Chapter 04 - The Value of Common Stocks

CHAPTER 4

1. Stock markets. True or false?

a. The bid price is always greater than the ask price.
b. An investor who wants to sell his stock immediately should enter a limit order.
c. The sale of shares by a large investor usually takes place in the primary market.
d. Electronic Communications Network refers to the automated ticker tape on the New York Stock
Exchange.

1. a. False, the ask is the higher price, at which traders are willing to sell to you. If you wish to
sell a share of stock, you will receive the lower bid price, at which traders are willing to
buy the share from you.

b. False, this investor should enter a market order.

c. False, investors sell their shares in the secondary market. If the investor was a private
equity investor, perhaps they would sell into the primary market, but this is less common.

d. False, electronic communication networks (ECNs) are another means of trading shares
of stock.

3. Stock quotes*. Here is a small part of the order book for Mesquite Foods:

a. Georgina Sloberg submits a market order to sell 100 shares. What price will she receive?
b. Norman Pilbarra submits a market order to buy 400 shares. What is the maximum price that he will
pay?
c. Carlos Ramirez submits a limit bid order at 105. Will it execute immediately?

3. a. $103.00

b. $103.80

c. Yes, if Carlos seeks to buy by placing a $105 buy limit order, it will execute since prices
are already below the $105 limit.

4. Stock quotes. Go to finance.yahoo.com (or some other web site) and get trading quotes for IBM.
a. What is the latest IBM stock price and market cap?
b. What is IBM’s dividend payment and dividend yield?
c. What is IBM’s trailing P/E ratio?
d. Calculate IBM’s forward P/E ratio using the EPS forecasted by analysts for the next year.
e. What is IBM’s price–book (P/B) ratio?

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Chapter 04 - The Value of Common Stocks

4. Internet exercise; answers will vary.

6. Dividend discount model. True or false?

a. All stocks in an equivalent-risk class are priced to offer the same expected rate of return.
b. The value of a share equals the PV of future dividends per share.
c. The value of a share equals the PV of earnings per share assuming the firm does not grow, plus the
NPV of future growth opportunities.

6. a. True.
b. True.
c. True. The expected return is equal to the yearly dividend divided by the share price. If the firm
does not grow and all earnings are paid out as dividends, then the expected return is also
equal to the EPS/share price. Therefore, P0 = DIV1 / r = EPS1 / r. We must still account for the
present value of the growth opportunities, however, so P0 = EPS1 / r + PVGO.

9. Dividend discount model. Company Y does not plow back any earnings and is expected to produce a
level dividend stream of $5 a share. If the current stock price is $40, what is the market capitalization
rate?

9. r = DIV1 / P0
r = $5 / $40
r = .125, or 12.5%

10. Constant-growth DCF model*. Company Z’s earnings and dividends per share are expected to grow
indefinitely by 5% a year. If next year’s dividend is $10 and the market capitalization rate is 8%, what is
the current stock price?
10. P0 = DIV1 / (r – g)
P0 = $10 / (.08 − .05)
P0 = $333.33

12. Constant-growth DCF model. Pharmecology just paid an annual dividend of $1.35 per share. It’s a
mature company, but future EPS and dividends are expected to grow with inflation, which is
forecasted at 2.75% per year.
a. What is Pharmecology’s current stock price? The nominal cost of capital is 9.5%.
b. Redo part (a) using forecasted real dividends and a real discount rate.

12. a. P0 = [DIV0 × (1 + g)] / (r – g)

P0 = [($1.35 × (1 + .0275)] / (.095 – .0275)
P0 = $20.55

b. r = (1 + R) / (1 + h) – 1
r = (1 + .095) / (1 + .0275) – 1
r = .0657, or 6.57%

In real terms, g equals 0, so DIV1 equals DIV0.

P0 = $1.35 / .0657
P0 = $20.55

16. Cost of equity capital. Each of the following formulas for determining shareholders’ required rate of
return can be right or wrong depending on the circumstances:
a. r = DIV1/P0 + g
b. r = EPS1/P0

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Chapter 04 - The Value of Common Stocks

For each formula, construct a simple numerical example showing that the formula can give wrong
answers and explain why the error occurs. Then construct another simple numerical example for
which the formula gives the right answer.

16. a. An Incorrect Application. Hotshot Semiconductor’s earnings and dividends have grown
by 30% per year since the firm’s founding 10 years ago. Current stock price is $100, and
next year’s dividend is projected at $1.25. Thus:

r = DIV1 / P0 + g = $1.25 / $100 + .30 = .3125, or 31.25%

This is wrong because the formula assumes perpetual growth; it is not possible for
Hotshot to grow at 30% per year forever.

A Correct Application. The formula might be correctly applied to the Old Faithful
Railroad, which has been growing at a steady 5% rate for decades. Its EPS 1 = $10, DIV1
= $5, and P0 = $100. Thus:

r = Div1 / P0 + g = $5 / $100 + .05 = .10, or 10%

Even here, you should be careful not to blindly project past growth into the future. If Old
Faithful hauls coal, an energy crisis could turn it into a growth stock.

b. An Incorrect Application. Hotshot has current earnings of $5 per share. Thus:

r = EPS1 / P0 = $5 / $100 = .05, or 5%

This is too low to be realistic. The reason P0 is so high relative to earnings is not that r is
low, but rather that Hotshot is endowed with valuable growth opportunities. Suppose
PVGO = $60:

P0 = EPS1 / r + PVGO
$100 = $5 / r + $60
r = 12.5%

A Correct Application. Unfortunately, Old Faithful has run out of valuable growth
opportunities. Since PVGO = 0:

P0 = EPS1 / r + PVGO
$100 = $10 / r + $0
r = 10%
19. Two-stage DCF model. Company Q’s current return on equity (ROE) is 14%. It pays out one half of
earnings as cash dividends (payout ratio = .5). Current book value per share is $50. Book
value per share will grow as Q reinvests earnings. Assume that the ROE and payout ratio

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Chapter 04 - The Value of Common Stocks

stay constant for the next four years. After that, competition forces ROE down to 11.5%
and the payout ratio increases to 0.8. The cost of capital is 11.5%.
a. What are Q’s EPS and dividends next year? How will EPS and dividends grow in years 2, 3, 4, 5, and
subsequent years?
b. What is Q’s stock worth per share? How does that value depend on the payout ratio and growth rate
after year 4?

