STOCKS AND THEIR

VALUATION
CHAPTER 10
 TOPICS
10-1 Legal Rights and Privileges of Common Stockholders
10-2 Types of Common Stock
10-3 Stock Price vs. Intrinsic Value
10-4 Discounted Dividend Model
10-5 Constant Growth Stocks
 TOPICS
10-6 Valuing Non-constant Growth Stocks
◦ LIMITATIONS OF THE DISCOUNTED DIVIDEND
10-7 Enterprise-Based Approach to Valuation
◦ THE VALIDITY OF EVA and MVA
10-8 Preferred Stock
What is the value of a stock?
Objectives
a. Discuss the legal rights to stockholders.
b. Explain the distinction between a stock’s price and its
intrinsic value.
c. Identify the two models that can be used to estimate a
stock’s intrinsic value: the discounted dividend model and
the corporate valuation model.
d. List the key characteristics of preferred stock, and describe
how to estimate the value of preferred stock.
10-1 Legal Rights and Privileges of Common
Stockholders
A corporation’s common stockholders are the owners of the
corporation, and as such, they have certain rights and
privileges
10-1a Control of the Firm
Stockholders;
▪ have the right to elect its directors who in turn elect the
officers who manage the business
▪ major stockholder is also the president and chair of the
board of directors
▪ can remove ineffective management team
10-1a Control of the Firm
According to the state and federal laws stockholder control should be
exercised;
1. Corporations must hold elections of directors periodically usually once a
year
2. Each share of stock has 1 vote
3. Stockholders can appear at the annual meeting to vote in person or transfer
their rights to their proxy
4. If earnings are poor and stockholders are dissatisfied, an outside group may
solicit the proxies in an effort to overthrow management and take control of
the business also known as proxy fight
10-1a Control of the Firm
Central issue in finance: Question of control
▪ Proxy fights increased, attempts of one corporation to take over
another by purchasing a majority of outstanding stock. An action also
known as takeovers
Examples:
KKR’s acquisition of RJR Nabisco, Chevron’s acquisition of Gulf Oil,
QVC/Viacom fight to take over Paramount and Kraft Foods made a hostile
takeover bid of $16.7 billion for Cadbury
10-1a Control of the Firm
Managers without more than 50% of their firm’s stock;
▪ are concerned about proxy fights and takeovers
▪ attempted to obtain stockholder approval for changes in
their corporate charters that would make takeovers more
difficult
▪ primary consideration is about their position
10-1a Control of the Firm
▪ Managers’ moves to make takeovers more difficult have been
countered by stockholders, especially large institutional
who do not like barriers erected to protect incompetent managers.
▪ Managers’ pay as another contentious issue
▪ SEC’s ruling has helped keep manager’s focused on stockholder
concerns
10-1a Control of the Firm
TERMS:
Proxy – A document giving one person the authority to act for
another, typically the power to vote shares of common stock
Proxy fight – An attempt by a person or group to gain control of a firm
firm by getting its stockholders to grant that person or group the
authority to vote its shares to replace the current management
Takeover – an action whereby a person or group succeeds in ousting a
a firm’s management and taking control of the entity
10-1b Pre-emptive Right
Common stockholders often have the right, called the pre-emptive
right, to purchase on a pro rata basis any additional shares sold by the
firm. Some pre-emptive right is automatically included in every
corporate charter and some is specifically inserted into the charter.
(Example pg. 366)
10-1b Pre-emptive Right
The purpose of the pre-emptive right is twofold;
1. Prevents the management of a corporation from issuing a large
number of additional shares and purchasing those shares itself.
Management can use this tactic to size control of the corporation
and frustrate the will of the current stockholders.
2. Protect stockholders from a dilution of value.
10-1b Pre-emptive Right
Thus, selling common stock at a price below the market value would
dilute a firm’s price and transfer wealth from its present stockholders
to those who were allowed to purchase the new shares. The pre-
emptive rights prevents this.
10-2 Types of Common Stock
Although most firms have only one type of common stock, classified
stock is used to meet special needs. Generally, when special
classifications are used, one type is designated Class A, another Class
B and so forth. Small new companies seeking funds from outside
sources frequently use different types of common stock. (Example pg. 367)
Dual class share structures of this type give special voting privileges to
key insiders. These structures are sometimes criticized because they
may enable insiders to make decisions that are counter to the
interests of the majority of stockholders.
10-3 Stock Price vs. Intrinsic Value
Stock price is simply the current market price and it is easily observed
for publicly traded companies. In contrast, intrinsic value which
represents the “true” value of the company’s stock, cannot be
directly observed and must instead be estimated.
10-3 Stock Price vs. Intrinsic Value

