Chapter 9

Stock Valuation

McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

Key Concepts and Skills
 Understand how stock prices depend on future
dividends and dividend growth
 Be able to compute stock prices using the
dividend growth model
 Understand how growth opportunities affect
stock values
 Understand the PE ratio
 Understand how stock markets work

9-2

3 Growth Opportunities 9.Chapter Outline 9.5 The Stock Markets 9-3 .1 The Present Value of Common Stocks 9.2 Estimates of Parameters in the Dividend Discount Model 9.4 Price-Earnings Ratio 9.

 Stock ownership produces cash flows from:  Dividends  Capital Gains  Valuation of Different Types of Stocks  Zero Growth  Constant Growth  Differential Growth 9-4 .1 The PV of Common Stocks  The value of any asset is the present value of its expected future cash flows.9.

Case 1: Zero Growth  Assume that dividends will remain at the same level forever Div1  Div 2  Div 3    Since future cash flows are constant. the value of a zero growth stock is the present value of a perpetuity: Div1 Div 2 Div 3 P0     (1  R ) (1  R ) (1  R) 1 2 3 Div P0  R 9-5 .

g. . Div1  Div 0 (1  g ) Div 2  Div1 (1  g )  Div 0 (1  g ) 2 Div 3  Div 2 (1  g )  Div 0 (1  g ) 3 .e. the value of a constant growth stock is the present value of a growing perpetuity: Div P0  1 Rg 9-6 . forever.Case 2: Constant Growth Assume that dividends will grow at a constant rate. Since future cash flows grow at a constant rate forever.. i..

15 .50.Constant Growth Example  Suppose Big D..92 9-7 . It is expected to increase its dividend by 2% per year.. Inc. just paid a dividend of $.50(1+.02) = $3.02) / (. If the market requires a return of 15% on assets of this risk level. how much should the stock be selling for?  P0 = .

we need to:  Estimate future dividends in the foreseeable future.  Estimate the future stock price when the stock becomes a Constant Growth Stock (case 2).  Compute the total present value of the estimated future dividends and future stock price at the appropriate discount rate.Case 3: Differential Growth  Assume that dividends will grow at different rates in the foreseeable future and then will grow at a constant rate thereafter. 9-8 .  To value a Differential Growth Stock.

9-9 .Case 3: Differential Growth  Assume that dividends will grow at rate g1 for N years and grow at rate g2 thereafter. .. Div1  Div 0 (1  g1 ) Div 2  Div1 (1  g1 )  Div 0 (1  g1 ) 2 .. . Div N  Div N 1 (1  g1 )  Div 0 (1  g1 ) N Div N 1  Div N (1  g 2 )  Div 0 (1  g1 ) (1  g 2 ) N .

Case 3: Differential Growth Dividends will grow at rate g1 for N years and grow at rate g2 thereafter Div 0 (1  g1 ) Div 0 (1  g1 ) 2 … 0 1 2 Div N (1  g 2 ) Div 0 (1  g1 ) N  Div 0 (1  g1 ) (1  g 2 ) N … … N N+1 9-10 .

Case 3: Differential Growth We can value this as the sum of:  a T-year annuity growing at rate g1 C  (1  g1 )  T PA   1 T  R  g1  (1  R)   plus the discounted value of a perpetuity growing at rate g2 that starts in year T+1  Div T 1     R  g2  PB  (1  R)T 9-11 .

we can “cash flow” it out.Case 3: Differential Growth Consolidating gives:  Div T 1      C  (1  g1 )   R  g 2  T P  1 T   R  g1  (1  R)  (1  R ) T Or. 9-12 .

The dividend is expected to grow at 8% for 3 years. What is the stock worth? The discount rate is 12%. 9-13 .A Differential Growth Example A common stock just paid a dividend of $2. then it will grow at 4% in perpetuity.