19. a. Plowback ratio = 1 – payout ratio

Plowback ratio = 1 – .5
Plowback ratio = .5

gYears 1-4 = plowback ratio × ROE

gYears 1-4 = .5 × .14
gYears 1-4 = .07

EPS0 = ROE × book equity per share

EPS0 =.14 × $50
EPS0 = $7.00

DIV0 = payout ratio × EPS0

DIV0 = .5 × $7.00
DIV0 = $3.50

Remember:
EPS: DIV=EPS*payout ratio, Retained earnings=plowback ratio
Payout ratio + plowback ratio = 1 (or 100%)

g Year 5 and later = plowback ratio × ROE

g Year 5 and later = (1 – .8) × .115
g Year 5 and later = .023, or 2.3%

The annual EPS and DIV are as follows:

Year EPS DIV

0 $7.00 $3.50
1 $7.00 × 1.07 = $7.49 $7.49 × .5 = $3.75
2 $7.00 × 1.072 = $8.01 $8.01 × .5 = $4.01
3 $7.00 × 1.073 = $8.58 $8.58 × .5 = $4.29
4 $7.00 × 1.074 = $9.18 $9.18 × .5 = $4.59
5 $7.00 × 1.074 × 1.023 = $9.39 $9.39 × .8 = $7.51

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Chapter 04 - The Value of Common Stocks

P(0)=DIV(1)/(r-g)

b. PH = [DIV5 × (1 + g2)] / (r – g2)

PH = ($7.51 × 1.023) / (.115 - .023)
PH = $83.50

P0 = DIV1 / (1 + r) + DIV2 / (1 + r)2 + DIV3 / (1 + r)3 + DIV4 / (1 + r)4

+ DIV5 / (1 + r)5 + PH / (1 + r)5
P0 = $3.75 / 1.115 + $4.01 / 1.1152 + $4.29 / 1.1153 + $4.59 / 1.1154
+ $7.51 / 1.1155 + $83.50 / 1.1155
P0 = $65.45

The last term in the above calculation is dependent on the payout ratio and the growth
rate after year 4.

22. Growth opportunities. Look up Intel (INTC), Oracle (ORCL), and HP (HPQ) on finance.yahoo.com.
Rank the companies’ forward P/E ratios from highest to lowest. What are the possible reasons for the
different ratios? Which of these companies appears to have the most valuable growth opportunities?

22. Internet exercise; answers will vary.

26. Horizon value. What is meant by the “horizon value” of a business? How can it be
estimated?

26. Horizon value is the value of a firm at the end of a forecast period. Horizon value can be
estimated using the constant-growth DCF formula or by using the comparables method (e.g.
price-earnings or market-book ratios for similar companies).

31. Valuing a business*. Phoenix Corp. faltered in the recent recession but is recovering. Free cash flow
has grown rapidly. Forecasts made in 2019 are as follows:

Phoenix’s recovery will be complete by 2024, and there will be no further growth
in net income or free cash flow.
a. Calculate the PV of free cash flow, assuming a cost of equity of 9%.
b. Assume that Phoenix has 12 million shares outstanding. What is the price (value) per share?
c. Confirm that the expected rate of return on Phoenix stock is exactly 9% in each of the years from 2020
to 2024.

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Chapter 04 - The Value of Common Stocks

31. a. PV2019 = FCF2020 / (1 + r) + FCF2021 / (1 + r)2 + FCF2022 / (1 + r)3 +

FCF2023 / (1 + r)4 + FCF2024 / (1 + r)5 + (FCF 2025 / r) / (1 + r)5
PV2019 = $0 / 1.09 + $1 / 1.092 + $2 / 1.093 + $2.3 / 1.094 + $2.6 / 1.095
+ ($2.6 / .09) / 1.095
PV2019 = $24.48 million

b. Assuming no debt, the share price would be:

Value per share2019 = PV2019 / number of shares

Value per share2019 = $24.48 / 12
Value per share2019 = $2.04

c. The PV of the cash flows at various points in time are as follows:

PV2020 = $1 / 1.09 + $2 / 1.092 + $2.3 / 1.093 + $2.6 / 1.094 +

($2.6 / .09) / 1.094.
PV2020 = $26.68

PV2021 = $2 / 1.09 + $2.3 / 1.092 + $2.6 / 1.093 + ($2.6 / .09) / 1.093

PV2021 = $28.09

PV2022 = $2.3 / 1.09 + $2.6 / 1.092 + ($2.6 / .09) / 1.092

PV2022 = $28.61

PV2023 = $2.6 / .09

PV2023 = $28.89

PV2024 = $2.6 / .09

PV2024 = $28.89
Using the formula, r0 = (DIV1 + P1 – P0) / P0, the annual rates of return are:

Rate of return2021 = ($1 + 28.09 – 26.68 / $26.68 = .09, or 9%

Rate of return2022 = ($2 + 28.61 – 28.09 / $28.09 = .09, or 9%

Rate of return2023 = ($2.3 + 28.89 – 28.61) / $28.61 = .09, or 9%

Rate of return2024 = ($2.6 + 28.89 – 28.89) / $28.89 = .09, or 9%

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McGraw-Hill Education.