Ton Duc Thang University

Finance and Banking Faculty

Corporate Finance Department

FOUDATION OF FINANCE

CHAPTER 7
THE VALUE OF COMMON STOCKS

Course Code: B02084

Prepared by: Corporate Finance Department

3/27/2024 B02084 – Chapter 7: The value of common stocks 1

 TOPICS COVERED IN
CHAPTER 7
• What is a Stock?
• Selling Price, Dividend, rate of return
• Present Value of a Stock
• PV of a Stock keeping in 1 year
• PV of a Stock keeping in n years
• PV of a Stock keeping forever
• Selling or Holding

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 WHAT IS A STOCK?

Balance Sheet

Liabilities

Assets
Equity

3/27/2024 B02084 – Chapter 7: The value of common stocks 3

 WHAT IS A STOCK?

Balance Sheet

Long term debt

=> BOND
Assets
Equity =>
STOCK

3/27/2024 B02084 – Chapter 7: The value of common stocks 4

 WHAT IS A STOCK?

How Common Stocks Are Traded?

• Primary market: When new shares of common stocks are sold
in the market to raise capital, it is called a primary market
transaction. A good example of a primary market transaction is
the IPO (Initial Public Offering).
• Secondary market: When already issued stocks are traded in
the market, it is called a secondary market transaction. Most
transactions in the stock market are secondary market
transactions.

3/27/2024 B02084 – Chapter 7: The value of common stocks 5

 WHAT IS A STOCK?

How Common Stocks Are Traded?

• There are two types of exchanges that are prevalent in the USA.
They are auction markets and dealer markets. The New York
Stock Exchange is an example of an auction market. Here
specialists act as auctioneers and match up would-be buyers
and sellers. The Nasdaq is an example of a dealer market. In
the case of a dealer market, all trades take place between a
group of dealers and the investors. Dealer markets are also
active in trading many other types of financial instruments such
as bonds.

3/27/2024 B02084 – Chapter 7: The value of common stocks 6

 WHAT IS A STOCK?

How Common Stocks Are Traded?

• Market capitalization rate: The rate of return expected by the
investors in common stocks is called the market capitalization
rate. It is also called the cost of equity capital. For a constant
growth stock, it is the dividend yield plus the growth rate in
dividends.
• The major secondary market for GE shares is: New York Stock
Exchange
• The following are foreign companies that are traded on the New
York Stock Exchange: Toyota, Brazil Telecom, Nokia, Endesa.

3/27/2024 B02084 – Chapter 7: The value of common stocks 7

 WHAT IS A STOCK?

How Common Stocks Are Traded?

• The dividend yield reported as Yld. % in The Wall Street Journal
quotation is calculated as follows: dividends/close
• The exchange-traded fund (EFT) that tracks the Nasdaq 100
index is called: QQQQ
• The following are auction markets are: New York Stock
Exchange, London Stock Exchange, Tokyo Stock Exchange.
• An example of a dealer market: Nasdaq

3/27/2024 B02084 – Chapter 7: The value of common stocks 8

 WHAT IS A STOCK?

How Common Stocks Are Traded?

• In New York Stock Exchange, specialists act as the auctioneers.
• In the following exchanges (London Stock Exchange, Tokyo
Stock Exchange, Frankfurt Stock Exchange), a computer acts
as the auctioneer.
• Income stocks: Dow Chemicals, Cummins, Inc
• Growth stocks: Starbucks, e2v Technologies, Microsoft,
Starbucks

3/27/2024 B02084 – Chapter 7: The value of common stocks 9

 WHAT IS A STOCK?

How Common Stocks Are Traded?

• Book Value - Net worth of the firm according to the balance
sheet.
• Dividend - Periodic cash distribution from the firm to the
shareholders.
• P/E Ratio - Price per share divided by earnings per share.
• Market Value Balance Sheet - Financial statement that uses
market value of assets and liabilities.

3/27/2024 B02084 – Chapter 7: The value of common stocks 10

 WHAT IS A STOCK?

3/27/2024 B02084 – Chapter 7: The value of common stocks 11

 WHAT IS A STOCK?
Return Measurements
Div1
Restated P0 =
r−g
Div1
Dividend Yield = Div1
P0 r= +g
P0

Return on Equity = ROE

EPS
ROE =
Book Equity Per Share
 WHAT IS A STOCK?

• Constant dividend growth formula: There are two important assumptions that are
necessary for the formula to work correctly. First assumption is that the growth rate
in dividends is constant. The second assumption is that the discount rate is greater
than the growth rate in dividends

• Dividend growth rate for a stable firm can be estimated as:

g = plow back rate x the return on equity (ROE)

• The growth rate in dividends is a function of two ratios: ROE and the Retention
Ratio
• Generally high growth stocks pay Low or no dividends

3/27/2024 B02084 – Chapter 7: The value of common stocks 13

 WHAT IS A STOCK?
• The P/E ratio is a widely used financial indicator, but is also quite ambiguous.
Generally, a high P/E ratio indicates that the investors think a firm has good growth
potential. It is the ratio of current market price and earnings of a stock.

