Stocks and Their Valuation

■ Features of common stock

■ Determining common stock values
 Common Stock: Owners, Directors,
and Managers
■ Represents ownership.
■ Ownership implies control.
■ Stockholders elect directors.
■ Directors hire management.
■ Since managers are “agents” of
shareholders, their goal should be:
Maximize stock price.
 When is a stock sale an initial public
offering (IPO)?

■ A firm “goes public” through an IPO

when the stock is first offered to the
public.
■ Prior to an IPO, shares are typically
owned by the firm’s managers, key
employees, and, in many situations,
venture capital providers.
 What is a seasoned equity offering
(SEO)?

■ A seasoned equity offering occurs

when a company with public stock
issues additional shares.
■ After an IPO or SEO, the stock trades
in the secondary market, such as the
NYSE or Nasdaq.
 Different Approaches for Valuing
Common Stock

■ DIVIDEND GROWTH MODEL

■ CAPITAL ASSET PRICING MODEL
(CAPM)
 Stock Value = PV of Dividends

What is a constant growth stock?

One whose dividends are expected

to
grow forever at a constant rate, g.
 For a constant growth stock,

If g is constant, then:
 $

0.25

0 Years (t)
 What happens if g > rs?

■ If rs< g, get negative stock price,

which is nonsense.
■ We can’t use model unless (1) g < rs
and (2) g is expected to be constant
forever. Because g must be a
long-term growth rate, it cannot be >
r s.
 Numericals
D0 was Rs. 2.00 and g is a constant 6%. rs= 13%
1. Find the expected dividends for the next 3 years,
and their PVs.
2.What’s the stock’s market value? (30.29)
3.What is the stock’s market value one year from
now, P1? (32.1)
4.Find the expected dividend yield and capital gains
yield during the first year? (7.0% , 6%)
5.Find the total return during the first year (13%)
6.What would P0 be if g = 0? (15.38)
 7 - 11

D0 was Rs. 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 4

D0=2.00 2.12 2.2472 2.3820

13%
1.8761
1.7599
1.6508
 7 - 12

What’s the stock’s market value?

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

Constant growth model:

2.12 2.12
= = = 30.29.
0.13 - 0.06 0.07
 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,
 7 - 14
Find the expected dividend yield and
capital gains yield during the first year.

D1 2.12
Dividend yield = = = 7.0%.
P0 30.29

^
P1 - P 0 32.10 - 30.29
CG Yield = =
P0 30.29
= 6.0%.
 Find the total return during the
first year.

■ Total return = Dividend yield +

Capital gains yield.
■ Total return = 7% + 6% = 13%.
■ Total return = 13% = rs.
■ For constant growth stock:
Capital gains yield = 6% = g.
Rearrange model to rate of return form:

^
Then, rs = 2.12/30.29 + 0.06
= 0.07 + 0.06 = 13%.
 7 - 17

What would P0 be if g = 0?

The dividend stream would be a

perpetuity.
0 r =13% 1 2 3
s

2.00 2.00 2.00

^ PMT 2.00
P0 = = = 15.38.
r 0.13
 VALUING STOCKS : NON CONSTANT
GROWTH RATE

■ For some firms during the early part of their

lives their growth is much faster than that of
the economy as a whole; then they match the
economy’s growth and then finally their growth
is slower than that of economy. For e.g.
Microsoft US co., flipkart 40%
■ Infosys grew by more than 100% in FY01
when the expected growth to be 30%.,
CRISIL, Cera ceramics, La’opala These
companies show supernormal growth rate
after 10-15 yrs from establishment.
■ In supernormal case expected growth rate is
not a constant – it declines at the end of the
period of supernormal growth.
■ First we assume that dividends will grow at non
constant rate (generally high rate) for N periods
and after which it will grow at constant rate g. N
is called the terminal date. At this date it is no
longer necessary to forecast individual
dividends.
■ Terminal Value : This is the value at the terminal
date, of all dividends expected thereafter.
 Intrinsic Value

It is an estimate of a stock’s “true”

value based on accurate risk and
return data. The intrinsic value can be
estimated but not measured precisely.
The stock’s intrinsic value P0 is the present value of the
horizon value.

PV of dividends during non constant PV of dividends during

growth constant growth

To implement this equation go thro’ following steps:

1. Find the PV of the dividends during the period of
non constant growth
2. Find the price of the stock at the end of the
nonconstant growth period at which point it has
become a constant growth stock and discount
this price back to the present
3. Add these two components to find the intrinsic
value of the stock P0
 Numericals
1. If we have supernormal growth of
30% for 3 years, then a long-run constant g =
6%, what is P0? r is still 13%. 54.1067=P0
2. What is the expected dividend yield and
capital gains yield at t = 0? At t = 4? (4.8%,
8.2%) (7%,6%)
3. Is the stock price based on short-term growth?
4. If g = -6%, would anyone buy the stock? If so,
at what price? 9.89
5. What are the annual dividend and capital
gains yield? (7.8%, 5.2%)
 Nonconstant growth followed by constant
growth:

0 1 2 3 4
rs=13%
g = 30% g = 30% g = 30% g = 6%
D0 = 2.00 2.60 3.38 4.394 4.6576

2.3009
2.6470
3.0453
46.1135
^
54.1067 = P0
■ During nonconstant growth, dividend
yield and capital gains yield are not
constant.
■ If current growth is greater than g,
current capital gains yield is greater
than g.
■ After t = 3, g = constant, so the t t = 4
capital gains gains yield = g%.
■ Because rs = 13%, the t = 4 dividend
yield = rs – g%
 If most of a stock’s value is due to
long-term cash flows, why do so many
managers focus on quarterly earnings?

■ Sometimes changes in quarterly

earnings are a signal of future
changes in cash flows. This would
affect the current stock price.
■ Sometimes managers have bonuses
tied to quarterly earnings.
 7 - 26

Suppose g = 0 for t = 1 to 3, and then g

^
is a constant 6%. What is P0?

0 1 2 3 4
rs=13%
...
g = 0% g = 0% g = 0% g = 6%
2.00 2.00 2.00 2.12

1.7699
1.5663
1.3861 2.12
20.9895 
P3 = = 30.2857
25.7118 0.07
 7 - 27

If g = -6%, would anyone buy the

stock? If so, at what price?

Firm still has earnings and still

pays ^
dividends, so P0 > 0:

2.00(0.94) 1.88
= = = 9.89.
0.13 - (-0.06) 0.19
 Capital Asset Pricing Model (CAPM)
■ The CAPM, gives the risk/return relationship for
individual stocks.
■ rs = rRF + (RPM) βσi = rRF + (rM - rRF ) βi ,
where RPM = rM - rRF is risk premium
■ rs is return on security i, rRF, risk-free rate of return ;
rM expected return on market portfolio
■ Risk premium is scaled up or down to reflect the
particular stock’s risk exposure as measured by its
beta coefficient.
■ β is systematic risk, σ2M variance of return on
market portfolio ; σiM covariance of return between
security i and market
 CAPM
■ The tendency of a stock to move up and down
with the market, and thus its market risk, is
reflected in its beta coefficient, b.
■ The market risk of a stock is measured by its
beta coefficient, which is an index of the stock’s
relative volatility.
Assume β = 1.2, rRF = 7%, and RPM =
5%. What is the required rate of return
on the firm’s stock?

rs = rRF + (RPM)βFirm
= 7% + (5%) (1.2)
= 13%.
 Capital Asset Pricing Model (CAPM)
■ The most widely used approach to the cost of common
equity is the Capital Asset Pricing Model (CAPM) follows
these steps:
■ Step 1: Estimate the risk-free rate, rRF. Many analysts use
the 10-year Government bond rate as a measure of the
risk-free rate.
■ Step 2: Estimate the stock’s beta coefficient, bi, and use it
as an index of the stock’s risk. The i signifies the ith
company’s beta.
■ Step 3: Estimate the expected market risk premium. Market
risk premium is the difference between the return that
investors require to hold an average stock and the risk-free
rate.
■ Step 4: Substitute the preceding values into the CAPM
equation to estimate the required rate of return on the stock
in question:
 7 - 32

Why are stock prices volatile?

■ rs = rRF + (RPM) βi could change.

● Inflation expectations
● Risk aversion
● Company risk

■ g could change.
 Preferred Stock

■ Hybrid security.
■ Similar to bonds in that preferred
stockholders receive a fixed dividend
which must be paid before dividends
can be paid on common stock.
■ However, unlike bonds, preferred stock
dividends can be omitted without fear
of pushing the firm into bankruptcy.
 What’s the expected return on
preferred stock with Vps = 50 and
annual dividend = 5?