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Chapter 07
Equity Markets and Stock
Valuation

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
 Key Concepts and Skills
• Understand how stock prices depend on future dividends
and dividend growth.
• Be able to compute stock prices using the dividend growth
model.
• Understand how corporate directors are elected.
•
Loading…
Understand how stock markets work.
• Understand how stock prices are quoted.

© McGraw Hill, LLC 3

 Chapter Outline
7.1 Common Stock Valuation.
7.2 Some Features of Common and Preferred Stock.
7.3 The Stock Markets.

© McGraw Hill, LLC 4

 Cash Flows for Stockholders
If you own a share of stock, you can receive cash in two
ways.
• The company pays dividends.
• You sell your &
shares, either to another investor in the
market or back to the company.
Loading… ↑ VER-lib

As with bonds, the price of the stock is the present value of

-

these expected cash flows.

-

• Dividends → cash income.

• Selling → capital gains. 4050 - 10 Capital gain
40 30 e lot Capital loss

© McGraw Hill, LLC 5

 One-Period Example 1

Suppose you are thinking of purchasing the stock of Moore

Oil, Inc.
• You expect it to pay a $2 dividend in one year.
• You believe you can sell the stock for $14 at that time.
• You require a return of 20 percent on investments of this
risk.
• What is the maximum you would be willing to pay?
Fu

© McGraw Hill, LLC 6

 One-Period Example 2

&
D1 = $2 dividend expected in one year.
R = 20 percent.
P1 = $14.
CF1 = $2 + 14 = $16.
Compute the PV of the expected cash flows.
IAB EEM
($2 + 14 )
P0 = = $13.33
1.20

© McGraw Hill, LLC 7

 Two-Period Example
What if you decide to hold the stock for two years?
FREE DE#
&
• D1 = $2.00 CF1 = $2.00.
• D2 = $2.10.
CF2 = $2.10 + 14.70 = $16.80
• P2 =
$14.70.
• Now how much would you be willing to pay?

F-E EEA EXT

2 ($2.10 + 14.70 )
P0 = + = $13.33
1.20 1.20&2

#HER THIR

1 .
FREE 2 .

than
© McGraw Hill, LLC 8
 Three-Period Example
What if you decide to hold the stock for three years?
• D1 = $2.00 CF1 =
$2.00.
• D2 = CF2 =
$2.10 $2.10.
• D3 = $2.205.
CF3 = $2.205 + 15.435 = $17.640
• P3 = $15.435.
• Now how much would you be willing to pay?
D, Dr D3 + P3
2 $2.10 2.205 + 15.435
P0 = + 2
+ 3
= $13.33
1.20 1.20 1.20

© McGraw Hill, LLC 9

 Three-Period Example Using TI BAII + Cash
Flow Worksheet
Fi
Cash Flows: Display
Display You
YouEnter
Enter
CF
CF0 = 0 C00 0 Enter, Down
CF1 = 2.00 C01 2 Enter, Down
CF2 = 2.10 F01 1 Enter, Down
CF3 = 17.64 C02 2.10 Enter, Down
F02 1 Enter, Down
C03 17.64 Enter, Down
F03 1 Enter, Down NPV
I 20 Enter, Down CPT
NPV $13.33

© McGraw Hill, LLC 10

 Developing the Model 1 F
Valuation model
You could continue to push back when you would sell the
stock.
You would find that the price of the stock is really just the
present value of all expected future dividends.

Loading…

© McGraw Hill, LLC 11

 Stock Value = PV of Dividends
IA
MARFt
D1 D2 D3 D∞
Pˆ0 = 1
+ 2
+ 3
+…+
(1+ R ) (1+ R ) (1+ R ) (1+ R )∞

∞
Dt
DCF Pˆ0 = ∑ t
t=1 (1+ R )

How can we estimate all future dividend payments?

