Stocks and Their

Valuation

Facts about Common Stock

• Represents ownership.
• Ownership implies control.
• Stockholders elect directors.
• Directors elect management.
• Management s goal Maximi e stock
price.

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Expected Returns
Expected Return - The percentage yield that an investor
forecasts from a specific investment over a set period of
time. Sometimes called the holding period return (HPR).

𝐷 𝑃 𝑃
𝐸 𝑅
𝑃

The Valuation Process

Valuation is a process by which an investor uses risk and
return concepts to determine the worth of a security.
• If forecasted rate of return equals or exceeds our
required yield, the stock could be a worthwhile
investment candidate.
• If the intrinsic worth equals or exceeds the current
market value, the stock could be a worthwhile
investment candidate.

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One-Period Stock Valuation
You are buying a share of stock today and planning to sell
the stock in one year when the stock will be worth $70.
You predict the stock will pay a $10 per share dividend. If
you require a 25% return on your investment, what is the
most you would pay for the stock?

In other words what is the present value today s price of

the $10 dividend along with the $70 ending value at 25%?

P0 =

Multi-Period Stock Valuation

The price of the stock today is equal to the present value

of all future dividends:

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Valuing a Company and Its Future

The single most important issue in the stock valuation

process is what a stock will do in the future.
• Value of a stock depends upon its future returns from
dividends and capital gains/losses.
• We use historical data to gain insight into the future
direction of a company and its profitability.
• Past results are not a guarantee of future results.

Assume beta = 1.2, Rf = 7%, and Market

Risk Premium = 5%. What is the required
rate of return on the firm s stock

Use the SML to calculate Rs:

Rs = Rf + (E(RM) - Rf)bStock
=

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 D0 was $2.00 and g is a constant 6%.
Find the expected dividends for the
next 3 years, and their PVs. Rs = 13%.

0 g = 6% 1 2 3

D0 = 2.00
13%

Constant growth
Suppose we know that the dividend for some company
always grows at a steady rate. Call this growth rate g. If we
let D0 be the dividend just paid, then the next dividend,
D1, is:
D1 = D0 × (1+g)
The dividend in two periods is:
D2 = D1 × (1+g)
= [D0 × (1+g)] × (1+g)
= D0 × (1+g)2
The dividend t periods into the future, Dt, is given by:

Dt = D0 × (1+g)t

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Constant growth

The dividend growth model determines the current price

of a stock as its dividend next period divided by the
discount rate less the dividend growth rate, and can be
written as follows, so long as the growth rate, g, is less
than the discount rate, R:

We can use the dividend growth model to get the stock

price at any point in time; in general, the price of the stock
as of Time t is:

Constant Growth Stock Valuation

Suppose D0 is $2.30, R is 13%, and g is 5%.

P0 = D0 × (1 + g)/(R g)

Suppose we are interested in the price of the stock in five

years, P5. The price of the stock in five years is:

P5 =

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 $ 𝐷 𝐷 1 𝑔

2.0 𝐷
𝑃𝑉𝐷
1 𝑅

P0 = PVD t

0 Years (t)

What s the stock s market value

D0 = 2.00, Rs = 13%, g = 6%.

Constant growth model:

D1
P0 =
Rs g

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 What is the stock s market value one
year from now, P1?

D1 will have been paid, so expected

dividends are D2, D3, D4 and so on. Thus,
D2
P1 =
Rs – g

Components of Returns

Earlier, we calculated P0 as: P0 = D1/(R g). If we

rearrange this to solve for R, we get:

Total return, R, has two components:

1. Dividend yield is a stock s expected cash dividend
divided by its current price (i.e., D1/P0).
2. Dividend growth rate, g, can be interpreted as the
capital gains yield, the rate at which the value of
an investment grows.

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 Find the expected dividend yield,
capital gains yield, and total return
during the first year.

D1
Dividend yield = =
P0
P1 P0
Cap gains yield = =
P0

Total return =

Growth Rates (g)

If a firm elects to pay a lower dividend,

and reinvest the funds, the stock price
may increase because future dividends
may be higher.

Payout Ratio - Fraction of earnings paid

out as dividends
Retention Ratio - Fraction of earnings
retained by the firm.

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 Growth Rates (g)

Growth can be derived from applying the

return on equity to the percentage of
earnings plowed back into operations.

g = Retention Ratio Return on Equity

Growth Rates (g)

Example
Our company forecasts to pay a $5.00 dividend next year,
which represents 100% of its earnings. This will provide
investors with a 12% required return. Instead, we decide
o plo back of he earning a he firm c rren
return on equity of 20%. What is the value of the stock
before and after the plowback decision?

