VALUING STOCKS

By Le Dang Thuy Trang, MSc.

TOPICS COVERED
 Stocks & Stock market
 Cash flows to stockholders
 Stock valuation: Dividend Discount Model
(DDM)
◦ Zero growth common stocks
◦ Constant growth common stocks
◦ Differential (non – constant) growth common
stocks
 Growth stocks and Income stocks
 Equity vs. debt
FACTS ABOUT COMMON
STOCK
 Common stockholders are the owners of
the firm.
 They elect the firm’s board of directors,
who in turn appoint the firm’s top
management team.
 Claim on Assets
◦ In case of liquidation, common stockholders
have residual claim on assets.
◦ However, bankrupt firms rarely have enough
assets to satisfy the claims of bondholders.
STOCK MARKET
 Primary market
◦ Market for the sale of new securities by
corporations. The corporation receives
money from sale of its securities only in the
primary market.
 Secondary Market
◦ Market in which already issued securities are
traded by investors.
 PRIMARY vs. SECONDARY
MARKETS: EXAMPLE

Shannon sells 100 shares of Google stock from her

portfolio for $500 per share to help pay for her
son Domenic’s college education.

How much does Google receive from the sale of its shares?

Does this transaction occur on the primary or secondary

market?
 VALUATION FUNDAMENTALS

Future Cash Flows Risk

Valuation 7
 THE BASIC VALUATION MODEL

 P0 = Price of asset at time 0 (today)

 CFt = cash flow expected at time t
 r = discount rate (reflecting asset’s risk)
 n = number of discounting periods (usually years)

This model can express the price of any asset at t = 0

mathematically.
8
CASH FLOWS TO STOCKHOLDERS
 If you buy a share of stock, you can
receive cash in two ways
◦ The company pays dividends (dividend yield)
◦ You sell your shares, either to another
investor in the market or back to the
company (capital gain)
 As with bonds, the price of the stock is
the present value of these expected cash
flows.
DIVIDEND CHARACTERISTICS
 Dividends are not a liability of the firm until a
dividend has been declared by the Board
 Consequently, a firm cannot go bankrupt for
not declaring dividends
 Dividends and Taxes
◦ Dividend payments are not considered a business
expense; therefore, they are not tax deductible.
THE EQUITY COST OF CAPITAL
 Equity cost of capital (rE):
◦ The expected rate of return that investors
could earn in the market on other
investments with equivalent risks to the firm’s
shares
◦ Used as a discount rate for equity cash flows
D1  P1  P0 D1  P1 D1 P1  P0
rE   1  
P0 P0 P0 P0

D1  P1
P0  Dividend Capital
1  rE yield gain yield
HOW TO MAKE MONEY IN THE
STOCK MARKET
1. The standard answer – “Buy Low, Sell
High” (i.e. Earn capital gains.)
2. From dividends – Over the long run,
historically speaking almost ½ of the
total return to stock market investors
was from dividends.
THE DIVIDEND DISCOUNT
MODEL
 A one-period investor:
◦ Potential Cash Flows
 Dividend
 Sale of Stock
◦ Timeline for One-Year Investor

◦ Since the cash flows are risky, we must

discount them at the equity cost of capital.
THE DIVIDEND DISCOUNT
MODEL (CONT’D)
 A one-period investor
D1  P1
P0 
1  rE
◦ If the current stock price were less than this
amount, expect investors to rush in and buy it,
driving up the stock’s price.
◦ If the stock price exceeded this amount, selling
it would cause the stock price to quickly fall.
THE DIVIDEND DISCOUNT
MODEL (CONT’D)
 One-period example:
◦ Suppose you are thinking of purchasing the
stock of Blue Skies company.You expect it to
pay a $3 dividend in one year, and you believe
that you can sell the stock for $81 at that
time. If you require a return of 12% on
investments of this risk, what is the maximum
you would be willing to pay?
 Price = (3 + 81) / (1.12) = $75
THE DIVIDEND DISCOUNT
MODEL (CONT’D)
 A two-period investor:
◦ What is the price if we plan on holding the
stock for two years?

