CHAPTER 8

VALUING STOCKS

M: Finance 3rd Edition

Cornett, Adair, and Nofsinger
Copyright © 2016 by McGraw-Hill Education. All rights reserved.
Common Stock
• Represents ownership in corporation
• Value of common stock based on
• Company’s profitability and growth potential
• Current market interest rates
• Overall stock market conditions
Stock Markets
• Provide liquidity through stock
exchanges
• Provide means for buyers and sellers
to transact
Stock Markets
• New York Stock Exchange (NYSE)
• American Stock Exchange (AMEX)
• NASDAQ
• FTSE
• Nikkei
Stock Markets
• Stock market indexes
• Dow Jones Industrial Average tracks 30 large
industry-leading stocks
• Standard & Poor’s 500 tracks largest 500 U.S.
firms
• NASDAQ Composite Index primarily tracks
technology firms
Stock Markets
• Trading Stocks
• Quoted bid is highest price at which market
makers will buy
• Quoted ask is lowest price at which market
makers will sell
Example
• On March 5, 2013, the Dow Jones Industrial
Average set a new high. The index closed at
16,634.53, which was up 154.20 that day. What
was the return (in percent) of the stock market
that day?
A. 0.94%
B. 0.49%
C. 9.04%
D. 4.09%
Example
• Your discount brokerage firm charges $8.70 per
trade. How much money do you need to buy 160
shares of Pfizer, Inc. (PFE), which trades at
$40.42?
A. $9574.60
B. $5746.90
C. $7469.50
D. $6475.90
Basic Stock Valuation
• Present value calculations used
• Unlike present value for bonds, stock
cash flows are unknown
• Dividends
• Future selling price
Basic Stock Valuation
• Find present value of future dividends
and future selling price
• One-year-holding-period timeline
example
Basic Stock Valuation
• Today’s value = present value of next
year’s dividend and price
Basic Stock Valuation
• Two-year-holding-period timeline
example
Basic Stock Valuation
• For a holding period of n years, the
value of a stock is measured by the
present value of dividends over n
years plus the sale price
Dividend Discount Model
• Stock’s value is the present value of
an infinite stream of dividends and no
future final sales price
Always remember
• D0 is referred to as
• Dividend just paid
• Current dividends
• Recently paid dividends
• D1 is referred to as
• Future dividends
• Next years dividends
• Expected dividends
Example
• A firm is expected to pay a dividend of
$1.55 next year and $1.70 the following
year. Financial analysts believe the stock
will be at their price target of $50 in two
years. Compute the value of this stock with
a required return of 11.5 percent
Question 8.1
• Suppose that you estimate D1=$0.72,
D2=$0.76, D3=$0.84, and D4=$0.88 for a
stock. At the end of fourth year you sell the
stock for $7.12. If the required return of the
stock is 14.6%, what is the stock’s current
price?
Question 8.2
• Stock valuation model make clear that
lower discount rates lead to:
A. lower valuations.
B. higher valuations.
C. lower growth rates.
D. higher growth rates.
Question 8.3
• We can estimate a stock's value by:
A. using the book value of the total
stockholder equity section.
B. discounting the future dividends and future
stock price appreciation.
C. compounding the past dividends and past
stock price appreciation.
D. using the book value of the total assets
divided by the number of shares
outstanding.
Growing Dividends
• D0= Dividend just paid or previously paid
• D1= D0 (1+g)
• D2 = D0 (1+g)2 or D1 (1+g)
• D3 = D0 (1+g)3 or D2 (1+g)
• D4 = D0 (1+g)4 or D3 (1+g)
• D5 = D0 (1+g)5 or D4 (1+g)
Example
• Firm ABC just paid a dividend of $2.80.
Compute the dividends over the next five
years given a growth rate of 10%.
• D1= D0 (1+g) =?
• D2 = D0 (1+g)2 or D1 (1+g) = ?
• D3 = D0 (1+g)3 or D2 (1+g) = ?
• D4 = D0 (1+g)4 or D3 (1+g) = ?
• D5 = D0 (1+g)5 or D4 (1+g) = ?
Example
• Annual dividends of AT&T Corp (T)
grew from $0.89 in 2000 to $1.14 in
2012. What was the annual growth
rate?
Question 8.4
• Annual dividends of General Electric
(GE) grew from $0.84 in 2001 to $1.21
in 2006.What was the annual growth
rate?
Preferred Stock
• Has priority over common stock in
bankruptcy
• Pays a constant dividend
• Valued using constant-growth model
Constant Growth Model
• Assumes growth rate smaller than
discount rate
• Next year’s dividend ÷ (Discount rate –
Growth rate)
Example
• Financial analysts forecast Safeco Corp.’s
(SAF) growth rate for the future to be 10
percent. Safeco’s recent dividend was
$1.55. What is the value of Safeco stock
when the required return is 12 percent?
Question 8.5
• Financial analysts forecast Limited
Brands (LTD) growth rate for the future
to be 10.5 percent. LTD’s recent
dividend was $0.85. What is the value
of Limited Brands stock when the
required return is 12.5 percent?
Expected Return Formula
Question 8.6
• Jand, Inc., currently pays a dividend of
$1.54, which is expected to grow
indefinitely at 6%. If the current value
of Jand’s shares based on the
constant-growth dividend discount
model is $41.41, what is the required
rate of return?
Question 8.7
• Turnips and Parsley common stock
sells for $39.86 a share at a market
rate of return of 9.5%. The company
just paid its annual dividend of $1.20.
What is the rate of growth?
Two-Stage Growth Valuation
• Variable-growth-rate stock
• Stock value = Present value of each
dividend during first growth stage +
Present value of second growth stage
Example
• Deployment Specialists pays a current
(annual) dividend of $1 and is
expected to grow at 18% for two years
and then at 4% thereafter. If the
required return for Deployment
Specialists is 7.5%, what is the
intrinsic value of Deployment
Specialists stock?
Question 8.8
• A fast-growing firm recently paid a
dividend of $0.65 per share. The
dividend is expected to increase at a
10 percent rate for the next three
years. Afterwards, a more stable 5
percent growth rate can be assumed.
If a 6 percent discount rate is
appropriate for this stock, what is its
value today?
Question 8.9
• A fast-growing firm recently paid a
dividend of $0.95 per share. The
dividend is expected to increase at a 15
percent rate for the next three years.
Afterwards, a more stable 10 percent
growth rate can be assumed.
• If an 11 percent discount rate is
appropriate for this stock, what is its
value today?
Estimating Future Stock Price
• Future price using the P/E ratio
formula
Example
• Ultra Petroleum (UPL) has earnings
per share of $1.43 and a P/E ratio of
32.68.What’s the stock price?

