stock exchange
I Stock exchanges are used to buy and sell second-hand
shares—the secondary market
I Buyer and seller of stock need not ever meet—they can place
their market order and limit order with brokers
I Market order: Selling the stock at best price
I Limit order: Buying the stock at the best price
Valuation of stocks

Book values
I One way to value stocks is to look at the company’s balance
sheets
I Assets—plants, machinery, cash etc.
I Liabilities—loans, taxes due etc.
I The difference between assets and liabilities is the book value
of a company’s equity. Valuation of stock by book value has
positives as well as negatives
I Positive: associated with liquidation value; measures asset cost
minus depreciation
I Negative: based on historical estimates—does not account for
intangible assets, inflation etc.
Valutation of stocks

Valuation by comparables
I One way to value stock is to observe comparable firms and
impute stock value from their averages
I Price-to-book ratios
I Price-to-earnings ratios
I This method is simple and may offer insights especially in the
absence of rich information about the firm
I However, it simplicity is among its limitations, especially in
sectors where there is a lack of comparables
Valuation of stocks

Stock prices and dividends

I Firms can use their earnings in two main ways
I Reinvest in projects that are worth financing—plowback
I Pay back dividends to shareholders—payout
I As expected, market price of stocks should be the sum of their
discounted cashflows
Valuation of stocks

Stock prices and dividends

I Two aspects of stock ownership
I Divident payment
I Capital gains or losses (due to change in stock price)
I Suppose the current price of a share is P0 and the expected
price (per share) at the end of the year is P1 . Assume
expected dividends (per share) at the end of the year to be D1 .
Holding period expected return is defined as:

D1 + (P1 − P0 )
r=
P0
Valuation of stocks
Example
Corporation Z’s stock sells for $100 per share. Investors expect $5
dividend over the next year and expect to sell the stock for $110 at
the end of the year.

D1 + (P1 − P0 ) 5 + (110 − 100)

r= = = 0.15
P0 100

Stock price and dividends

I Equivalently, for an estimate of today’s price in terms of
future expected estimates
D 1 + P1
P0 =
1+r
I r is the cost of equity or market capitalization rate
Valuation of stocks

Stock price and dividends

I Hence based on future estimates, today’s price of corporation
Z’s stock is:
D1 + P1 5 + 110
P0 = = = 100
1+r 1 + 0.15
I Given future expected estimates, the same logic suggests the
following for P1 :
D 2 + P2
P1 =
1+r
I Incorporating this, we get for P0

D1 D 2 + P2
P0 = +
1+r (1 + r )2
Valuation of stocks

Stock price and dividends

I Suppose for corporation Z, the estimates for dividends and
price in year two are $5.5 and $121 respectively.
D 2 + P2 5.5 + 121
P1 = = = 110
1+r 1+r
D 1 + P1 5 + 110
P0 = = = 100
1+r 1+r
I Equivalently,

D1 D2 + P2 5 5.5 + 121
P0 = + 2
= + = 100
1+r (1 + r ) 1 + 0.15 (1 + 0.15)2
Valuation of stocks
Stock price and dividends
I Of course, current prices can be expressed in terms of future
expectations of arbitrary horizon:
D1 D2 D T + PT
P0 = + + ... +
1+r 1+r (1 + r )2
T
!
X Dt PT
P0 = t
+
(1 + r ) (1 + r )T
t=1
I As T increases, the contribution of the last term becomes
PT
smaller and smaller: lim = 0. This leads to
T →∞ (1 + r )T

∞
X Dt
P0 =
(1 + r )t
t=1
Valuation of stocks

Stock prices and dividends

I Note that in the limit the marginal contribution from the
terminal price becomes smaller and smaller
I While the assumption was that prices are influnced by both
future expected dividends and prices, as the horizon increases,
only dividends matter
I Note however, that many successful companies—Google,
Amazon etc.—have never paid a dividend
Valuation of stocks

Stock prices and dividends

I Note that in the limit the marginal contribution from the
terminal price becomes smaller and smaller
I While the assumption was that prices are influnced by both
future expected dividends and prices, as the horizon increases,
only dividends matter
I Note however, that many successful companies—Google,
Amazon etc.—have never paid a dividend
I That may still be in the interest of shareholders if all projects
undertaken have positive NPV
Estimating the cost of equity
Growing dividends
I Consider the case when expected dividends grow at a constant
rate g forever
I This means that shareholders get dividends D, D(1 + g ), . . .,
growing perpetuity:
D
PV =
r −g
I r is the discount rate which is interpreted as the “cost of
equity capital” or expected return on equally risky securities
I Equivalently,
D
r= +g
P0