D1 D2  P2
P0  
1  rE (1  rE ) 2
THE DIVIDEND DISCOUNT
MODEL (CONT’D)
 Two-period example:
◦ Now, what if you decide to hold the stock for
two years? In addition to the dividend in one
year, you expect a dividend of $3.24 in two
years and a stock price of $87.48 at the end
of year 2. Now how much would you be
willing to pay?
◦ PV = 3 / (1.12) + (3.24 + 87.48) / (1.12)2 =
$75
THE DIVIDEND DISCOUNT
MODEL (CONT’D)
 A three-period investor:
◦ What is the price if we plan on holding the
stock for three years?

D1 D2 D3  P3
P0   
1  rE (1  rE ) (1  rE ) 3
2
THE DIVIDEND DISCOUNT
MODEL (CONT’D)
 Three-period example:
◦ What if you decide to hold the stock for three years?
In addition to the dividends at the end of years 1 and
2, you expect to receive a dividend of $3.5 at the end
of year 3 and the stock price is expected to be
$94.48. Now how much would you be willing to pay?
◦ PV = 3 / 1.12 + 3.24 / (1.12)2 + (3.5 + 94.48) /
(1.12)3 = $75
THE DIVIDEND DISCOUNT MODEL
(CONT’D)
 But how is P1 determined?
◦ This is the PV of expected stock price P2, plus dividend at
time 2.
◦ P2 is the PV of P3 plus dividend at time 3, etc.

D1 D2 Dt  Pt
P0    ... 
1  rE (1  rE ) 2
(1  rE ) t
 Repeating this logic over and over, you find that
today’s price equals PV of the entire dividend
stream the stock will pay in the future
THE DIVIDEND DISCOUNT
MODEL (CONT’D)
 DDM assumes that the price of any stock is
equal to the present value of the expected
future dividends it will pay.
 The company’s dividend may have:
◦ Zero growth
◦ Constant growth
◦ Non-constant growth
ESTIMATING DIVIDENDS –
SPECIAL CASES
 Constant dividend
◦ The firm will pay a constant dividend forever
◦ Similar to preferred stock
◦ The price is computed using the perpetuity formula
 Constant dividend growth
◦ The firm will increase the dividend by a constant percent
every period
◦ The price is computed using the growing perpetuity
model
 Supernormal growth
◦ Dividend growth is not consistent initially, but settles
down to constant growth eventually
◦ The price is computed using a multi-stage model
THE DIVIDEND DISCOUNT
MODEL (CONT’D)
ZERO GROWTH DIVIDEND
 Company with constant (no-growth)
dividend
D1  D2  D3  D  constant
 Stock can be viewed as an perpetuity
D
P0 
rE
◦ Discount rate rE (equity cost of capital): rate
of return demanded by investors in other
stocks with the same risk.
ZERO GROWTH DIVIDEND -
EXAMPLE
 Paradise Prototyping Co. has a policy of
paying a $10 per share dividend every
year. If this policy is to be continued
indefinitely, what is the value of a share of
stock if the required return is 20%?
PREFERRED STOCK
 Dividend:
◦ In general, size of preferred stock dividend is
fixed, and it is either stated as a dollar amount
or as a percentage of the preferred stock’s par
value.
◦ Unlike common stockholders, preferred
stockholders receive the same fixed dividend
regardless of how well the firm does.
PREFERRED STOCK (CONT’D)
 Claims on Assets and Income:
◦ In the event of bankruptcy, preferred stockholders
have priority over common stock. However, they have
lower priority than the firm’s debt holders.
◦ Firm must pay dividends on preferred stock prior to
paying dividend on common stock.
◦ Most preferred stock carry a cumulative feature.
Cumulative feature requires that all past unpaid
dividends to be paid before any common stock
dividends can be declared.
◦ Thus, preferred stocks are less risky than common
stocks but more risky than bonds.
PREFERRED STOCK (CONT’D)
 Preferred Stock as a Hybrid Security
◦ Like common stocks, preferred stocks do not
have a fixed maturity date. Also, like common
stocks, nonpayment of dividends does not
lead to bankruptcy of the firm.
◦ Like debt, preferred stocks have a fixed
dividend. Also, most preferred stocks are
periodically retired even though there is no
stated maturity date.
CONSTANT GROWTH
DIVIDEND
 Also called “Gordon growth model”
 Dividends are expected to grow at a
constant rate of g per period.
Dt  D0  (1  g ) t

