Chapter Four

STOCK VALUATION

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Differences Between Debt and Equity

• Debt includes all borrowing incurred by a firm,

including bonds, and is repaid according to a fixed
schedule of payments.
• Equity consists of funds provided by the firm’s
owners (investors or stockholders) that are repaid
subject to the firm’s performance.

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Table 7.1 Key Differences between Debt
and Equity

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Differences Between Debt and Equity:
Voice in Management
• Unlike creditors, holders of equity (stockholders)
are owners of the firm.
• Stockholders generally have voting rights that
permit them to select the firm’s directors and vote
on special issues.
• In contrast, debtholders do not receive voting
privileges but instead rely on the firm’s contractual
obligations to them to be their voice.

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Differences Between Debt and Equity:
Claims on Income and Assets
• Equityholders’ claims on income and assets are
secondary to the claims of creditors.
– Their claims on income cannot be paid until the claims of
all creditors, including both interest and scheduled principal
payments, have been satisfied.
• Because equity holders are the last to receive
distributions, they expect greater returns to
compensate them for the additional risk they bear.

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Differences Between Debt and Equity:
Maturity

• Unlike debt, equity capital is a permanent

form of financing.
• Equity has no maturity date and never has
to be repaid by the firm.

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Differences Between Debt and Equity: Tax
Treatment
• Interest payments to debtholders are treated as
tax-deductible expenses by the issuing firm.
• Dividend payments to a firm’s stockholders are not
tax-deductible.
• The tax deductibility of interest lowers the
corporation’s cost of debt financing, further causing
it to be lower than the cost of equity financing.

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Common and Preferred Stock:
Common Stock
• Common stockholders, who are sometimes referred
to as residual owners or residual claimants, are the
true owners of the firm.
• As residual owners, common stockholders receive
what is left—the residual—after all other claims on
the firms income and assets have been satisfied.
• They are assured of only one thing: that they
cannot lose any more than they have invested in
the firm.
• Because of this uncertain position, common
stockholders expect to be compensated with
adequate dividends and ultimately, capital gains.

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Common Stock: Dividends

• The payment of dividends to the firm’s

shareholders is at the discretion of the company’s
board of directors.
• Dividends may be paid in cash, stock, or
merchandise.

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Preferred Stock

• Preferred stock gives its holders certain privileges

that make them senior to common stockholders.
• Preferred stockholders are promised a fixed periodic
dividend, which is stated either as a percentage or
as a dollar amount.

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Preferred Stock: Basic Rights of Preferred
Stockholders
• Preferred stock is often considered quasi-debt
because, much like interest on debt, it specifies a
fixed periodic payment (dividend).
• Preferred stock is unlike debt in that it has no
maturity date.
• Because they have a fixed claim on the firm’s
income that takes precedence over the claim of
common stockholders, preferred stockholders are
exposed to less risk.
• Preferred stockholders are not normally given a
voting right, although preferred stockholders are
sometimes allowed to elect one member of the
board of directors.
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Common Stock Valuation

• Common stockholders expect to be rewarded

through periodic cash dividends and an increasing
share value.
• Some of these investors decide which stocks to buy
and sell based on a plan to maintain a broadly
diversified portfolio.
• Other investors have a more speculative motive for
trading.
– They try to spot companies whose shares are
undervalued—meaning that the true value of the shares is
greater than the current market price.
– These investors buy shares that they believe to be
undervalued and sell shares that they think are overvalued
(i.e., the market price is greater than the true value).

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Basic Common Stock Valuation Equation

The value of a share of common stock is equal to the

present value of all future cash flows (dividends) that
it is expected to provide.

where
P0 = value of common stock
Dt = per-share dividend expected at the
end of year t
rs = required return on common stock

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Common Stock Valuation:
The Zero Growth Model
The zero dividend growth model assumes that the
stock will pay the same dividend each year, year after
year.

𝐷1
𝑃0 =
𝑟𝑠
The equation shows that with zero growth, the value
of a share of stock would equal the present value of a
perpetuity of D1 dollars discounted at a rate rs.

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Example

• Chuck Swimmer estimates that the dividend of

Denham Company, an established textile producer,
is expected to remain constant at $3 per share
indefinitely.

• If his required return on its stock is 15%, the

stock’s value is:
$20 ($3 ÷ 0.15) per share

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Common Stock Valuation:
Constant-Growth Model
The constant-growth model is a widely cited
dividend valuation approach that assumes that
dividends will grow at a constant rate, but a rate that
is less than the required return.

The Gordon model is a common name for the

constant-growth model that is widely cited in dividend
valuation.

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Common Stock Valuation:
Constant-Growth Model (cont.)
Emmy Lou, Inc. has an expected dividend next year
of $1.50 per share, a growth rate of dividends of 7
percent, and a required return of 15percent. Calculate
the value of a share of Emmy Lou, Inc.'s common
stock.

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Common Stock Valuation:
Variable-Growth Model
• The zero- and constant-growth common stock
models do not allow for any shift in expected
growth rates.
• The variable-growth model is a dividend
valuation approach that allows for a change in the
dividend growth rate.
• To determine the value of a share of stock in the
case of variable growth, we use a four-step
procedure.

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Common Stock Valuation:
Variable-Growth Model (cont.)
Step 1. Find the value of the cash dividends at the
end of each year, Dt, during the initial growth period,
years 1 though N.

Dt = D0 × (1 + g1)t

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Common Stock Valuation:
Variable-Growth Model (cont.)
Step 2. Find the present value of the dividends
expected during the initial growth period.

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Common Stock Valuation:
Variable-Growth Model (cont.)
Step 3. Find the value of the stock at the end of the
initial growth period, PN = (DN+1)/(rs – g2), which is
the present value of all dividends expected from year
N + 1 to infinity, assuming a constant dividend
growth rate, g2.

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Common Stock Valuation:
Variable-Growth Model (cont.)
Step 4. Add the present value components found in
Steps 2 and 3 to find the value of the stock, P0.

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Common Stock Valuation:
Variable-Growth Model (cont.)
The most recent annual (2012) dividend payment of Warren
Industries, a rapidly growing boat manufacturer, was $1.50 per
share. The firm’s financial manager expects that these dividends
will increase at a 10% annual rate, g1, over the next three years.
At the end of three years (the end of 2015), the firm’s mature
product line is expected to result in a slowing of the dividend
growth rate to 5% per year, g2, for the foreseeable future. The
firm’s required return, rs, is 15%.

Steps 1 and 2 are detailed in Table 7.3 on the following slide.

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Table 7.3 Calculation of Present Value of
Warren Industries Dividends

2012

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Common Stock Valuation:
Variable-Growth Model (cont.)
Step 3. The value of the stock at the end of the initial growth
period

(N = 2015) can be found by first calculating DN+1 = D2016.

D2016 = D2015  (1 + 0.05) = $2.00  (1.05) = $2.10

By using D2016 = $2.10, a 15% required return, and a 5%

dividend growth rate, we can calculate the value of the stock at
the end of 2015 as follows:

P2015 = D2016 / (rs – g2) = $2.10 / (.15 – .05) = $21.00

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Common Stock Valuation:
Variable-Growth Model (cont.)
Step 3 (cont.) Finally, the share value of $21 at the end of 2015
must be converted into a present (end of 2012) value.

P2012 / (1 + rs)3 = $21 / (1 + 0.15)3 = $13.81

Step 4. Adding the PV of the initial dividend stream (found in

Step 2) to the PV of the stock at the end of the initial growth
period (found in Step 3), we get:

P2012 = $4.14 + $13.82 = $17.93 per share

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