CHAPTER 5

STOCKS AND THEIR VALUATION

"Bull markets are born in pessimism, grow on skepticism, mature on optimism, and die of
euphoria."-- Sir John Templeton.
After studying this chapter, students should be able:

 To identify some of the rights, characteristics, and features of both common and preferred
stock.
 To analyze some basic common stock valuation techniques using zero-growth (dividend),
constant- growth (dividend), and variable-growth (dividend) models.
 To determine the value of a preferred stock and calculate its expected return.
 To discuss the free cash flow valuation model and the book value, liquidation value, and
price/earnings (P/E) multiples approaches.
 To show how fundamental analysts differ with technical analysis in analyzing the value of a
common stock.
 To discuss the efficient market hypothesis and the implications of it on stock valuation.
Stock represents ownership in a corporation which is equity financing. It enables investors to
participate in the profits and growth generated by the business enterprise. Initially an
entrepreneur or an owner of a firm would basically sell the stake of the company to the
stockholders to gain additional capital to grow the company further or pay off some liabilities.
Afterwards, (IPO) the firm is controlled by the majority shareholders. Once the Initial Public
Offerings (IPOs) are conducted the shares is ready to trade in the secondary market under the
control of a stock exchange like Dhaka Stock Exchange. Whenever some say share, equity, or
stock, it all means the same thing.

There are basically two types of stocks; preferred and common stock. Preferred stock represents
some degree of ownership in a firm but usually doesn’t come with the same voting right like
common shareholders. With preferred shares the investors are kind of guaranteed a fixed
dividend forever whereas it is not the case for common shareholders. Another very important
feature of preferred shares is in the event of liquidation, they will be paid before the common
shareholders but after the bondholders. Since common shareholders dividend is not guaranteed
and are the last to get paid in line in the event of the closure of the business they are compensated
with the voting right to elect the board of directors who suppose to look after their benefits.
Besides, common shareholders can buy and sell the share almost instantly (In Bangladesh,
usually a common shareholder can sell after 3 working days).

Actually preferred share is considered a hybrid security. This is because preferred stock has
many characteristics of both common stock and bonds. It has characteristics of common stock,
such as no fixed maturity date, nonpayment of dividends does not force bankruptcy, and the non-
deductibility of dividends for tax purposes. But it is like bonds because the dividends are fixed
in amount like interest payments. From some preferred stockholder’s point of view, this is not
the most advantageous combination. On one hand, the dividends are limited as with bond
interest, but the security of forced payment by the threat of bankruptcy is not there. Thus, from
the point of view of the preferred share investor, it is the worst features of common stock and
bonds which are combined together.

Some important features of preferred stock:

1. Owners of preferred stock receive dividends instead of interest.

2. Most preferred stocks are perpetuities (non-maturing).
3. Multiple classes, each having different characteristics, can be issued.
4. Preferred stock has priority over common stock with regard to claims on assets in the case of
bankruptcy.
5. Most preferred stock carries a cumulative feature that requires all past unpaid preferred stock
dividends to be paid before any common stock dividends are declared.
6. Preferred stock may contain other protective provisions, such as granting voting rights in the
event of non-payment of dividends.
7. Preferred stock may contain provisions to convert to a predetermined number of shares of
common stock.
8. Some preferred stock contains provisions for an adjustable rate of return.
9. If there is a participation feature, it allows preferred stockholders to participate in earnings
beyond the payment of the stated dividend.
10. Payment-in-kind (PIK) preferred stock, grants the investor additional preferred stock instead
of dividends for a given period of time. Eventually cash dividends are paid.
11. Retirement features for preferred stock are frequently included.
a. Callable preferred refers to a feature which allows preferred stock to be called, or retired, like
a bond.
b. A sinking fund provision requires the firm periodically set aside an amount of money for the
retirement of its preferred stock.

Some important features of Common Stock:

1. As owners of the corporation, common shareholders have the right to the residual income and
assets after bondholders and preferred stockholders have been paid.
2. Common stockholders are generally the only security holders with the right to elect the board
of directors.
3. Preemptive rights (if granted) entitle the common shareholder to maintain a proportionate
share of ownership in the firm.
4. Common stockholder’s liability as an owner of the corporation is limited to the amount
invested in the stock.
5. Common stock’s value is equal to the present value of all future cash flows expected to be
received by the stockholder.

Common shareholders usually receive dividends (stock or cash or mixture of both) at the end of
the respective firm’s closing date but it is not guaranteed at all and also can make capital gain or
loss due to appreciation or depreciation of the price of the stock.

Pros and Cons of common stock ownership:

Pros:

 Allow common investors to share in the rewards of business enterprise.

 Historically best investment return on average over time. Investors can earn both dividends
and lock in capital gains.
 Stock is the most liquid investment in the western world just as anyone can buy and sell
within second but in Bangladesh usually there is a 3 day waiting period unless it is trading on
the spot market.
 Common shareholders bear the limited liability unlike sole-proprietorship owners who bear
unlimited liability.
 Overall, investing in share market increases the living standard of common shareholders.

Cons:

 It is not necessary now to mention about the riskiness of the stock market after seen most of
the common shareholders lost their equity in the last two years.
 Stock market all over the world is volatile which causes speculation among the investors and
thus some manipulators commit insider trading by receiving some vital information
beforehand.
 Stock market crash can cause social unrest as we have witnessed the vandalizing in front of
DSE office and thus law and order could deteriorate.

Primary market:

The market in which new issues of securities are sold to the public which is known as Initial
Public offering or IPO. It is the first public sale of a company. In Bangladesh, most of the time a
lottery is drawn among the applicants who apply for IPOs and are expressed as lottery winners
who receive one lot of share at the subscription price which is a 10 taka face value plus any
premium over the face value. Most retail investors don’t participate in the primary market.

Why issue IPO or why “Go Public?”

A firm issue common stock due

 To raise money to expand an existing business.

 To help pay for any liabilities like bank loan or bondholders.
 To gain prestige among the business community.
 To manage the business more strategically.
 To create better brand and image of the company.

Raising money from the share market compare to the bond market is that the firm doesn’t have
to repay the money. It is under no obligation to repurchase the shares of the company. On the
other hand, if the firm goes to the bond market then it has to make the coupon payment
periodically and failing to do so could bring the company to bankruptcy. But raising money from
the share market also mean the firm must disclose their audited annual financial report and
unaudited quarter report which simply means there is not much secrecy on the part of the
performance of the company and the available information may inspire other firms to join the
business if it finds the profit is quite attractive and the firm must at least convey one annual
public meeting where common shareholders will voice their concern and if not happy could
theoretically throw the board and elect a new board since they have the voting power. But in
reality, the common shareholders proportion of ownership is not big enough to do so. It is like
you are sick and you go to Beximco Pharma and ask them for some free medicines since you
own 100 of their shares!

Secondary market:

The market in which securities are traded after they have been issued to the public. It simply
means after the IPO lottery it must be listed in an stock exchange so that it could be traded. It is
the secondary market where vast majority of transactions take place. In Bangladesh we have
Dhaka Stock Exchange and Chittagong Stock Exchange where those issued IPOs could be listed
and traded. As of February 17th, there are 254 shares are listed at the Dhaka Stock Exchange
along with 41 mutual funds. Besides there is another market called Over The Counter (OTC)
market where poor performing and firm with huge loss and failed to fulfill the regulatory
requirements are listed and traded.

Even though Stock owners usually used to receive a piece of certificate of ownership when they
bought shares but due to both advancement in technology and the sheer massive volume of
shares trade on any working day all shares are now converted to electronic share. For example,
on 13th February, 2013 a total of 2,32,18,781 shares of United Air exchanged hands!