© McGraw Hill, LLC 12

 AR Fct 3. *4 DDM (Dividend discount models
Estimating Dividends Special Cases
Constant dividend/Zero Growth. 12XEn FFE
• Firm will pay a constant dividend forever.
• Like preferred stock. 9 TREAL#5X3
• Price is computed using the perpetuity formula.
Constant dividend growth. Et A bXEnEE
• Firm will increase the dividend by a constant percent every
period.
Supernormal growth. PXY
• Dividend growth is not consistent initially, but settles down
to constant growth eventually.

© McGraw Hill, LLC 13

D ABF1)Xn ** F
Zero Growth D is a constant

g = 0
L'AL3TREA344-5)
Dividends expected at regular intervals forever = perpetuity.
TERRY Yo D Dz= .
Dn= = .

)
2
.. :

P0 = D / R FT DIR

Suppose stock is expected to pay a $.50 dividend every

4
quarter and the required return is 10 percent with quarterly
compounding. What is the price? #
↓ 3155)
(i) 14 5 :

$.50
P0 = = $20
.10
4

© McGraw Hill, LLC 14

& ENE% 5X in E (Gordon Model)
Constant Growth Stock
One whose dividends are expected to grow forever at a
constant rate, g. #19 **
1
D1 = D0 (1 +O
g)
2
D2 = D0 (1 + g )
t
Dt = D0 (1 + g )

D0 = Dividend JUST
PAID.
D1 to Dt = Expected
dividends.
© McGraw Hill, LLC 15
 Projected Dividends
D0 = $2.00 and constant g = 6 percent.

D1 = D0(1 + g) = 2(1.06) = $2.12.

D2 = D1(1 + g) = 2.12(1.06) = $2.2472.
D3 = D2(1 + g) = 2.2472(1.06) = $2.3820.

© McGraw Hill, LLC 16

 Dividend Growth Model

Aut

·
t
ˆ
∞
(1+ g )
P0 = D0 ∑ t
t =1 (1+ R )

= Po >
-
&in
D (1+ g ) D1
ˆ
P = 0 = Di :
F -
ELAIRENEY
0 R−g R−g R XJE'J AAAB
:

9 :
&E A P5XEn&
“Gordon growth model”

© McGraw Hill, LLC 17

 Fr
#t
[BF7

FFER >
-
K

© McGraw Hill, LLC 18

 DGM: Example 1

Do
Suppose Big D, Inc., just paid a dividend of $.50. It is
expected to increase its dividend by92 percent per year. If the
market requires a return ofR15 percent on assets of this risk,
how much should the stock be selling for?

• D0= $.50.
D0 (1 + g ) = Di
• g = 2%. P0 =
R−g
• R = 15%.
$.50 (1+ .02 )
P0 = = $3.92 ↑ 5
.15 − .02

Valuation :T + I Fair Price

© McGraw Hill, LLC 19

 DGM: Example 2

Di
Suppose TB Pirates, Inc., is expected to pay a $2 dividend in
one year. If the dividend is expected to grow atg5 percent per
year and the required returnRis 20 percent, what is the price?

• D1 = $2.00
D1
• g = 5% P0 =
R−g
• r = 20%
$2.00
P0 = = $13.33
.20 − .05

© McGraw Hill, LLC 20

 Stock Price Sensitivity to Dividend Growth,
g gEx
i
[i]

g
g
stock price
Access the text alternative for slide images.

© McGraw Hill, LLC 21

 Stock Price Sensitivity to Required Return,
R R& ↑ KEY
E 2

Go :g R &, share priced

R
stock price o
Access the text alternative for slide images.

© McGraw Hill, LLC 22

 Example 7.3 Gordon Growth Company I
Gordon Growth Company is expected to pay a dividend of $4
next period and dividends are expected to grow at 6 percent
per year. The required return is 16 percent.
What is the current price?

D1
P0 =
R−g

$4.00
P0 = = $40
.16 − .06

© McGraw Hill, LLC 23

*
Example 7.3 Gordon Growth Company II 1

What is the price expected to be in Year 4?

D4 (1 + g ) D&
Pob
4 = = 5

R−g R−g

4
D5 = D1 (1 + g )

4
$4.00 (1 + .06 )
P4 = = $50.50
.16 − .06

© McGraw Hill, LLC 24

 Example 7.3 Gordon Growth
Company II 2

What is the implied return given the change in price during

the four-year period?
4
$50.50 = $40 (1 + return ) ; return = 6 percent

4 N; − 40 PV; 50.50 FV; 0 PMT; CPT I/Y = 6%

The price grows at the same rate as dividends.