Figure 10.1
Determinants of Intrinsic Value
and Stock Price
10-3 Stock Price vs. Intrinsic Value
As the Figure 10.1 suggests, market equilibrium occurs when the
stock’s price is equals its intrinsic value. If the stock market is
reasonably efficient, gaps between the stock price and intrinsic value
should not be very large and they should not resist for very long. In
some cases, an individual company’s stock price may be much higher
or lower than its intrinsic value.
10-3a Why do investors and Companies Care
About Intrinsic Value?
When investing in common stocks, one’s goal is to purchase stocks
that are undervalued and avoid stocks that are overvalued. Many
individual investors are interested in finding reliable models that help
predict a stock’s intrinsic value.
 10-3 Stock Price vs. Intrinsic Value
Investors obviously care about intrinsic value but managers also need
to understand how intrinsic value is estimated;
1. Managers need to know how alternative actions are likely to affect stock prices
that will be demonstrated by the intrinsic value model
2. Managers should consider whether their stock is significantly undervalued or
overvalued before making certain decisions. (Example pg. 369)
2 Basic Models used to estimate Intrinsic Value:
a. Discounted Dividend Model
b. Corporate Valuation Model
10-4 The Discounted Dividend Model
The dividend discount model (DDM) is a quantitative method used
for predicting the price of a company's stock based on the theory that
its present-day price is worth the sum of all of its
future dividend payments when discounted back to their present
value. It attempts to calculate the fair value of a stock irrespective of
the prevailing market conditions and takes into consideration the
dividend payout factors and the market expected returns. If the value
obtained from the DDM is higher than the current trading price of
shares, then the stock is undervalued and qualifies for a buy, and vice
versa.
10-4 The Discounted Dividend Model
The value of share of a common stock depends on the cash flows it is
expected to provide, and those flows consist of two elements:

1. The dividends the investor receives each year while he or she holds
the stock and
2. The price received when the stock is sold.
10-4 The Discounted Dividend Model
The following terms are used:
Dt- the dividend a stockholder expects to receive at the end of each year(t). D0 is
the last dividend the company paid.
Our primary concern id with Dt as forecasted by the marginal investor.
P0 – actual market price of the stock today. It is known with certainty, but
predicted future prices are subject to uncertainty.
GROWTH RATE (g)
g - expected growth rate in dividends as predicted by a investor. If dividends are
expected to grow at a constant rate, g should equal the expected growth rate in
earnings and the stock’s price.
10-4 The Discounted Dividend Model
𝑟𝑠 - required, or minimum acceptable, rate of return on the stock
considering its riskiness and the returns available on other
investments.
rŝ - expected rate of return that an investor believes the stock will
provide in the future.
rs̅ - actual or realized rate of return,
𝐷1 /𝑃𝑜 - dividend yield- the expected dividend divided by the current
price of a share of stock.
10-4 The Discounted Dividend Model
(𝑃1 -𝑃𝑜 )/𝑃𝑜 -capital gains yield- capital gain during a given year divided
by the beginning price.
r̂𝑠 - expected total return- the sum of the expected dividend yield by
the beginning price.
10-4a Expected Dividends as the Basis for
Stock Values
To find the value of a bond; the equation is the present value of
interest payments over the bond’s life plus the present value of its
maturity (or par)value:

𝐼𝑁𝑇 𝐼𝑁𝑇 𝐼𝑁𝑇 𝑀

( 1+ 𝑟𝑑 )
1 + ( 1+ 𝑟𝑑 )
2 +…. ( 1+ 𝑟 )N+ ( 1+ 𝑟 )N
𝑑 𝑑
10-4a Expected Dividends as the Basis for
Stock Values
Stock prices are likewise determined as the present value of a stream
cash flows, and the basic stock valuation equation is similar to the
one for bonds.
For any individual investor, the expected cash flows consists of
expected dividends plus the expected sale price of the stock.
However, the sale price to the current investor depends on the
dividends some future investor expects, and that investor’s expected
sale price is also dependent on some future dividends, and so forth.
Therefore, for all present and future investors in total, expected cash
flows must be must be based on expected future dividends.
10-4a Expected Dividends as the Basis for
Stock Values
10-5 Constant Growth Stocks
Constant growth or Gordon Model named after Myron J. Gordon,
who did much to develop and popularize it.
We know that if the stock is in equilibrium, the required rate of return
must equal the expected rate of return, which is the expected
dividend yield plus an expected capital gains.
10-5 Constant Growth Stocks
10-5b Dividends vs. Growth
TheDiscountedDividendModelas expressedinEquation10.2showsthat, otherthingsheld
constant, a higher value for D1 increases a stock’s price. However, Equation
10.2 showsthathighergrowth ratealsoincreases thestock’s price.
10-5b Dividends vs. Growth

