Chapter

6 Common Stock
Valuation

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 Learning Objectives

Separate yourself from the commoners by having a good

Understanding of these security valuation methods:

1. The basic dividend discount model.

2. The two-stage dividend growth model.
3. The residual income model.
4. Price ratio analysis.

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 Common Stock Valuation

• Our goal in this chapter is to examine the methods

commonly used by financial analysts to assess the
economic value of common stocks.

• These methods are grouped into three categories:

– Dividend discount models
– Residual Income models
– Price ratio models

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 Security Analysis: Be Careful Out There

• Fundamental analysis is a term for studying a

company’s accounting statements and other financial and
economic information to estimate the economic value of a
company’s stock.

• The basic idea is to identify “undervalued” stocks to buy

and “overvalued” stocks to sell.

• In practice however, such stocks may in fact be correctly

priced for reasons not immediately apparent to the
analyst.

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 The Dividend Discount Model

• The Dividend Discount Model (DDM) is a method to estimate the

value of a share of stock by discounting all expected future dividend
payments. The basic DDM equation is:

D1 D2 D3 DT
P0    
1  k  1  k  1  k 
2 3
1  k  T
• In the DDM equation:
– P0 = the present value of all future dividends
– Dt = the dividend to be paid t years from now
– k = the appropriate risk-adjusted discount rate

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 Example: The Dividend Discount Model

• Suppose that a stock will pay three annual dividends of

$200 per year, and the appropriate risk-adjusted discount
rate, k, is 8%.

• In this case, what is the value of the stock today?

D1 D2 D3
P0   
1  k  1  k  2 1  k  3

$200 $200 $200

P0     $515.42
1  0.08  1  0.08  1  0.08 
2 3

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 The Dividend Discount Model:
the Constant Growth Rate Model

• Assume that the dividends will grow at a constant growth rate g. The
dividend next period (t + 1) is:

D t 1  D t  1  g

So, D 2  D1  (1  g)  D 0  (1  g)  (1  g)

• For constant dividend growth for “T” years, the DDM formula
becomes:
D1 (1  g)   1  g  
T

P0  1     if k  g
k  g   1  k  

P0  T  D 0 if k  g

6-7
Example: The Constant Growth Rate Model

• Suppose the current dividend is $10, the dividend growth rate is

10%, there will be 20 yearly dividends, and the appropriate discount
rate is 8%.

• What is the value of the stock, based on the constant growth rate
model?

D 0 (1  g)   1  g  
T

P0  1    
k  g   1  k  

$10  1.10    1.10  

20

P0  1      $243.86
.08  .10   1.08  

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 The Dividend Discount Model:
the Constant Perpetual Growth Model.

• Assuming that the dividends will grow forever at a

constant growth rate g.

• For constant perpetual dividend growth, the DDM formula

becomes:

D 0   1  g D
P0   1 (Important : g  k)
kg kg

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Example: Constant Perpetual Growth Model

• Think about the electric utility industry.

• In 2007, the dividend paid by the utility company, DTE Energy Co.
(DTE), was $2.12.
• Using D0 =$2.12, k = 6.7%, and g = 2%, calculate an estimated value
for DTE.

$2.12  1.02 
P0   $46.01
.067  .02

Note: the actual mid-2007 stock price of DTE was $47.81.

What are the possible explanations for the difference?

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 The Dividend Discount Model:
Estimating the Growth Rate

• The growth rate in dividends (g) can be estimated in a

number of ways:

– Using the company’s historical average growth rate.

– Using an industry median or average growth rate.

– Using the sustainable growth rate.

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 The Historical Average Growth Rate
• Suppose the Broadway Joe Company paid the following dividends:

– 2002: $1.50 2005: $1.80

– 2003: $1.70 2006: $2.00
– 2004: $1.75 2007: $2.20

• The spreadsheet below shows how to estimate historical average

growth rates, using arithmetic and geometric averages.
Year: Dividend: Pct. Chg:
2007 $2.20 10.00%
2006 $2.00 11.11%
2005 $1.80 2.86% Grown at
2004 $1.75 2.94% Year: 7.96%:
2003 $1.70 13.33% 2002 $1.50
2002 $1.50 2003 $1.62
2004 $1.75
Arithmetic Average: 8.05% 2005 $1.89
2006 $2.04
Geometric Average: 7.96% 2007 $2.20

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 The Sustainable Growth Rate

Sustainable Growth Rate  ROE  Retention Ratio

 ROE  (1 - Payout Ratio)

• Return on Equity (ROE) = Net Income / Equity

• Payout Ratio = Proportion of earnings paid out as dividends

• Retention Ratio = Proportion of earnings retained for investment

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 Example: Calculating and Using the
Sustainable Growth Rate

• In 2007, American Electric Power (AEP) had an ROE of 10.17%,

projected earnings per share of $2.25, and a per-share dividend of
$1.56. What was AEP’s:
– Retention rate?
– Sustainable growth rate?