Is investing in the stock market like gambling?

The answer could be “yes and no”. It is gambling basically for those who buy a share looking at
T + 3 means they want to own the share for just 3 days. For them, the way to make quick money
is buying and selling every day and add up the small gain who are sometimes called “Day
Traders.”

On the other hand there are people who look at the market as a way to participate in the growth
and prosperity of the firm along with the economy and they invest into the future of the firm
whom we call them investors. They will invest a portion of their savings in a firm which they
believe has a bright future and won’t join in day to day trading.

Secondary stock market could be bull market or bear market. Bull market is when the stock
index is rising amid investors’ optimist buoyant with some positive news and bear market is
associated with falling share prices amid investors’ pessimism along with some negative news.
From December 6, 2009 to December 5, 2010 the DSE general index DGEN experienced one of
the biggest bull run in recent memory where the index was 4383 on 6 th December 2009 and it
was 8918 on 5th December 2010 and gained 4535 points or more than 103% within just one year!
But afterwards, the stock market crash and continued the bear run in the next two years and
counting where it has lost more than 60%.
Common stock has got three values. One is called par value or face value which is normally 10
taka in Bangladesh except some shares like ICB which has got a face value of 100 taka still. Face
value is almost meaningless since vey rarely you will find a share trading at face value.

Book value is the amount of shareholders’ equity in a firm; equals the amount of the firm’s
assets minus the firm’s liabilities and any preferred stock. So book value per share is the book
value divided by the number of shares.

On the other hand, it is the market value which concerns the most to the common shareholders. It
is the day to day selling price which an investor will receive by selling his stock.

Valuing Stock

Book Value: Book value is the value of an asset shown on a firm’s balance sheet which is
determined by its historical cost rather than its current worth.

Liquidation Value: Liquidation value is the amount that could be realized if an asset is sold
individually and not as part of a going concern.

Market Value: Market value is the observed value of an asset in the marketplace where buyers
and sellers negotiate an acceptable price for the asset.

Intrinsic Value: Intrinsic value is the value based upon the expected cash flows from the
investment, the riskiness of the asset, and the investor’s required rate of return. It is the value in
the eyes of the investor and is the same as the present value of expected future cash flows to be
received from the investment.

It may come for a debate “why bother valuing stocks at all?” With the value of stocks being
determined by “the market” or market manipulators why just let the luck dictate? The answer is
pretty simple. You need to know those quantative analyses just to discover whether you are
paying too high or too low or the market is overpriced or underpriced based on some fair value.
Also you may need to price a new stock (IPO) to estimate whether this IPO would be
undersubscribed or not.

Stock that trades on Dhaka Stock Exchange or Chittagong Stock Exchange doesn’t generate new
funding for the company whose shares are being traded. When an investor buys a share from the
secondary market, he is more likely buying it from another individual investor. This transaction
has got nothing to do with the firm that issued the stock through IPOs, as it is a private
transaction between two separate legal entities. New stock issued in the primary market,
however, does result in both income to the firm and possible dilution of existing shareholders
ownership interest in the firm. Initial Public Offerings obviously are between investors and the
firm and generate capital that the firm can use in its operation.

So, why do stock prices change? The best answer is that nobody really knows for sure. Some
believe that it isn't possible to predict how stock prices will change, while others think that by
drawing charts and looking at past price movements, you can determine when to buy and sell.
The only thing we do know is that stocks are volatile and can change in price extremely rapidly.

The important things to notice about the valuation of stock are the following:

1. At the most fundamental level, supply and demand in the market determines stock price.
2. Price times the number of shares outstanding (market capitalization) is the value of a
company. Comparing just the share price of two companies is meaningless.
3. Theoretically, earnings are what affect investors' valuation of a company, but there are other
indicators that investors use to predict stock price. Remember, it is investors' sentiments,
attitudes and expectations that ultimately affect stock prices.
4. There are many theories that try to explain the way stock prices move the way they do.
Unfortunately, there is no one theory that can explain everything.

The Basic Common Stock Valuation Equation

The value of an asset, be it a bond or stock, is a function of four elements:

1. The amount of the asset’s expected cash flows (FV),

2. The timing of the cash flows (t),
3. The riskiness of these cash flows,
4. The investor’s required rate of return for undertaking the investment which is a function of the
riskiness of the expected cash flows.

The Intrinsic value is that value which an investor places on an asset given his information set
(that is all the information that he has) and his expectations (beliefs). Thus one asset can have
different values depending on the investor valuing it.

Like the value of a bond, the value of a common stock is equal to the present value of all future
cash flows (dividends) that is expected to receive over an infinite period of time. Therefore, from
a valuation point of view only dividends are relevant.

The dividend discount model (DDM) is based on the rationale that the intrinsic value of a
common stock is the present value of its future dividends.
The basic valuation model [also known as the Discounted Cash Flow (DCF) method] therefore
is given by:
n
CF 1 CF 2 CF 3 CF n CF t
^
P 0= + + +… = ∑
1 2 3
(1+r ) t=1 (1+r )t
n
( 1+ r) (1+ r) (1+r )

Common Stocks like other assets derive their values from expected future cash flows. These cash
flows are comprised of dividends which are paid from the income of the corporation and, if
applicable, the selling price of the stocks at the end of some holding period. The investor expects
to earn capital gains from the latter . From here onwards however, we will assume that the
investor does not wish to sell the stock (hence he will only receive dividends every year), and
therefore the basic stock valuation model is given by:
 n
D1 D2 D3 Dn Dt
^
P 0= + + +… = ∑
1 2 3
(1+r ) t=1 (1+r )t
n
( 1+ r) (1+ r) (1+r )

Where Dt = expected dividend at time t.

and r = investor's required rate of return.

Zero growth stock

Since the value of a stock is dependent on the dividend then the valuation models should reflect
the dividend pattern. Consider a stock which is expected to pay a constant dividend through time.
It will experience no growth or decline in the future. This is a zero growth stock which is similar
to perpetuity. The price of the stock is given by:

D D D D D
P 0=
^ + + +… =
1 2
( 1+ r) (1+ r) (1+r )3
(1+r )∞
K
 
Note - a preferred stock is a type of zero growth stock

Normal /Constant Growth Model

The Gordon growth model or constant growth model assumes the annual growth rate of
dividends, g, is constant. Hence, next year’s dividend, D1, is D0(1+g), the second year’s
dividend, D2, is D0(1+g)^2, and so on. The extended equation using the assumption gives the
present value of the expected future dividends as:

D 0 ( 1+ g )1
P 0=
1 D0 ( 1+ g )2
( 1+ k ¿¿ e) + 3
¿
2 D 0 ( 1+ g )
(1+k ¿ ¿ e) + ¿
(1+ k ¿¿ e)3 + …. ¿

Multiply both sides by (1+ke)/(1+g), we get

=> P0 (1+ke) = D0 + D0(1+g) + D0(1+g)2 +…….

(1+g) (1+ke) (1+ke)2
=> P0 (1+ke) = D0 + P0 [ Since P0 = D0(1+g)/(1+ke) + D0(1+g)2/(1+ke)2 +…..]
(1+g)
=> P0 (1+ke) – P0 = D0
(1+g)

=> P0 [(1+ke ) 1] = D0
(1+g)
=> P0 [(1+ke )– (1+g)] = D0
(1+g)
=> P0 (ke – g) = D0 (1+g)
=> P0 = D0 (1+g)/ (ke – g)

D1
P 0=
( K e −g )

Stock Price = Dividends (D1) / (Expected Return (ke) - Dividend Growth Rate (g))

Assumptions and implications of Gordon growth model

 Dividends are the appropriate measure of shareholder wealth,

 Dividends are assumed to continue growing at a constant rate forever,
 The required return on stock, ke, are never expected to change,
 Ke must be greater that g. If not, the math will not work.