Fig. 10.2 Present Values of

Dividends of a Constant
Growth Stock Where DG=
$1.15, g = 8.3%, rs =13.7%
10-5b Dividends vs. Growth
• Dividends are paid out ofearnings
• Therefore, growth in dividends requires growth in earnings.
• Earnings growth in the long run occurs primarily because firms retain
earnings and reinvest them inthe business.
• Therefore, the higher the percentage of earnings retained, the higher the
growth rate.
10-5b Dividends vs. Growth
Illustration:
Suppose you inherit abusiness that has$1,000,000 of assets and no debt, thus
$1,000,000 of equity. The expected return on equity (ROE)equals 10.0%, so its
expected earnings for the coming year are (0.10)(($1,000,000) =$100,000. You
could take out the entire $100,000 of earnings in dividends, or you could
reinvest some or all of the $100,00 in the business. If you pay out all the
earnings, you will have $100,000 of dividend income this year, but dividends
will not grow because assets, and therefore earnings, will notgrow.
10-5b Dividends vs. Growth
However, suppose you decide to have the firm pay out 40% and retain 60%. Now
your dividend income in 1 Year will be $40,000; but assets will rise by
$60,000, andearningsand dividendswilllikewiseincrease:
Next year’s earnings = Prior earnings + ROE (Retained Earnings)
=$100,000 +0.1($60,000)
=$106,000

Next year’s dividends = 0.4 ($106,000) = $42,400

10-5b Dividends vs. Growth
Moreover, your dividend income will continue to grow by 6% per year
thereafter:
Growth Rate =(1 –Payout ratio) ROE

=(1 –0.4) 10.0%

=0.6 (10.0%) =6.0%

This demonstrates that in the long run, growth in dividends depends primarily on the
firm’s payoutration and its ROE.
10-5c Which is better: Current dividends or
Growth?
▪ Afirm can provide arelatively high current dividendor ahigh growth
rate, BUTNOTBOTH.
▪ Which would Stockholdersprefer?
▪ Somestockholders prefer current dividends while others prefer a
lower payout ratio andfuture growth.
▪ Empirical studies have been unable to determine which strategy is
optimal for maximizing a firm’s stock price.
10-5c Which is better: Current dividends or
Growth?
• Dividend policy is an issue that the management must decide on the basis of
its judgment, NOT a mathematical formula.
• Shareholders should prefer for the company to retain more earnings if the firm
hasexceptionallygoodinvestment opportunities.
• Shareholders shouldpreferahighpayoutifinvestment opportunitiesarepoor.
10-5c Which is better: Current dividends or
Growth?
• First, the required rate of return, rs ,must be greater than the long-run growth
rate, g.
• Second, the constant growth model as expressed in Equation 10.2 is not appropriate
unless a company’s growth rate is expected to remain constant in the future. This
condition almost never holds for the new start-up firms, but it does exist
for many mature companies
10-5c Which is better: Current dividends or
Growth?
Note that Equation 10.2 is sufficiently general to handle the caseof azero
growth stock, where the dividend is expected to remain constant over time.
If g=o, Equation 10.2 reduces to Equation 10.5

Equation 10.5
10-6 Valuing Nonconstant Growth Stocks
• For many companies, it is not appropriate to assume that dividends will grow at a
constant rate.
• Most firms go through life cycle where they experience different growth
rates duringdifferent parts of the cycle.
• In their early years, most firms grow much faster that the economy as a
whole; then they match the economy’s growth; and finally they grow
slower than the economy.
10-6 Valuing Nonconstant Growth Stocks
▪ Automobile manufacturers in the 1920s, computer software firms such
asMicrosoftinthe1990s,andGoogleinthe 2000sareexamplesoffirmsintheearlypart
of their cycle.
▪ These firms are defined as supernormal, ornonconstant, growthfirms.
▪ Supernormal (Nonconstant)Growth
Thepartofthefirm’slifecycleinwhichitgrowsmuch faster that the economy
asawhole.
10-6 Valuing Nonconstant Growth Stocks

Illustrates nonconstant
growth and compares it
with normal growth,
zero growth, and negative
growth.
10-6 Valuing Nonconstant Growth Stocks
BecauseEquation 10.2 requires aconstant growth rate, we obviously cannot
use it to value stocks that are not growing at aconstant rate. However,
assuming that a company currently enjoying supernormal growth will
eventually slow down and become aconstant growth, we can combine
Equation 10.1 and 10.2 to construct a new formula, Equation 10.6,for valuing
thestock.
10-6 Valuing Nonconstant Growth Stocks

Equation 10.6
10-6 Valuing Nonconstant Growth Stocks
• First, we assume that the dividend will grow at a nonconstant rate (generally a
relatively high rate) for N periods, after which it will grow at a constant
rate, g. N is often called horizon,orterminal,date.
• Second, we use the constant growth formula, Equation 10.2, to determine what the
stock’s horizon,orcontinuing, valuewill be N periods from today:
10-6 Valuing Nonconstant Growth Stocks
Horizon (Terminal)Date
▪Thedate whenthegrowth ratebecomes constant.Atthisdate,itisno longer
necessary to forecast the individual dividends.

