Lecture Note 5.

Stock Valuation

Financial Management
Main Contents

Stock Basics

The Dividend-Discount Model (DDM)

Estimating Dividends in the DDM

Zero dividend growth model
Constant dividend growth model

Limitations of the DDM

Share Repurchases and the Total Payout Model

Putting It All Together

Financial Management 2 Lecture Note 5. Stock Valuation

Learning Objectives

Describe the basics of common and preferred stocks

Value a stock as the present value of its expected future dividends

Understand the tradeoff between dividends and growth in stock valuation

Appreciate the limitations of valuing a stock based on expected dividends

Value a stock as the present value of the company’s total payout

Financial Management 3 Lecture Note 5. Stock Valuation

1. Stock Basics

The stock
It represents the equity capital of the issuing firm or shareholders’ value

Types of stock
Common stock
A share of ownership in the corporation, which confers rights to any common dividends as well
as rights to vote on election of directors, mergers, and other major events
£ All rights accruing to the shareholders are in proportion to the number of shares they hold
However, common stock holder has the lowest priority in distributing the residual property
when the firm is liquidated
Dual class stock
£ Different types of common stock for the same company
l Some countries including U.S. are allowing a single company to issue various types of share, such as
Class A and Class B
£ Often carrying different voting rights and dividend payments
l One class is offered to the general public with limited voting rights, while the other is offered to
founders, executives and family with more voting power to have majority control of the company

Financial Management 4 Lecture Note 5. Stock Valuation

1. Stock Basics (Cont.)

Types of stock (Cont.)

Preferred stock
Stock with preference over common shares in payment of dividends and in liquidation
£ However, preferred stock does not have a voting right
It is regarded as a mixed security because it has a character of bond as well as a character of
common stock
Cumulative vs. non-cumulative preferred stock
£ In case of cumulative preferred stock, all missed preferred dividends before must be paid
before any common dividends may be paid
£ In case of non-cumulative preferred stock, all missed preferred dividends do not accumulate
and only the current dividend is owed before common dividends can be paid
Participating vs. non-participating preferred stock
£ In case of participating preferred stock, preferred stock holders have the right to receive extra
dividends from residual incomes after receiving the promised dividends for the preferred
stock

Financial Management 5 Lecture Note 5. Stock Valuation

2. The Dividend-Discount Model

A one-year investor
Suppose an investor who buys a stock and holds it only for one year, then there are two
potential sources of cash flows from owning the stock
Dividends during one year
Selling the stock in one year

Cost and benefit analysis for the stock investment

Cost = current stock price, P0
Benefit = total dividends, Div1 + future stock price, P1

Financial Management 6 Lecture Note 5. Stock Valuation

2. The Dividend-Discount Model (Cont.)

A one year investor (cont.)

The dividends during one year and stock price in one year are not known with certainty
Their values are based on the investor’s expectations at the time the stock is purchased
The investor is willing to pay a current price up to the point at which the benefits equal the cost
The current price equals the present value of the expected future dividend and sale price

The equity cost of capital

Because cash flows from the stock investment are not risk-free but risky, we cannot discount
them using the risk-free interest rate, but instead must use the cost of capital for the firm’s
equity, rE
The equity cost of capital is equal to the expected return, E(r) required by the stockholders (or
stock investors)

The dividend-discount model for a one-year investor

  +    + 
 = = (5.1)
1 +  1 + ()

Financial Management 7 Lecture Note 5. Stock Valuation

2. The Dividend-Discount Model (Cont.)

A one year investor (cont.)

The equity cost of capital, rE is decomposed into two components
Dividend yield: the expected annual dividend of a stock divided by its current price
£ The percentage return an investor expects to earn from the dividend paid by the stock
Capital gain: the amount by which the selling price of a stock exceeds its initial price
£ Capital gain rate is an expression of capital gain as a percentage of the initial price of the
stock
  +    +     − 
 = ⟹  = −1= +
1 +    
Problem 1
Suppose you expect Longs Drug Stores to pay an annual dividend of $0.56 per share in the
coming year and to trade $45.50 per share at the end of the year
If investments with equivalent risk to Longs’ stock have an expected return of 6.80%, what is
the most you would pay today for Longs’ stock? What dividend yield and capital gain rate
would you expect at this price?
£ P0 = ($0.56 + $45.50) / (1+0.0680) = $43.13
£ Dividend yield = $0.56/$43.13 = 1.30% and Capital gain = ($45.50–$43.13)/$43.13 = 5.50%