3/27/2024 B02084 – Chapter 7: The value of common stocks 14

 How Common Stocks Are Valued
Present Value of the Growth Opportunities (PVGO)

• A high proportion of the value of a growth stock comes from PVGO (Present Value of
the Growth Opportunities)
• Example: Why Microsoft experienced a significant drop in price when it announced its
first ever regular dividend along with huge profits: Under the concept of PVGO,
Microsoft was converting form a company with significant growth to a company with no
growth. An increase in the dividend for a growth company is often a sign of reduced
growth. Thus, the market would have reacted negatively to the news.

3/27/2024 B02084 – Chapter 7: The value of common stocks 15

 Stock Price and Earnings
Per Share
• If a firm elects to pay a lower dividend, and
reinvest the funds, the stock price may
increase because future dividends may be
higher.

Payout Ratio - Fraction of earnings paid out as

dividends
Plowback Ratio - Fraction of earnings retained
by the firm

3/27/2024 B02084 – Chapter 7: The value of common stocks 16

 Stock Price and Earnings
Per Share
Example
Our company forecasts to pay a $8.33
dividend next year, which represents
100% of its earnings. This will provide
investors with a 15% expected return.
Instead, we decide to plowback 40% of
the earnings at the firm’s current return
on equity of 25%. What is the value of
the stock before and after the plowback
decision?

3/27/2024 B02084 – Chapter 7: The value of common stocks 17

 Stock Price and Earnings
Per Share
Example
Our company forecasts to pay a $8.33 dividend next year, which
represents 100% of its earnings. This will provide investors with a
15% expected return. Instead, we decide to plowback 40% of the
earnings at the firm’s current return on equity of 25%. What is the
value of the stock before and after the plowback decision?

No Growth With Growth

8.33 g = .25  .40 = .10

P0 = = $55.56
.15
5.00
P0 = = $100.00
.15 − .10

3/27/2024 B02084 – Chapter 7: The value of common stocks 18

 Stock Price and Earnings
Per Share
Example - continued
If the company did not plowback some earnings, the
stock price would remain at $55.56. With the
plowback, the price rose to $100.00.

The difference between these two numbers is called

the Present Value of Growth Opportunities (PVGO).

PVGO = 100.00 − 55.56 = $44.44

 Stock Price and Earnings
Per Share
Present Value of Growth Opportunities
(PVGO) - Net present value of a firm’s
future investments.

Sustainable Growth Rate - Steady rate at

which a firm can grow: plowback ratio X
return on equity.

3/27/2024 B02084 – Chapter 7: The value of common stocks 20

 Valuing a Business
Valuing a Business or Project
The value of a business or Project is usually
computed as the discounted value of FCF out to
a valuation horizon (H).
The valuation horizon is sometimes called the
terminal value and is calculated like PVGO.

FCF1 FCF2 FCFH PV H

PV = + + ... + +
(1 + r ) (1 + r )
1 2
(1 + r ) H
(1 + r ) H

3/27/2024 B02084 – Chapter 7: The value of common stocks 21

 SELLING PRICE, DIVIDEND,
RATE OF RETURN

Dividend

Long
Equity
term=>
debt
Selling Price
=>
STOCK
BOND
Equity =>
STOCK
Required Rate of
Return

3/27/2024 B02084 – Chapter 7: The value of common stocks 22

 SELLING PRICE, DIVIDEND,
RATE OF RETURN

Dividend
(Di)

Long
Equity
term=>
debt
Selling Price
=>
STOCK
BOND
Equity =>
STOCK
Required Rate of
Return

3/27/2024 B02084 – Chapter 7: The value of common stocks 23

 SELLING PRICE, DIVIDEND,
RATE OF RETURN

Dividend
(Di)

Long
Equity
term=>
debt Selling Price
=>
STOCK
BOND (Pn)
Equity =>
STOCK
Required Rate of
Return

3/27/2024 B02084 – Chapter 7: The value of common stocks 24

 SELLING PRICE, DIVIDEND,
RATE OF RETURN

Dividend
(Di)

Long
Equity
term=>
debt Selling Price
=>
STOCK
BOND (Pn)
Equity =>
STOCK
Required Rate of
Return : r (%)

3/27/2024 B02084 – Chapter 7: The value of common stocks 25

 PRESENT VALUE OF A STOCK

Equity =>
STOCK
Dividend received Selling price at year
at year (i): Di (n): Pn
D1 D2 D3 D4 D5 D6 D7 D8 D9 (D10 + P10)

0 1 2 3 4 5 6 7 8 9 10
Required Rate of
Return : r (%)
3/27/2024 B02084 – Chapter 7: The value of common stocks 26
 PRESENT VALUE OF A STOCK

Dividend received Selling price at year

at year (i): Di (n): Pn
Required Rate of
Return : r (%)
D1 D2 D3 D4 D5 D6 D7 D8 D9 (D10 + P10)

0 1 2 3 4 5 6 7 8 9 10
𝑫𝟏 𝑫𝟐 𝑫𝒏 + 𝑷𝒏
𝑷𝟎 = + 𝟐
+ ⋯+
𝟏+𝒓 𝟏+𝒓 𝟏+𝒓 𝒏

3/27/2024 B02084 – Chapter 7: The value of common stocks 27

 PRESENT VALUE OF A STOCK
Example - PV of a Stock keeping in 1 year

1. A company’s stockholders expect to receive a year-end

dividend of $5 per share and then be sold for $115 dollars
per share. If the required rate of return for the stock is
20%, what is the current value of the stock?