where D0 = dividend just paid

Dt = dividend at time t periods
into the future
g = dividend growth rate
CONSTANT GROWTH
DIVIDEND (CONT’D)
 Stock can be viewed as a growing
perpetuity

D1 D2 D3
P0     ...
1  rE (1  rE ) 2
(1  rE ) 3

D0  (1  g ) D0  (1  g ) 2 D0  (1  g )3
P0     ...
1  rE (1  rE ) 2
(1  rE ) 3

D1 D  (1  g ) where D0 = dividend just paid

P0   0 D1 = dividend paid next period
rE  g rE  g g = dividend growth rate
CONSTANT GROWTH
DIVIDEND – EXAMPLES
 Example 1: Suppose Big D, Inc., just paid a
dividend of $0.5 per share. It is expected
to increase its dividend by 2% per year. If
the market requires a return of 15% on
assets of this risk, how much should the
stock be selling for?
◦ P0 = 0.5(1 + 0.02) / (0.15 - 0.02) = $3.92
CONSTANT GROWTH DIVIDEND –
EXAMPLES (CONT’D)
 Example 2: Suppose TB Pirates, Inc., is
expected to pay a $2 dividend in one year.
If the dividend is expected to grow at 5%
per year and the required return is 20%,
what is the price?
◦ P0 = 2 / (0.2 - 0.05) = $13.33
◦ Why isn’t the $2 in the numerator multiplied
by (1.05) in this example?
WHAT HAPPENS IF g > rE?
 If g > rE, the constant growth formula
leads to a negative stock price, which
does not make sense.
 The constant growth model can only be
used if:
◦ A dividend is paid on a regular basis.
◦ rE > g
◦ g is expected to be constant forever.
WHAT CAUSES STOCK PRICES
TO GO UP AND DOWN?
 Constant growth dividend model indicates that
there are three variables that drive share value:
◦ The most recent dividend (D0): The more, the higher.
◦ Expected rate of growth in future dividends (g): The
higher, the higher.
◦ Investor’s required rate of return (rE ): The higher, the
lower.
 Since most recent dividend (D0) has already
been paid, it cannot be changed. Thus, variations
in the other two variables, rE and g, can lead to
changes in stock prices.
ESTIMATING GROWTH RATE (g)
 Historical growth rates
◦ If dividends and earnings growth have been
stable
◦ Only apply for mature, slow-growing
companies
 Analysts’ forecast
 Retention growth model
ESTIMATING GROWTH RATE (g)
(CONT’D)
 A firm can do one of two things with its
earnings:
◦ It can pay them out to investors.
◦ It can retain and reinvest them.
 Retention growth model
◦ Payout ratio
 Fraction of earnings paid out as dividend
◦ Plowback ratio (retention rate)
 Fraction of earnings retained and reinvested in the
firm
g  Return on new investment  Plowback ratio
Plowback ratio  1  payout ratio
CHANGING GROWTH RATES
 We cannot use the constant dividend
growth model to value a stock if the growth
rate is not constant.
 Although we cannot use the constant
dividend growth model directly when
growth is not constant, we can use the
general form of the model to value a firm by
applying the constant growth model to
calculate the future share price of the stock
once the expected growth rate stabilizes.
NON-CONSTANT GROWTH
DIVIDENDS

