Chapte

r8
Stock Valuation

8-1

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

• Bond and Stock Differences

• Common Stock Valuation
• Features of Common Stock
• Features of Preferred Stock
• The Stock Markets

8-2
 Chapter Outline

• Bond and Stock Differences

• Common Stock Valuation
• Features of Common Stock
• Features of Preferred Stock
• The Stock Markets

8-3
 Bonds and Stocks:
Similarities
• Both provide long-term
funding for the organization
• Both are future funds that an
investor must consider
• Both have future periodic
payments
• Both can be purchased in a
8-4
marketplace at a price
“today”
 Bonds and Stocks:
Differences
• From the firm’s perspective: a
bond is a long-term debt and
stock is equity

• From the firm’s perspective: a

bond gets paid off at the
maturity date; stock continues
indefinitely.

• We will discuss the mix of bonds

8-5
(debt) and stock (equity) in a
 Bonds and Stocks:
Differences
• A bond has coupon payments
and a lump-sum payment;
stock has dividend payments
forever

• Coupon payments are fixed;

stock dividends change or
“grow” over time

8-6
 A visual representation
of a bond with a coupon
payment (C) and a
maturity value (M)
1 2 3 4 5

$C1 $C2 $C3 $C4 $C5

$M

8-7
 A visual
representation of a
share of common
stock with dividends
1 2
(D) forever
3 4 5 ∞

$D1 $D2 $D3 $D4 $D5 $D

∞

8-8
 Comparison
Valuations
Bond
0 1 2 3

P0 C C C
M

Common Stock
0 1 2 3

P0 D1 D2 D3 D∞
8-9
 Notice these differences:
• The “C’s” are constant and equal
• The bond ends (year 5 here)
• There is a lump sum at the end

1 2 3 4 5

$C1 $C2 $C3 $C4 $C5

$M

8-10
 Notice these differences:
• The dividends are different
• The stock never ends
• There is no lump sum

1 2 3 4 5 ∞

$D1 $D2 $D3 $D4 $D5 $D∞

8-11
 Chapter Outline

• Bond and Stock Differences

• Common Stock Valuation
• Features of Common Stock
• Features of Preferred Stock
• The Stock Markets

8-12
 Our Task:
To value a share
of Common
Stock
8-13
 And how will
we accomplish
our task?

8-14
 B Bring
A All
E Expected
F Future
E Earnings
I Into
P Present
V Value
8-15 T Terms
 Just remember:

BAEFEIPVT

8-16
 Cash Flows for
Stockholders
If you buy a share of
stock, you can
receive cash in two
ways:
1. The company
pays dividends
2. You sell your
shares, either to
another investor
8-17
in the market or
 One-Period Example
Receiving one future
dividend and one
future selling price of a
share of common stock

8-18
 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
8-19
risk, what is the maximum
you would be willing to pay?
 Visually this would look like:
1
R = 20%

D1 = $2
P1 = $14

8-20
 Compute the Present
Value
1
R = 20%

$1.67 D1 = $2
$11.67 P1 = $14
PV =$13.34

8-21
 TI BA II Plus

1 year = N
-13.34
20% = Discount rate

$2 = Payment (PMT)

$14 = FV

1st PV = ?
2nd
8-22
 1 year = N
20% = Discount rate
HP 12-
$2 = Payment (PMT) C
PV = ? $14 = FV

-13.34

8-23
 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. Now how much would
8-24
you be willing to pay?
 Visually this would look like:
R = 20%
1 2

D1 = $2 D2 = $ 2.10
P2 = $14.70

8-25
 Compute the Present
Value
R = 20%
1 2

$1.67 D1 = $2 D2 = $ 2.10
$1.46
$ 10.21 P2 = $14.70

$ 13.34 = P0

8-26
 What is the Observed
Pattern?
We value a share of
stock by bringing back
all expected future
dividends into present
value terms

8-27
 Future
Dividends
So the key is to
determine the
future dividends
when given the
growth rate of
those dividends,
whether the
growth is zero,
constant, or
unusual first and
then levels off to a
8-28
 So how do you
compute the future
dividends?
Three scenarios:

1.A constant dividend (zero

growth)

2.The dividends change by a

constant growth rate

3.We have some unusual

growth periods and then level
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off to a constant growth rate
 So how do you
compute the future
dividends?
Three scenarios:

1. A constant dividend (zero

growth)

2. The dividends change by a

constant growth rate

3. We have some unusual

growth periods and then level
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off to a constant growth rate
 1. Constant Dividend
–
Zero Growth
• The firm will pay a
constant dividend
forever

• This is like preferred

stock

• The price is computed

using the perpetuity
formula:
8-31
 So how do you
compute the future
dividends?
Three scenarios:

1. A constant dividend (zero

growth)

