STOCK VALUATION

I.K. Gunarta
Institut Teknologi Sepuluh Nopember
Surabaya
2020
Learning Objectives
1. Mengidentifikasi karakateristik dasar dan fitur
dari saham biasa (common stock) dan
menggunakan model discounted cash flow
untuk menilai saham biasa perusahaan
(common shares).
2. Menggunakan price/earnings (P/E) ratio
untuk menilai saham biasa (common stock).
3. Mengidentifikasi karakteristik dasar dan fitur dari
preferred stock and menilai preferred shares
perusahaan.
10.1 COMMON STOCK
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. The
firm’s management team then carries out the
day-to-day management of the firm.
Characteristics of Common Stock
Common stock does not have a maturity date but
exists as long as the firm does. Nor does common
stock have an upper or lower limit on its
dividend payments. In the event of bankruptcy, the
common stockholders – as owners of corporation –
have the most junior claim.
Claim on Income
• Common stockholders have the right to the
firm’s income that remains after bondholders and
preferred stockholders have been paid. The
common stockholders will either receive cash
payments in the form of dividends or, any
increase in value that results from the
reinvested earnings.
• The right to residual income means the potential
return is unlimited. However, it also means that
there may be little or nothing left after paying the
bondholders and preferred shareholders.
Claim on Assets
Just as common stock has residual claim on
income, it also has a residual claim on assets in
case of liquidation. Unfortunately, when
bankruptcy does occur, the claims of the common
stockholders generally go unsatisfied. This residual
claim on assets adds to the risk of common stock.
Voting Rights
• The common stockholders elect the board of directors
and are in general the only security holders given a
vote. Common stockholders also must approve any
changes in the corporate charter. A typical charter
change might involve the authorization to issue new
stock or perhaps engage in a merger.
• Vote for directors and charter changes occurs at the
corporation’s annual meeting. Some shareholders
vote in person, but the majority generally vote by
proxy.
Agency Costs and Common Stock
• In theory, common stockholders elect the board of
directors and the board of directors pick the
management team. In reality, board members are
nominated by the management. As a result,
management effectively elects the board. This
may lead to agency problems.
Valuing Common Stock Using the
Discounted Dividend Model
As with bonds, a common stock’s value is equal to
the present value of all future cash flows that the
stockholder expects to receive from owning the
share of stock. However, unlike bonds, the common
stock does not offer its owners a promised interest
payment, maturity payment, or dividend.
Three Step Procedure for Valuing
Common Stock (1 of 2)
Step 1: Estimate the amount and timing of the
receipt of the future cash flows the common stock is
expected to provide.
Step 2: Evaluate the riskiness of the common
stock’s future dividends to determine the stock’s
required rate of return.
Three Step Procedure for Valuing
Common Stock (2 of 2)
Step 3: Calculate the present value of the expected
dividends by discounting them back to the present
at the stock’s required rate of return.
The three steps show that the value of a common
stock is equal to the present value of all future
dividends.
The Constant Dividend Growth Rate Model
If a firm’s cash dividend grow by a constant rate,
then the common stock can be valued as follows:

 Dividend 
Dividend in Year 0  1+ 
Vcs =  Growth Rate 
=
Dividend in Year 1
Stockholder's Required Dividend Stockholder's Required Dividend
− −
Rate of Return Growth Rate Rate of Return Growth Rate
CHECKPOINT 10.1: CHECK YOURSELF
Valuing Common Stock
The Problem
What is the value of a share of common stock that
paid $6 dividend at the end of last year and is
expected to pay a cash dividend every year from
now to infinity, with that dividend growing at a rate of
5 percent per year, if the investor’s required rate of
return is 12 percent on that stock?
Step 1: Picture the Problem
With a perpetuity, a timeline goes on for ever with the
growing cash flow occurring every period.
i = 12%
Years 0 1 2… Blank …
Cash flow $6 $6(1.05) $6(1.05)2 Blank Blank

Value of common
stock = Present
Value of Expected
Dividends. The growing
dividends go on
forever
Step 2: Decide on a Solution Strategy
• The value of a share of stock can be viewed as a
the present value of a growing perpetuity.
• Here we know the expected dividends, the growth
rate, and investor’s required rate of return.
• We can use equation 10-2 to determine the value
of a share of common stock.
Step 3: Solve (1 of 2)
• We need to first determine D1, the dividend next
period.
• Since dividends at the end of last year was $6 and
dividends are expected to grow at a rate of 5%,
dividends for next period will be:
• D1 = D0 (1+g) = $6 (1.05) = $6.30
 Step 3: Solve (2 of 2)

Expected Rate Risk-Free Rate Common Stock  Expected Rate of Return Risk-Free Rate 
= +  − 
of Return of Interest Beta Coefficient  on the Market Portfolio of Interest 

• Vcs = $6.30 ÷ (0.12−0.05)

