Stock Valuation

Outline
 How to Value Common Stock

 Dividend Discount Model (DDM)

 No-Growth Model

 Constant Growth Model

 Present Value of Future Growth Opportunities

 Stock Valuation

 What should the market value of an

asset (a stock, for example) be?
 In well-functioning financial markets, the
value of any financial asset should be equal
to the present value of its expected future
cash flows discounted at the risk-adjusted
discount rate.
 Fair value of stock price
 The dividend discount model (DDM) is
used to find the ‘Fair Value’ of the
stock. It can be different than the
actual market value.
 The discount factor used in the model is
called ‘required rate of return by
shareholders’ .
Dividend Discount Model (DDM) :
The General Case

Dt
Po  
t  1 (1  r )
t

 P0 = Fair Price of Stock or Intrinsic Value

 Dt = Dividend at time t
 r = required rate of return or discount rate
Dividend Discount Model (DDM) :
The General Case
Stock Value = PV of future dividend payments

 P0 = Fair Price of Stock or Intrinsic Value

 Dt = Dividend at time t
 r = required rate of return or discount rate
 No Growth DDM

D
Po 
r

D is a dividend that is expected to remain
constant forever
 r = required rate of return by shareholders
 No Growth DDM: Example

D
Po  r

D = $5.00
r = .15
P0 = $5.00 / .15 = $33.33
 Constant Growth DDM

D1
Po 
r g

 D1=D0(1 + g)
 g = constant perpetual growth rate
 r= required return of return
 Constant Growth DDM:
Example

D1
Po 
r g

r = 15% D1 = $5.00 g = 8%
P0 = 5.00 / (.15 - .08) = $71.43
 What happens if g>r

D1
Po  Requires r> g
r g
 If r<g, we get negative stock prices which
does not make sense.
 We can not use this model unless r>g. g is
assumed to be constant forever.
 Constant Growth DDM:
Example

D1
Po 
r g
r = 15% D1 = $5.00 g = 8%
P0 = 5.00 / (.15 - .08) = $71.43
• What is the stock value one year from
now. Namely at t=1, P1= D2/(r-g) = ?
• P2=?
• P3=?
 PV of Growth Opportunities
 P0 = Price (no growth) + PVGO

 71.43 = 33.33 + PVGO

 PVGO = 71.43-33.33 =$38.10