Chapter 8

Stock Valuation

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

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
• Understand how stock markets work
• Understand how stock prices are quoted

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Chapter Outline
• Common Stock Valuation
• Some Features of Common and
Preferred Stocks
• The Stock Markets

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1
 Cash Flows for
Stockholders
• If you buy 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
• As with bonds, the price of the stock
is the present value of these
expected cash flows
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One-Period Example
• Suppose you are thinking of purchasing
the stock of Moore Oil, Inc. You expect it
to pay a $2 dividend in one year, and you
believe that you can sell the stock for $14
at that time. If you require a return of 20%
on investments of this risk, what is the
maximum you would be willing to pay?
▪ Compute the PV of the expected cash flows
▪ Price = (14 + 2) / (1.2) = $13.33
▪ Or FV = 16; I/Y = 20; N = 1; CPT PV = -13.33

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Two-Period Example
• Now, what if you decide to hold the
stock for two years? In addition to the
dividend in one year, you expect a
dividend of $2.10 in two years and a
stock price of $14.70 at the end of
year 2. Now how much would you be
willing to pay?
▪ PV = 2 / (1.2) + (2.10 + 14.70) / (1.2)2 =
13.33

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 Three-Period Example
• Finally, what if you decide to hold the
stock for three years? In addition to the
dividends at the end of years 1 and 2, you
expect to receive a dividend of $2.205 at
the end of year 3 and the stock price is
expected to be $15.435. Now how much
would you be willing to pay?
▪ PV = 2 / 1.2 + 2.10 / (1.2)2 + (2.205 +
15.435) / (1.2)3 = 13.33

8-7

Developing The Model

• You could continue to push back the
year in which you will sell the stock
• You would find that the price of the
stock is really just the present value
of all expected future dividends
• So, how can we estimate all future
dividend payments?

8-8

Estimating Dividends:
Special Cases
• Constant dividend
▪ The firm will pay a constant dividend forever
▪ This is like preferred stock
▪ The price is computed using the perpetuity formula
• Constant dividend growth
▪ The firm will increase the dividend by a constant
percent every period
▪ The price is computed using the growing perpetuity
model
• Supernormal growth
▪ Dividend growth is not consistent initially, but
settles down to constant growth eventually
▪ The price is computed using a multistage model
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 Zero Growth
• If dividends are expected at regular intervals
forever, then this is a perpetuity and the present
value of expected future dividends can be found
using the perpetuity formula
▪ P0 = D / R
• Suppose stock is expected to pay a $0.50
dividend every quarter and the required return is
10% with quarterly compounding. What is the
price?
▪ P0 = .50 / (.1 / 4) = $20

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Dividend Growth Model

• Dividends are expected to grow at a
constant percent per period.
▪ P0 = D1 /(1+R) + D2 /(1+R)2 + D3 /(1+R)3 + …
▪ P0 = D0(1+g)/(1+R) + D0(1+g)2/(1+R)2 +
D0(1+g)3/(1+R)3 + …
• With a little algebra and some series work,
this reduces to:
D 0 (1 + g) D
P0 = = 1
R -g R -g
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DGM – Example 1
• Suppose Big D, Inc., just paid a dividend
of $0.50 per share. It is expected to
increase its dividend by 2% per year. If the
market requires a return of 15% on assets
of this risk, how much should the stock be
selling for?
• P0 = .50(1+.02) / (.15 - .02) = $3.92

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4
 DGM – Example 2
• Suppose TB Pirates, Inc., is
expected to pay a $2 dividend in one
year. If the dividend is expected to
grow at 5% per year and the required
return is 20%, what is the price?
▪ P0 = 2 / (.2 - .05) = $13.33
▪ Why isn’t the $2 in the numerator
multiplied by (1.05) in this example?

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Stock Price Sensitivity to

Dividend Growth, g
250
D1 = $2; R = 20%
200
Stock Price

150

100

50

0
0 0.05 0.1 0.15 0.2
Growth Rate

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Stock Price Sensitivity to

Required Return, R
250
D1 = $2; g = 5%
200
Stock Price

150

100

50

0
0 0.05 0.1 0.15 0.2 0.25 0.3
Growth Rate

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5
 Example 8.3 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% per
year. The required return is 16%.
• What is the current price?
▪ P0 = 4 / (.16 - .06) = $40
▪ Remember that we already have the dividend
expected next year, so we don’t multiply the
dividend by 1+g

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Example 8.3 – Gordon Growth

Company - II
• What is the price expected to be in year 4?
▪ P4 = D4(1 + g) / (R – g) = D5 / (R – g)
▪ P4 = 4(1+.06)4 / (.16 - .06) = 50.50
• What is the implied return given the change in price
during the four year period?
▪ 50.50 = 40(1+return)4; return = 6%
▪ PV = -40; FV = 50.50; N = 4; CPT I/Y = 6%
• The price is assumed to grow at the same rate as the
dividends

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Nonconstant Growth
Example - I
• Suppose a firm is expected to increase
dividends by 20% in one year and by 15%
in two years. After that, dividends will
increase at a rate of 5% per year
indefinitely. If the last dividend was $1 and
the required return is 20%, what is the
price of the stock?
• Remember that we have to find the PV of
all expected future dividends.