3/27/2024 B02084 – Chapter 7: The value of common stocks 28

 PRESENT VALUE OF A STOCK
Example - PV of a Stock keeping in n years

1. A company expects to pay a dividend of $2 per share at the end of

year-1, $3 per share at the end of year-2 and then be sold for $32
per share. If the required rate on the stock is 15%, what is the
current value of the stock?
2. A company last paid a $1.50 per share annual dividend. The
company is planning on paying $3, $5, $7.50, and $10 a share
over the next four years, respectively. After that the dividend will
be a constant $2.50 per share per year. What is the current price
of this stock if the rate of return is 14 percent?
3. A company last annual dividend was $2 a share. The company
plans to lower the dividend by $.50 each year for the next three
years. In Year 5, it will pay a final liquidating dividend of $22 a
share. If the required return is 16 percent, what is the current per
share value of this stock?

3/27/2024 B02084 – Chapter 7: The value of common stocks 29

 PRESENT VALUE OF A STOCK
Example - PV of a Stock keeping forever

1. A company has decided to issue preferred stock with an

annual dividend of $4 a share. Similar stocks are
currently yielding 11 percent. What price should the firm
expect to receive for each new share issued?
2. A company is going to pay $1, $2.50, and $5 a share over
the next three years, respectively. After that, the company
plans to pay annual dividends of $1.25 per share
indefinitely. If your required return is 13 percent, how
much are you willing to pay for one share today?
3. A company is expected to pay a dividend of $3 per share
at the end of year-1 (D1) and these dividends are
expected to grow at a constant rate of 6% per year
forever. If the required rate of return on the stock is 18%,
what is current value of the stock today?
3/27/2024 B02084 – Chapter 7: The value of common stocks 30
 PRESENT VALUE OF A STOCK
Example - PV of a Stock keeping forever

4. A company has just now paid a dividend of $2.83 per

share (D0); the dividends are expected to grow at a
constant rate of 6% per year forever. If the required rate
of return on the stock is 16%, what is the current value on
stock?
5. A company has just paid a dividend of $3.12 and is
expected to grow at a constant rate of 5 percent. The
required rate of return is 23 percent. What is the current
price of the stock?
6. A company just announced its next annual dividend will
be $1.50 a share with future dividends increasing by 1.8
percent annually. How much will one share of this stock
be worth five years from now if the required return is 15.5
percent?
3/27/2024 B02084 – Chapter 7: The value of common stocks 31
 PRESENT VALUE OF A STOCK
Example - PV of a Stock keeping forever

7. A company will pay an annual dividend of $2.10 a share

on its common stock next year. Last week, the company
paid a dividend of $2 a share. The company adheres to a
constant rate of growth dividend policy. What will one
share of this stock be worth ten years from now if the
applicable discount rate is 9 percent?
8. A company paid its first annual dividend yesterday in the
amount of $.28 a share. The company plans to double
each annual dividend payment for the next three years.
After that, it will pay a constant $1.50 per share dividend
indefinitely. What is one share of this stock worth today if
the market rate of return on similar securities is 11.5
percent?

3/27/2024 B02084 – Chapter 7: The value of common stocks 32

 PRESENT VALUE OF A STOCK
Example - Selling or Holding

You expect your company to pay the following dividend

pattern for three years as follows:
D1 = $1.7 D2 = $1.2 D3=$3
a. After three years, you sell your shares for $32 per share.
If the required rate of return demanded by investors is
15%, what is the current price of your company stock?
b. Assume that after three years, you won’t sell your shares
and the dividends are expected to grow at a constant rate
of 9% per year. If the required rate of return demanded by
investors is 15%, what is the current price of your
company stock?
c. If your stock was selling on the market for $35. Should
you hold or sell the stock?

3/27/2024 B02084 – Chapter 7: The value of common stocks 33

 Web Resources

Click to access web sites

Internet connection required

www.dividenddiscountmodel.com
www.valuepro.net
www.nyse.com
www.nasdaq.com
www.londonstockexchange.com
www.tse.or.jp
www.123world.com/stockexchanges
www.rba.co.uk
www.fibv.com
 Ton Duc Thang University
Finance and Banking Faculty
Corporate Finance Department

Thank you for your attention

I wish you all the best!

Dr. Ngô Nguyễn Quỳnh Như

3/27/2024 B02084 – Chapter 7: The value of common stocks 35