If any one of these assumptions is not met, the model is not appropriate.

Gordon growth model predicts that current stock price P0 will be lower if:

 Current dividend D0 is lower;

 Or the expected dividend growth rate g is lower;
 Or the required return on equity ke is larger.

Trouble valuing when

 Companies pay no dividends means D = 0

 Companies grow faster than expected rate of return.

Example: Gordon growth model valuation (One year DDM valuation)

Problem 5.1: Calculate the Value of a stock that paid 4 taka dividend recently and is expected it
to grow at 12% every year forever, and the required return on equity is 15%.
Solution:
Determine D1 : D0(1+g) = 4(1+0.12) = 4.48 taka.
Calculate the stock’s value = D1 / (ke – g)
= 4.48 / (0.20 – 0.12)
= 56 taka.

This constant growth stock pricing model does not mean the stock's dividends will remain the
same over time; the assumption is the growth rate is constant over a long period of time. Closely
examining this stock pricing formula reveals that it only works when the expected return, or
discount rate, is greater than the dividend growth rate. An assumption that is quite logical.

Problem 5.2: Calculate the value of a stock that paid a 6 taka dividend this year if next year’s
dividend will be 10% higher and the stock will sell for 78 taka at year end. The required return is
18%.
Answer: The next year dividend is the current dividend increased by the estimated growth rate
in this case, we have
D1 = D0 + ( 1 + dividend growth rate) = 6(1+.1) = 6.60 taka.

The present value of the expected future cash flows is:

Dividend: 6.60 / 1.18 = 5.59 Tk, year-end price: 78 / (1.18) = 66.10 Tk.

The current value based on the investor’s expectation is:

Stock value = 5.59 + 66.10 = 71.69 taka.

Multiple-year holding period DDM

With a multiple-year holding period, we simply sum the present values of the estimated
dividends over the holding period and the estimated terminal value.

So for a two-year holding period, we have:

Stock Price after two years: D1/(1+ke) + D2/(1+ke)2 + P2/(1+ke)2

Using this equation it is possible to price a stock after 5 years or even longer period of time. For
example, to find a share price after 5 years the equation will be:

D0 ( 1+ g )6
P 5=
( K e −g )

Problem 5.3: If GrameenPhone paid 14 taka cash dividend this year and is expected to
experience dividend growth of 12% in the next 6 years when the expected return on equity is
20% then how much do you expect the price of a GP share would be after 5 years?
Solution:
D0 ( 1+ g )6
P 5=
( K e −g )

Here, P5 is the price of GP after 5 years which is what we need to find.

g = 0.12, ke = 0.20 and D0 = 14 taka.

So P5 = 14( 1+ 0.12)6
(0.20 - 0.12)
= 345.42 taka.

It aims to find the expected value of a stock which is experiencing growth at about the same rate
as that of the economy. The assumption is that if the company maintains its dividend payout ratio
then dividends will grow at about the same rate as the economy.
Problem 5.4: A stock recently paid a dividend of 8 taka which is expected to grow at 8% per
year. The required rate of return is 16%. Calculate the value of this stock assuming that it will be
priced at 88 taka two years from now.
Solution: Find the present value of the future dividends first:

D1 = 8 (1 +0.08) / (1+.16) = 7.44 taka

D2 = 8(1+.08)(1+.08) / (1+.16)2 = 6.93 taka.

PV of dividends = 7.44 + 6.93 = 14.37 taka.

Now let’s find the PV of the future price of this stock:

88 / (1.16)2 = 65.398 taka.
Add the present values. The current value based on the investor’s expectations is
14.37 + 65.398 = 79.77 taka .

Problem 5.5: The current dividend on a stock is 2 taka per share and investors require a rate of
return of 12%. Dividends are expected to grow at a rate of 20% per year over the next three years
and then at a rate of 5% per year thereafter. What should be the price of this stock today?
Solution:
D1 = 2(1+.20) = 2.40 taka
D2 = 2.40 (1.20) = 2.88 taka
D3 = 2.88(1+.20) = 3.456 taka
D4 = 3.456(1+.05) = 3.6288 taka

P3 = 3.6288/ (.12-.05) = 51.84 taka

P0 = 2.40 + 2.88 + 3.456 + 51.84

(1+.12)1 (1+.12)2 (1+.12)3 (1+.12)3

= 2.142 + 2.296 + 2.46 + 36.8986

= 43.80 taka.

Estimating Dividend Growth Rates

We can estimate the dividend growth rate of g from different ways like:

 Historical average
 Average analyst forecast
 Sustainable growth g = ( 1 – payout ratio) x ROE
 Required return versus dividend yield.

An estimate of a company's dividend growth rate can be made by examining a company's

projected earnings growth rate. This estimate assumes the return on equity for a company and its
payout ratio remains constant. Dividend growth can then be estimated using the following
calculation:
Dividend Growth (g) = Plowback Ratio x Return on Equity
Where:
Plowback Ratio = 1 – Payout Ratio, and
Payout Ratio = Dividends paid/Earning per Share, and
Return on Equity = Earnings per Share / Book Equity per Share.

All of these variables can be easily calculated when researching a stock. Sticking with our
example, if Stock A has a payout ratio of 60%, which means they pay out 60% of earnings in
terms of dividends, their plowback ratio is 1 - 60%, or 40%. Let's also assume the company's
return on equity is 10.0%. That means their estimated dividend growth rate is:
Dividend Growth (g) = 40% x 10% = 4.0%

As we know ke = D1 + g = D0(1+g) + g
P0 P0
=> g = ke – (D0 + D0.g)
P0
=> g = ke – D0 – D0.g
P0 P0
=> g + D0.g = ke – D0
P0 P0
 g(1+ D0 ) =( Ke – D0/P0)
P0
D

g=
(K e− 0 )
P0
( 1+ D 0 )
P0

Problem 5.6: If a company paid 2.5 taka divivdend this year and the price of the stock is 30 taka
whereas the cost of equity is 16% then what is the dividend growth rate of this stock?
Solution: We know,

g = (Ke – D0/P0)
(1+ D0)/P0
g = (.16 – 2.5/30)
(1+ 2.5/30)
g = 0.0707 or 7.07%

Non-Constant Growth Case

Suppose the dividend growth rate changes during the period of evaluation. There is usually a
period of supra-normal growth, followed by a normal growth rate. (Important: Supra-normal
growth cannot be sustained for extended periods).

Illustration: Earnings (and dividends) growing at a 20% rate would more than double in 4 years;
triple in about 6 years; and increase by more than 6 times in 10 years. This is not likely.
To estimate the value of a stock with non-constant growth requires that the different growth rate
periods be handled separately.

Problem 5.7: Suppose that British American Tobacco’s dividends this year is Tk. 1.20 per share
and that dividends will grow at 10% per year for the next three years, followed by a 6% annual
growth rate. The appropriate discount rate for British American Tobacco’s common stock is
12%. What is the value of a share of British American Tobacco common stock?