Financial Management 8 Lecture Note 5. Stock Valuation

2. The Dividend-Discount Model (Cont.)

A multi-year investor
Suppose an investor who buys a stock and holds it for N years, then the cash flows
from the stock investment are
Dividends during N year, (Div1+Div2+··DivN) and selling the stock in N years, PN
Since the current stock price equal to the present value of the future cash flows
      + 
 = + + ⋯ + (5.2)
1 +  (1 +  ) 1 +  

Dividend-discount model equation

An investor can hold a stock forever when the issuing firm eventually pays dividends
and is never acquired or liquidated, in this case, equation (5.2) changes as following
     
 = + + ⋯ + +⋯ (5.3)
1 +  (1 +  ) 1 +  

The price of the stock is equal to the present value of all the expected future dividends it will
pay

Financial Management 9 Lecture Note 5. Stock Valuation

3. Estimating Dividends in the DDM

Zero dividend growth model

Assumes that dividends will not grow forever
A firm pays a fixed dividend to stockholders forever
In this case, equation (5.3) for DDM is written as following and the current stock price is the
present value of a perpetuity
    
 = + + ⋯ + +⋯= =
1 +  (1 +  ) 1 +    

If a firm has zero dividend growth, then the dividend per share equals to the earning per share
(EPS) of the firm

Problem 2
Consolidated Edison, Inc.(Con Edison), is a regulated utility company that services the New
York City area. Suppose Con Edison plans to pay $2.30 per share in dividends forever. If its
equity cost of capital is 7% and dividends are fixed at $2.30 per share, estimate the value of
Con Edison’s stock
 2.30
 = = = $32.86
 0.07

Financial Management 10 Lecture Note 5. Stock Valuation

3. Estimating Dividends (Cont.)

Constant dividend growth model

Assumes that dividends will grow at a constant rate, g, forever
The current stock price depends on the dividend level of next year, divided by the equity cost of
capital adjusted by the growth rate
In this case, equation (5.3) for DDM is written as following and P0 is the present value of a
growing perpetuity (where, rE > g)
    (1 + )   1 +    
 = + + ⋯ + + ⋯ =
1 +  (1 +  ) 1 +    − 

Problem 3
Suppose Con Edison plans to pay $2.30 per share in dividends in the coming year. If its equity
cost of capital is 7% and dividends are expected to grow by 2% per year in the future, estimate
the value of Con Edison’s stock
  2.30
 = = = $46.00
 −  0.07 − 0.02
If Con Edison plans already paid $2.30 per share in dividends for this year and other things are
all the same, what is the value of Con Edison’s stock?
£ P0 = 2.30(1.02)/(0.07 – 0.02) = $ 46.92

Financial Management 11 Lecture Note 5. Stock Valuation

3. Estimating Dividends (Cont.)

Dividends versus investment and growth

What determines the rate of growth of a firm’s dividends?

A simple model of growth

The dividend each year is equal to the firm’s earnings per share (EPS) multiplied by its
dividend payout rate
£ Dividend payout rate: the fraction of a firm’s earnings that the firm pays out as dividends
each year ⟺ retention rate (the faction of a firm’s current earnings that the firm retains)

The firm can increase its dividend in three ways:

£ It can increase its earnings
£ It can increase its dividend payout rate
£ It can decrease its number of shares outstanding

Financial Management 12 Lecture Note 5. Stock Valuation

3. Estimating Dividends (Cont.)

Dividends versus investment and growth (cont.)

Tradeoff between earning growth rate and dividend payout ratio
If the number of share outstanding is fixed, to increase dividends, the firm tries to increase its
earnings and dividend payout rate
But there is a tradeoff between earnings and dividend payout rate

If all increases in future earnings result exclusively from new investment made with
retained earnings, then
Earnings growth rate = Change in earnings/Earnings
= Retention rate × Return on new investment
£ Change in Earnings = New investment × Return on new investment
£ New investment = Earnings × Retention rate = Earnings × (1 – Dividend payout ratio)

If the firm choose to keep its dividend payout rate constant, then the growth in its
dividends will equal the growth in its earnings
g = Retention rate × Return on new investment

Financial Management 13 Lecture Note 5. Stock Valuation

3. Estimating Dividends (Cont.)

Dividends versus investment and growth (cont.)