© McGraw Hill, LLC 25

 Constant Growth Model Conditions
• Dividend expected to grow at g forever.
• Stock price expected to grow at g forever.
• Expected dividend yield-
is constant. AP
• Expected capital gains yield is constant and equal to g.
• Expected total return, R, must be > g. ex
D
.

• Expected total return (R): 11

74Ta

= Expected dividend yield (DY). bank

Po =
+ Expected growth rate (g).
=>
PoxR-Poxg Di
= Dividend yield +#
g.
=

E => PoxR =
D1 + Poxy
R XJE'J AAAB
A
:

+
g 3933
=

&E A P5XEn&
=> R =

9 :

© McGraw Hill, LLC R215241* 26

⑪ X
Nonconstant Growth Po =
(+
2) +
(1138 +9.

66)
X 22
-

Suppose a firm is expected to increase dividends by 20

percent in one year and by 15 percent in two years. After that
dividends will increase at a rate of 5 percent per year
indefinitely. If the last dividend was $1 and the required return
is 20 percent, what is the price of the stock?
Remember that we have to find the PV of all expected future
dividends.
Di = 1 .
2 Po =
"Yug
12 1 38 this the stock price at years
/yrg
=
is
P2 >
.
-

9166
=
=

D3 k449
it
=

The present vale of dividend in year is

The price at year 2 9 66

dindat
=

of
years
.

The present vale in

the dividend at year 2 = 1 2 :

The present vale in

year 223 9 66 = 019583
labf
.

↓ inded of yearz
614083
:
(1 2)
2=

95833 + 6 7083
El
.

1+
=

Po =
0 . :

27
© McGraw Hill, LLC
&
Nonconstant Growth – Solution
2 #A 1XE
9F]

Compute the dividends until growth levels off. RARE

Do (1 + % >
• D1 = 1(1.2) = $1.20.
=g
20
Pr
=

9 66 =
-

• D2 = 1.20(1.15) = $1.38. D, < = 1+ 15 %)

• D3 = 1.38(1.05) = $1.449. = D2) 1 + 5 % )

Find the expected future price at the beginning of the

constant growth period:
• P2 = D3 / (R – g ) = $1.449 / (.2 − .05 ) = $9.66.

Find the present value of the expected future cash flows.

(1 + R
=
%)
20

• P0 = $1.20 /1.2 + ($1.38 + 9.66 ) /1.22 = $8.67.

Du Pr
F
© McGraw Hill, LLC 28
 Nonconstant + Constant Growth 1

Basic PV of all Future Dividends Formula

D1 D2 D3 D∞
Pˆ0 = 1
+ 2
+ 3
+ ... + ∞
(1+ R ) (1+ R ) (1+ R ) (1+ R )
Dividend Growth Model Loading…
ˆ Dt+1
Pt =
R−g

© McGraw Hill, LLC 29

 Nonconstant + Constant Growth 2

D1 D2 P2
Pˆ0 = 1
+ 2
+ 2
(1 + R ) (1 + R ) (1 + R )

∞
Dt
Because P1 = ∑ t
t =3 (1 + R )
If g constant after t = 2, then g22 **E
# # Gordon model
D3
~ P2 =
R−g

© McGraw Hill, LLC 30

 Nonconstant Growth Followed by Constant
Growth

Access the text alternative for slide images.