Solution: To value this stock, first compute the present value of the first three dividend
payments as follows:

Year Growth Rate (g) Expected Dividend Present Value

1 10% Tk. 1.3200 Tk. 1.1786
2 10% Tk. 1.4500 Tk. 1.1575
3 10% Tk. 1.5972 Tk. 1.1369

The present value of the first three dividend payments is Tk. 3.4730. Next, compute the dividend
for year 4:

D4 = Tk.1.20 x (1.10)3 x (1.06) = Tk. 1.6930

The price as of year 3 can be determined by using the formula for the present value of a stock
whose dividends grow at a constant rate:

P3 = D4 = Tk.1.6930 = Tk. 28.2167

(r-g) (.12 - .06)
Note that the above formula values the stock as of year 3, using the year 4 dividend in the
numerator. To find the present value, as of year 0, of this year 3 price:

PV = Tk.28.2167 = Tk. 20.0841

(1.12)3
Therefore, P0 = Tk. 3.4730 + Tk. 20.0841 = Tk. 23.56

P0 = Tk. 20; D0 = Tk. 1.00; g = 10%; P1 and Ke =?

P1 = P0(1 + g) = Tk. 20(1.10) = Tk. 22.

D1 1 ( 1+0.10 )
K e= + g= +0.10
P0 20
= 15.50%

The problem asks you to determine the constant growth rate, given the following facts: P 0 = Tk.
80, D1 = Tk.4, and Ke = 14%. Use the constant growth rate formula to calculate g:
 D1
K e= +g
P0
4
0.14= + g
80

g=0.9=9 %
Problem 5.8: ABC Corporation's next annual dividend (D1) is expected to be ৳4. The growth
rate in dividends over the following three years is forecasted at 15%. After that, ABC's growth
rate is expected to equal the industry average of 5%. If the required return is 18%, what is the
current value of the stock?

Solution:
D1 = ৳4
D2 = D1 * (1 + g) =৳ 4 * (1+ 0.15) = ৳4.6
D3 = D2 * (1 + g) = ৳4.6 * (1+ 0.15) = ৳5.29
D4 = D3 * (1 + g) = ৳5.29 * (1+ 0.15) = ৳6.0835
D5 = D4 * (1 + g) = ৳6.0835 * (1+ 0.05) = ৳6.388

D5 6.388
Stock price , P 4= = =৳ 49.136
( K e −g ) ( 0.18−0.05 )

4 4.60
Stock price , P0 = 1
+
( 1.18 ) ¿¿

Super normal /Non Constant growth

Some stocks will experience growth at a higher rate than that being experienced by the general
economy. This may be due to several reasons:
1. The company may be new
2. The company may just have found an innovative way of doing things
3. The company may have captured prime management.

These factors would have provided the company with a competitive advantage over its rivals.
The higher rate of growth as a result of the above will only last for a limited period after which
the company will settle down to more stable growth.
To find the value of such a stock we need a three step approach. In step 1 we discount the
individual dividends during the supernormal/non constant growth period and sum the results. In
step 2 we find the price of the stock at the end of the supernormal/non constant growth period
(a.k.a. Terminal/Horizon date) using only those cash flows expected in the normal growth
period and then discount this price back to time zero (0). Finally, in step 3, we add the results
from steps 1 & 2. 

Suppose we have a one-year horizon. Price = P0, then

P0 = D1 + P1 , where D1 = next year dividend

 (1+r) (1+r) P1 = Selling Price
r = our opportunity cost
Suppose whoever buys the stock at price P1 also has a one-year horizon, then

P1 = D2 + P2 , so substituting
(1+r) (1+r)

P0 = D1 + D2 + P2 ,and so on
(1+r) (1+r)2 (1+r)2

D 0 ( 1+ g )1
P 0=
1 D0 ( 1+ g )2
( 1+ k ¿¿ e) + 3
¿
2 D 0 ( 1+ g )
(1+k ¿ ¿ e) + ¿
(1+ k ¿¿ e)3 + …. ¿

=> P0 = D1/(ke – g)

One year holding period DDM. For a holding period of one year, the value of the stock today is
the present value of any dividends during the year plus the present value of the expected price of
the stock at the end of the year (referred to as its terminal value).

So the one-year holding period DDM is simply:

Stock Price after one year = dividend to be received / (1+ke) + year-end price/(1+ke).

Estimating the Required Return for Equity

The Capital Asset Pricing Model (CAPM) provides an estimate of the required rate of return (ki)
for security i as a function of its systematic risk (Bi), the risk-free rate (Rf), and the expected
return on the market [ E(Rmrk)] as:

Ki = Rf + Bi[E(Rmkt) – Rf]

There is some controversy over whether the CAPM is the best model to calculate the required
return on equity. Also, different analysts will likely use different inputs, so there is no single
number that is correct.

Valuation of Preferred Stock

Since the preferred dividends are generally fixed and usually have an indefinite maturity, it can
be valued as a constant growth stock with a dividend growth rate equal to zero. Thus, the price of
a share of preferred stock can be determined using the following equation:

Dp
P p=
Kp
Here, Pp is the price of a preferred stock, Dp is the preferred dividend, and kp is the required rate
of return from the preferred stock.

Problem 5.9: A company’s 1000 taka face value preferred stock pays dividend of 16% and has a
required rate of return 12%. Calculate the value of the preferred stock.

Solution: Price of the Preferred stock

Pp = Dp / kp = 160/0.12 = 1333.33 taka.

Preferred stock is defined as equity with priority over common stock with respect to the payment
of dividends and the distribution of assets in a liquidation. Preferred stock is a hybrid security
which shares features with both common stock and debt.
Preferred stock is similar to common stock in that it entitles its owners to receive dividends
which the firm must pay out of after-tax income. Moreover, the use of preferred stock as a source
of financing does not increase the probability of bankruptcy for the firm.
However, like the coupon payments on debt, the dividends on preferred stock are generally
fixed. Also, the claims of the preferred stockholders against the assets of the firm are fixed as are
the claims of the debt holders.

Preferred stock has the following features:

Par Value

The par value represents the claim of the preferred stockholder against the value of the firm.

Preferred Dividend / Preferred Dividend Rate

The preferred dividend rate is expressed as a percentage of the par value of the preferred stock.
The annual preferred dividend is determined by multiplying the preferred dividend rate times the
par value of the preferred stock.
Since the preferred dividends are generally fixed, preferred stock can be valued as a constant
growth stock with a dividend growth rate equal to zero. Thus, the price of a share of preferred
stock can be determined using the following equation:

Dp
P p=
Kp
where
Pp = the preferred stock price,
Dp = the preferred dividend, and

Problem 5.10: Find the price of a share of preferred stock given that the par value is Tk.100 per
share, the preferred dividend rate is 8%, and the required return is 10%.
Solution:
.08∗100 8
P p= = =Tk .80
.10 .10
Concepts of market efficiency

Economics provides concepts of efficiency – allocative and operational efficiency.

 An allocationally efficient market is one where prices are determined where market
demand equals market supply.
 An operationally efficient market is one where transactions costs of moving resources
around are zero. Eg: perfect capital markets.

Efficient capital markets

 Efficient markets in finance is less restrictive than the concept of perfect capital markets.
 In an efficient capital market, prices fully and instantaneously reflect all available relevant
information – informationally efficient.
 A capital market may be informationally efficient but not allocatively or operationally
efficient. E.g. imperfect competition (allocatively inefficient) or transactions costs like the
proposed Tobin tax (operationally inefficient).

Efficient market hypothesis (EMH)

Expectations are unobserved and we need expectations of future stock price to calculate expected
return. The theory of rational expectations tells us that expectations are the optimal forecasts
based on all the available information. The supply and demand for securities will determine an
equilibrium price of securities therefore the expected price of stocks will be given by the market
equilibrium. The expected return on a security will equal the equilibrium return given by the
market conditions for that particular security.

Weak form efficiency

A capital market is said to be weakly efficient if current stock prices fully incorporate the
information about past stock prices. If a market is weak form efficient, it would not make sense
to try to predict future prices from an analysis of past prices. Professional analysts who try to
make predictions about future prices from past prices are called technical analysts (or
chartists).