Profitable growth
A firm can increase its growth rate by retaining more of its earnings
£ Increasing retention rate, however, results in decreasing the amount of dividends
To increase stock price, should a firm cut its dividends and invest more, or should a firm cut its
investments and increase its dividends?
The answer to this question will depend on the profitability of the firm’s investments

The dividend-discount model includes an implicit forecast of the firm’s profitability

which is discounted back at the firm’s equity cost of capital

Financial Management 14 Lecture Note 5. Stock Valuation

3. Estimating Dividends (Cont.)

Dividends versus investment and growth (cont.)

Problem 4: profitable growth case
Crane Sporting Goods expects to have EPS of $6 in the coming year. Rather than reinvest these
earnings and grow, the firm plans to pay out all of its earnings as a dividend. With these
expectations of no growth, Crane’s current share price is $60
Suppose Crane could cut its dividend payout rate to 75% for the foreseeable future and use the
retained earnings to open new stores. The return on investment in these stores is expected to be
12%. If we assume that the risk of these new investments is the same as the risk of its existing
investments, then the firm’s equity cost of capital is unchanged. What effect would this new
policy have on Crane’s stock price?

Solution of Problem 4
Estimate the equity cost of capital
£ rE = Div1 / P0 + g = $6 / $60 + 0 = 0.10 or 10%
Estimate the dividend growth rate
£ g = Retention rate × Return on new investment = 0.25 × 0.12 = 0.03 or 3%
Calculate the new stock price of Crane Sporting Goods when dividend payout rate is 75%
£ P0 = Div1 / (rE – g) = $6 × 0.75 / (0.10 – 0.03) = $4.5 / 0.07 = $62.29 > $60

Financial Management 15 Lecture Note 5. Stock Valuation

3. Estimating Dividends (Cont.)

Dividends versus investment and growth (cont.)

Problem 5: unprofitable growth case
Suppose Crane could cut its dividend payout rate to 75% to invest in new stores as Problem 1
for the foreseeable future and use the retained earnings to open new stores. But now suppose
that the return on these new investments is 8%, rather than 12%. Given its expected EPS this
year of $6 and its equity cost of capital of 10% (we again assume that the risk of the new
investments is the same as its existing investments), what will happen to Crane’s current share
price in this case?

Solution of Problem 5
Estimate the equity cost of capital = 10%
Estimate the dividend growth rate
£ g = Retention rate × Return on new investment = 0.25 × 0.08 = 0.02 or 2%
Calculate the new stock price when dividend payout rate is 75% and growth rate is 2%
£ P0 = Div1 / (rE – g) = $6 × 0.75 / (0.10 – 0.02) = $4.5 / 0.08 = $56.25 < $60

Financial Management 16 Lecture Note 5. Stock Valuation

3. Estimating Dividends (Cont.)

Changing growth rates

For a rapidly growing young firm, we cannot use the constant DDM to value the stock
of such a firm for two reason
Firms often pay no dividends when they are young
Their growth rate continues to change over time until they mature

We can use the general form of the DDM to calculate the future share price of the
stock PN once the firm matures and its expected growth rate stabilizes
Suppose a company with expected dividends of $2, $2.5, and $3 in each of the next three years.
After that point, its dividends are expected to grow at a constant rate of 5%. If its equity cost of
capital is 12%, how to estimate the current price of the stock?
£ Estimate the stock price in year 3
l P3 = Div4 / (rE – g) = $3(1.05) / (0.12 – 0.05) = $45
£ Calculate the current stock price
      +  $2 $2.5 $3 + $45
 = + + = + + = $37.94
1 +  (1 +  ) 1 +   1.12 (1.12) 1.12 

Financial Management 17 Lecture Note 5. Stock Valuation

3. Estimating Dividends (Cont.)

Changing growth rates (cont.)

Problem 6
Small Fry, Inc., has just invented a potato chip that looks and tastes like a French fry. Given the
phenomenal market response to this product, Small Fry is reinvesting all of its earnings to
expand its operations. Earnings were $2 per share this past year and are expected to grow at a
rate of 20% per year until the end of year 4. At that point, other companies are likely to bring
out competing products. Analysts project that at the end of year 4, Small Fry will cut its
investment and begin paying 60% of its earnings as dividends. Its growth will also slow to a
long-run rate of 4%. If Small Fry’s equity cost of capital is 8%, what is the current stock price?

