Chapter 9

Stocks and Their Valuation

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Topics Covered
• Common and Preferred Stock Properties
• Valuing Preferred Stocks
• Valuing Common Stocks - the Dividend Growth
Model
▫ No growth
▫ Constant growth
▫ Non-constant or supernormal growth
• Valuing the Entire Corporation – Free Cash
Flow Approach
• Stock Market Equilibrium
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Facts about common stock

• Represents ownership
• Ownership implies control
• Stockholders elect directors
• Directors elect management
• Management’s goal: Maximize the stock price
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Preferred Stock Characteristics

• Unlike common stock, no ownership interest
• Second to debt holders on claim on company’s
assets in the event of bankruptcy.
• Annual dividend yield as a percentage of par
value
• Preferred dividends must be paid before
common dividends
• If cumulative preferred, all missed past
dividends must be paid before common
dividends can be paid.
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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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Preferred Stock Valuation

• Promises to pay the same dividend year after
year forever, never matures.
• A perpetuity.
• VP = DP/rP
• Expected Return: rP = DP/P0
• Example: GM preferred stock has a $25
par value with a 8% dividend yield. What
price would you pay if your required
return is 7%?
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What do investors in common stock want?

• Periodic cash flows: dividends, and…

• To sell the stock in the future at a higher price
• Management to maximize their wealth
Stock Valuation: Dividend Growth Model

Stock Value = PV of Future

Expected Dividends
D1 D2 D3 D
P0     ... 
1  r  1  r  1  r 
1 2 3
1  r 

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Stock Valuation: Dividend Patterns

• For Valuation: we will assume stocks fall into
one of the following dividend growth patterns.
▫ Constant growth rate in dividends
▫ Zero growth rate in dividends, like preferred stock
▫ Variable (non-constant) growth rate in dividends
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Stock Valuation Case Study: Doh! Doughnuts

• We have found the following information for

Doh! Doughnuts:
• current dividend = $2.00 = Div0
• The current T-bill rate is 5% and investors
demand an 9% market risk premium.
• Doh!’s beta = 1.2.
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Analysts Estimates for Doh! Doughnuts

• NEDFlanders predicts a constant annual growth
rate in dividends and earnings of zero percent
(0%)
• Barton Kruston Simpson predicts a constant
annual growth rate in dividends and earnings of
10 percent (9%).
• Homer Co. expects a dramatic growth phase of
30% annually for each of the next 3 years
followed by a constant 10% growth rate in year 4
and beyond.
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Our Task: Valuation Estimates

• What should be each analyst’s estimated value of
Doh! Doughnuts?
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Valuing Common Stocks: No Growth

If we forecast no growth, and plan to hold out
stock indefinitely, we will then value the stock as
a PERPETUITY.
Div1 EPS1
Perpetuity  P0  or
r r
Assumes all earnings are
paid to shareholders.
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Ned Flanders’ Valuation

• D0 = $2.00, rS = 15.8% or 0.158, g = 0%
Constant Growth Valuation Model
• Assumes dividends will grow at a constant rate
(g) that is less than the required return (rS )
• If dividends grow at a constant rate forever, you
can value stock as a growing perpetuity,
denoting next year’s dividend as D1:

D (1 + g )
0 D 1
P = r -g = r -g
0
S S

Commonly called the Gordon growth model

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Barton Kruston Simpson’s Valuation

• D0 = $2.00, g = 9%, rS = 15.8%
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Expected Return of Constant Growth

Stocks
• Expected Rate of Return = Expected Dividend
Yield + Expected Capital Gains Yield
• D1/P0 = Expected Dividend Yield
• g = Expected Capital Gains Yield
• r = (D1/P0) + g = (D0(1+g)/P0) + g
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Example
• Burns International’s stock sells for $80 and
their expected dividend is $4. The market
expects a return of 15%.
• What constant growth rate is the market
expecting for Burns International?
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Variable Growth Stock Valuation

• Framework: Assume Stock has period of non-
constant growth in dividends and earnings and
then eventually settles into a normal constant
growth pattern (gc).
0 g1 1 g2 2 g3 3 gc 4 gc 5 gc ...