Non-constant growth phase Constant growth phase

DN 1
PN 
rE  g
D1 D2 DN 1 DN 1
P0    ...   
1  rE (1  rE ) 2
(1  rE ) N
(1  rE ) N
rE  g
NON-CONSTANT GROWTH
DIVIDENDS
 Find the PV of each dividend during the
period of non-constant growth and sum
them (1).
 Find the expected price of the stock at the end
of the non-constant growth period, at which
point it has become a constant growth stock
so it can be valued with the constant growth
model, and discount this price back to the
present (2).
 Add (1) and (2) to find the intrinsic value of
the stock.
NON-CONSTANT GROWTH
DIVIDENDS – EXAMPLE 1
 Estimate the current value of Morris
Industries' common stock, P0
 Assume:
◦ The most recent annual dividend payment
of Morris Industries was $2 per share.
◦ Investors expect that these dividends will
increase at an 30% annual rate over the
next 3 years.
◦ After three years, dividend growth will level
out at 6%.
◦ The firm's required return, r , is 13%.
 NON-CONSTANT GROWTH
DIVIDENDS – EXAMPLE 1

0 r = 13% 1 2 3 4
E
...
g = 30% g = 30% g = 30% g = 6%
D0 = 2 2.6 3.38 4.394 4.658
2.301
2.647
3.045
4.658
46.116 P$ 3   $66.54
^ 0.13  0.06
54.109 = P0
 NON-CONSTANT GROWTH
DIVIDENDS – EXAMPLE 1: STEP 1
 Compute the value of dividends in year 1, 2, and 3 as
(1+g1)=1.3 times the previous year’s dividend
Div1= Div0 x (1+g1) = $2 x 1.3 = $2.6
Div2= Div1 x (1+g1) = $2.6 x 1.3 = $3.38
Div3= Div2 x (1+g1) = $3.38 x 1.3 = $4.394

 Find the PV of these three dividend payments:

PV of Div1= Div1  (1+r)1 = $ 2.6  (1.13) = $2.301
PV of Div2= Div2  (1+r)2 = $ 3.38  (1.13)2 = $2.647
PV of Div3= Div3  (1+r)3 = $ 4.394  (1.13)3 = $3.045
Sum of discounted dividends = $2.301 + $2.647 + $3.045 = $7.993
 NON-CONSTANT GROWTH
DIVIDENDS – EXAMPLE 1: STEP 2
Find the value of the stock at the end of the initial
growth period using the constant growth model.

 Calculate next period dividend by multiplying D3

by 1+g2, the lower constant growth rate:
D4 = D3 x (1+ g2) = $4.394 x (1.06) = $4.658
 Then use D4=$4.658, g =0.06, r =0.13 in Gordon
growth model:

D 4 $ 4.658 $ 4.658
P3 = = = = $ 66.54
r - g 2 0.13- 0.06 0.07
 NON-CONSTANT GROWTH
DIVIDENDS – EXAMPLE 1: STEP 2
 Find the present value of this stock price
by discounting P3 by (1+r)3
P 3 $66.54
PV0 = = = $46.12
(1  r ) 3
(1.13) 3
NON-CONSTANT GROWTH
DIVIDENDS – EXAMPLE 1: STEP 3
 Add the PV of the initial dividend stream
(Step 2) to the PV of stock price at the
end of the initial growth period (P3):

P0 = $7.99 + $46.12 = $54.11

Current
stock price

Remember: Because future growth rates might

change, the variable growth model allows for a
changes in the dividend growth rate.
45
NON-CONSTANT GROWTH
DIVIDENDS – EXAMPLE 2
 Suppose a firm is expected to increase
dividends by 20% next year and by 15%
the following year. After that, dividends
will increase at a rate of 5% per year
indefinitely. If the last dividend was $1 and
the required return is 20%, what is the
price of the stock?
 Remember that we have to find the PV of
all expected future dividends.
NON-CONSTANT GROWTH
DIVIDENDS – EXAMPLE 2 SOLUTION
 Compute the dividends until growth levels
off
◦ D1 = 1(1.2) = $1.20
◦ D2 = 1.20(1.15) = $1.38
◦ D3 = 1.38(1.05) = $1.449
 Find the expected future price
◦ P2 = D3 / (R – g) = 1.449 / (0.2 - 0.05) = 9.66
 Find the present value of the expected
future cash flows
◦ P0 = 1.20 / (1.2) + (1.38 + 9.66) / (1.2)2 = 8.67
NON-CONSTANT GROWTH
DIVIDENDS – EXAMPLE 3
 The Highfield Co.’s dividend is expected
to grow at 20% for the next 5 years. After
that, the growth is expected to be 4%
forever. If the required return is 10%,
what’s the value of the stock? The
dividend just paid was $2.

