CHAPTER 8

STOCK VALUATION

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 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

8-2
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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

8-3
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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 = -
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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?

• CF0 = 0; C01 = 2; F01 = 1; C02 = 16.80; F02 = 1;

NPV; I = 20; CPT NPV = 13.33

8-5
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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?

• CF0 = 0; C01 = 2; F01 = 1; C02 = 2.10;

F02 = 1; C03 = 17.64; F03 = 1; NPV; I =
20; CPT NPV = 13.33
8-6
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 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?

8-7
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 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
8-8
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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
 Perpetuity = 0.5 x4 / 10%
8-9
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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
D (1  g)to: D
P0  0
 1
R -g R -g
8-10
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 DGM – EXAMPLE 1

• Suppose Big D, Inc., just paid a dividend of

$0.50 per share (D0). Growth
• 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 = D1 / (R – G)  D1 = D0 (1+ G)

• P0 = .50(1+.02) / (.15 - .02) = $3.92

8-11
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 DGM – EXAMPLE 2

• Suppose TB Pirates, Inc., is expected to pay a $2

dividend in one year (D1).
• If the dividend is expected to grow at 5% per year
and the required return is 20%, what is the price?
• Perpetuity

 P0 = 2 / (.2 - .05) = $13.33

 Why isn’t the $2 in the numerator multiplied by (1.05) in

this example?

8-12
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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

8-13
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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

8-14
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 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
8-15
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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

8-16
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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 (Fixed rate).
Constant Growth

• 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.
8-17
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 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 (Perpetuity)

 P2 = D3 / (R – g) = 1.449 / (.2 - .05) = 9.66
 D2 = 1.38 + 9.66 = 11.04
• Find the present value of the expected future
cash flows
• Calculator: CF0 = 0; C01 = 1.20; F01 = 1;
C02 = 11.04; F02 = 1; NPV; I = 20; CPT NPV
= 8.67
8-18
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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%.

8-20
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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) D1
R g  g
P0 P0

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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
8-23
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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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 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
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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

8-27
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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

8-28
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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?

8-29
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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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For Preffered stock you should always use Perpetuity/No growth model
 In class Example
Nonconstant Growth Model
Suppose that you came up with the next three year forecast for the dividends of ABC company’s stock.
After the third year, the dividend will grow at a constant rate of 5 percent per year. The required return is 10
percent. What is the value of the stock today?
Year Expected Dividend

1 $1
2 $2
3 $2.5