2. The dividends change by a

constant growth rate

3. We have some unusual

growth periods and then level
8-32
off to a constant growth rate
 2. Constant Growth
Rate of Dividends
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 + …

8-33
 2. Constant Growth
Rate of Dividends
With a little algebra this reduces
to:

D 0 (1  g) D1
P0  
R -g R -g

8-34
 2. Constant Growth
Rate of Dividends
Student caution:

D 0 (1  g) D1
P0  
R -g R -g
A. What happens if g >
8-35
R?
B. What happens if g =
 Model (DGM)
Assumptions
To use the Dividend Growth Model
(aka the Gordon Model), you must
meet all three requirements:

1.The growth of all future dividends

must be constant,

2.The growth rate must be smaller

than the discount rate ( g < R),
and

3.The growth rate must not be

8-36
equal to the discount rate (g ≠
 DGM – Example 1
Suppose Big D, Inc., just
paid a dividend (D0) 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
8-37
the stock be selling for?
 DGM – Example 1
Solution
D 0 (1  g) D1
P0  
R -g R -g
P0 = .50 ( 1 + .02)
.15 - .02
P0 = .51 = $3.92
.13
8-38
 DGM – Example 2
Suppose Moore Oil 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?
8-39
 DGM – Example 2
Solution
D 0 (1  g) D1
P0  
R -g R -g
P0 = 2.00
.20 - .05
P0 = 2.00 = $13.34
.15
8-40
 So how do you
compute the future
dividends?
Three scenarios:

1.A constant dividend (zero

growth)

2.The dividends change by a

constant growth rate

3.We have some unusual

growth periods and then level
8-41
off to a constant growth rate
 3. Unusual Growth;
Then Constant
Growth
Just draw the time line with
the unusual growth rates
identified and determine
if/when you can use the
Dividend Growth Model.
Deal with the unusual growth
dividends separately.
8-42
 Non-constant Growth
Problem Statement
Suppose a firm is expected
to increase dividends by 20%
in one year and by 15% for
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
8-43
 Non-constant Growth
Problem Statement
Draw the time line and compute
each dividend using the
corresponding growth rate:

1 2 3 4
= g = 20% g = 15% g = 15% g = 5%
D0 0
1.0
∞
$
D1 D2 D3

8-44
 Non-constant Growth
Problem Statement
Draw the time line and compute
each dividend using the
corresponding growth rate:

1 2 3 4
= g = 20% g = 15% g = 15% g = 5%
D0 0
1.0
∞
$
D =1.20D
1 2 D 3

D1 = ($1.00) (1 + 20%) = $1.00 x 1.20 = $1.20

8-45
 Non-constant Growth
Problem Statement
Draw the time line and compute
each dividend using the
corresponding growth rate:

1 2 3 4
= g = 20% g = 15% g = 15% g = 5%
D0 0
1.0
∞
$
D 1 D =1.38D
2 3

D2 = ($1.20) (1 + 15%) = $1.20 x 1.15 = $1.38

8-46
 Non-constant Growth
Problem Statement
Draw the time line and compute
each dividend using the
corresponding growth rate:
1 2 3 4
= g = 20% g = 15% g = 15% g = 5%
D0 0
1.0
∞
$
D1 D2 D3 =1.59

D3 = ($1.38) (1 + 15%) = $1.38 x 1.15 = $1.59

8-47
 Non-constant Growth
Problem Statement
Now we can use the DGM starting
with the period of the constant
growth rate at our time frame of
year 3: R = 20%
1 2 3 4
= g = 20% g = 15% g = 15% g = 5%
D0 0
1.0
∞
$
D1 D2 D3

P3 = D4/R – g P3 = D3 (1 + g) / R - g
8-48
 Non-constant Growth
Problem Statement
Now we can use the DGM starting
with the period of the constant
growth rate at our time frame of
year 3: R = 20%
1 2 3 4
= g = 20% g = 15% g = 15% g = 5%
D0 0
1.0
∞
$
D1 D2 D3
P3 = D3 (1 + g) / R - g
8-49
P3 = 1.59 (1.05)/ .20 - .05 = $11.13
 Non-constant Growth
Problem Statement
We now have all of the dividends
accounted for and we can compute
the present value for a share of
common stock:R = 20%
1 2 3 4
= g = 20% g = 15% g = 15% g = 5%
D0 0
1.0
∞
$
D1 D2 D3
1.20 1.38 1.59
8-50
P3 = 11.13
 Non-constant Growth
Problem Statement
BAEFEIPVT!
R = 20%
1 2 3 4
= g = 20% g = 15% g = 15% g = 5%
D0 0
1.0
∞
$
D1 D2 D3
1.20 1.38 1.59
$9.32
8-51 P3 = 11.13
 Sensitivity to
Dividend Growth, g
D1 = $2; R = 20%