• Payout ratio = $1.56 / $2.25 = .693

• So, retention ratio = 1 – .693 = .307 or 30.7%

• Therefore, AEP’s sustainable growth rate = .1017  .307 = .03122, or

3.122%

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 Example: Calculating and Using the
Sustainable Growth Rate, Cont.

• What is the value of AEP stock, using the perpetual growth model,
and a discount rate of 6.7%?

$1.56  1.03122
P0   $44.96
.067  .03122

• The actual mid-2007 stock price of AEP was $45.41.

• In this case, using the sustainable growth rate to value the stock
gives a reasonably accurate estimate.

• What can we say about g and k in this example?

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 The Two-Stage Dividend Growth Model

• The two-stage dividend growth model assumes that a

firm will initially grow at a rate g1 for T years, and
thereafter grow at a rate g2 < k during a perpetual second
stage of growth.

• The Two-Stage Dividend Growth Model formula is:

D 0 (1  g1 )   1  g1    1  g1  D 0 (1  g 2 )
T T

P0  1     
k  g1   1  k    1  k  k  g2

6-16
 Using the Two-Stage
Dividend Growth Model, I.

• Although the formula looks complicated, think of it as two

parts:
– Part 1 is the present value of the first T dividends (it is the same
formula we used for the constant growth model).
– Part 2 is the present value of all subsequent dividends.

• So, suppose MissMolly.com has a current dividend of

D0 = $5, which is expected to shrink at the rate, g1 = 10%
for 5 years, but grow at the rate, g2 = 4% forever.

• With a discount rate of k = 10%, what is the present value

of the stock?

6-17
 Using the Two-Stage
Dividend Growth Model, II.

D 0 (1  g1 )   1  g1    1  g1  D 0 (1  g 2 )
T T

P0  1     
k  g1   1  k    1  k  k  g2

$5.00(0.90 )   0.90    0.90  $5.00(1  0.04)

5 5

P0  1     
0.10  ( 0.10)   1  0.10    1  0.10  0.10  0.04

 $14.25  $31.78

 $46.03.

• The total value of $46.03 is the sum of a $14.25 present value of the
first five dividends, plus a $31.78 present value of all subsequent
dividends.

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 Example: Using the DDM to Value a Firm
Experiencing “Supernormal” Growth, I.

• Chain Reaction, Inc., has been growing at a phenomenal rate of 30%

per year.

• You believe that this rate will last for only three more years.

• Then, you think the rate will drop to 10% per year.

• Total dividends just paid were $5 million.

• The required rate of return is 20%.

• What is the total value of Chain Reaction, Inc.?

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 Example: Using the DDM to Value a Firm
Experiencing “Supernormal” Growth, II.

• First, calculate the total dividends over the “supernormal” growth

period:

Year Total Dividend: (in $millions)

1 $5.00 x 1.30 = $6.50
2 $6.50 x 1.30 = $8.45
3 $8.45 x 1.30 = $10.985

• Using the long run growth rate, g, the value of all the shares at
Time 3 can be calculated as:

P3 = [D3 x (1 + g)] / (k – g)

P3 = [$10.985 x 1.10] / (0.20 – 0.10) = $120.835

6-20
 Example: Using the DDM to Value a Firm
Experiencing “Supernormal” Growth, III.

• Therefore, to determine the present value of the firm today, we need

the present value of $120.835 and the present value of the dividends
paid in the first 3 years:

D1 D2 D3 P3
P0    
1  k  1  k  2  1  k  3 1  k  3

$6.50 $8.45 $10.985 $120.835

P0    
1  0.20  1  0.20  1  0.20  1  0.20  3
2 3

 $5.42  $5.87  $6.36  $69.93

 $87.58 million.

