Stocks and Their Valuation

Accounting and
Finance Class
Instructure : Usman Arief, S.E., M.S.M.

ugm.ac.id LOCALLY ROOTED, GLOBALLY RESPECTED

TABLE OF CONTENTS
01 Features of Common Stock

02 Intrinsik Value and Stock Price

03 Determining Common Stock Values

- Discount Dividend Model
- Corporate Valuation Model
- Other Approaches
04
04 Preferred Stock
 Before All Else – What Is Value?
• Value = Price ?
• Value = the amount that buyer (seller) willing and agrees to pay for an
asset
• Book Value = the original purchase price of an asset less its
accumulated depreciation.
• Intrinsic Value = value of an asset to a particular investor. It can be
determined by calculating the present value of the expected future
cash flows at that investor’s required return.
• Market Value = The price of an asset as determined in a competitive
marketplace.
Facts About Common Stock
Represents Ownership

Ownership implies control

Stockholders elect directors

Directors elect
management
Management’s goal : Maximize
stock price
Facts About Common Stock

• Each share of stock has one vote

• Proxy = A document giving one person the authority to act for
another, typically the power to vote shares of common stock.
• Proxy Fight = An attempt by a person or group to gain control
of a firm by getting its stockholders to grant that person or
group the authority to vote its shares to replace the current
• Takeover = An action whereby a person or group succeeds in
ousting a firm’s management and taking control of the
company.
Facts About Common Stock – The
Preemptive Right
Definition
• A provision in the corporate
charter or by laws that gives
common stockholders the right
to purchase on a pro rata basis
new issues of common stock (or
convertible securities).
Purpose
• It prevents the management of a corporation from
issuing a large number of additional shares and
purchasing those shares itself.
• Far more important, reason for the preemptive right is to
protect stockholders from a dilution of value.
• For example, suppose 1,000 shares of common stock,
each with a price of $100, were outstanding, making
the total market value of the firm $100,000. If an
additional 1,000 shares were sold at $50 a share, or
for $50,000, this would raise the firm’s total market
value to $150,000. When the new total market value
is divided by the 2,000 total shares now outstanding,
a value of $75 a share is obtained. The old
stockholders would thus lose $25 per share, and the
new stockholders would have an instant profit of $25
per share
Type of Common Stock
• Classified Stock = Common stock that is given a special
designation such as Class A or Class B to meet special needs of
the company.
• For example, when Google went public, it sold Class A stock to the
public while its Class B stock was retained by the company’s insiders.
• The key difference is that the Class B stock has 10 votes per share
while the Class A stock has 1 vote per share.
• Founders’ Shares = Stock owned by the firm’s founders that
enables them to maintain control over the company without
having to own a majority of stock.
 Intrinsic Value and Stock Price
• Outside investors, corporate insiders, and analysts use a
variety of approaches to estimate a stock’s intrinsic value (P0).
• In equilibrium we assume that a stock’s price equals its
intrinsic value.
• Outsiders estimate intrinsic value to help determine which stocks are
attractive to buy and/or sell.
• Stocks with a price below (above) its intrinsic value are undervalued
(overvalued).

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 Determinants of Intrinsic Value and
Stock Prices
Managerial Actions, the Economic
Environment, Taxes, and the Political Climate

“True” Investor “True” “Perceived” Investor “Perceived”

Cash Flows Risk Cash Flows Risk

Stock’s Stock’s
Intrinsic Value Market Price

Market Equilibrium:
Intrinsic Value = Stock Price

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Why Do Companies and Investors Care About
Intrinsic Value
• Investors : Purchase undervalued and avoid overvalued stock
• Companies
• managers need to know how alternative actions are likely to affect
stock prices
• managers should consider whether their stock is significantly
undervalued or overvalued before making certain decisions. For
example, firms should consider carefully the decision to issue new
shares if they believe their stock is undervalued

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 Different Approaches for Estimating the Intrinsic
Value of a Common Stock

• Discounted dividend model

• Corporate valuation model
• P/E multiple approach
• EVA approach

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 Discounted Dividend Model
• Value of a stock is the present value of the
future dividends expected to be generated
by the stock.

D1 D2 D3 D
P̂0 = + + + ... + 
(1 + rs )1
(1 + rs ) 2
(1 + rs ) 3
(1 + rs )

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 Constant Growth Stock
• A stock whose dividends are expected to grow
forever at a constant rate, g.
D1 = D0(1 + g)1
D2 = D0(1 + g)2
Dt = D0(1 + g)t
• If g is constant, the discounted dividend formula
converges to:
D 0 (1 + g) D1
P̂0 = =
rs − g rs − g

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 Future Dividends and Their Present
Values
$ D t = D 0 (1 + g) t

0.25 Dt
PVD t =
( 1 + r )t

P0 =  PVD t

0 Years (t)

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 What happens if g > rs?
• If g > rs, the constant growth formula leads to a
negative stock price, which does not make sense.
• The constant growth model can only be used if:
• rs > g.
• g is expected to be constant forever.

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 Use the SML to Calculate the Required
Rate of Return (rs)
• If rRF = 7%, rM = 12%, and b = 1.2, what is the
required rate of return on the firm’s stock?

rs = rRF + (rM – rRF)b

= 7% + (12% – 7%)1.2
= 13%

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 Find the Expected Dividend Stream for the Next 3 Years and
Their PVs

D0 = $2 and g is a constant 6%.

0 g = 6%
1 2 3

2.12 2.247 2.382

1.8761
rs = 13%
1.7599
1.6509

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 What is the stock’s intrinsic value?

