Stocks and Their Valuation

 Features of Common Stock

 Determining Common Stock Values
 Preferred Stock

9-1
Facts about Common Stock

 Represents ownership
 Ownership implies control
 Stockholders elect directors
 Directors elect management
 Management’s goal: Maximize the stock price

9-2
Common stock valuation

 Pay out ratio = D/EPS

 Retention ratio = (1 - Pay Out Ration)
 Sustainable growth rate = ROE x Retention
ratio .
 Ie. = ROE x (1 - pay out ratio )
 Fundamental Analysis :- Examination of
Financial and economic information to assess
the economic value of a firm.

9-3
Different Approaches for Estimating the
Intrinsic Value of a Common Stock

 Discounted dividend model

 Corporate valuation model
 Using the multiples of comparable firms

9-4
Use the SML to Calculate the Required
Rate of Return (rs)

 If rRF = 7%, rM = 12%, and b = 1.2, what is the

required rate of return on the firm’s stock?
rs = rRF + (rM – rRF)b
= 7% + (12% – 7%)1.2
= 13%

9-5
What is the stock’s intrinsic value?

Using the constant growth model:

D1 $2.12
P̂0  
rs  g 0.13  0.06
$2.12

0.07
 $30.29

9-6
What would the expected price today
be, if g = 0?
The dividend stream would be a perpetuity.

0 1 2 3
rs = 13%

2.00 2.00 2.00

PMT $2.00
P̂0    $15.38
r 0.13

9-7
Common stock valuation

 1- no growth model : P0 = D1 / I
 2-constant perpetual growth :
P0 = D0(1+g ) / K – G
P0 = D1 / K-G

3- two stage dividend growth model :

P0 = D0(1+g1)/k-g * (1- 1+g/1+k) +
(1+g)/1+k * ( D0 (1+g2) / k-g2

9-8
Common stock valuation

9-9
Common stock valuation

9-10
Common stock valuation

 RIM is the same approach of constant

growth model However it is more flexible
because it could also be applied in no
dividend payment cases.

 P0 = EPS(t1) – B(t0) *G/ K-G

 = D(t1) / K-G

9-11
Corporate Valuation 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 = EBIT(1 – T) – Net capital investment

9-12
Firm Multiples Method

 Analysts often use the following multiples to

value stocks.
 P/E
 P/CF
 P/Sales
 EXAMPLE: Based on comparable firms,
estimate the appropriate P/E. Multiply this by
expected earnings to back out an estimate of
the stock price.

9-13
Common stock valuation

 Price Ratio Analysis

 High P/E Ratio ( Growth Stock)
 Low P/E Ratio ( Value Stock)
 P/CF = current stock price/cash flow per
share.
 P/Sales = current stock price/sales per share
 P/Book ratio =current stock price/book value
per share

9-14
Common stock valuation

 Expected price per share P0 =

 Historical P/E * Current EPS*(1+EPS growth
Rate (G)).
 Historical P/CFPS*Current CFPS*(1+CFPS
growth rate)
 Historical P/S *current SPS*(1+projected
sales growth rate
 Historical price ratio X Current X (1+
projected growth

9-15
If preferred stock with an annual dividend of $5
sells for $50, what is the preferred stock’s
expected return?

D
Vp 
rp
$5
$50 
rp

$5
r̂p 
$50
 0.10  10%

9-16