06 Computing the Price of

Common Stock
Mark Antony A. Rosales, CPA
Department of Accountancy, CEBA
 Computing the price of a common stock
• Basic principle: “The value of any investment is found by computing
the value today of all cash flows the investment will generate over
its life.”

Computing the Price of Common Stock

 Valuation models
1. The One-Period Valuation Model

2. The Generalized Dividend Valuation Model

3. The Gordon Growth Model

4. Price Earnings Valuation Model

Computing the Price of Common Stock

 The One-Period Valuation
Model

Computing the Price of Common Stock

 The One-Period Valuation Model
• This model assumes the simplest possible scenario: you buy the
stock, hold it for one period to get a dividend, then sell the stock.

Computing the Price of Common Stock

 The One-Period Valuation Model
• Suppose that after watching Wall Street Week on TV you decide
that you want to buy Intel Corp. stock. You call your broker and find
that Intel stocks are currently selling at $50 per share and pays
dividends of $0.16 per year. The analyst on Wall Street Week
predicts that the stock will be selling for $60 in one year. Should you
buy this stock?

Computing the Price of Common Stock

 The One-Period Valuation Model

Computing the Price of Common Stock

 The One-Period Valuation Model
• Suppose that after watching Wall Street Week on TV you decide that you want to buy Intel
Corp. stock. You call your broker and find that Intel stocks are currently selling at $50 per share
and pays dividends of $0.16 per year. The analyst on Wall Street Week predicts that the stock
will be selling for $60 in one year. Should you buy this stock?

Computing the Price of Common Stock

 The Generalized Dividend
Valuation Model

Computing the Price of Common Stock

 The Generalized Dividend Valuation Model
• The generalized dividend valuation model is simply an extension of
the one-period valuation model.

• This model also says that the value of a stock is the present value of
all future cash flows (i.e., present value of the dividends and the
final sales price when the stock is sold).

Computing the Price of Common Stock

 The Generalized Dividend Valuation Model

• Under this formula, you must first estimate the value that the stock
will have at some point in the future.

• However, if Pn is far in the future, it will not affect P0. Why?

Computing the Price of Common Stock

 The Generalized Dividend Valuation Model
• Hence, we can rewrite the previous formula as follows:

• The generalized dividend valuation model states that the current

value of a stock can be found as simply the present value of the
future dividend stream.

Computing the Price of Common Stock

 The Generalized Dividend Valuation Model
• The generalized dividend valuation model states that the current
value of a stock can be found as simply the present value of the
future dividend stream.

• However, many stocks do not pay dividends, so how is it that these

stocks have value?

Computing the Price of Common Stock

 The Gordon Growth Model

Computing the Price of Common Stock

 The Gordon Growth Model
• The generalized dividend valuation model requires that we compute
the present value of an infinite stream of dividends, a process that
could be difficult, to say the least.

• Many firms strive to increase their dividends at a constant rate each

year.

Computing the Price of Common Stock

 The Gordon Growth Model

Computing the Price of Common Stock

 The Gordon Growth Model

A few assumptions:
1. Dividends are assumed to continue growing at a constant
rate forever.

2. The growth rate is assumed to be less than the required

return on equity, ke.

Computing the Price of Common Stock

 The Gordon Growth model
Example:
Find the current market price of Coca-cola stock, assuming
dividends grow at a constant rate of 10.95%, D0 = $1.00, and the
required rate of return is 13%.

Computing the Price of Common Stock

 Price Earnings Valuation
Method

Computing the Price of Common Stock

 Price Earnings Valuation Method
• The price earnings ratio (PE) is a widely watched measure of how
much the market is willing to pay for $1 of earnings from a firm.

Computing the Price of Common Stock

 Price Earnings Valuation Method
Example:
The average industry PE ratio for restaurants similar to
Applebee’s, a pub restaurant chain, is 23. What is the current
price of Applebee’s stock if the earnings per share are projected
at $1.13?

Computing the Price of Common Stock

 Additional examples

Computing the Price of Common Stock

 Problem No. 1
What is the present value of a stock, if the price for now is $40? Use a
discount rate of 10% and period of 45 years. Please refer to the
generalized dividend valuation model.

Computing the Price of Common Stock

 Problem No. 2
Langsuka Holdings expects to pay an annual dividend of $1.50 per
share and stock analysts expect the dividend to grow by %7
indefinitely. If Langsuka Holding’s current share price is $25, what
would be the required rate of return?

Computing the Price of Common Stock

 Problem No. 3
Auckland Company's last dividend was $1.55. The dividend growth
rate is expected to be constant at 1.5% for 2 years, after which
dividends are expected to grow at a rate of 8.0% forever. The firm's
required return (ke) is 12.0%. What is the best estimate of the current
stock price?

Computing the Price of Common Stock

 Problem No. 3
ABC Corporation just paid a dividend of D0 = $0.75 per share, and that
dividend is expected to grow at a constant rate of 6.50% per year in the
future. The company's beta is 1.25, the required return on the market
is 10.50%, and the risk-free rate is 4.50%. What is the company's
current stock price?

Computing the Price of Common Stock