No Growth With Growth

P0 = P0 =

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Valuing Common Stocks

Example - continued
If the company did not plowback some earnings, the
stock price would remain at $41.67. With the
plowback, the price rose to $75.00.

The difference between these two numbers

(75.00-41.67=33.33) is called the Present Value of
Growth Opportunities (PVGO).

Valuing Common Stocks

Present Value of Growth Opportunities
(PVGO) - Net present value of a firm s
future investments.

Sustainable Growth Rate - Steady rate at

which a firm can grow:

Retention ratio ROE

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Stock value vs. changes in Rs and g
D1 = $2, Rs = 10%, and g = 5%:
P0 = D1 / (Rs-g) = $2 / (0.10 - 0.05) = $40

What if Rs or g change?
g g g
Rs 4% 5% 6%
9%
10%
11%

Common Stock Valuation:

Variable-Growth Model

The zero- and constant-growth common stock models

do not allow for any shift in expected growth rates.
The variable-growth model is a dividend valuation
approach that allows for a change in the dividend
growth rate.
To determine the value of a share of stock in the case
of variable growth, we use a four-step procedure.

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 If a company has supernormal growth of 30%
for 3 years, then expects a long-run constant
g = 6%, what is P0? Rs is 13%.

0 R = 13% 1 2 3 4
s ...
g = 30% g = 30% g = 30% g = 6%
D0 = 2.00 D1 D2 D3 D4

• Can no longer use constant growth model.

• However, growth becomes constant after 3 years.

Two-stage growth
In this case, the dividend will grow at a rate of g1 for t years and
then grow at a rate of g2 thereafter, forever
The value of the stock can be written as:

• First term in expression is the PV of a growing annuity

• In first stage, g1 can be greater than R
• Second part is PV of stock price once second stage begins at Time t

We can calculate Pt as follows:

• In this second stage, g2 must be less than R

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 If we have supernormal growth of 30% for 3 years,
then a long-run constant g = 6%, what is P0? R is 13%.

0 R = 13% 1 2 3 4
s ...
g = 30% g = 30% g = 30% g = 6%
D0 = 2.00

P =
3
= P0

Is the stock price based on short-

term or long-term growth?

•The current stock price is $54.11.

•The PV of dividends beyond year 3 is
$46.11 (P3 discounted back to t = 0).
•The percentage of stock price due to
long-term dividends is

$46.11
$54.11 =

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Suppose g = 0 for t = 1 to 3, and then g is a
constant 6%. What is P0?

0 R =13% 1 2 3 4
s ...
g = 0% g = 0% g = 0% g = 6%
2.00

P =
3
$

The Multiples Approach to

Valuing Common Stock

This method estimates the value of the firm s stock

as a multiple of some measure of firm s
performance. The most common metric is earnings
per share. Thus, values are determined from the
price-to-earnings ratio of comparable firms.

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Price to Earnings Ratio

𝑃 𝑀𝑎 𝑘𝑒 𝑝 𝑖𝑐𝑒 𝑝𝑒 ℎ𝑎 𝑒
𝐸 𝐸𝑎 𝑛𝑖𝑛𝑔 𝑝𝑒 ℎ𝑎 𝑒

• Other things equal, higher growth firms will have

higher PE ratios than lower growth firms.
• Other things equal, high-risk firms will have lower
PE ratios than lower risk firms.
• Other things equal, firms with lower reinvestment
needs will have higher PE ratios than those with
higher investment rates.

Stock valuation using multiples

If the company is profitable (i.e., has positive

earnings), use the PE ratio, calculated as the ratio of a
stock s price per share to its earnings per share EPS
over the previous year

• Benchmark PE ratio could come from a variety of

sources (e.g., based on similar companies, based
on a company s own historical values)

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Example
Heals’ Company CFO suggested that the earnings
projection are too conservative and earnings for the
coming year could easily jump to $2.00. The industry
benchmark PE Ratio is 18.2.

What does this do for your estimate of the value of

Heals shares

P0 =

Features of 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
• Claims on Assets and Income: Preferred stockholders
have priority over those of common stockholders for
payment of dividends and in settlement of claims at
bankruptcy. Most preferred stock carry a cumulative
feature, i.e., all past unpaid dividends must be paid
before any common stock dividends can be declared.

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What would P0 be if g = 0?

The dividend stream would be a

perpetuity.

0 1 2 3
13% ...
2.00 2.00 2.00

D
P0 = =
R

Q&A

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