© McGraw Hill, LLC 31

 Quick Quiz: Part 1
What is the value of a stock that is expected to pay a
constant dividend of $2 per year if the required return is 15
percent?
X model
I $2.00
R P0 = = $13.33 g = 0

.15

What if the company starts increasing dividends by 3 percent

per year beginning with the next dividend? The required
return remains at 15 percent.
Gordon model

g
$2.00 (1.03) = Di
P0 = = $17.17
.15 − .03 R-9

© McGraw Hill, LLC 32

 Using the DGM to Find R
Start with the DGM:

D0 (1 + g ) D1
P0 = =
R−g R−g

Rearrange and solve for R:

↑ Capital gain xied-g 3881 *

P
Expected

D
,

D0 (1 + g ) D1
Total 7 R= +g= +g
Return
P0 P0

Dividend Yield

© McGraw Hill, LLC 33

 Finding the Required Return Example 1

A firm’s stock is selling for $10.50. They just paid a $1

dividend and dividends are expected to grow at 5 percent per
year.

What is the required return?

© McGraw Hill, LLC 34

 Finding the Required Return Example 2

P0 = $10.50.
D0 = $1.
g = 5 percent per year.
What is the required return?

D0 (1 + g ) D1
R= +g= +g
F
P0 P0

1.00 (1.05 )
R= + .05 = 15%
10.50

© McGraw Hill, LLC 35

 Finding the Required Return
Example 3

P0 = $10.50.
D0 (1+ g )
D0 = $1. R= +g
P0
g = 5 percent per year.
D1
What is the dividend yield? R= +g
P0
$1(1.05 ) / $10.50 = .10, or 10%. $1.00 (1.05 )
R= + .05 = 15%
$10.50
What is the capital gains yield? ↓ ↓
Dividend Capital
g = 5%. Yield Gains Yield
TRENE =Y

© McGraw Hill, LLC 36

 Valuation Using Multiples
REME
&
NFE* or
For stocks that don’t pay dividends (or have erratic dividend
growth rates), we can value them using the price-earnings
(PE) ratio and/or the price-sales ratio: #
Price at time t = Pt #
= Benchmark PE ratio × Earnings per sharet
share
price
x

Price at time t = Pt ↑ T **GE =

Sales Revenue

= Benchmark price-sales ratio × Sales per sharet

⑭
• The price-sales ratio can be especially useful when
earnings are negative.

© McGraw Hill, LLC 37

 Valuation Using Multiples Example
Suppose we are trying to value the company Inactivision, a
video game developer that does not pay dividends. If the
appropriate industry PE for this type of company is 20 and
you predict earnings to be $2.50 per share for the coming
year, then the forecasted stock price for a year from now, or
target price, is the following:

Target price = 20 × $2.50 = $50

© McGraw Hill, LLC 38

 Table 7.2 1

Table 7.2 Summary of Stock Valuation

I. The general case
In general, the price today of a share of stock, P0, is the present value
of all of its future dividends, D1, D2, D3, … :
D1 D2 D3
P0 = 1
+ 2
+ 3
+…
(1+ R ) (1+ R ) (1+ R )
where R is the required return.
II. Constant growth case
If the dividend is constant and equal to D, then the price can be written
as:
D
P0 =
R

© McGraw Hill, LLC 39

 Table 7.2 2

If the dividend grows at a steady rate g, then the price can be written as:
D1
P0 =
R−g
This result is called the dividend growth model.
I. Nonconstant Growth
If the dividend grows steadily after t periods, then the price can be
written as:
D1 D2 Dt Pt
P0 = 1
+ 2
+ !+ t
+ t
(1 + R ) (1 + R ) (1 + R ) (1 + R )
where:

Dt × (1 + g )
Pt =
(R − g )
© McGraw Hill, LLC 40
 Table 7.2 3

IV. The required return, R, can be written as the sum of two things:
R = D1 / P0 + g
where D1 / P0 is the dividend yield and g is the capital gains yield
(which is the same thing as the growth rate in dividends for the steady
growth case).
I. Valuation Using Comparables
For stocks that don’t pay dividends (or have erratic dividend growth
rates), we can value them using the PE ratio and/or the price-sales
ratio:

Pt = Benchmark PE ratio × EPSt

Pt = Benchmark price – sales ratio × Sales per share t

© McGraw Hill, LLC 41

 Features of Common Stock A 1

Voting Rights.
• Stockholders elect directors.
• Cumulative voting versus Straight voting.
• Boards are often staggered, or “classified.”
• Proxy voting. 3

Classes of stock.
• Founders’ shares. Eil LA &Y
• Class A and Class B shares.

