Chapter 8

Stock Valuation
 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 stock markets work

 Perpetuities Valuation (Brief Review)

• Perpetuity: an infinite series of equal or growing payments,

e.g., dividend payments on stocks

• Value a perpetuity which has a constant stream of cash

flows forever:
é 1 ù
t =¥
1 -
ê (1 + r) t ú C
C C C C C
PV= + + + ... + =å = lim C ê ú=
(1 + r)1 (1 + r) 2 (1 + r) 3 (1 + r) t i =1 (1 + r) i t ®¥ ê r ú r
êë úû

• Value a growing perpetuity whose cash payments grow at

“g” forever (g<r):
é 1+ g t ù
C C * (1 + g ) C (1 + g ) 2 C (1 + g ) t -1 t =¥ C (1 + g ) i -1 ê1 - ( 1 + r ) ú C
PV= 1
+ 2
+ 3
+ ... + t
= å i
= lim C ê ú =
(1 + r) (1 + r) (1 + r) (1 + r) (1 + r) ê r-g ú r-g
t ®¥
i =1
êë úû
 Facts about Common Stock

• Claim on income after interest and dividend payments to the

creditors and preferred stock holders
• Represents ownership
• Ownership implies control
• Limited liability
• Stockholders elect directors = voting rights
• Directors elect management
• Management’s goal: Maximize shareholders’ wealth (=
Maximize stock price)
 Facts about Preferred Stock

• Unlike common stock, no ownership interest

• Second to debt holders on claim on company’s assets in the
event of bankruptcy
• Annual dividend yield as a percentage of par value
• Preferred dividends must be paid before common
dividends
• If cumulative preferred, all missed past dividends must be
paid before common dividends can be paid
 Common Stock Valuation

• A share of common stock is more difficult to value than a

bond.
– Cash flows are hardly known in advance.
– Common stock has no maturity.
– The required return is not easily observable.

• However, we can solve the present value (i.e., price) of a

share of stock by using:
– Dividend growth model (DGM): in some special cases
– Peer comparison analysis: price multiples
 Cash Flows to 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
 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
 One-Period Example: Using a Timeline
expect a $2 dividend in 1 year
and sell the stock for $14

0 20% 1 2 3

D1=$2
+
P1=14
P0 $16
Expect to sell stock at this price
 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?

Compute the PV of the expected cash flows

– Price = 2 / (1.2) + (2.10 + 14.70) / (1.2)2 = 13.33
 Two-Period Example: Using a Timeline
dividend of $2 at yr 1
dividend of $2.10 at yr 2
stock price of $14.70 at yr 2

0 20% 1 2 3

1.667 D1 = $2 D2=$2.10
P2=$14.70
+
11.667 $16.80
$13.33

P0
 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?

Compute the PV of the expected cash flows

– Price = 2 / (1.2) + 2.10 / (1.2)2 + (2.205 + 15.435) /
(1.2)3 = 13.33
 Three-Period Example: Using a Timeline
dividend of $2 at yr 1
dividend of $2.10 at yr 2
dividend of $2.205 at yr 3
stock price of $15.435 at yr 3
0 20% 1 2 3

1.667 D1 = $2
D3= $2.205

1.458 D2= $2.10

P3=$15.435

+ 10.208 $17.64

$13.33
P0
 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.
D t +1 D t+2 D t +3 D¥
Pt = t +1
+ t+2
+ t +3
+ ... +
(1 + rs ) (1 + rs ) (1 + rs ) (1 + rs ) ¥

• So, how can we estimate all future dividend payments?

 Estimating Dividends: Special Cases
• Under assumptions about the pattern of future dividends, we
consider three special cases:

• Constant dividend (i.e., zero growth)

– The firm will pay a constant dividend forever
– This is like a share of 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

• Nonconstant (supernormal) growth

– Dividend growth is not consistent initially, but settles down to a
constant growth eventually
– The price is computed using a multistage model
 Zero Growth

• If dividends are expected to be constant at regular intervals

forever, then this is a perpetuity.
– D1 = D2 = D3 =……= Dt = D = constant
• The present value of expected future dividends can be
found using the perpetuity formula
D D D D D
PV = + + + ... + =
(1 + r)1 (1 + r) 2 (1 + r)3 (1 + r) t r

– P0 = D / R

• e.g., suppose a stock is expected to pay a $0.50 dividend

every quarter and the required return is 10%. What is the
price?
– P0 = .50 / (0.1 / 4) = $20
 Constant Dividend Growth Model

• Dividends are expected to grow at a constant rate “g”.

• A stock with constantly growing dividends is like a growing
perpetuity.
– Let D0 be the dividend just paid, then the next dividend D1= D0 * (1+g),
D2 = D1 * (1+g) = D0 * (1+g)2, ……, Dt = D0 * (1+g)t , ……
– 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 + …

• As long as “g < R”, this reduces to:

D 0 (1 + g) D1
P0 = =
R -g R -g
• In general, the price of the stock as of time t is:
D t (1 + g) D t +1
Pt = =
R -g R -g
 Constant Dividend Growth Model:
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?