12) P  $5.12  .89 9-14 .75 3 (1.8966   $32.58  $23.04  P  1  3  .08) 3 (1.31 P  $28.12) 3 P  $54  1  .With the Formula  $2(1.12)  (1.12  .08  (1.08)  (1.08)   3 .04)      $2  (1.

12 (1.52  growth phase .08) $2(1. $2.33 $2.62 The constant $2.89 1.52  $32.62 P3   $32.08) (1.33 $2.12) $2.12) (1.16 $2.04 beginning in year 4 can be valued as a 0 1 2 3 growing perpetuity at time 3.75 P0   2  3  $28.08) 2 $2(1.75 .04) … 0 1 2 3 4 $2.08 9-15 .12  .16 $2. With Cash Flows 3 3 $2(1.08) $2(1.

R.9.  Where does g come from? g = Retention ratio × Return on retained earnings 9-16 . g. and its discount rate.2 Estimates of Parameters  The value of a firm depends upon its growth rate.

 The dividend yield  The growth rate (in dividends)  In practice. there is a great deal of estimation error involved in estimating R.Where Does R Come From?  The discount rate can be broken into two parts. 9-17 .

Using the DGM to Find R  Start with the DGM: D 0 (1  g) D1 P0   R -g R -g Rearrange and solve for R: D 0 (1  g) D1 R g  g P0 P0 9-18 .

EPS P  NPVGO R 9-19 .  The value of a firm can be conceptualized as the sum of the value of a firm that pays out 100% of its earnings as dividends plus the net present value of the growth opportunities.9.3 Growth Opportunities  Growth opportunities are opportunities to invest in positive NPV projects.

NPVGO must be: $75 .75 9-20 .$31. a discount rate of 16%.NPVGO Model: Example Consider a firm that has forecasted EPS of $5. and is currently priced at $75 per share.25 = $43.  We can calculate the value of the firm as a cash cow. EPS $5 P0    $31.25 R .16  So.

then increased retention increases firm value since reinvested capital earns more than the cost of capital.Retention Rate and Firm Value  An increase in the retention rate will:  Reduce the dividend paid to shareholders  Increase the firm’s growth rate  These have offsetting influences on stock price  Which one dominates?  If ROE>R. 9-21 .

 The Wall Street Journal uses last 4 quarter’s earnings Price per share P/E ratio  EPS 9-22 .9.  The price-earnings ratio is calculated as the current stock price divided by annual EPS.4 Price-Earnings Ratio  Many analysts frequently relate earnings per share to price.

P  NPVGO R  Dividing every term by EPS provides the following description of the PE ratio: 1 NPVGO PE   R EPS  So. a firm’s PE ratio is positively related to growth opportunities and negatively related to risk (R) 9-23 .PE and NPVGO EPS  Recall.

Brokers  New York Stock Exchange (NYSE)  Largest stock market in the world  License Holders (formerly “Members”)  Entitled to buy or sell on the exchange floor  Commission brokers  Specialists  Floor brokers  Floor traders  Operations  Floor activity 9-24 .5 The Stock Markets  Dealers vs.9.

brokers & dealers  Level 3 – view and update quotes.NASDAQ  Not a physical exchange – computer-based quotation system  Multiple market makers  Electronic Communications Networks  Three levels of information  Level 1 – median quotes. registered representatives  Level 2 – view quotes. dealers only  Large portion of technology stocks 9-25 .

Stock Market Reporting Gap pays a dividend of 34 Gap has cents/share. the last year.06. Gap ended trading at been as high $11. 9-26 . 8 times earnings.1%.89 in cents from yesterday. Given the current price.41 in price. which is up 45 as $21. 8.829. the last year. the PE ratio is trading. the dividend yield is 3.800 shares traded Gap has been as Given the current hands in the last day’s low as $9.

 Discuss the importance of the PE ratio.Quick Quiz  What determines the price of a share of stock?  What determines g and R in the DGM?  Decompose a stock’s price into constant growth and NPVGO values.  What are some of the major characteristics of NYSE and Nasdaq? 9-27 .