= $6.30 ÷ 0.07
= $90
Step 4: Analyze
Equation 10-2 is based on the assumption that
dividends will grow at a constant rate for ever. While
not a realistic assumption, it enables us to
determine the value of common stock easily and
also helps us to identify the factors that move the
stock prices.
What Causes Stock Prices to Go Up and
Down? (1 of 2)
Equation 10-2 indicates that there are three
variables that drive share value:
– The most recent dividend (D0),
– Investor’s required rate of return (rcs ), and
– Expected rate of growth in future dividends (g).
What Causes Stock Prices to Go Up and
Down? (2 of 2)
Since most recent dividend (D0) has already been
paid, it cannot affect price. Thus the other two
variables, rcs and g, can vary and lead to changes in
stock prices.
Determinants of the Investor’s Required
Rate of Return (1 of 3)
The investor’s required rate of return is determined
by two key factors:
1. The level of interest rates in the economy;
2. The risk of the firm’s stock.
 Determinants of the Investor’s Required
Rate of Return (2 of 3)
CAPM suggests that if risk-free rate and/or
systematic risk (beta) rises, the investor’s required
rate of return will rise and the stock price will fall.

Expected Rate Risk-Free Rate Common Stock  Expected Rate of Return Risk-Free Rate 
= +  − 
of Return of Interest Beta Coefficient  on the Market Portfolio of Interest 
Determinants of the Growth Rate of Future
Dividends (3 of 3)
The growth rate of future dividends (g) can also
change and lead to a change in the stock price. The
two key determinants of a firm’s growth
opportunities relate to:
– the return on equity (ROE), and
– the retention ratio (b)
Figure 10.3 (1 of 2)

A Quick Reference Guide for the Growth Rate in

Earnings and Dividends
The rate of growth a firm can expect in its future
dividends is a function of how much of the firm’s
earnings are reinvested in the firm (i.e., the
dividend retention ratio, b), and the rate of return
the firm is expected to earn on the reinvested
earnings (ROE).
g = (1 − D1 /E1 )  ROE

Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Figure 10.3 (2 of 2)

Important Definitions and Concepts:

• g = the expected annual rate of growth in dividends.
• D1/E1 = the dividend payout ratio, reflecting the ratio of
cash dividends to be paid next period divided by the firm’s
earnings.
• b = (1 − D1/E1), which is the proportion of firm earnings or
net income that is retained and reinvested in the firm.
• ROE = the return on equity earned when the firm reinvests
a portion of its earnings back into the firm.
• Equation (10–3) requires that the retention ratio, b, and
ROE remain constant for all future periods.

Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
10.2 THE COMPARABLES APPROACH
TO VALUING COMMON STOCK
The Comparables 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 performance is
metric is earnings per share, which means that the
values are determined from the price/earnings ratio,
or the earnings multiplier, of comparable firms.
Defining the P/E Ratio Valuation Model

Value of
 Appropriate   Estimated Earnings  P
Common Stock, =   =  E1
Vcs  Price/Earnings Ratio   per Share for Year 1 E1

• Vcs = the value of common stock of the firm.

• P/E1 = the price earnings ratio for the firm based
on the current price per share divided by earnings
for end of year 1.
• E1 = estimated earnings per share of common
stock for the end of year 1.
CHECKPOINT 10.2: CHECK YOURSELF
Valuing Common Stock
Using the P/E Ratio
The Problem
After some careful analysis and reflection on the
valuation of the Heals’ shares the company CFO
suggested that the earnings projection are too
conservative and earnings for the coming year
could easily jump to $2.00. What does this do for
your estimate of the value of Heals’ shares?
Step 1: Picture the Problem

EPS P/E Stock Price

= $2.00 Multiple
Step 2: Decide on a Solution Strategy
• The common stock value can be computed by
multiplying the firm’s estimated earnings per share
for the coming year by what the analyst estimates
to be an appropriate P/E ratio.
• We can use equation 10-4 to estimate the value of
common stock.
Step 3: Solve

Value of
 Appropriate   Estimated Earnings  P
Common Stock, =   =  E1
Vcs  Price/Earnings Ratio   per Share for Year 1 E1

Vcs = 18.20  $2
= $3 6 .4 0
Step 4: Analyze
• We estimated the value of Heales’ shares based
on the P/E ratios of three comparable firms.
However, this estimate is contingent on the
appropriateness of the comparable set of
companies to the Heals Shoe Company.
• Furthermore, if the market conditions change by
the time the shares are sold in the market, the
price estimate will not be appropriate.
What Determines the P/E Ratio for a
Stock? (1 of 2)
Using Equation 10-5a and 10-5b, there are two
fundamental determinants of a firm’s P/E ratio:
1. Growth Rate in Dividends (higher the growth rate, the
higher the P/E ratio), and
2. Investor-Required Rates of Return (higher the
required rate, the lower the P/E ratio)
What Determines the P/E Ratio for a
Stock? (2 of 2)
What causes the growth rate in dividends (and earnings) and
the investor’s required rate of return to go up and down?
These are the real determinants of the P/E ratio:
• Firm factors impacting the investor’s required rate of return
• Economic or macro factors impacting the investor’s
required rate of return
• Firm factors impacting the growth rate. The growth rate in
dividends is determined by two variables – dividend policy
and the profitability of the firm’s investment opportunities.