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chapter 8
Stocks, Stock Valuation,
and Stock Equilibrium
 Topics in Chapter
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• Features of common stock

• Determining common stock values
• Efficient markets
• Preferred stock

8-2
 Common Stock: Owners,
Directors, and Managers
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• Represents ownership.
• Ownership implies control.
• Stockholders elect directors.
• Directors hire management.
• Managers are “agents” of
shareholders, they always solicit
shareholders’ proxies and usually
succeed.
8-3
 Control of the Firm
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• Shareholders often have the right (i.e.

preemptive right) to purchase any additional
shares sold by the firm.
• This preemptive right protects the control of
the present shareholders and also prevents
dilution of their value.
• The preemptive right makes it more difficult
to raise equity capital from new large
shareholders

8-4
 Types of Common Stock
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• Not all common shares are created

equally
• Most firms have only one type of
common stock
• A system of dual-class shares is used
to meet the special needs of the
company

8-5
 Classified Stock
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• Classified stock has special

provisions.
• Could classify existing stock as
founders’ shares, with voting rights
but dividend restrictions.
• New shares might be called “Class A”
shares, with voting restrictions but full
dividend rights.
8-6
 Stock Market Reporting
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• In the past, tracking stock is through the

business section of a daily newspaper.
• Today, we can get quotes all during the day
from a wide variety of Internet sources (e.g.
Globeinvestor.com).
• Comparing with once a day from the
newspaper prints, the 20-minute delay with
the Internet information is nothing.
• The quote provides the price a buyer would
have to pay (“Ask”) and the price someone
can sell the stock (“Bid”) for.

8-7
 Different Approaches for
Valuing Common Stock
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• Most stock’s expected total return =

dividend yield + capital gains yield
• Intrinsic value of a stock is the
present value of its expected future
cash flow stream
– Dividend growth model
– Free cash flow approach
– Using the multiples of comparable firms

8-8
 Stock Value = PV of
expected future dividends
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^ D1 D2 D3 D∞
P0 = + + +…+
(1+rs)1 (1+rs)2 (1+rs)3 (1+rs)∞

What is a constant growth stock?

One whose dividends are expected

to grow forever at a constant rate, g.
8-9
 For a constant growth stock:
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D1 = D0(1+g)1
D2 = D0(1+g)2
Dt = D0(1+g)t
If g is constant and less than rs, then:
^ D0(1+g) D1
P0 = =
rs - g rs - g
Use decimals, not % in the calculation
8-10
 Dividend and Earnings
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Growth
• Growth in dividends occurs primarily as
a result of growth in EPS.
• Earnings growth results from a number
of factors: (1) inflation, (2) reinvested
profit, and (3) ROE.
• Firms cannot increase stock price by just
raising the current dividend.
• There is a tradeoff between current
dividends and future dividends.
8-11
 Intrinsic Stock Value vs.
Quarterly Earnings
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• If most of a stock’s value is due to long-

term cash flows, why do so many
managers focus on quarterly earnings?
• Sometimes changes in quarterly
earnings are a signal of future changes
in cash flows. This would affect the
current stock price.
• Sometimes managers have bonuses tied
to quarterly earnings.

8-12
 What happens if g > rs?
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^ D0(1+g)1 D0(1+g)2 D0(1+gs)∞

P0 = + +…+
(1+rs)1 (1+rs)2 (1+rs)∞

If g > rs, then (1+g)t ^

> 1, and P0 = ∞
(1+rs)t

So g must be less than rs to use the

constant growth model.
8-13
 Projected Dividends
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• D0 = $2 and constant g = 6% = 0.06

• D1 = D0(1+g) = 2(1.06) = $2.12

• D2 = D1(1+g) = 2.12(1.06) =
$2.2472
• D3 = D2(1+g) = 2.2472(1.06) =
$2.3820
8-14
 Expected Dividends and PVs
(rs = 13%, D0 = $2, g = 6%)
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0 g=6% 1 2 3 4

2.12 2.2472 2.3820

13 %
1.8761
1.7599
1.6508

8-15
 Intrinsic Stock Value:
D0 = $2.00, rs = 13%, g = 6%
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Constant growth model:

^ D0(1+g) D1
P0 = =
rs - g rs - g

$2.12 $2.12
= = $30.29
0.13 - 0.06 0.07

8-16
 Expected value one year
from now:
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• D1 will have been paid, so expected

dividends are D2, D3, D4 and so on.

