Chapter 8

Stock Valuation

8-1
Differences Between Debt and Equity
• Debt includes all borrowing incurred by a firm,
including bonds, and is repaid according to a fixed
schedule of payments.
• Equity consists of funds provided by the firm’s
owners (investors or stockholders) that are repaid
subject to the firm’s performance.
– A firm can obtain equity either internally, by retaining
earnings rather than paying them out as dividends to its
stockholders, or externally, by selling common or
preferred stock.

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Table 7.1 Key Differences between Debt
and Equity

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Differences Between Debt and Equity:
Voice in Management
• Unlike creditors, holders of equity (stockholders)
are owners of the firm.
• Stockholders generally have voting rights that
permit them to select the firm’s directors and vote
on special issues.
• In contrast, debtholders do not receive voting
privileges but instead rely on the firm’s contractual
obligations to them to be their voice.

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Differences Between Debt and Equity:
Claims on Income and Assets
• Equityholders’ claims on income and assets are
secondary to the claims of creditors.
– Their claims on income cannot be paid until the claims of
all creditors, including both interest and scheduled principal
payments, have been satisfied.
• Because equity holders are the last to receive
distributions, they expect greater returns to
compensate them for the additional risk they bear.

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Differences Between Debt and Equity:
Maturity

• Unlike debt, equity capital is a permanent

form of financing.
• Equity has no maturity date and never has
to be repaid by the firm.

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Differences Between Debt and Equity: Tax
Treatment
• Interest payments to debtholders are treated as
tax-deductible expenses by the issuing firm.
• Dividend payments to a firm’s stockholders are not
tax-deductible.
• The tax deductibility of interest lowers the
corporation’s cost of debt financing, further causing
it to be lower than the cost of equity financing.

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Common and Preferred Stock:
Common Stock
• Common stockholders, who are sometimes referred
to as residual owners or residual claimants, are the
true owners of the firm.
• As residual owners, common stockholders receive
what is left—the residual—after all other claims on
the firms income and assets have been satisfied.
• They are assured of only one thing: that they
cannot lose any more than they have invested in
the firm.
• Because of this uncertain position, common
stockholders expect to be compensated with
adequate dividends and ultimately, capital gains.

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Common Stock: Par Value

• The par value of common stock is an arbitrary

value established for legal purposes in the firm’s
corporate charter, and can be used to find the total
number of shares outstanding by dividing it into the
book value of common stock.
• When a firm sells news shares of common stock,
the par value of the shares sold is recorded in the
capital section of the balance sheet as part of
common stock.
• At any time the total number of shares of common
stock outstanding can be found by dividing the
book value of common stock by the par value.

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Common Stock: Preemptive Rights

• A preemptive right allows common stockholders

to maintain their proportionate ownership in the
corporation when new shares are issued, thus
protecting them from dilution of their ownership.
– For example, a shareholder has 1,000 shares in a
company, which currently has 5,000 shares outstanding
(20% ownership of the business).
– The company wants to sell another 5,000 shares in order
to raise funds. If the shareholder wants to maintain the
same proportional ownership of the business, it must buy
1,000 of these additional shares.

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Common Stock: Dividends

• The payment of dividends to the firm’s shareholders

is at the discretion of the company’s board of
directors.
• Dividends may be paid in cash, stock, or
merchandise.
• Before dividends are paid to common stockholders
any past due dividends owed to preferred
stockholders must be paid.

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Preferred Stock
• Preferred stock gives its holders certain privileges
that make them senior to common stockholders.
• Preferred stockholders are promised a fixed periodic
dividend, which is stated either as a percentage or
as a dollar amount.
• Par-value preferred stock is preferred stock with
a stated face value that is used with the specified
dividend percentage to determine the annual dollar
dividend.
• No-par preferred stock is preferred stock with no
stated face value but with a stated annual dollar
dividend.

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Preferred Stock: Basic Rights of Preferred
Stockholders
• Preferred stock is often considered quasi-debt
because, much like interest on debt, it specifies a
fixed periodic payment (dividend).
• Preferred stock is unlike debt in that it has no
maturity date.
• Because they have a fixed claim on the firm’s
income that takes precedence over the claim of
common stockholders, preferred stockholders are
exposed to less risk.

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Preferred Stock:
Features of Preferred Stock
• Cumulative preferred stock is preferred stock for
which all passed (unpaid) dividends in arrears,
along with the current dividend, must be paid
before dividends can be paid to common
stockholders.
• Noncumulative preferred stock is preferred stock
for which passed (unpaid) dividends do not
accumulate.

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Types of stock market
transactions
◼ Secondary market
◼ Primary market
◼ Initial public offering market
(“going public”)

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Secondary market :
• The market for outstanding shares, or used shares,
is the secondary market.
• The company receives no new money when sales
occur in this market.

Primary market :
• The market in which newly issued securities are
sold for the first time.

Initial public offering market:

whenever stock in a closely held corporation is offered
to the public for the first time, the company is said to
be going public.
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Common Stock Valuation
• The value of a common stock is equal to the
present value of the expected cash flows from that
stock.