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 What is the stock’s expected value, one year
from now?
• D1 will have been paid out already. So, expected
P1 is the present value (as of Year 1) of D2, D3, D4,
etc.
D2 $2.247
P̂1 = =
rs − g 0.13 − 0.06
= $32.10

• Could also find expected P1 as:

P̂1 = P0 (1.06) = $32.10

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 Find Expected Dividend Yield, Capital
Gains Yield, and Total Return During
First Year
• Dividend yield
= D1/P0 = $2.12/$30.29 = 7.0%

• Capital gains yield

= (P1 – P0)/P0
= ($32.10 – $30.29)/$30.29 = 6.0%

• Total return (rs)

= Dividend yield + Capital gains yield
= 7.0% + 6.0% = 13.0%

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 What would the expected price today
be, if g = 0?
The dividend stream would be a perpetuity.

0 rs = 13% 1 2 3

2.00 2.00 2.00

PMT $2.00
P̂0 = = = $15.38
r 0.13

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 Supernormal Growth: What if g = 30% for 3
years before achieving long-run growth of 6%?
• Can no longer use just the constant growth model
to find stock value.
• However, the growth does become constant after
3 years.

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 Valuing Common Stock with
Nonconstant Growth
D0 = $2.00.
0 rs = 13% 1 2 3 4

g = 30% g = 30% g = 30% g = 6%

2.600 3.380 4.394 4.658
2.301
2.647
3.045
4.658
46.114 P̂3 = = $66.54
0.13 − 0.06
54.107 = P̂0

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 Find Expected Dividend and Capital
Gains Yields During the First and Fourth
Years
• Dividend yield (first year)
= $2.60/$54.11 = 4.81%
• Capital gains yield (first year)
= 13.00% – 4.81% = 8.19%
• During nonconstant growth, dividend yield and
capital gains yield are not constant, and capital
gains yield ≠ g.
• After t = 3, the stock has constant growth and
dividend yield = 7%, while capital gains yield =
6%.
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Nonconstant Growth: What if g = 0% for 3
years before long-run growth of 6%?
D0 = $2.00.
0 rs = 13% 1 2 3 4

g = 0% g = 0% g = 0% g = 6%
2.00 2.00 2.00 2.12
1.77
1.57
1.39
2.12
20.99 P̂3 = = $30.29
0.13 − 0.06
25.72 =P̂0

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Find Expected Dividend and Capital Gains
Yields During the First and Fourth Years
• Dividend yield (first year)
= $2.00/$25.72 = 7.78%

• Capital gains yield (first year)

= 13.00% – 7.78% = 5.22%

• After t = 3, the stock has constant growth and

dividend yield = 7%, while capital gains yield =
6%.

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 If the stock was expected to have negative growth (g = -6%), would
anyone buy the stock, and what is its value?

• Yes. Even though the dividends are declining, the stock

is still producing cash flows and therefore has positive
value.

D1 D (1 + g)
P̂0 = = 0
rs − g rs − g
$2.00 (0.94) $1.88
= = = $9.89
0.13 − (-0.06) 0.19

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 Find Expected Annual Dividend and Capital Gains
Yields

• Capital gains yield

= g = -6.00%

• Dividend yield
= 13.00% – (-6.00%) = 19.00%

• Since the stock is experiencing constant growth,

dividend yield and capital gains yield are
constant. Dividend yield is sufficiently large (19%)
to offset negative capital gains.

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 Corporate Valuation Model
• Also called the free cash flow method. Suggests
the value of the entire firm equals the present
value of the firm’s free cash flows.
• Remember, free cash flow is the firm’s after-tax
operating income less the net capital investment.

 Depr. and   Capital 

FCF = EBIT(1 − T) + − +  NOWC
 amortizati on expenditures 

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 Applying the Corporate Valuation
Model
• Find the market value (MV) of the firm, by finding
the PV of the firm’s future FCFs.
• Subtract MV of firm’s debt and preferred stock to
get MV of common stock.
• Divide MV of common stock by the number of
shares outstanding to get intrinsic stock price
(value).

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 Issues Regarding the Corporate
Valuation Model
• Often preferred to the discounted dividend
model, especially when considering number of
firms that don’t pay dividends or when dividends
are hard to forecast.
• Similar to discounted dividend model, assumes at
some point free cash flow will grow at a constant
rate.
• Horizon value (HVN) represents value of firm at
the point that growth becomes constant.

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 Use the Corporate Valuation Model to Find the Firm’s
Intrinsic Value

Given: Long-Run gFCF = 6% and WACC = 10%

0 r = 10% 1 2 3 4

g = 6%
-5 10 20 21.20
-4.545
8.264
15.026
21.20
398.197 530 = = HV3
0.10 − 0.06
416.942

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 What is the firm’s intrinsic value per
share?
The firm has $40 million total in debt and
preferred stock and has 10 million shares of
common stock.
MV of equity = MV of firm − MV of debt and preferred
= $416.94 − $40
= $376.94 million

Value per share = MV of equity/# of shares

= $376.94 /10
= $37.69

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 Firm Multiples Method
• Analysts often use the following multiples to
value stocks.
• P/E
• P/CF
• P/Sales

• EXAMPLE: Based on comparable firms, estimate

the appropriate P/E. Multiply this by expected
earnings to back out an estimate of the stock
price.

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 EVA Approach
EVA = Equity capital(ROE – Cost of equity)

MVEquity = BVEquity + PV of all future EVAs

Value per share = MVEquity/# of shares

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 Preferred Stock
• Hybrid security.
• Like bonds, preferred stockholders receive a fixed
dividend that must be paid before dividends are
paid to common stockholders.
• However, companies can omit preferred dividend
payments without fear of pushing the firm into
bankruptcy.

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 If preferred stock with an annual dividend
of $5 sells for $50, what is the preferred
stock’s expected return?
D
Vp =
rp
$5
$50 =
rp

$5
r̂p =
$50
= 0.10 = 10%

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