D 0 (1 + g) 0.50 * (1.02)
P0 = = = 3.92
R -g 0.15 - 0.02
Why is the $0.50 in the numerator multiplied by 1.02?
 Constant Dividend Growth Model:
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?
D 0 (1 + g) D1 2
P0 = = = = 13.33
R -g R - g 0.2 - 0.05

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

example?
 Constant Dividend Growth Model:
Example 3
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?
D 0 (1 + g) D1 4
P0 = = = = 40
R -g R - g 0.16 - 0.06

– Remember that we already have the dividend expected

next year, so we don’t multiply the dividend by 1+g
 Constant Dividend Growth Model:
Example 3
• What is the price expected to be in year 4?

D5 D1 (1 + g) 4 4(1 + 0.06) 4
P4 = = = = 50.50
R -g R -g 0.16 - 0.06

• What is the implied return given the change in price during

the four year period?

P4 = P0 (1 + r) 4
50.50 = 40(1 + r) 4 Þ r = 0.06 = 6%
• The price grows at the same rate as the dividends.
 Nonconstant (Supernormal) Growth

• Allow for supernormal growth rates over some finite length of time.
Afterwards, the dividends grow at a constant rate.
• In dealing with nonconstant growth, a time line can be helpful.

0 1 2 3 4 5 6

Dividends $1 $2 $2.5 $2.5*1.05 $2.5*1.052 $2.5*1.053

0 – 3: nonconstant growth After time 3: constant growth at 5%

• Remember that we have to find the PV of all expected future

dividends.
D1 D2 Dt Pt
P0 = + + ... + +
(1 + R)1 (1 + R) 2 (1 + R) t (1 + R) t
D (1 + g )
where, Pt = t
R -g
 Nonconstant Growth: An Example

• Suppose a firm is expected to increase dividends by 20%

for one year and then by 15% in the year following. After
that, dividends will increase at a rate of 5% per year
indefinitely. If the dividend at time 0, D0, was $1 and the
required return is 20%, what is the price of the stock?

0 1 2 3 4 5 6

$1 $1.2 $1.38 $1.38*1.05 $1.38*1.052 $1.38*1.053

0 – 2: nonconstant growth After time 2: constant growth at 5%

 Nonconstant Growth: Example Solution

• 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

D1 D2 P2
P0 = + +
1 + R (1 + R) 2 (1 + R) 2
1.2 1.38 9.66
= + 2
+ 2
= 8.67
1 + 0.2 (1 + 0.2) (1 + 0.2)
 Find Required Return

• With zero growth model:

D
P0 =
R
D
So, R =
P0

• With the constant growth model:

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

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

D1
P0 is called dividend yield
 Find Required Return: Example 1

If preferred stock with an annual dividend of $5 sells for $50,

what is the preferred stock’s expected return?

D
P0 =
r
D 5
r = = = 0.10 = 10%
P0 50
 Find Required Return: Example 2

Suppose a firm’s stock is selling for $10.50. It just paid a $1

dividend, D0, and dividends are expected to grow at 5% per
year.
•What is the required return?
D 0 (1 + g) 1(1 + 0.05)
R= +g= + 0.05 = 15%
P0 10.50

•What is the dividend yield, D1/P0?

D1 D 0 (1 + g) 1(1 + 0.05)
div yield = = = = 10%
P0 P0 10.50
•What is the capital gains yield?
g =5%
 Preferred Stock Valuation

• Promises to pay the same dividend year after year

forever, never matures.

• A perpetuity (Zero Growth)

• Pps = D/Rps
Preferred Stock Valuation: An Example

Example: GM preferred stock has a $25 par value with

a 8% dividend yield. What price would you pay if your
required return is 9%?

D 25 * 0.08
Pps = = = 22.22
R ps 0.09
Stock Valuation Summary
 Other Stock Valuation Methods:
Market Multiple Method

• Also known as the peer comparison method:

– Find multiples of comparable firms: e.g., industry average multiples
– Apply a certain multiplier to the company’s profitability parameter.
• Analysts often use the following multiples to value stocks.
– Price-to-earnings multiple (P / E ratio): price per share / earnings per share
– Price-to-sales multiple: price per share / sales per share
– Price-to-cash flow multiple: price per share / cash flow per share
• Example:
– Based on comparable firms, estimate the appropriate P/E ratio.
– Multiply this ratio by expected earnings to obtain an estimate of the
stock price.
 Problems with Market Multiple Method

• Often hard to find comparable firms.

• The average ratio from a sample of comparable firms can
have a wide range.
– e.g., the average P/E ratio of comparable firms is 20 but
the range is from 10 to 50.
 Stock Market
• Primary market:
– Companies issue stocks to raise equity capital: IPO (Initial Public
Offering), SEO (Seasoned Equity Offering)
• Secondary market:
– Stocks are traded among investors.
• Dealers vs. Brokers
– A dealer maintains an inventory.
– A broker arranges transactions among investors, matches buyers and
sellers, but does not maintain an inventory.
• Members in a stock exchange (NYSE): own seats on the
exchange
– Commission brokers: to execute customer orders
– Specialists: market makers, to maintain a fair and orderly market for
securities
– Floor brokers: to execute orders for commission brokers on a fee basis
– Floor traders: to trade for their own accounts, try to profit from
temporary price fluctuations
 Reading Stock Quotes

• Sample Quote

• What information is provided in the stock quote?

 Quick Quiz
• A company has just paid a dividend of $2. What is the value
of its stock if it expects to maintain this level of dividend
every year. Assume that 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%.
• 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?