I Expected rate of return (on equally risky securities) equals the

dividend yield plus the expected growth rate of dividends
Estimating the cost of equity

Problem
Corp W’s shares sold for $47.30 at start of 2012. Dividend
payments for 2013 were expected to be $1.86 a share with no
growth. What is the expected rate of return? What if the growth
rate of dividends is 7%
Estimating the cost of equity

Problem
Corp W’s shares sold for $47.30 at start of 2012. Dividend
payments for 2013 were expected to be $1.86 a share with no
growth. What is the expected rate of return? What if the growth
rate of dividends is 7%

Answer
Since g = 0, expected rate of return should equal the dividend
yield:
D 1.86
r= = = 3.9%
P0 47.30
.
If growth rate is g = 0.07, expected return is:

D 1.86
r= +g = + 0.07 = 10.9%
P0 47.30
Estimating the cost of equity

Payout ratios
I A firm can decide to either return surplus cash to shareholders
or reinvest it in projects that need financing
I Hence earnings can be
I paid out as dividends
I plowed back as reinvestments
I The ratio of dividends-to-earnings (per share) is the payout
ratio. Hence the plowback ratio is

D
plowback ratio = 1 − payout ratio = 1 −
E
I Note that D ≤ E (Why?)
Estimating the cost of equity

Return on equity
I Return on equity (ROE) measures profitability over (net)
assets

earnings (per share)

ROE =
book-value of equity (per share)
Estimating the cost of equity

Return on equity
I Return on equity (ROE) measures profitability over (net)
assets

earnings (per share)

ROE =
book-value of equity (per share)

I We assume that reinvested cash is used to increase the book

equity
Estimating the cost of equity

Problem
Corp W’s stock price is $40 and dividend is $2. Its return on equity
is 11% and the payout ratio is 60%. Can you estimate the cost of
equity?
Estimating the cost of equity

Problem
Corp W’s stock price is $40 and dividend is $2. Its return on equity
is 11% and the payout ratio is 60%. Can you estimate the cost of
equity?

Answer
I Since payout ratio is 60% it means that the plowback ratio is
40%
I Since the plowback ratio is 40% it means that earnings
increase by

change in E = ROE × change in BV

∆E = 0.11 ∗ (0.40) = 0.044 = 4.4%
Estimating the cost of equity

I Since earnings increase by 4.4% it means that dividends

increase by 4.4% (since payout ratio does not change)
Estimating the cost of equity

I Since earnings increase by 4.4% it means that dividends

increase by 4.4% (since payout ratio does not change)
I Since dividends grow by 4.4%, cost of equity must be dividend
yield plus dividend growth:
D
r = +g
P0
2
r = + 0.044 = 9.4%
40

Caution!
I Note the implicit (unrealistic) assumption that D will grow at
the same rate forever
Estimating the cost of equity

Two-stage growth models

I Many firms—such as startups or those in the
tech-sector—show very high initial growth rates
I However, to expect them to grow at the same rate is unrealistic
I Usually after reaching certain size, complexity etc. growth
rates come down
I We can assume that the first growth stage occurs for the first
few years, then is replaced by a lower rate in perpetuity
I The same idea can be extended to get three-stage growth
models etc.
Estimating the cost of equity

Two-stage growth models

Recall the stock price formula

D1 D2 DT PT
P0 = + + ... + +
1+r (1 + r )2 (1 + r )T (1 + r )T

I We assume the first-stage of high growth lasts till the first T

periods, then the second-stage continues forever with low
growth g2
I This gives a way to express PT

DT +1
PT =
r − g2
Estimating the cost of equity

Problem
Corp Z pays dividends of $0.5 and stock price $50. It plowed back
80% earnings and has ROE = .25. What is the cost of equity?
Estimating the cost of equity

Problem
Corp Z pays dividends of $0.5 and stock price $50. It plowed back
80% earnings and has ROE = .25. What is the cost of equity?