• The expected cash flows consist of two elements:

1. The dividends expected in each year and,
2. The price investors expect to receive when they sell the
stock.

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Different approaches for valuing
common stock
◼ Dividend growth model
◼ Corporate value model
◼ Using the multiples of comparable
firms

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Basic Common Stock Valuation Equation

The value of a share of common stock is equal to the

present value of all future cash flows (dividends) that
it is expected to provide.

where
P0 = value of common stock
Dt = per-share dividend expected at the
end of year t
Rs = required return on common stock

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This formula, with modifications, is generally
applied to three different circumstances:

1. Constant growth in dividends : g is constant

overtime) .
2. No growth in dividends : g=0
3. Variable growth in dividends (supernormal growth
rate) : g is not constant

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Case 1: Constant growth stock
• A stock whose dividends are expected to
grow forever at a constant rate, g.

D1 = D0 (1+g)1
D2 = D0 (1+g)2
Dt = D0 (1+g)t

– D0: the most recent dividend, which has already been paid.
– D1: the expected dividend in year 1
– D2: the expected dividend in year 2
– Dt : the expected dividend in year t.

0 1 2 3
D1 = D0 (1+g) D2 = D1 (1+g) D3 = D2 (1+g)
D0 D2 = D0 (1+g)2 D3 = D0 (1+g)3

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Example
if X Company just paid a dividend of $1.15 and if
investors expect 8% growth rate then:

• D1 = 1.15 (1.08) = $1.24

• D2 = 1.15(1.08)2 = $1.34 or 1.24(1.08) = $1.34
• D3 = 1.15(1.08)3 = $1.45 or 1.34(1.08) = $1.45

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Case 1 Formula: Constant growth stock

• If g is constant, the dividend growth formula for

finding the value converges to:
^ D 0 (1 + g) D1
P0 = =
ks - g ks - g

• D0: the last dividend that has already been paid .

• D1 : the expected dividend in year 1 .
• g : annual growth rate in the company’s earnings and
dividends.
• Ks : required rate of return on the stock .
• Po : actual market price of the stock today .

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What happens if g > ks?

• If g > ks, the constant growth formula leads to a

negative stock price, which does not make sense.
• The constant growth model can only be used if:
– ks > g
– g is expected to be constant forever

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Example:
•Suppose that IBM has just distributed $2 dividend
per share, the company’s dividend is expected to
grow at 8% annually forever, the investor requires
18% rate of return . What is the price of IBM
stock?

Solution
•D1 = D0 (1+g)
= 2 (1+0.08) = $2.16

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Example
If D0= $2 , g is constant =6% and, KRF= 7% ,
Km=12% and β = 1.2.

1. What is the required rate of return on the firm’s

stock?
2. Find the expected dividends for the next 3 years
and their PVs.
3. What is the current market value ?
4. What is the expected market price of the stock,
one year from now?
5. What is the expected dividend yield, capital gains
yield, and total return during the first year?

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1. Use the SML to calculate the required rate of
return (ks):

ks = kRF + (kM – kRF)β

= 7% + (12% - 7%)1.2
= 13%

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 2. The expected dividend stream for
the next 3 years, and their PVs.

0 1 2 3
g = 6%

D0 = 2.00 2.12 2.247 2.382

1.8761
ks = 13%
1.7599
1.6509

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3. Current stock market price

◼ Using the constant growth model:

D1 $2.12
P0 = =
k s - g 0.13 - 0.06
$2.12
=
0.07
= $30.29

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4.What is the expected market price of
the stock, one year from now?

◼ D1 will have been paid out already. So,

P1 is the present value (as of year 1) of
D2, D3, D4, etc.
^
D2 $2.247
P1 = =
k s - g 0.13 - 0.06
= $32.10

◼ Could also find expected P1 as:

^
P1 = P0 (1.06) = $32.10
8-30
 Finding the dividend Yield, Capital
gain yield and Total return (Ks)

◼ Total return = Dividend yield + Capital gain yield

◼ Ks = D1/P0 + g

Dividend Yield = D1/P0

Capital Gain Yield = (P1 – P0) / P0
=g

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What is the expected dividend yield, capital
gains yield, and total return during the first
year?

◼ Dividend yield
= D1 / P0 = $2.12 / $30.29 = 7.0%
◼ Capital gains yield
= (P1 – P0) / P0
= ($32.10 - $30.29) / $30.29 = 6.0%
◼ Total return (ks)
= Dividend Yield + Capital Gains Yield
= 7.0% + 6.0% = 13.0%

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 9 - 33

Rearrange model to rate of return form:

D D
$
P0 = 1 $
to k s = 1
+ g.
ks - g P0

^
Then, ks = $2.12/$30.29 + 0.06
= 0.07 + 0.06 = 13%.

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Case 2: Zero growth rate

• Zero growth stock is a common stock whose future

dividends are not expected to grow at all , that is,
g=0
• The dividend stream would be perpetuity.
• In this case D1=D2=D3 and so on.

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What would the expected price
today be, if g = 0?
◼ The dividend stream would be a
perpetuity.

0 1 2 3
ks = 13%
...
2.00 2.00 2.00
^ PMT $2.00
P0 = = = $15.38
k 0.13

8-35