In Weak form efficiency, no investor can earn excess returns by developing trading rules based
on historical price/returns data. So, technical analyst cannot beat the market.

Semi-strong form efficiency

A market is semi-strong-form efficient if prices incorporate all publicly available information,

such as information from published accounting statements for the firm as well as historical price
information.
No investor can earn excess returns from trading rules based on any publicly available
information. Implication is that all publicly available information is fully reflected in the actual
asset price. Market reaction to new publicly available information is instantaneous and unbiased.
No over- or under-reaction. Fundamental analysis based on publicly available information
shouldn’t result in abnormal returns.

Strong form efficiency

No investor can earn excess returns using any information – public or private. Strong form
efficiency implies that all information is fully reflected in the price of the asset. Even private
information! – Insider trading is ineffective

Exercises with solutions:

Exercise 1: What should be the price of a stock next year if it is expected to pay 6 taka dividend
in year 1 and the price of the stock today is 50 taka when the expected required return of equity
is 15%?

Solution:
Value of common stock = Dividend in year 1 + Price in year 1
(1+required rate) (1+required rate)

50 = 6/(1+.15) + P1/(1+.15)

P1 = 50(1.15) – 6
= 51.50 taka.

Exercise 2: What is the expected return of common stock if a company is expected to pay 2.00
taka this year and expected to grow at 10% and the market price of thos stock is 22.50 taka

Solution:
Expected rate of return on common stock = Dividend in year 1/Market price + growth rate

Kcs = 2/22.50 +.10

= .1889, or 18.89%

Exercise 3: What is the value of a common stock when it paid 3.50 taka dividend this year and is
expected to pay 5% when the expected rate of return is 20%?
Solution:

Vcs = 3.50(1+.05)/(0.20 – 0.05) = 24.50 taka.

Exercise 4: What is the expected rate of return when the dividend was 2.94 taka and expected to
grow at 9.5% when the price of the stock is 32.84 taka?

Solution: Ke = 2.94(1.095)/32.84 + 0.095

 Ke = 0.193 + 0.095 = 0.293 or 29.3% (Check)

Exercise 5: If a stock is selling for 43 taka today and is expected to sell for 48 taka in year 1
whereas the expected dividend in year 1 is 2.84 taka then what is the expected return on this
common stock?

Solution:
Current Price = Dividend in Year 1/(1+kcs) + Price in Year 1/(1+kcs)
Ke = (Dividend in Year 1 + Price in Year 1) – 1
Current price
= [(2.84 + 48)/43] – 1
= 0.1823 – 1
= 17.23%.

Exercise 6: If a company paid 1.12 taka wheras the market price is 49 taka, what is the dividend
yield?
Solution: Dividend yield: Dividend /stock price = 1.12/49 = 0.0229 or 2.29%.

Exercise 7: If GP paid 17 taka dividend this year and expected to pay 12% more next year then
what is the expected price of a GP share today when the expected return is 15%?

Solution: You know that,

P0= D0(1+g)
(ke - g)
Here g = 0.12, ke = 0.15 and D0 = 17 taka.

So P5 = 17( 1+ 0.12)
(0.15 -0.12)

= 634.67 taka.

So, you should pay a maximum of 634.67 Tk. for one GP share.

Exercise 8: If Beximco has paid 22 taka dividend this year and is expected to increase it 10% for
the coming years. What should be the expected price in 5 years when the expected return from
equity is 14%?

Solution: There are 5 years of constant growth

D1 = 22(1+.10) = 24.2 taka
D2 = 24.2 (1+.10) = 26.62 taka
D3= 26.62 (1+.10) = 29.282 taka
D4= 29.282 (1+.1) = 32.21 taka
D5= 32.21 (1+.1) = 35.43 taka

P0= 24.20 + 26.62 + 29.282 + 32.21 + 35.43

(1+.12) (1+.12)2 (1+.12)3 (1+.12)4 (1+.12)5
 =21.60+21.22+20.84+20.47+20.10

= 104.23 taka.

So, the expected price should be 104.23 Taka

Dividend Characteristics

Dividends – return on shareholder capital.

1. Payment of dividends is at the discretion of the board. A firm cannot default on an undeclared
dividend, nor be forced to file for bankruptcy because of nonpayment of dividends.

2. Dividends are not tax deductible for the paying firm.

3. Dividends received by individuals are usually considered ordinary income, while dividends
received by a corporation are at least 70% tax-exempt.

Dividend Payout Ratio

Dividend payout ratio is the ratio of dividend per share divided by earnings per share. It is a
measure of how much earnings a company is paying out to its shareholders as compared to how
much it is retaining for reinvestment.
Formula
Dividend per Share
Dividend Payout Ratio = 
Earnings per Share
Dividend payout ratio can also be calculated as total dividends divided by net income.

Analysis:

A shareholder has two sources of return, namely periodic income in the form of dividends and
capital appreciation. Dividend payout ratio tells what percentage of total earnings the company is
paying back to shareholders. A healthy dividend payout ratio leads to investor confidence in the
company.
Plowback ratio (also called retention rate) is equals 1 − payout ratio and it equals the earnings
retained divided by total earnings for the period.
Example
ABC Ltd. earned an EPS of 2 taka in FY 2013 when it paid 1 taka per share as dividends. Find
its dividend payout ratio.

Solution
Dividend Payout Ratio = DPS/EPS = 1/2 = 50%
Case Study 1: Why do the stock markets crash all over the world when we can so easily value
the price of a stock?

A stock market crash is a sudden dramatic decline of stock prices across a significant cross-
section of a stock market, resulting in a significant loss of paper wealth. Crashes are driven by
panic as much as by underlying economic factors. They often follow speculative stock market
bubbles.
Generally speaking, crashes usually occur under the following conditions: a prolonged period of
rising stock prices and excessive economic optimism, a market where P/E ratios exceed long-
term averages, and extensive use of margin debt and leverage by market participants. Most
common scenario is when investors display a sense of irrational exuberance like good days will
never end whereas the smart investors keep unloading their long position by selling their shares
and within very short period of time there is no buyers and the market hit the circuit breakers and
panic takes the center stage and every investor wants to get out but a big majority cannot get out
and they see their portfolios are down over 50% in matter of few weeks. Especially highly
leveraged investors will see their portfolio’s equity becomes negative.
Now the question is why does it happen? It didn’t just happen in Bangladesh in 1996 or in 2010
but in the USA it is even very common like the great crash of 1929s or the crash of 1987 which
wiped out more than 500 billion in few months.
There are so many tools available to find a fair value of a stock but why things will go so wrong
that a stock will lose 80-90% of its value in matter of few weeks?
We analyzed the CAPM model which seems not good enough and made some unrealistic
assumptions and has emphasized more on the past date and then we used the dividend discount
model but here we had to forecast the growth of dividend of a company which is not an easy
task. Whatever theory we use it doesn’t seem make all senses to predict the direction of stock
movements.
There are also technical analysts who are known as chartists who believe through careful
analysis stock prices can be predicted and obviously there are fundamental analysts who believe
stock prices is directly linked with the performance of the national aggregate economy.
But still stock markets all over the world have a notorious history of overshooting which at some
point crashed the market. There may be an explanation or a theory to explain.
May be; again may be, the random walk theory have a better explanation about the stock market.
For example, one might consider a drunken person’s path of walking to be a random walk
because the person is out of his mind and his walk would not follow any predictable path.
Applying random walk theory in picking stocks means the price of a stock change randomly,
making it impossible to predict stock prices.
Now you know even having all the financial knowledge if you discover yourself in the losing
side in the stock market, you can always point your finger to “The Random Walk Theory”.