D1   1  g1  
t
1 Dt 1
P0   1      
rE  g1   1  rE   (1  rE ) t rE  g 2
 
where Dt 1  D0  1  g1   1  g 2 
t
LIMITATIONS OF DDM
 There is a tremendous amount of
uncertainty associated with forecasting a
firm’s dividend growth rate and future
dividends.
 Small changes in the assumed dividend
growth rate can lead to large changes in
the estimated stock price.
COMPONENTS OF THE
REQUIRED RETURN
 We can use DDM to find the required
return
D0  1  g  D1
P0  
rE  g rE  g
D0  1  g  D1
rE  g g
P0 P0

D1
where  Dividend yield
P0
g  Capital gains yield
FINDING THE REQUIRED
RETURN – EXAMPLE
 Suppose a firm’s stock is selling for $10.50. It
just paid a $1 dividend, and dividends are
expected to grow at 5% per year. What is the
required return?
◦ rE = [1(1.05)/10.50] + 0.05 = 15%
 What is the dividend yield?
◦ 1(1.05) / 10.50 = 10%
 What is the capital gains yield?
◦ g =5%
If D0 = $2, rE = 13% and the stock was expected to
have negative growth (g = -6%), would anyone buy
the stock, and what is its value?

 The firm still has earnings and pays dividends,

even though they may be declining, they still have
value.
^ D1 D0 ( 1  g )
P0  
rE - g rE - g
$2 (0.94) $1.88
   $9.89
0.13 - (-0.06) 0.19
GROWTH STOCKS VS. INCOME
STOCKS
 Growth stock: investors interested in capital
gains.
◦ A growth stock usually does not pay a
dividend, as the company would prefer to
reinvest retained earnings in capital projects.
◦ Most technology companies are growth
stocks.
 Income stock: investors interested in dividends.
◦ Limited future growth options.
◦ The excess cash flow from profits can
therefore be directed back toward investors
on a regular basis.
DIFFERENCES BETWEEN DEBT AND
EQUITY
 Debt
◦ Not an ownership interest
◦ Creditors do not have voting
rights
◦ Interest is considered a cost
of doing business and is tax
deductible
◦ Creditors have legal recourse
if interest or principal
payments are missed
◦ Excess debt can lead to
financial distress and
bankruptcy
 Equity
◦ Ownership interest
◦ Common stockholders vote
for the board of directors and
other issues
◦ Dividends are not considered
a cost of doing business and
are not tax deductible
◦ Dividends are not a liability of
the firm, and stockholders
have no legal recourse if
dividends are not paid
◦ An all equity firm can not go
bankrupt merely due to debt
since it has no debt
REVISION EXERCISES
1. Fletcher Company’s current stock price
is $36, its last dividend was $2.40, and its
required rate of return is 12%. If dividends
are expected to grow at a constant rate, g,
in the future, and if required return is
expected to remain at 12% , what is
Fletcher’s expected stock price 5 years
from now?
REVISION EXERCISES (CONT’D)
2. Snyder Computers Inc. is experiencing
rapid growth. Earnings and dividends are
expected to grow at a rate of 15% during
the next 2 years, 13% the following year,
and at a constant rate of 6% during Year 4
and thereafter. Its last dividend was $1.15,
and its required rate of return is 12%.
a. Calculate the value of the stock today.
b. Calculate the expected price of the stock in
year 1 and 2.
THE END