Financial Management 18 Lecture Note 5. Stock Valuation

3. Estimating Dividends (Cont.)

Changing growth rates (cont.)

Solution of Problem 6
Expected earnings and dividends of Small Fry for each year
Year 1 2 3 4 5 6
EPS growth rate 20% 20% 20% 20% 4% 4%
EPS (current $2.00) $2.40 $2.88 $3.46 $4.15 $4.31 $4.49
Dividend payout rate 0% 0% 0% 60% 60% 60%
Dividend $0.00 $0.00 $0.00 $2.49 $2.59 $2.69

Estimate the stock price in year 3

£ P3 = Div4 / (rE – g) = $2.49 / (0.08 – 0.04) = $62.25

Calculate the current stock price

      +  $0.00 $0.00 $0.00 + $62.25
 = + + = + + = $49.42
1 +  (1 +  ) 1 +   1.08 (1.08) 1.08 

Financial Management 19 Lecture Note 5. Stock Valuation

4. Limitations of the DDM

Uncertain dividend forecasts

The DDM values a stock based on a forecast of the future dividends paid to
stockholders
But a firm’s future dividends carry a tremendous amount of uncertainty
It is difficult to know which estimate of the dividend growth rate is more reasonable
Forecasting dividends requires forecasting the firm’s earnings, dividend payout rate, and future
share count
£ Because borrowing and repurchase decisions are at management’s discretion, they are more
difficult to forecast reliably than other fundamental aspects of the firm’s cash flows

Non-dividend-paying stock
Many companies do not pay dividends
A small modification to the DDM to capture total payouts to stockholders whether the payouts
are dividends or not
£ Those approach will be more meaningful once we have covered how financial managers
create value within the firm through decisions about which projects to approve

Financial Management 20 Lecture Note 5. Stock Valuation

5. The Total Payout Model

Share repurchase and the total payout model

Share repurchase is a transaction in which a firm uses cash to buy back its own stock
An increasing number of firms have replaced dividend payouts with share repurchase
Share repurchase has two consequences for the DDM
The more cash the firm uses to repurchase shares, the less cash it has available to pay dividends
By repurchasing shares, the firm decreases its share count, which increases its earnings and
dividends on a per-share basis
Total payout model
A method that values shares of a firm by discounting the firm’s total payouts to stockholders
and then dividing by the current number of shares outstanding
£ Where, total payouts are all the cash distributed as dividends and net stock repurchases
It may be more reliable when a firm repurchases shares
(Future total dividends and net repurchases)
 =
current shares outstanding

We can apply the same simplifications to the total payout method that we obtained by assuming
constant growth DDM

Financial Management 21 Lecture Note 5. Stock Valuation

5. The Total Payout Model

Share repurchases and the total payout model (cont.)

Problem 7
Titan Industries has 217 million shares outstanding and expects earnings at the end of this year
of $860 million. Titan plans to pay out 50% of its earnings in total, paying 30% as a dividend
and using 20% to repurchase shares. If Titan’s earnings are expected to grow by 7.5% per year
and these payout rates remain constant, determine Titan’s share price assuming an equity cost
of capital of 10%
Solution of Problem 7
£ Calculate the total payouts this year = 50% × $860 = $430 million
£ Calculate the PV of future total dividends and repurchases using the constant growth DDM
$430 million
 Future total dividends and net repurchases = = $17.2billion
0.10− 0.075
£ Calculate the current stock price using total payout model

$17.2 billion
 = = $79.26 per share
217 million shares

Financial Management 22 Lecture Note 5. Stock Valuation

6. Putting It All Together

How would an investor decide whether to buy or sell a stock?

The investor would value the stock using her/his own expectations
If her/his expectations were substantially different with the current market price,
she/he might conclude that the stock was over- or under-priced
Based on that conclusion, she would buy or sell the stock

How could a stock suddenly be worth more or less after an information

(such as earnings) announcement?
As investors digest the news, they update their expectations and buying or selling
pressure would then drive the stock price up or down until the buys and sells came into
balance

What should managers do to raise the stock price further?

The only way to raise the stock price is to make value-increasing decisions
Through capital budgeting analysis, managers can identify projects that add value to the
company

Financial Management 23 Lecture Note 5. Stock Valuation