Question 1: Why do stock markets all over the world crash?

Question 2: What are some of the stock valuation techniques?
Question 3: Why leveraging high pose a greater risk of negative equity?
Question 4: What is “The Random Walk Theory” and how does it explain the direction of share
market?

Case Study 2: Three Americans win economics Nobel Prize.

Three American scientists won the 2013 economics Nobel Prize on Monday for research that has
improved the forecasting of asset prices in the long term and helped the emergence of index
funds in stock markets, the award-giving body said.

“There is no way to predict the price of stocks and bonds over the next few days or weeks,” The
Royal Swedish Academy of Sciences said in awarding the 8 million crown (1.25 million) prize to
Eugene Fama, Lars Peter Hansen and Robert Shiller.

“But it is quite possible to foresee the broad course of these prices over longer periods, such as
the next three to five years. These findings ... were made and analyzed by this year’s Laureates,”
the academy said.

Shiller helped create a closely watched gauge of US housing prices and in June this year warned
of a potentially new housing bubble in some of America’s largest cities.

Fama, tipped as a Nobel winner for many years, has been called the father of modern finance and
is well-known for research showing that certain groups of stocks tend to outperform over time.

The behaviour of asset prices are key to decisions such as savings, house buying and national
economic policy, the academy said.

“Mispricing of assets may contribute to financial crises and, as the recent global recession
illustrates, such crises can damage the overall economy,” it added.

Fama and Hansen are professors at the University of Chicago, while Shiller is a professor at Yale
University.

“A lot of people had told me they hoped I would win it, but I am aware that there are so many
other worthy people that I had discounted it, so I would say no, I did not expect it,” Schiller told
a news conference.

The economics prize, officially called the Sveriges Riksbank Prize in Economic Sciences in
Memory of Alfred Nobel, was established in 1968. It was not part of the original group of
awards set out in dynamite tycoon Nobel’s 1895 will.

Question 1: Why is there no way to predict the price of a stock or bond in the short term?
Question 2: Why do the financial experts believe long term pricing is quite possible for stocks
and bonds?
Question 3: How asset prices are related to macro-economic policy?

Integrated Case study on stock valuation

Premier Bengal Company Inc.

Stock Valuation
Mr. Robin Choudhury is the senior vice presidents of the Premier Bengal Company Inc. He is
being responsible for equity investments. He is invited is a seminar titled “investment in equity
market” and he has asked you to analyze the stock performance of ABC corporation.

You are to answer the following questions.

A. (1) Describe briefly the legal rights and privileges of common stockholders.
Answer: The common stockholders are the owners of a corporation, and as such they have
certain rights and privileges as described below.
1. Ownership implies control. Thus, a firm’s common stockholders have the right to elect its
firm’s directors, who in turn elect the officers who manage the business.
2. Common stockholders often have the right, called the preemptive right, to purchase any
additional shares sold by the firm. In some states, the preemptive right is automatically included
in every corporate charter; in others, it is necessary to insert it specifically into the charter.

A. (2) Write a formula that can be used to value any stock, regardless of its dividend pattern.
Answer: The value of any stock is the present value of its expected dividend stream:

^ D1 D2 D3 D∞
P 0=
^
1
+ 2
+ 3
+ …+
( 1+ ℜ) ( 1+ ℜ ) ( 1+ ℜ ) ( 1+ ℜ )∞

However, some stocks have dividend growth patterns that allow them to be valued using short-
cut formulas.
A. (3) What is a constant growth stock? How are constant growth stocks valued?
Answer: A constant growth stock is one whose dividends are expected to grow at a constant rate
forever. “Constant growth” means that the best estimate of the future growth rate is some
constant number, not that we really expect growth to be the same each and every year. Many
companies have dividends that are expected to grow steadily into the foreseeable future, and
such companies are valued as constant growth stocks.

For a constant growth stock:

2
D1 = D0(1 + g), D2 = D1(1 + g) = D0(1 + g) , and so on.
With this regular dividend pattern, the general stock valuation model can be simplified to the
following very important equation:
.
^
^ D1 D 0(1+ g)
P 0= ❑=
( ℜ−g ) ( ℜ−g )❑

This is the well-known “Gordon,” or “constant-growth” model for valuing stocks. Here D 1 is the
next expected dividend, which is assumed to be paid 1 year from now, re is the required rate of
return on the stock, and g is the constant growth rate.
A. (4) What are the implications if a company forecasts a constant g that exceeds its r e? Will
many stocks have expected g > re in the short run (that is, for the next few years)? In the long
run (that is, forever)?
Answer: The model is derived mathematically, and the derivation requires that re > g. If g is
greater than re, the model gives a negative stock price, which is nonsensical. The model simply
cannot be used unless (1) re > g, (2) g is expected to be constant, and (3) g can reasonably be
expected to continue indefinitely.
Stocks may have periods of supernormal growth, where g > re; however, this growth rate cannot
be sustained indefinitely. In the long-run, g < re.

B. Assume that ABC inc. has a beta coefficient of 1.2, that the risk-free rate (the yield on T-
bonds) is 7%, and that the required rate of return on the market is 12%. What is ABC’s
required rate of return?
Answer: Here we use the SML to calculate ABC’s required rate of return:
re = rRF + (rM – rRF)b
= 7% + (12% – 7%)(1.2)
= 7% + (5%)(1.2) = 7% + 6% = 13%.

C. Assume that ABC inc. is a constant growth company whose last dividend (D 0, which was paid
yesterday) was 2.00 taka and whose dividend is expected to grow indefinitely at a 6% rate.
(1) What is the firm’s expected dividend stream over the next 3 years?

Answer: ABC is a constant growth stock, and its dividend is expected to grow at a constant rate
of 6% per year.

Expressed as a time line, we have the following setup; then keep multiplying by 1 + g = 1.06 to
get D1, D2, and D3:

0 1 2 3
re =13%

D0 = 2.00 g =6% 2.12/(1+.13) 2.247/(1+.13)2 2.382/(1+.13)3

= 1.88

= 1.76

= 1.65
.
.
.
C. (2) What is its current stock price?
Answer: We could extend the time line on out forever, find the value of ABC’s dividends for
every year on out into the future, and then the PV of each dividend discounted at re =13%. For
example, the PV of D1 is Tk. 1.8761; the PV of D 2 is Tk. 1.7599; and so forth. Note that the
dividend payments increase with time, but as long as re > g, the present values decrease with
time. If we extended the graph on out forever and then summed the PVs of the dividends, we
would have the value of the stock.
However, since the stock is growing at a constant rate, its value can be estimated using the
constant growth model:

^ D1
P 0=
^ ❑
( ℜ−g )
2.12
=( )
0.13−0.6

= 30.29 taka

C. (3) What is the stock’s expected value 1 year from now?

Answer: After one year, D1 will have been paid, so the expected dividend stream will then be
D2, D3, D4, and so on. Thus, the expected value one year from now is 32.10 taka:

^ D2
P 0=
^ ❑
( ℜ−g )

^ 2.247
P 0=
^ ❑
( 0.13−0.06 )

= 32.10 taka.
A. (4) What are the expected dividend yield, capital gains yield, and total return during the first
year?
Answer: The expected dividend yield in any Year t is
D
Dividend yield= t
Pt−1
^

While the expected capital gains yield is

Capital gains yield =

^ P
P− ^ t−1
Capital gains yield =
Pt −1
^
.
Thus, the dividend yield in the first year is 7%, while the capital gains yield is 6%:
Total return = 13.0%
Dividend yield = 2.12/30.29 = 7.0%
Capital gains yield = 6.0%.
B. Now assume that the stock is currently selling at Tk. 30.29. What is its expected rate of
return?
Answer: The constant growth model can be rearranged to this form:

D1
^
ℜ= +g
p0
Here the current price of the stock is known, and we solve for the expected return. For ABC:
^ 2.12
ℜ= +0.060
30.29

= 0.070 + 0.060 = 13%.