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 Discount Rates for
Dividend Discount Models

• The discount rate for a stock can be estimated using the capital
asset pricing model (CAPM ).
• We will discuss the CAPM in a later chapter.
• However, we can estimate the discount rate for a stock using this
formula:

Discount rate = time value of money + risk premium

= U.S. T-bill Rate + (Stock Beta x Stock Market Risk Premium)

T-bill Rate: return on 90-day U.S. T-bills

Stock Beta: risk relative to an average stock
Stock Market Risk Premium: risk premium for an average stock

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 Observations on Dividend
Discount Models, I.

Constant Perpetual Growth Model:

• Simple to compute
• Not usable for firms that do not pay dividends
• Not usable when g > k
• Is sensitive to the choice of g and k
• k and g may be difficult to estimate accurately.
• Constant perpetual growth is often an unrealistic assumption.

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 Observations on Dividend
Discount Models, II.

Two-Stage Dividend Growth Model:

• More realistic in that it accounts for two stages of growth

• Usable when g > k in the first stage
• Not usable for firms that do not pay dividends
• Is sensitive to the choice of g and k
• k and g may be difficult to estimate accurately.

6-24
 Residual Income Model (RIM), I.

• We have valued only companies that pay dividends.

– But, there are many companies that do not pay dividends.

– What about them?
– It turns out that there is an elegant way to value these
companies, too.

• The model is called the Residual Income Model (RIM).

• Major Assumption (known as the Clean Surplus Relationship, or

CSR): The change in book value per share is equal to earnings per
share minus dividends.

6-25
 Residual Income Model (RIM), II.

• Inputs needed:
– Earnings per share at time 0, EPS 0
– Book value per share at time 0, B 0
– Earnings growth rate, g
– Discount rate, k

• There are two equivalent formulas for the Residual Income Model:

EPS 0 (1  g)  B 0  k
P0  B 0 
kg BTW, it turns out that the
RIM is mathematically the
or same as the constant
perpetual growth model.
EPS 1  B 0  g
P0 
kg

6-26
 Using the Residual Income Model.

• Superior Offshore International, Inc. (DEEP)

• It is July 1, 2007—shares are selling in the market for $10.94.
• Using the RIM:
– EPS0 = $1.20
– DIV = 0
– B0 = $5.886
EPS 0  (1  g)  B 0  k
– g = 0.09 P0  B 0 
kg
– k = .13
$1.20  (1  .09)  $5.886  .13
P0  $5.886 
.13  .09
• What can we say
about the market $1.308  $.7652
P0  $5.886   $19.46.
price of DEEP? .04

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 DEEP Growth

• Using the information from the previous slide, what growth rate
results in a DEEP price of $10.94?

EPS 0  (1  g)  B 0  k
P0  B 0 
k g

$1.20  (1  g)  $5.886  .13

$10.94  $5.886 
.13  g

$5.054  (.13  g)  1.20  1.20g  .7652

$.6570  5.054g  1.20g  .4348

.2222  6.254g

g  .0355 or 3.55%.

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 Price Ratio Analysis, I.

• Price-earnings ratio (P/E ratio)

– Current stock price divided by annual earnings per share (EPS)

• Earnings yield
– Inverse of the P/E ratio: earnings divided by price (E/P)

• High-P/E stocks are often referred to as growth stocks,

while low-P/E stocks are often referred to as value
stocks.

6-29
 Price Ratio Analysis, II.

• Price-cash flow ratio (P/CF ratio)

– Current stock price divided by current cash flow per share
– In this context, cash flow is usually taken to be net income plus
depreciation.

• Most analysts agree that in examining a company’s

financial performance, cash flow can be more informative
than net income.

• Earnings and cash flows that are far from each other may
be a signal of poor quality earnings.

6-30
 Price Ratio Analysis, III.

• Price-sales ratio (P/S ratio)

– Current stock price divided by annual sales per share
– A high P/S ratio suggests high sales growth, while a low P/S ratio
suggests sluggish sales growth.

• Price-book ratio (P/B ratio)

– Market value of a company’s common stock divided by its book
(accounting) value of equity
– A ratio bigger than 1.0 indicates that the firm is creating value for
its stockholders.

6-31
 Price/Earnings Analysis, Intel Corp.