Answer

Dividend growth rate = ROE × plowback ratio

Cost of equity = Dividend yield + Dividend growth rate
g = 0.25 ∗ 0.80 = 0.20
0.50
r= + 0.20 = 0.21
50
Estimating the cost of equity

Problem
Suppose now that at the end of year 3 the ROE of the firm drops
to 16% and the firm reduces plowback to 50%. What is the new
growth rate? What is the stock price if Z follows this two-stage
growth and opportunity cost of capital is 10%? (Assume book
value 10%)

Answer

g2 = 0.16 ∗ 0.50 = 0.08

D4
P3 =
r − 0.08
D1 D2 D3 1 D4
P0 = + 2
+ 3
+ 3
1+r (1 + r ) (1 + r ) (1 + r ) r − 0.08
Estimating the cost of equity

Table 4.4
1 2 3 4
Book equity 10 12 14.4 15.55
Earnings 2.50 3 2.30 2.48
ROE 0.25 0.25 0.16 0.16
Payout ratio 0.20 0.20 0.50 0.50
Dividend 0.50 0.60 1.15 1.24
Dividend growth - 0.20 0.92 0.08
Price and earnings

Relation
I Two sources of investor wealth—dividends (income stock) and
capital gains (growth stock)
I For firms that have growth rate 0, all earnings are converted
to dividends—perpetuity of constant dividends
I Hence expected return (cost of equity) is dividend yield
(dividend-to-price ratio)
I Since dividends equals earnings (D = E ), expected return
equals the earnings-to-price ratio
Price and earnings

Problem
A no-growth firm pays $10 dividends and has stock price $100.
What is the earning-to-price ratio for this firm? What is the cost
of equity?
Price and earnings

Problem
A no-growth firm pays $10 dividends and has stock price $100.
What is the earning-to-price ratio for this firm? What is the cost
of equity?

Answer
Since the firm does not grow, it means it pays out all earnings as
dividends. Hence D = E . Hence earnings-to-price ratio equals
dividend yield.
D 10
earnings-to-price ratio = = = 0.10
P 100
Cost of equity = dividend yield
D E
r= = 0.10 =
P P
Price and earnings

Cost of equity and earnings

I For no-growth firms with D = E , cost of equity equals the
earnings-to-price ratio
I However, for positive growth firms, cost of equiy can equal
the earnings-to-price ratio if NPV = 0 for all projects
I In general, (NPVGO = net present value of growth
opportunities)
E
P = + NPVGO
r
and hence  
E NPVGO
=r 1−
P P
Price and earnings
Problem: Growth stock
Assume that firm W has market capitalization rate r = 0.15,
dividend $5, its growth rate is 10%, and earnings $8.33. What
must be the market’s assessment of the net present value of
growth opportunities of W?
Price and earnings
Problem: Growth stock
Assume that firm W has market capitalization rate r = 0.15,
dividend $5, its growth rate is 10%, and earnings $8.33. What
must be the market’s assessment of the net present value of
growth opportunities of W?
Answer
D 5
P= = = 100
r −g 0.15 − 0.10
If growth were 0, stock price would be the earnings-to-price ratio.
Hence the difference must be the net present value of growth
opportunities
E
NPVGO = P −
r
8.33
NPVGO = 100 − = 44.44
0.15
Price and earnings
Problem
Google’s stock price is $495 and earnings are $26.05. Assume cost
of equity 10%. What is NPVGO for Google?
Answer
If growth rate of Google were 0, cost of equity would equal dividend
yield which in turn equals the earnings-to-price ratio. Equivalently,
E
PV = = 26.05/0.10 = 260.50
r
Since the market prices Google’s stock at $495, it means that the
difference must be the market’s assessment of what the NPVGO is:
E
NPVGO = P − = 495 − 260.50 = 235
r
Since NPVGO (per share) is almost 50% of the full stock value,
Google is a growth stock
Problems

BMA Chapter 4 #18

Consider the following three stocks:
1. Stock A is expected to provide a dividend of $10 forever
2. Stock B is expected to provide a dividend of $5 next year
which grows thereafter at 4% per year
3. Stock C is expected to provide a dividend of $5 next year
which grows thereafter at 5% per year for five years and 0
after year 6
If the market capitalization rate for each stock is 10% which stock
is most valuable? What if the rate is 7%?
Problems

Answer
1.
D 10
PA = = = 100
r 0.10
2.
D 5
PB = = = 83.3
r −g .10 − .04
3. Di+1 = Di (1 + 0.05) (i ∈ {1, . . . , 5})

D1 D6 D7 1
PC = + ... + 6
+ = 104.5
1.1 1.1 0.1 1.17
Hence C is best
For r = 7%, PA = 142.86, PB = 166.67, PC = 156.48, Hence B is
best
I