K. What would the stock price be if its dividends were expected to have zero growth?

Answer: If ABC’s dividends were not expected to grow at all, then its dividend stream would be
perpetuity.

D 2
P 0= ℜ =
^
0.13

= 15.38

Note that if a preferred stock is perpetuity, it may be valued with this formula.

E. Now assume that ABC is expected to experience non-constant growth of 30% for the next 3
years, then return to its long-run constant growth rate of 6%. What is the stock’s value under
these conditions? What are its expected dividend and capital gains yields in Year 1 and Year 4?

Answer: ABC is no longer a constant growth stock, so the constant growth model is not
applicable. Note, however, that the stock is expected to become a constant growth stock in 3
years. Thus, it has a non-constant growth period followed by constant growth. The easiest way to
value such non-constant growth stocks is to set the situation up on a time line as shown below:

0 1 2 3 4
re =13%
g=30% g=30% g=30% g=6%
2.60/(1+.13) 3.38/(1+.13)2 4.394/(1+.13)3 4.657

= 2.301

= 2.647

= 3.045
4.657
66.54/(1.13)3 P 0=
^ =66.54 taka
( 0.13−0.60 )
= 46.114
 = 54.107 taka is the estimated price of ABC’s stock .
The dividend yield in Year 1 is 4.80%, and the capital gains yield is 8.2%:
Dividend yield = 2.60 / 54.107 = 4.8%
Capital gains yield = 13.00% – 4.8% = 8.2%.

During the non-constant growth period, the dividend yields and capital gains yields are not
constant, and the capital gains yield does not equal g. However, after Year 3, the stock becomes
a constant growth stock, with g = capital gains yield = 6.0% and dividend yield = 13.0% – 6.0%
= 7.0%.

F. Suppose ABC is expected to experience zero growth during the first 3 years and then resume
its steady-state growth of 6% in the fourth year. What would be its value then? What would be
its expected dividend and capital gains yields in Year 1 and in Year 4?

Answer: Now we have this situation:

0 1 2 3 4
re =13%

g = 0% g = 0% g = 6%
D0 = 2.00 g =0% 2.00/(1+.13) 2.00/(1+.13)2 2.00/(1+.13)3 2.12

= 1.77

= 1.57

= 1.39
2.12
= 20.99 30.29/(1+.13)3 P 0=
^ =30.29 taka
( 0.13−0.60 )

= 25.72 taka is the estimated price of ABC stock.

During Year 1:

2
Dividend Yield=
25.72
¿ 7.78 %

Capital gains yield = 13.00% – 7.78% = 5.22%.

Again, in Year 4 ABC becomes a constant growth stock; hence g = capital gains yield = 6.0%
and dividend yield = 7.0%.
G. Finally, assume that ABC’s earnings and dividends are expected to decline at a constant rate
of 6% per year, that is, g = -6%. Why would anyone be willing to buy such a stock, and at what
price should it sell? What would be its dividend and capital gains yields in each year?

Answer: The Company is earning something and paying some dividends, so it clearly has a
value greater than zero. That value can be found with the constant growth formula, but where g
is negative:

^ D1 D 0(1+ g) 2[1+ (−0.06 )]

P 0=
^ ❑= =
( ℜ−g ) ( ℜ−g ) [0.13−(−.06 ) ]

= 9.89 taka.
Since it is a constant growth stock:
g = Capital gains yield = -6.0%,
Hence:
Dividend yield = 13.0% – (-6.0%) = 19.0%.
As a check:
Dividend yield = 1.88
9.89
= 0.190 = 19.0%.

The dividend and capital gains yields are constant over time, but a high (19.0%) dividend yield is
needed to offset the negative capital gains yield.

H. Suppose Mr. Choudhury embarked on an aggressive expansion that requires additional

capital. Management decided to finance the expansion by borrowing Tk. 40 million and by
halting dividend payments to increase retained earnings. Its WACC is now 10%, and the
projected free cash flows for the next 3 years are –Tk. 5 million, Tk. 10 million, and Tk. 20
million. After Year 3, free cash flow is projected to grow at a constant 6%. What is ABC’s total
value? If it has 10 million shares of stock and Tk. 40 million of debt and preferred stock
combined, what is the price per common share?

Answer:

0 1 2 3 4
WACC =13%

g = 6%
- 5.00/(1+.10) 10.00/(1+.10)2 20.00/(1+.10)3 21.20

= -4.545

= 8.264

= 15.026
 21.20
= 398.197 530/(1+.10)3 P 0=
^ =530 million taka
( 0.10−0.60 )
416.942 = Total value

Value of equity = Total value – Debt

= Tk. 416.94 million – Tk. 40 million = Tk. 376.94 million.
Price per share = 376.94/10 = 37.69 taka per share.

I. Suppose Mr. Choudhury decided to issue preferred stock that would pay an annual dividend of
5 taka and that the issue price was 50 taka per share. What would be the stock’s expected return?

Answer:
Dp
r^p =
Vp

= 5/ 50 = 10%
.
State whether each of the following statements is True (T) or False (F).

1. Intrinsic value and market price of equity shares are always equal
2. In Dividend Discount Model, the valuation of equity shares is based on expected stream of
dividends.
3. No-growth dividend model does not involve present value concept.
4. Gordon's Model and Constant Growth Model are one and same.
5. In Constant Growth model, the value of equity share ii sensitive to growth rate.
6. In Constant Growth model, the value of equity share not sensitive to required rate of return.
7. The constant growth formula for stock valuation does not work for firms with negative growth
(declining) rates in dividends.
8. For companies which are not expected to pay dividends equity shares cannot be valued.
9. CAPM helps in determining required rate of return.
10. The dividend discount model should not be used to value stocks in which the dividend does
not grow. 
11. Sustainable growth rates can be estimated by multiplying a firm's ROE by its dividend
payout ratio. 
12. If the market is efficient, stock prices should only be expected to react to new information
that is released. 
13. According to the dividend discount model, a stock's price today depends on the investor's
horizon for holding the stock. 
14. If security prices follow a random walk, then on any particular day, the odds are that an
increase or decrease in price is equally likely. 
15. Market price is not the same as book value or liquidation value. 
16. The dividend yield of a stock is much like the current yield of a bond. Both ignore
prospective capital gains or losses. 
17. Investors known as fundamental analysts try to achieve superior returns by spotting and
exploiting patterns in stock prices. 