Intel Corp (INTC) - Earnings (P/E) Analysis

5-year average P/E ratio 27.30

Current EPS $.86
EPS growth rate 8.5%

Expected stock price = historical P/E ratio  projected EPS

$25.47 = 27.30  ($.86  1.085)

Mid-2007 stock price = $24.27

6-32
 Price/Cash Flow Analysis, Intel Corp.

Intel Corp (INTC) - Cash Flow (P/CF) Analysis

5-year average P/CF ratio 14.04

Current CFPS $1.68
CFPS growth rate 7.5%

Expected stock price = historical P/CF ratio  projected CFPS

$25.36 = 14.04  ($1.68  1.075)

Mid-2007 stock price = $24.27

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 Price/Sales Analysis, Intel Corp.

Intel Corp (INTC) - Sales (P/S) Analysis

5-year average P/S ratio 4.51

Current SPS $6.14
SPS growth rate 7%

Expected stock price = historical P/S ratio  projected SPS

$29.63 = 4.51  ($6.14  1.07)

Mid-2007 stock price = $24.27

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 An Analysis of the
McGraw-Hill Company

The next few slides contain a financial

analysis of the McGraw-Hill Company, using
data from the Value Line Investment Survey.

6-35
The McGraw-Hill Company Analysis, I.

6-36
The McGraw-Hill Company Analysis, II.

6-37
 The McGraw-Hill Company Analysis, III.

• Based on the CAPM, k = 3.1% + (.80  9%) = 10.3%

• Retention ratio = 1 – $.66/$2.65 = .751

• Sustainable g = .751  23% = 17.27%

• Because g > k, the constant growth rate model cannot be

used. (We would get a value of -$11.10 per share)

6-38
 The McGraw-Hill Company Analysis
(Using the Residual Income Model, I)

• Let’s assume that “today” is January 1, 2008, g = 7.5%, and k = 12.6%.

• Using the Value Line Investment Survey (VL), we can fill in column two
(VL) of the table below.

• We use column one and our growth assumption for column three (CSR) of
the table below.

End of 2007 2008 (VL) 2008 (CSR)

Beginning BV per share NA $6.50 $6.50
EPS $3.05 $3.45 $3.2788
DIV $.82 $.82 $2.7913
Ending BV per share $6.50 $9.25 $6.9875

3.05  1.075 6.50  1.075

" Plug"  3.2788 - (6.9875 - 6.50)

6-39
 The McGraw-Hill Company Analysis
(Using the Residual Income Model, II)
EPS 0  (1  g)  B 0  k
P0  B 0 
• Using the CSR assumption: kg

$3.05  (1  .075)  $6.50  .126

P0  $6.50 
.126  .075
Stock price at the time = $57.27.
What can we say? P0  $54.73.

EPS 0  (1  g)  B 0  k
• Using Value Line numbers for P0  B 0 
kg
EPS1=$3.45, B1=$9.25
B0=$6.50; and using the actual
change in book value instead of an $3.45  ($9.25 - 6.50)
estimate of the new book value, P0  $6.50 
.126  .075
(i.e., B1-B0 is = B0 x k)

P0  $20.23

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The McGraw-Hill Company Analysis, IV.

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 Useful Internet Sites

• www.nyssa.org (the New York Society of Security Analysts)

• www.aaii.com (the American Association of Individual
Investors)
• www.eva.com (Economic Value Added)
• www.valueline.com (the home of the Value Line Investment
Survey)

• Websites for some companies analyzed in this chapter:

• www.aep.com
• www.americanexpress.com
• www.pepsico.com
• www.intel.com
• www.corporate.disney.go.com
• www.mcgraw-hill.com

6-42
 Chapter Review, I.

• Security Analysis: Be Careful Out There

• The Dividend Discount Model

– Constant Dividend Growth Rate Model
– Constant Perpetual Growth
– Applications of the Constant Perpetual Growth Model
– The Sustainable Growth Rate

6-43
 Chapter Review, II.

• The Two-Stage Dividend Growth Model

– Discount Rates for Dividend Discount Models
– Observations on Dividend Discount Models

• Residual Income Model (RIM)

• Price Ratio Analysis

– Price-Earnings Ratios
– Price-Cash Flow Ratios
– Price-Sales Ratios
– Price-Book Ratios
– Applications of Price Ratio Analysis

• An Analysis of the McGraw-Hill Company

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