• Pn = (P/E)n x En
= 32.68 x 1.43
= 46.73
Example
• A firm’s recent EPS is $3.80. It is
expected to grow at 10 percent. The
P/E ratio is expected to be 15 within 4
years. What is the stock price in 4
years?
Expected Return
• Investors demand higher returns from
higher-risk investments
• Dividend yield and expected stock
price appreciation comprise Expected
Return
Example
• Suppose that a firm’s recent earnings per share
and dividend per share are $3.90 and $2.90,
respectively. Both are expected to grow at 7
percent. However, the firm’s current P/E ratio of
20 seems high for this growth rate. The P/E ratio
is expected to fall to 16 within five years.
• Compute the dividends over the next five years.
• Compute the value of this stock in five years.
• Calculate the present value of these cash flows
using a 9 percent discount rate.
Discussion
• What are the differences between
common stock and preferred stock?
• Which is higher, the ask quote or the
bid quote? Why?
• Describe the difference in the timing of
trade execution and the certainty of
trade price between market orders and
limit orders.
Discussion
• Which stock valuation model would
you use to estimate the price of stock
that pays a constant dividend?
• Which stock valuation model would
you use to estimate the price of stock
that pays a dividend that is growing at
the same rate?
Discussion
• Under what conditions would the
constant-growth model not be
appropriate?
• Which stock valuation model would
you use to estimate the price of stock
that pays a dividend that is growing at
various rates?
Discussion
• Can the variable-growth-rate model be
used to value a firm that has a
negative growth rate in Stage 1 and a
stable and positive growth in Stage 2?