Return to Quiz

© McGraw Hill, LLC 42

 Features of Common Stock 2

Other Rights.
Share proportionally in declared dividends.
Share proportionally in remaining assets during liquidation.
Preemptive right.
• Right of first refusal to buy new stock issue to maintain
proportional ownership if desired.

Return to Quiz

© McGraw Hill, LLC 43

 Dividend Characteristics
Dividends are not a liability of the firm until declared by the
Board of Directors.
• A firm cannot go bankrupt for not declaring dividends.
Dividends and Taxes.
• Dividends are not tax deductible for firm.
• Taxed as ordinary income for individuals.
• Dividends received by corporations have a minimum 70
percent exclusion from taxable income.

© McGraw Hill, LLC 44

 Features of Preferred Stock
Dividends.
Must be paid before dividends can be paid to common
stockholders.
Not a liability of the firm.
Can be deferred indefinitely.
Most preferred dividends are cumulative.
• Missed preferred dividends have to be paid before
common dividends can be paid.

Preferred stock generally does not carry voting rights.

Return to Quiz

© McGraw Hill, LLC 45

 The Stock Markets
Primary versus Secondary Markets.
• Primary = new-issue market. HERE (ex . HE)
• Secondary = existing shares traded among investors. REBITE =

(ex = )
Dealers versus Brokers.
• Dealer: Maintains an inventor.
Ready to buy or sell at any time.
Think “Used car dealer.”
• Broker: Brings buyers and sellers together.
Think “Real estate broker.”

© McGraw Hill, LLC 46

 New York Stock Exchange (NYSE)
NYSE.
• Merged with Euronext in 2007.
• NYSE Euronext merged with the American Stock
Exchange in 2008.
Members (Historically).
• Buy a trading license (own a seat).
• Designated market makers, DMMs (formerly known as
“specialists”).
• Floor brokers.
• Supplemental liquidity providers (SLPs).

© McGraw Hill, LLC 47

 NYSE Operations
Operational goal = attract order flow.
NYSE DMMs:
Assigned broker/dealer.
• Each stock has one assigned DMM.
• All trading in that stock occurs at the “DMM’s post.”

Trading takes place between customer orders placed with

the DMMs and “the crowd.”
“Crowd”= Floor brokers and SLPs.

© McGraw Hill, LLC 48

 Nasdaq
Nasdaq (merged with OMX in 2007).
Computer-based quotation system.
Multiple market makers.
Electronic Communications Networks.
Three levels of information.
• Level 1 – median quotes, registered representatives.
• Level 2 – view quotes, brokers & dealers.
• Level 3 – view and update quotes, dealers only.

Large portion of technology stocks.

© McGraw Hill, LLC 49

 ECNs
Electronic Communications Networks provide direct trading
among investors.
Developed in late 1990s.
ECN orders transmitted to Nasdaq.
Observe live trading online: markets.cboe.com/us/equities.

© McGraw Hill, LLC 50

 Reading Stock Quotes

What information is provided in the stock quote?

Click on this link to go to Bloomberg for current stock quotes.
Access the text alternative for slide images.

© McGraw Hill, LLC 51

 Work the Web
Not only are stock price quotes readily available online.
Some online trading sites display their “order book” or “limit
order book” live online.
The BATS Exchange was one of these websites until it was
purchased by the CBOE in 2016.
Follow this link to see current buy and sell orders for
Microsoft (MSFT).

© McGraw Hill, LLC 52

 Quick Quiz: Part 2 1

You observe a stock price of $18.75. You expect a dividend

growth rate of 5 percent and the most recent dividend was
$1.50. What is the required return?

D0 (1 + g ) D1
R= +g = +g
P0 P0

1.50 (1.05 )
R= + 0.5 = 13.4%
18.75

© McGraw Hill, LLC 53

 Quick Quiz: Part 2 2

What are some of the major characteristics of common

stock? (Slide 40 and Slide 41).
What are some of the major characteristics of preferred
stock? (Slide 43).

© McGraw Hill, LLC 54

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