MULTIPLE CHOICE QUESTIONS:

1. The value of a common stock today depends on:

A) Number of shares outstanding and the number of shareholders
B) The Wall Street analysts
C) The expected future dividends and the discount rate
D) Present value of the future earnings per share
2. BD.net Company's stock is selling for ৳100 per share today. It is expected that this stock
will pay a dividend of ৳5 per share, and then be sold for ৳120 per share at the end of one
year.
A) 25% B) 20% C) 15% D) 18%
3. Agni Company stockholders expect to receive a year-end dividend of ৳10 per share and then
be sold for ৳122 per share. If the required rate of return for the stock is 20%, what is the
current value of the stock?
A) ৳100 B) ৳110 C) ৳122 D) ৳132
4. Bata Company expects to pay a dividend of ৳6 per share at the end of year one, ৳8 per share
at the end of year two and then be sold for ৳136 per share. If the required rate on the stock is
20%, what is the current value of the stock?
A) ৳100 B) ৳110 C) ৳105 D) ৳115
5. The constant dividend growth formula P0 = D1/(r-g) assumes:
A) The dividends are growing at a constant rate g forever.
B) r > g
C) g is never negative.
D) Both A and B
6. ABC Co. is expected to pay a dividend of ৳6 per share at the end of year one and these dividends are
expected to grow at a constant rate of 8% per year forever. If the required rate of return on the stock
is 20%, what is current value of the stock today?
A) ৳50 B) ৳60 C) ৳55 D) ৳45

7. The required rate of return is estimated as follows:

A) Dividend yield + expected rate of growth in dividends
 B) Dividend yield - expected rate of growth in dividends
C) Dividend yield / expected rate of growth in dividends
D) (Dividend yield) * (expected rate of growth in dividends)
8. ABC Co. is expected to pay a dividend of ৳4 per share at the end of year one and the dividends are
expected to grow at a constant rate of 4% forever. If the current price of the stock is ৳25 per share
calculated the required rate of return or the market capitalization rate for the firms' stock.
A) 5% B) 10% C) 15% D) 20%
9. If a stock's P/E ratio is 13.5 at a time when earnings are ৳3 per year, what is the stock's
current price? 
A) ৳40.50 B) ৳ 10.5 C) ৳20.5 D)
৳30.5
10. How much should you pay for a share of stock that offers a constant growth rate of 10%,
requires a 16% rate of return, and is expected to sell for ৳50 one year from now? 
A) ৳40.50 B) ৳ 10.5 C) ৳20.5 D) ৳30.5
11. A stock paying ৳5 in annual dividends sells now for ৳80 and has an expected return of 14%.
What might investors expect to pay for the stock one year from now?
A) ৳86.20 B) ৳ 80.5 C) ৳120.5 D)
৳90.5
12. Dividend growth rate for a stable firm can be estimated as:
A) Plow back rate * the return on equity (ROE)
B) Plow back rate / the return on equity (ROE)
C) Plow back rate + the return on equity (ROE)
D) Plow back rate - the return on equity (ROE)
13. XYZ Co. pays out 60% of its earnings as dividends. Its return on equity is 20%. What is the stable
dividend growth rate for the firm?
A) 5% B) 8% C) 10% D) 15%
14. If Aftab Automobiles Company is currently paying a dividend of ৳1.50 per year. The dividends
are expected to grow at a rate of 20% for the next three years and then a constant rate of 6 %
thereafter. What is the expected dividend per share in year 5?
A) ৳ 2.91 B) ৳2.51 C) ৳2.21 D) ৳1.96
15. Great Lakes Co. is currently paying a dividend of ৳2.20 per share. The dividends are expected to
grow at 25% per year for the next four years and then grow 5% per year thereafter. Calculate the
expected dividend in year 6.
A) ৳5.37 B) ৳4.78 C) ৳3.98 D) ৳6.58
16. ABC Co. is expected to pay a ৳2.50 annual dividend next year. The market rate of return on
this security is 12 percent and the market price is ৳31.40 a share. What is the expected
growth rate of ABC?
A) 3.74% B) 3.89% c) 4.04% D) 4.12%
17. The common stock of the Paper Co. is selling for ৳41.40 a share and offers an 8.2 percent
rate of return. The dividend growth rate is constant at 4 percent. What is the expected amount
of the next dividend?
A)৳ 1.74 B) ৳2.51 C) ৳2.21 D) ৳1.56
18. The growth rate in dividends can be thought of as a sum of two parts. They are:
A) ROE and the Retention Ratio.
B) Dividend yield and growth rate in dividends
C) ROA and ROE
 D) Book value per share and EPS
19. The value of the stock:
A) Increases as the dividend growth rate increases
B) Increases as the required rate of return decreases
C) Increases as the required rate of return increases
D) Both A and B
20. ABC Company has a P/E ratio of 10 and a stock price of ৳50 per share. Calculate earnings per share
of the company.
A) ৳5 B) ৳10 C) ৳6 D) ৳12
21. Companies with higher expected growth opportunities usually sell for:
A) Lower P/E ratio
B) Higher P/E ratio
C) A price that is independent of P/E ratio
D) A price that the dependent upon the payment ratio
22. Suppose Bata has just issued a dividend of ৳3.25 per share. Subsequent dividends will
remain at ৳3.25 indefinitely. Returns on the stock of firms like Bata are currently running
10%. What is the value of one share of stock?
A) ৳32.50 B) ৳10.56 C) ৳42.50 D) ৳13.25
23. You would like to earn a 10 percent rate of return on an 8.5 percent preferred stock. How
much are you willing to pay for 100 shares?
A) ৳ 85,000 B) ৳45,000 C) ৳42,500 D) ৳150,000

SHORT QUESTIONS:

1. What are the pros and con of common stock ownership?

2. What is the difference between a primary market and a secondary market?
3. When you buy a stock in the secondary market, does the firm that issued the stock receive
cash?
4. Why does a firm issue IPO?
5. Explain the valuation formula for a constant growth stock.
6. What conditions must hold if a stock is to be evaluated using the constant growth model?
7. Explain how one would find the value of a supernormal growth stock?
8. Using a dividend forecast of ৳2.15, a required return of 9 percent, and a growth rate of 38%,
we obtained a price for EBL of ৳41.35. What would happen to this price if the market’s
required return on EBL increased?
9. What is market value and book value of a company?
10. What are the four elements that act as a function to value an asset?
11. What are the many ways one investor can estimate the dividend growth rate?
12. Why is it appropriate to use the perpetuity formula to estimate the value of preferred stock?
13. When a shareholder sells shares of common stock, what is being sold? What gives a share of
common stock value?
14. When can a firm experience a super normal growth?
15. What is the efficient market hypothesis?
16. What are the implications of the efficient market hypothesis for financial decisions?

BROAD QUESTIONS:

1. What are some of the important features of common Stock?

2. To what extent investing in the stock market could be argued as ‘Gambling’?
3. What are some of the major assumptions and implications of Gordon growth model?
4. Tallu Spin just paid a dividend of ৳1.75 per share and the dividends are expected to grow at
a constant rate of 6% per year, indefinitely. If investors require 18% return on Tallu, what is
the current price? What will be the price in five years?
5. The next dividend payment by GP will be ৳12.50 per share. The dividends are anticipated to
maintain a 5% growth rate, forever. If GP stock currently sells for ৳160 taka per share, what
is the required return on GP? Can you calculate the dividend yield of GP? What is the
expected capital gains yield?
6. Square Pharmaceuticals is expected to pay the following dividends over the next four years:
৳12.50, ৳11.50, ৳9.00, and ৳7.50. Afterwards, the company pledges to maintain a constant
5% growth rate in dividends, forever. If the required return on the stock is 18%, what is the
current share price of Square?
7. If a preferred stock has a face value of ৳1000 and 8% dividend per year indefinitely when
the required return from the preferred stock is 12%, what should be the price of this preferred
stock today?
8. A stock paying ৳5 in annual dividends sells now for ৳80 and has an expected return of 14%.
What might an investor expects to pay for this stock one year from now?
9. What are the three forms of market efficiency? Explain.
10. What is technical and fundamental analysis of stock valuation? Explain.
11. What are some of the major characteristics of dividend? What is dividend yield?
12. Describe, compare, and contrast the following common stock dividend valuation models:
a) Zero-growth b) constant-growth c) variable-growth.
13. Explain each of the three other approaches to common stock valuation:
a) Book value, b) liquidation value, c) price/earnings multiples. Which of those is
considered the best?