250

200
Stock Price

150

100

50

0
0 0.05 0.1 0.15 0.2

8-52
Growth Rate
 Sensitivity to
Required Return, R
D1 = $2; g = 5%
250

200
Stock Price

150

100

50

0
0 0.05 0.1 0.15 0.2 0.25 0.3
Required return
8-53
 Using the DGM to
Find R
Start with the DGM and then
algebraically rearrange the
equation to solve for R:
D 0 (1  g) D1
P0  
R -g R -g

D 0 (1  g) D1
R g  g
P0 P0
8-54
 Finding the Required
Return - Example
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
What year.
is the required return?
R = [1(1.05)/10.50]
+ .05is=the
What 15%
dividend yield?
1(1.05) / 10.50 =
10%
What is the capital gains
yield?
8-55
g =5%
 Stock Valuation
Alternative
But my
company
doesn’t pay
dividends!
How can I value
the stock?

8-56
 Valuation Using
Multiples
We can use the PE ratio
and/or the price-sales
ratio:
Pt = Benchmark PE ratio X
EPSt

Pt = Benchmark price-
8-57
sales ratio X Sales per
 Stock Valuation
Summary

8-58
 Chapter Outline

• Bond and Stock Differences

• Common Stock Valuation
• Features of Common Stock
• Features of Preferred Stock
• The Stock Markets

8-59
 Features of Common
Stock
• Voting Rights
• Proxy voting
• Classes of
stock

8-60
 Features of Common
Stock
Other Rights
• Share proportionally in
declared dividends
• Share proportionally in
remaining assets during
liquidation
• Preemptive right – first
shot at new stock issue to
8-61
maintain proportional
 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

8-62
 Dividend
Characteristics
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
8-63
 Chapter Outline

• Bond and Stock Differences

• Common Stock Valuation
• Features of Common Stock
• Features of Preferred Stock
• The Stock Markets

8-64
 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
8-65
be deferred indefinitely
 Features of Preferred
Stock
Dividends

• Most preferred dividends

are cumulative – any
missed preferred
dividends have to be paid
before common dividends
can be paid

8-66
 Features of Preferred
Stock
• Preferred stock generally does
not carry voting rights

8-67
 Chapter Outline

• Bond and Stock Differences

• Common Stock Valuation
• Features of Common Stock
• Features of Preferred Stock
• The Stock Markets

8-68
 Stock Market, Dealers vs.
Brokers
Dealer: trades with inventory
for bid and ask prices
Broker: matches buyers and
sellers for a fee

8-69
 Stock Market
• New York Stock Exchange
(NYSE)

• Largest stock market

in the world

• License holders (1,366)

• Commission brokers
• Specialists
• Floor brokers
• Floor traders
• Operations
8-70

• Floor activity
 NASDAQ
• Not a physical exchange – it is a
computer-based quotation
system
• Multiple market makers
• Electronic Communications
Networks

8-71
 NASDAQ
• Three levels of information:
• Level 1 – median quotes,
registered representatives
• Level 2 – view quotes, brokers
& dealers
• Level 3 – view and update
quotes, dealers only
• A large portion of technology
stocks are bought and sold each
8-72 day on NASDAQ
 Work the Web

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

8-73
 Reading Stock Quotes

8-74
 Work the Web
• Click on the web surfer to
go to Bloomberg for current
stock quotes.

8-75
 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
8-76
of stock traders to act unethically?
 Quick Quiz

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%.

8-77
 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?
8-78
 Terminology

Bonds versus Common Stock

Cash Dividends
Capital Gain Yield & Dividend Yield
Dividend Growth Model (DGM)
Preferred Stock
Stock Market – NYSE
Electronic Exchange – NASDAQ
Stock Quotes
8-79
 Formulas

Value of a P0 = D
Perpetuity
R
:
Value of a Share of Common Stock using
the DGM: D 0 (1  g) D1
P0  
R -g R -g

D 0 (1  g) D1
R g  g
8-80 P0 P0
 Formulas

Value of a Share of Common Stock

using Multiples

Pt = Benchmark PE ratio X
EPSt

Pt = Benchmark price-sales
ratio X Sales per sharet

8-81
 Key Concepts and
Skills
• Compute the future dividend
stream based on dividend
growth
• Use the Dividend Growth
Model (DGM) to determine
the price of stock
• Explain how stock markets
work
• Describe the workings of a
stock exchange
8-82
 What are the most
important topics of
this chapter?

1. A stock’s value is the

present value of all
expected future earnings.
2. Computing the future
dividends of a stock is the
key to understanding its
value
3. Issuing stock provides
8-83
the firm long-term funding
 What are the most
important topics of
this chapter?

4. The Dividend Growth Model

(DGM) provides us help with
infinite dividend streams

5. Stocks are bought and sold

each business day with
reporting via stock quotes

8-84
Questions?

8-85