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6
 Nonconstant Growth
Example - II
• Compute the dividends until growth levels off
▪ D1 = 1(1.2) = $1.20
▪ D2 = 1.20(1.15) = $1.38
▪ D3 = 1.38(1.05) = $1.449
• Find the expected future price
▪ P2 = D3 / (R – g) = 1.449 / (.2 - .05) = 9.66
• Find the present value of the expected future cash
flows
▪ P0 = 1.20 / (1.2) + (1.38 + 9.66) / (1.2)2 = 8.67

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Quick Quiz – Part I

• 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%?
• What if the company starts increasing
dividends by 3% per year, beginning
with the next dividend? The required
return stays at 15%.

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Using the DGM to Find R

• Start with the DGM:

D 0 (1 + g) D1
P0 = =
R -g R -g

D 0 (1 + g) D
R= +g= 1 +g
P0 P0

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7
 Example: Finding the
Required Return
• Suppose a firm’s stock is selling for $10.50.
It just paid a $1 dividend, and dividends are
expected to grow at 5% per year. What is
the required return?
▪ R = [1(1.05)/10.50] + .05 = 15%
• What is the dividend yield?
▪ 1(1.05) / 10.50 = 10%
• What is the capital gains yield?
▪ g = 5%

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Stock Valuation
Using Multiples
• Another common valuation approach is to
multiply a benchmark PE ratio by earnings
per share (EPS) to come up with a stock
price
• Pt = Benchmark PE ratio * EPSt
• The benchmark PE ratio is often an
industry average or based on a company’s
own historical values
• The price-sales ratio can also be used

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Example: Stock Valuation

Using Multiples
• Suppose a company had earnings
per share of $3 over the past year.
The industry average PE ratio is 12.
• Use this information to value this
company’s stock price.
• Pt = 12 x $3 = $36 per share

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8
 Table 8.1 - Stock Valuation Summary

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Features of Common Stock

• Voting Rights
• Proxy voting
• Classes of stock
• Other Rights
▪ Share proportionally in declared dividends
▪ Share proportionally in remaining assets
during liquidation
▪ Preemptive right – first shot at new stock
issue to maintain proportional ownership if
desired

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Dividend Characteristics
• Dividends are not a liability of the firm until a
dividend has been declared by the Board
• Consequently, a firm cannot go bankrupt for not
declaring dividends
• Dividends and Taxes
▪ Dividend payments are not considered a business
expense; therefore, they are not tax deductible
▪ The taxation of dividends received by individuals
depends on the holding period
▪ Dividends received by corporations have a
minimum 70% exclusion from taxable income

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9
 Features of Preferred Stock
• Dividends
▪ Stated dividend that must be paid before
dividends can be paid to common stockholders
▪ Dividends are not a liability of the firm, and
preferred dividends can be deferred indefinitely
▪ Most preferred dividends are cumulative – any
missed preferred dividends have to be paid
before common dividends can be paid
• Preferred stock generally does not carry
voting rights

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Stock Market
• Dealers vs. Brokers
• New York Stock Exchange (NYSE)
▪ Largest stock market in the world
▪ License holders (1,366)
• Commission brokers
• Specialists
• Floor brokers
• Floor traders
▪ Operations
▪ Floor activity

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NASDAQ
• Not a physical exchange – 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

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10
 Work the Web Example
• Electronic Communications Networks
provide trading in NASDAQ securities
• Click on the web surfer and visit Instinet

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Reading Stock Quotes

• What information is provided in the stock

quote?
• Click on the web surfer to go to Bloomberg
for current stock quotes.

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Quick Quiz – Part II

• You observe a stock price of $18.75. You
expect a dividend growth rate of 5%, and
the most recent dividend was $1.50. What
is the required return?
• What are some of the major
characteristics of common stock?
• What are some of the major
characteristics of preferred stock?

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11
 Ethics Issues
• The status of pension funding (i.e., over-
vs. under-funded) depends heavily on the
choice of a discount rate. When actuaries
are choosing the appropriate rate, should
they give greater priority to future pension
recipients, management, or shareholders?

• How has the increasing availability and

use of the internet impacted the ability of
stock traders to act unethically?
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Comprehensive Problem
• XYZ stock currently sells for $50 per
share. The next expected annual
dividend is $2, and the growth rate is
6%. What is the expected rate of return
on this stock?
• If the required rate of return on this
stock were 12%, what would the stock
price be, and what would the dividend
yield be?

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End of Chapter

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