9/20/2021

LECTURE 3: SOURCES OF FINANCE

Module 2: The Equity Market: Stock Valuation
Dr. Tien Nguyen
2021

ISSUING & TRADING STOCK

• Stock is issued by public corporations to finance

investments.
• Stock is initially issued in the primary market (IPO
and secondary / seasoned offerings)
• Stock is traded in the secondary market (NYSE,
NASDAQ, …).
• auction vs. dealer markets
• organized vs. OTC markets
• listed vs. over-the-counter (OTC) securities

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A BASIC STOCK QUOTE

TYPES OF STOCKS

PREFERRED STOCK COMMON STOCK

(ORDINARY)
- Ranks ahead of common stock for
- Stockholders are residual
 Dividends
claimants.
 Payout on liquidation
- Stockholders have the right to:
- Pays a constant dividend
 vote at company meetings
 Generally quoted as a
 proxy right
percentage of face value
 redemptive right
 Does not usually participate in
profit increases - Stockholders benefits in two ways:
 dividends
- No voting power
DIV1  (capital
P1  P0 )gains
Expected rate of return (r) =
over one period P0

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TRANSACTION INVOLVING STOCKS

BUY IF … SELL IF …

Savings motive (Buy-and-hold) Liquidity needs

Expect shares of stock to rise in value Expect shares of stock to fall in value
LONG position SHORT position

TRANSACTION INVOLVING STOCKS

 Short sell
• Expect shares of stock to fall in value
• Sell stock without first owning it.
• Borrow stock from your broker with the promise to repay it at some later
date.
 Sell the borrowed stock.
 Repurchase it at a later date to repay your broker.
• Responsible for all dividends and other distributions while short the
stock.

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CONCEPT OF SHORT SELLING

• Assume HVN (Vietnam Airlines JSC) is selling at $2. You believe they will fall
to $1.50. You don’t own HVN.
• Short selling HVN involves:
• A broker ‘lending’ you HVN shares of stock (with an understanding that
you will return them at a later date)
• You sell the HVN shares on market at $2
• When HVN does fall to say $1.50, you buy HVN on market and satisfy you
obligation to broker
• Have sold for $2 and bought at $1.50: profit $0.50
• Danger with short sale is if HVN actually rises!

STOCK VALUATION:
DIVIDEND DISCOUNTED MODEL (DDM)

 Stock price is the present value of all expected future cash flows from the
share:
• If hold share forever, receive an infinite stream of dividends:

d1 d2 d3
P0    
1  re  1  re  1  re 3
2


dt
  1  r 
t 1
t
e
with:
• dt is the dividend paid in year t
• Discount rate (re) – return on equity (opportunity cost)

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STOCK VALUATION

d1 d2 d3
P0    
1  re  1  re  1  re 3
2


dt
  1  r 
t 1
t
e

 The price an investor is willing to pay for a share of stock depends upon:
 The magnitude and timing of expected future dividends.
 The risk of the stock.
 The stock’s discount rate, re , is the rate of return investors can expect to earn
on securities with similar risk.

STOCK VALUATION:
DIVIDEND DISCOUNTED
MODEL (DDM)

 Constant dividends (zero

growth)

 Constant dividend growth

(Gorden Growth Model)

 Non-constant dividend growth

(different growth patterns)

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1. CONSTANT DIVIDEND MODEL

(Zero-growth)

• Assumes the same dividend is paid forever

… it is an application of a simple perpetuity!

d
P0  Usually for preferred
re stock valuation

 Ex: RJR Nabisco has a preferred stock outstanding with an annual dividend
of $2.50 per share. If securities with similar risk are expected to return 9.6%
p.a., what is the price of the preferred stock?
 P = 2.5/0.096

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2. CONSTANT GROWTH DIVIDEND MODEL

(Gordon Growth Formula)

• Assumes dividends grow at a constant rate of g per annum

0 1 2 3 4
...
d0 d0(1+g) d0(1+g)2 d0(1+g)3 d0(1+g)4

• Under constant growth of divs, share price is given by:

d1 d 1  g 
P0   0
re  g re  g

(need re > g)

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CONSTANT GROWTH DIVIDEND MODEL

(Gordon Growth Formula)

Illustration 1:
Suppose Duke Power just paid a dividend of $2.04 per share. Duke Power
expects its profits and dividends to grow at about 7% per year.
a) If stockholders require a 12% p.a. rate of return, what is the current market
price of Duke Power’s stock?
0 1 2 3 4 5
2.04 2.04(1.07) 2.04(1.07)2 2.04(1.07)3 2.04(1.07)4 2.04(1.07)5 ...
d 0 (1  g) 2.04  1.07 
PV   $43.66
r  g 0.12  0.07
b) What is the market price of Duke Power’s common stock in year 4?

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CONSTANT GROWTH DIVIDEND MODEL

(Gordon Growth Formula)

Illustration 2:
Suppose TB Pirates, Inc., is expected to pay a $2 dividend in next year. If the
dividend is expected to grow at 5% per year and the required return is 20%,
what is the current market price?
P0 = 2 / (.2 - .05) = $13.33
Why isn’t the $2 in the numerator multiplied by (1.05) in this example?
What is the price of TB Pirates Sock in year 4?
0 1 2 3 4 5

2 2(1.05) 2.(1.05)2 2.(1.05)3 2.(1.05)4 ...

