Financial Management

Unit 6: Valuation of Stocks

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 Learning Objectives
1. Identify some of the important rights of stock
ownership eg voting rights & proxy
2. Calculate the value and expected return of a
share of preferred stock
3. Determine the value of a share using the
appropriate stock valuation model
4. Calculate the expected rate of return on a
constant growth stock.
5. Explain the principle of stock market
equilibrium.
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 Agenda
n Ordinary Stocks
n Preference Stocks
n Valuation of Stocks
n Zero Growth Stocks

n Constant Growth (Gordon Growth Model)

n Super Normal Growth/Non-Constant

Growth

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 Ordinary (Common) Stock
n Represents ownership
n Includes voting rights
n Variable-income security
n Lowest priority for repayment on winding
up of the company (greatest risk)
n No pre-set dividend rate – no requirement
to pay dividends.
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 Preferred Stock or Share
n Limited or no voting rights
n Set dividend rate
n Claims for repayment are junior to debt
and bondholders but senior to common
stock holders
n Like an ordinary share – no fixed
maturity
n Like a bond – fixed dividend payments
n Features – redeemable, cumulative,
voting, convertible 5
 Valuation of Stocks
Expected future cash flows come in the form of
n Dividends – dividend yield

n Selling price of stock at the end of the holding

period – Capital gains yield

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 Stock Valuation
n Value of stock dependent on dividend
payments
n Valuation model reflects dividend pattern
n Zero growth – e.g. Preferred stock
n Normal or Constant growth
n Super normal or non-constant growth

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 Zero Growth Stock
n The same level of dividend will be paid
indefinitely – e.g. preferred stock dividends
n This is like a Level Perpetuity

𝑨𝒏𝒏𝒖𝒂𝒍 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅
n 𝑽𝒂𝒍𝒖𝒆 𝑽𝒑 =
𝑹𝒆𝒒𝒖𝒊𝒓𝒆𝒅 𝑹𝒂𝒕𝒆 𝒐𝒇 𝑹𝒆𝒕𝒖𝒓𝒏

𝑃! = 𝐷 𝐷
=
𝑘 " 𝑃!
𝑘"
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 Problem 1a: Zero Growth Stock
What is the fair price of a share of $100 par value
preferred stock that pays a $8 annual dividend for
an investor who requires a yield of 10%?

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 Problem 1b: Zero Growth Stock
What is the fair price of a share of $70 par value
preferred stock that pays dividends at a rate of
6.5%? The investor requires a yield of 10.35%.

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Normal/Constant Growth Model
n This stock is one whose dividends are
expected to grow forever at a constant rate.
n Assumption – if the company is retaining a
portion of its earnings for reinvestment,
future profits and dividends should grow.

If the stock’s dividend is expected to grow at

a constant rate of say 5% per year, the stock’s
price is also expected to grow at that rate.
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 Constant Growth Model
n Assumes ordinary dividends will
grow at a constant rate into the future

𝐷"
𝑃! =
𝑘# − 𝑔

n D1 = the dividend at the end of period 1 (future).

n ks = the required return on the ordinary shares.
n g = the constant, annual dividend growth rate.
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Copyright 2000 Prentice Hall
 Important Features of the
Constant Growth Model
n The growth rate in dividends (g) must be
less than the required rate of return (r)
n The growth rate in dividends is also the
capital gains yield on the stock.
n The total return from the stock is made up
of:
n dividend yield (D1 / P0) and

n capital gains yield (g)

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 Dividend Growth Model
𝐷! = 𝐷" (1 + 𝑔)! 𝑜𝑟 𝐷!#$ = 𝐷! (1 + 𝑔)

D0 = Most recent dividend (past)

D1 = Dividend at the end of year 1 (future)
Dt = Dividend at the end of year t
Dt + 1 = Dividend at the end of year t + 1
g = Dividend growth rate

𝐷% = 𝐷" (1 + 𝑔)% 𝑜𝑟 𝐷$ = 𝐷" (1 + 𝑔)

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 Dividend Growth Model
𝑌1 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝐷$ 𝐷" (1 + 𝑔)
𝑃*" = = =
𝑘−𝑔 𝑘−𝑔 𝑘−𝑔

𝐷!#$
𝑃*! = 𝑘 − 𝑔!#$ 𝐷$
𝑘* = +𝑔
𝑃"
Dividend Yield
𝐸𝑔. 𝑃*& = 𝐷% + Capital Gains Yield

𝑘 − 𝑔%
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 Problem 2: Constant growth share
A company last paid a dividend of $0.90. It is
expected that dividends will grow at 25% per
annum for the foreseeable future and the investors
are requiring 30% per annum for stocks in this risk
class. What is the fair price of the stock?

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 Problem 3: Constant growth share
A company is expected to pay a dividend of $1.20
next year. It is expected that dividends will grow at
8% per annum for the foreseeable future and the
investors are requiring 32% per annum for stocks in
this risk class. What is the fair price of the stock?

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 Problem 4: Constant growth share
A company last paid a dividend of $1.35. It is
expected to grow at 25% indefinitely and has a price
of $11.25. What is the expected rate of return on the
stock?

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 Super Normal/Non-Constant
Growth
n This occurs when the company has a
competitive advantage over its rivals and does
not usually last indefinitely.
n E.g. the company has just put out a new
product using new technology that has not yet
been duplicated.
n After a while the company will settle down to
more stable growth.
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Steps to Valuing Stocks with
Supernormal Growth

Calculate the value of all

future dividends during the
supernormal growth
period.

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Steps to Valuing Stocks with
Supernormal Growth

Find the terminal value

(price of the stock at the
end of the last year of
supernormal growth)

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Steps to Valuing Stocks with
Supernormal Growth

Find the total present

value of:
• The dividends during
the supernormal
growth period, and
• the terminal value

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 Problem 5: Supernormal Growth
What is the intrinsic value of a stock which last paid a
dividend of $1.75 and is expected to grow at 22% over the
next 2 years after which it will settle down at a stable rate
of 8% per annum? The investor’s required rate of return is
15%. What is the expected price at the end of year 1 (P1)?

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 Problem 6: Supernormal Growth
What is the intrinsic value of a stock which is expected to
pay a dividend of $2.75 next year, after which dividends
should grow at 25% for 2 years then settle down at a stable
rate of 5% per annum? The investor’s required rate of return
is 22%. What is the expected price at the end of year 2 (P2)?

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