D1 D2 D3

Non-constant Growth Period Constant Growth

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Today’s agenda
• Supernormal (non-constant) dividend growth
valuation
• Corporate value approach to stock valuation
• Stock Market Equilibrium
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Homer Co. Valuation

• Variable (non-constant) growth
• Years 1-3 expect 30% growth
• After year 3: constant growth of 10%
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Variable Growth Valuation Process

3 Step Process
• Estimate Dividends during non-constant growth
period.
• Estimate Price, which is the PV of the constant
growth dividends, at the end of non-constant growth
period which is also the beginning of the constant
growth period. This is called the horizon or terminal
value.
• Find the PV of non-constant dividends and horizon
value. The total of these PVs = Today’s estimated
stock value.
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Back to Homer Co’s Valuation: Step 1

• D0 = $2.00, g = 30% or 0.3 for next 3 years
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Homer Co’s Valuation: Step 2

• Find Horizon Value which is the constant growth
stock value at the end of year 3.
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Homer Co’s Valuation: Step 3

0 r = 15.8% 1 2 3 4
s
...
g = 30% g = 30% g = 30% gc = 10%
PV(CF) 2.600 3.380 4.394
2.245 +83.334
87.728
2.521
56.495 ^
$61.26 = P0
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Corporate value 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
▫ FCF = NOPAT – Net capital investment
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Applying the corporate value model

• Find the market value (MV) of the firm, by
finding the PV of the firm’s future FCFs at the
company’s weighted average cost of capital,
WACC.
• 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 value

model
• Often preferred to the dividend growth model,
especially when considering number of firms
that don’t pay dividends or when dividends are
hard to forecast.
• Similar to dividend growth model, assumes at
some point free cash flow will grow at a constant
rate.
• Terminal value (TVN) represents value of firm at
the point that growth becomes constant.
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An Example: Advanced Micro Devices

• AMD’s debt market value is $692
(AMD) million.
• No preferred stock
AMD • 486 million shares outstanding
• Current free cash flow is $286
million.

Assume that AMD will experience 21% year 1, 19%

year 2 and 18% FCF growth in year 3 and 11%
constant annual growth thereafter.

AMD’s WACC is approximately 17%.

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An Example: AMD Projected

FCFs($millions)
End of Year Growth Growth FCF Calculation
Status Rate (%)

1 Variable 21 $286(1.21) = $346.1

2 Variable 19 $346.1 x (1.19) = $411.8

3 Variable 18 $411.8 x (1.18) = $485.9

4 Constant 11 $485.9 x (1.11) = $539.4

Use non-constant growth to estimate AMD’s

corporate value.
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AMD’s FCF Corporate Valuation

($millions)
0 WACC=17%1 2 3 4
...
gc = 11%
346.1 411.8 485.9 539.4
295.8
300.8
303.4
539.4
5613.0 $
TV  8989.8
3
^ 0.17 - 0.11
6513.0 = Firm Value
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AMD’s Stock Value per share

• MV of firm = $6513 million
• MV of debt = $692 million
• MV of equity (stock) = $6513 - $692 = $5821
million
• 486 million shares outstanding
• P0 = MV of equity/shares = $5821/486 = $11.98
• Recent price = $13.50
Stock Market Equilibrium
• In equilibrium, stock prices are stable and there is
no general tendency for people to buy versus to sell.
• In equilibrium, two conditions hold:
▫ The current market stock price equals its intrinsic
value (P0 = P0).
▫ Expected returns must equal required returns.

^ D1
rs   g  rs  rRF  (rM - rRF )b
P0
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How is market equilibrium established?

• If price is below intrinsic value …
▫ The current price (P0) is “too low” and
offers a bargain.
▫ Buy orders will be greater than sell orders.
▫ P0 will be bid up until expected return
equals required return.
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Doh! In equilibrium?
• Doh! Doughnuts current stock price is $30.
• Required return = 5% + 9%(1.2) = 15.8%
• Let’s assume the 2nd analyst is correct and Doh!
Has a constant growth rate of 9% and its current
dividend is $2.
• Is Doh! Doughnuts’ current stock price in
equilibrium?
Expected Return of Constant Growth
Stocks
• Expected Rate of Return = Expected Dividend Yield
+ Expected Capital Gains Yield
• D1/P0 = D0(1+g)/P0 = Expected Dividend Yield
• g = Expected Capital Gains Yield
• From our example, D1=$2(1.09) = $2.18, P0=$30, g
= 9% or 0.09

^ D1 $2.18
rs  g   9%  7.3%  10%  17.3%
P0 $30

DOH! Doh! Doughnuts

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The Effect On the Stock Price
20%
15%
10%
5%
0%
0 0.2 0.4 0.6 0.8 1 1.2 1.4

• Expected Return needs to fall to the required return

of 15.8%. This means the stock price must rise to
the equilibrium price that yields the required return
of 15.8%
• New Price = D1/(rs- g)=$2.18/(.158 - .09)= $32.06

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Stock Valuation Summary

• Looked at Dividend Discount Model: Value =
PV of future expected dividends. All else equal:
▫ Higher interest rates (rs) yields lower stock prices
(inverse relationship)
▫ Higher growth rate yields higher stock price.
• Other Stock Valuation Methods
▫ “Multiples” Method: P/E, P/CF, P/S
▫ For example: Price Estimate = PE Ratio x
expected EPS