Horizon (Continuing)Value
▪The value at the horizon date of alldividends expected thereafter.
10-6 Valuing Nonconstant Growth Stocks
To implement Equation 10.6, we go through the following three steps:

1. Find the PV of each dividend during the period

of nonconstant growth and sum them
2. Find the expected stock price at the end of
the nonconstant growth period. At this point it has become a constant
growthstock,soitcanbevaluedwiththeconstantgrowthmodel.Discountthispricebacktothe
present.
3. Addthesetwocomponentstofindthestock’s intrinsicvalued.
10-6 Valuing Nonconstant Growth Stocks
10-7 Enterprise-Based Approach to Valuation
Corporate-Valuation Model

▪A valuation model used as an alternative to the discounted dividend

model to determine a firm's value, especially one with no history of
dividends, or the value of a division of a larger firm.
▪The corporate model first calculates the firm's free cash flows, then
finds their present values to determine the firm's value.
10-7 Enterprise-Based Approach to Valuation
Rather than starting with a forecast of dividends, the corporate valuation model
focuses on firm's future free cash flows.

FCF= [EBIT(1-T) + Depreciation and amortization]- [Capital expenditures + Net

operating working
capital]
EBIT- earnings before interest and taxes
FCF(free cash flow)- represents the cash generated from current operations less
the cash that must be spent on investment in fixed assets and working capital to
support future growth
10-7a The Corporate-Valuation Model
Market Value can be expressed as follows:

FCF- free cash flow in Year t; and the discount rate

WACC- weighted average cost of all the firm's capital
10-7a The Corporate-Valuation Model
Two points about WCC:
1. The firm finances with debt, preferred stock, and common equity.
The WACC is the weighted average of these three types of capital
2. Free cash flow is the cash generated before any payments are
made to any investors; so it must be used to compensate common
stockholders, preferred stockholders, and bondholders. Each type
of investor has a required rate of return; and the weighted
average of those returns is the WACC,which is used to discount
the free cash flows.
10-7a The Corporate-Valuation Model
Free cash flows are generally forecasted for 5 to 10 years, after which it is
assumed that the final explicitly forecasted FCF willl grow at some long-run
constant rate
Formula to calculate the market value of the company as of that date:

Corporate model is applied internally by the firm's financial staff and by outside
security analysts.
10-7b Comparing the Corporate Valuation and
Discounted Models
▪ Analysts use both discounted dividend model and the corporate Valuation model
when valuing mature, dividend-paying firms
▪They generally use the corporate model when valuing divisions and firms that do
not pay dividends
▪We should find the same intrinsic value using either model, but differences are
often observed
▪When conflicts exists, the assumption embedded in the corporate model can be
reexamined, once the analyst is convinced they are reasonable, the results of that
model are used.
10-7b Comparing the Corporate Valuation and
Discounted Models
In practice, intrinsic value estimates based on the two models
normally deviate from one another and from actual stock prices,
leading different analyst to reach different conclusions about the
attractiveness of a given stock.
Does it matter whether you use the corporate
model or the dividend model to value stocks?
Yes, it does

Ex. If we had to value 100 mature companies whose dividends were

expected to grow steadily in the future.

(Discounted dividend model)

Does it matter whether you use the corporate
model or the dividend model to value stocks?
If we were studying just one company or a few companies, especially
companies still in the high-growth stage of their life cycles, we would
want to project future financial statements before estimating future
dividends.

(Corporate Model)
10-8b Preferred Stock
Preferred stock is a hybrid- it is similar to a bond in some respects and to
common stock in others.
Entitles it's owners to regular, fixed dividend payments. If the payments last
forever the issue is a perpetuity whose value, Vp is found as follows
10-8b Preferred Stock
Vp- value of preferred stock
Dp -preferred dividend
rp- required rate of return on the preferred
10-8b Preferred Stock
In equilibrium, the expected return rs must be equal to the required
return rp.

If we know the preferred current price and dividend, we can solve for
the expected rate of return as follows: