Valuation and

Characteristics of Stocks
Session 4
The income statement overview
 Stock Valuation
• Step 1 (CF): Estimate amount and timing of the
expected future cash flows:
• Step 2 (r) Determine the investor’s required rate of
return per period
• Step 3: Calculate the intrinsic value of the stock.
• Stock Value
= PV (Dividend, received every period)
 Preferred Stock
• Preferred stock is often referred to as a
hybrid security because it has many
characteristics of both common stock and
bonds.
 Hybrid Nature of
Preferred Stocks
Like common stocks, preferred stocks
– have no fixed maturity date
– failure to pay dividends does not lead to
bankruptcy
– dividends are not a tax-deductible expense
Like Bonds/Debt
– dividends are fixed in amount (either as a $
amount or as a % of par value)
 The Characteristics of
Preferred Stocks
• Multiple series of preferred stock
• Preferred stock’s claim on assets and
income
• Cumulative dividends
• Protective provisions
• Convertibility
• Retirement provisions
 The Characteristics of
Preferred Stocks
• Multiple Series
– A company can issue more than one series of
preferred stock, and each series can have
different characteristics
• Claim on Assets:
– Preferred stockholders claims are honored
before common stockholders, but after bonds
in case of bankruptcy.
• Claim on Income:
– Preferred stock also has priority over common
stock with regard to dividend payments.
 The Characteristics of
Preferred Stocks
• Cumulative feature (if it exists):
– All past, unpaid preferred stock dividends be
paid before any common stock dividends are
declared.
• Protective provisions:
– Allow for voting rights in the event of
nonpayment of dividends, or they restrict the
payment of common stock dividends if
sinking-funds payments are not met or if the
firm is in financial difficulty
 The Characteristics of
Preferred Stocks
• Convertibility
– Convertible preferred stock can be converted
into a predetermined number of shares of
common stock.
• Retirement Provisions
– Some method for retiring the stock
• Call provision entitles the corporation to
repurchase its preferred stock at stated prices over
a given time period.
• Sinking fund provision requires the firm to set
aside an amount of money for the retirement of its
preferred stock.
 Valuing Preferred Stock
• The economic or intrinsic value of a
preferred stock is equal to the present
value of all future dividends.

• Value of preferred stock:

= Annual dividend/required rate of return
= D/r
 Preferred Stock Valuation
Consider a $25 par value share of
preferred stock with an 8% dividend rate
(paid quarterly in perpetuity). The required
return is 12% APR. Find the share’s fair
value today.

Value = PV(dividends)
 Preferred Stock Valuation

The value of the stock would be:

0.5/0.03 = $16.6667

N=10,000 i=3 PMT=0.5 FV=100 PV= -16.6667

 Common Stock
• Common stock is a certificate that
indicates ownership in a corporation.
When you buy a share, you buy a
“part/share” of the company and attain
ownership rights in proportion to your
“share” of the company.
• Common stockholders are the true owners
of the firm. Bondholders and preferred
stock holders can be viewed as creditors.
 Characteristics of Common
Stock
• Claim on Income
– Common shareholders have the right to
residual income after bondholders and
preferred stockholders have been paid
• Common stock has a residual claim on
assets in the case of liquidation.
– Residual claim implies that the claims of debt
holders and preferred stockholders have to be
met prior to common stockholders.
 Valuing Common Stock
• Like bonds and preferred stock, the value
of common stock is equal to the present
value of all future expected cash flows
(i.e., dividends).
• However, dividends are neither fixed nor
guaranteed, which makes it harder to
value common stocks compared to bonds
and preferred stocks.
The Dividend Discount Model –
General Case

D1 D2 D3 Dt
P0      ......
1r  1r  1r 
2 3
1r t


Dt
P0 
t 1 1r 
t
Common Stock Valuation – Special
Cases
The per share annual dividend on a common stock
is expected to be $3.00 one year from today.
Stockholders require a 12% rate of return. Find the
fair value of the stock for each of the following
cases:
1. Zero Growth: dividends are constant every year.
2. Constant Growth: dividends are growing at a constant
rate of 5% per year forever.
3. Non constant Growth: D1=$3; D2=$3.5; D4=$3.6, after
year 4 g=5%
4. Two Growth: dividends will grow at 25% for 3 years and
then at 5% per year forever.
1. Zero Growth - Example

The dividends of $3.00 per share form a

perpetuity.

D1 $3.00
P0    $25.00
r 0.12

N=10,000 i=12 PMT=3 FV=0 PV= -25.00

 2.Constant Growth Case
Assume dividends are growing at a constant
percentage rate of g per year.

D2 D11 g 
D3 D2 1 g D11 g 1 g D11 g 
2

D4 D 1 g 
3
1


Dt D 1 g 
t 1
1
2. Constant Growth Model
D11 g 
  t 1
Dt
P0   
t 1 1r  1r 
t t
t 1

D1
P0 
rg 
More generally, from any period with
constant growth forever after time t:
Dt
Pt 1 
rg 
2. Constant Growth Case –
Example
Recall that D1 = $3.00; r = 12%; and g = 5%

$3.00
P0   $42.86
0.120.05

N=10,000 i=7 PMT=3 FV=0 PV= -42.86

3. Non constant growth

D1 D2 D3 Dt Pt
P0       
1r  1r 2 1r 3 1r t 1r t

Dt (1  g )
Pt 
r g 
3. Non constant growth -
Example

?
4. Two-Stage Growth Model
3×(1.25) 3×(1.25)2 5.86×(1.05)
3×(1.25)3
$3.00 $3.75 $4.69 $5.86 $6.15

2
…
0 1 3 4 5
 Two Stage Growth Model
•