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3. NON-CONSTANT DIVIDEND GROWTH MODEL

• For some companies, dividends may be expected to grow at varying rates:

 a new company may start with no or low dividends, gradually move
to high dividends, and settle on relatively constant dividends as the
business matures

19XX-20XX 20XX-20XX 20XX-20XX 20XX-20XX

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3. NON-CONSTANT DIVIDEND GROWTH MODEL

Illustration 1:
BPH Co. paid a dividend of $2 per share yesterday and expects that the rate
of growth in dividends will be 10% per year for the next 3 years, and then 4%
per year thereafter.
a) What is the current value of this stock if the required return is 12% p.a.,
and the company pays dividends annually?
2 1.1  1.04 
3

21.1  21.1  2 1.1 

2 3
PV     0.12  0.04  30.42
1.12  1.12  1.12 3
2
1.12 3
0 1 2 3 4 5
2 2(1.1) 2(1.1)2 2(1.1)3 2(1.1)3 (1.04) 2(1.1)3 (1.04)^2 ...

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3. NON CONSTANT DIVIDEND GROWTH MODEL

Illustration 2 (Handout 15):

JAH Ltd does not currently pay a dividend, but you expect that it will begin
paying a $0.50 per share dividend at the end of year 2. The dividend is expected
to grow at 20% per year for 3 years, and then slow to a sustained growth rate of
4% per year thereafter. The market opportunity rate for investors in JAH shares
is 13% p.a.
What is the price per share today that you expect JAH shares to sell at?

0.5 1.2  1.04 

3

0.5 1.2  0.5 1.2 

2
0.5 0.5(1.2) 3
PV      0.13  0.04  7.14
1.13 2 1.13 3 1.13 4 (1.13) 5 1.13 5

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Estimate Cost
of Equity

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ESTIMATE COST OF EQUITY

• Constant growth model:

d1
P0 
re  g

d
• Market capitalization rate
re  g
P
Growth rate
Dividend
yield

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ESTIMATE COST OF EQUITY

• Illustration 1: The common stock of Flo’s Home Furnishings has a 3.5%

dividend yield. You expect the company to grow by 6% annually. What is
the required return on this stock?
Answer: 9.5%

• Illustration 2: The common stock of Roy’s Outdoor Sport Store has a

market rate of return of 17.5% and the market price of $15.00 per share.
Roy’s will pay their annual dividend next week in the amount of $2.10 per
share. What is the capital gain yield (g) on this stock?
Answer: 3.5% = 0.175 – (2.1/15)

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ESTIMATE DIVIDEND GROWTH (g)

• Preliminaries:
• EPS (Earnings per Share)
• net earnings attributable to each common stockholder
Earnings attributable for common stockholders
EPS = # issued common stock

• DPS (Dividends per Share)

• dividend paid to stockholder for each share held
Total dividend paid for common stockholders
DPS =
# issued common stock

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ESTIMATE DIVIDEND GROWTH (g)

• If not all earnings are paid as dividends

• (DPS/EPS < 1)
• Then the excess cash (EPS – DPS) can be reinvested
• Reinvested cash will earn re Why?
• So earnings will grow by (EPS – DPS)re
• Implying a growth rate of

g
EPS  DPS r  DPS 
 1 
e re
EPS  EPS 

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ESTIMATE DIVIDEND GROWTH (g)

• Illustration 1:
David Jones Limited (DJS)
• EPS 10.49¢
• DPS 8¢
• ROE 9.32% (estimated)
• Share price $1.2
• Opportunity cost of capital 9%

Data collected from www.tradingroom.com.au on 3/4/X1

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ESTIMATE DIVIDEND GROWTH (g)

Next year:
EPS
EPS = 10.49¢
= 10.49¢

Payout 76.3% Plow-back 23.7%

DPS = 8¢ Retained Profit = 2.49¢

.081.0221 Reinvest at ROE of 9.32%

P  $1.2
.09  .0221

Growth = 0.23¢
(g = 2.21%=23.7%  9.32%)
growth rate = return on equity x plowback ratio

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ESTIMATE DIVIDEND GROWTH (g)

• Illustration 2:
CEG – Commune Electricity Group, Vietnam – is currently in the stable growth
period.
• Following is the financial data at the end of 20X1:
• EPS = VND2,690/share = Eo
• DPS = VND1,700/share = D0  payout = 1700/2690 = 0.6319
• ROE = 15% p.a.
• Opportunity cost of capital = 12% p.a.
• What is the current share price of CEG?
• g = (1-DPS/EPS)*0.15 = 0.0552
• P = 1700(1.0552)/(0.12-0.0552) = 27,682.72

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MHD Ltd is in the high-tech industry

• Currently the company is running at a loss, but
MHD expects to report EPS of 10¢ (10 cent)
and payout 50% of earnings as a dividend in
the second year
Comprehensive • Once profitable, earnings and dividends will
problem grow at 15% for 5 years (years 3-7).
• From year 8, growth will slow to 4%
 If MHD’s re is 20%, what are MHD shares
worth?

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Textbook Chapter 7, Problem 27:

You expect a share of stock to pay dividends of
$1.00, $1.25, $1.5 in each of the next 3 years.
You believe the stock will sell for $20 at the end
of the third year.
Textbook
 What is the stock price if the discount rate is
Problem 27 10%?

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