^ D2 $2.2427
P1 = =
rs - g 0.07
= $32.10 = $30.29(1+0.06)

8-17
 Expected Dividend Yield and
Capital Gains Yield (Year 1)
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D1 $2.12
Dividend yield = = = 7.0%
P0 $30.29

^
P1 - P0 $32.10 - $30.29
CG Yield = =
P0 $30.29
= 6.0%
8-18
 Total Year-1 Return
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• Total return = Dividend yield +

Capital gains yield.
• Total return = 7% + 6% = 13%
• Total return = 13% = rs
• For constant growth stock:
– Capital gains yield = 6% = g

8-19
 Expected Rate of Return on
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a Constant Growth Stock

^ D1 ^ D1
P0 = to rs = +g
rs - g P0

^
Then, rs = $2.12/$30.29 + 0.06
= 0.07 + 0.06 = 13%

8-20
 If g = 0, the dividend stream
is a perpetuity
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0 r =13% 1 2 3
s

2.00 2.00 2.00

^ PMT $2.00
P0 = = = $15.38
r 0.13

8-21
 Supernormal (Non-constant)
Growth Stock
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• Supernormal growth of 30% for 3

years, and then long-run constant g
= 6%.
• Can no longer use constant growth
model.
• However, growth becomes constant
after 3 years.

8-22
 Nonconstant growth followed
by constant growth (D0 = $2):
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0 1 2 3 4
rs=13%

g = 30% g = 30% g = 30% g = 6%

2.60 3.38 4.394 4.6576
2.3009
2.6470
3.0453
46.1135 ^ $4.6576
P3 = = $66.5371
54.1067 = ^P0 0.13 – 0.06
8-23
 Dividend Growth Rates
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8-24
 Suppose g = 0 for t = 1 to 3, and
then g is a constant 6%
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0 1 2 3 4
rs=13%
g = 0% g = 0% g = 0% g = 6%
2.00 2.00 2.00 2.12

1.7699
1.5663
1.3861
 2.12
20.9895 P3   30.2857
25.7118 0.07

8-25
 If g = -6%, would anyone buy
the stock? If so, at what price?
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Firm still has earnings and still pays

^
dividends, so P0 > 0:

^ D0(1+g) D1
P0 = =
rs - g rs - g

$2.00(0.94) $1.88
= = = $9.89
0.13 - (-0.06) 0.19
8-26
 Stock Valuation:
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FCF Approach
• Firm value is the present value of
its future expected free cash flows
(FCF) discounted at the WACC.
• Since PV (FCF) is the present value
of a growing annuity, we have
FCF (1  g )
V 
WACC  g

8-27
 Using Stock Price Multiples
to Estimate Stock Price
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• Analysts often use the P/E multiple

(the price per share divided by the
earnings per share).
• Example:
– Estimate the average P/E ratio of
comparable firms. This is the P/E
multiple.
– Multiply this average P/E ratio by the
expected earnings of the company to
estimate its stock price.
8-28
 Using Entity Multiples
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• The entity value (V) is:

– the market value of equity (# shares of stock
multiplied by the price per share)
– plus the value of debt.
• Pick a measure, such as EBITDA, Sales,
Customers, Eyeballs, etc.
• Calculate the average entity ratio for a
sample of comparable firms. For
example,
– V/EBITDA
– V/Customers

8-29
 Using Entity Multiples (cont’d)
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• Find the entity value of the firm in

question. For example,
– Multiply the firm’s sales by the V/Sales
multiple.
– Multiply the firm’s # of customers by the
V/Customers ratio
• The result is the total value of the firm.
• Subtract the firm’s debt to get the total
value of equity.
• Divide by the number of shares to get
the price per share.

8-30
 Problems with Market
Multiple Methods
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• It is often hard to find comparable firms.

• The average ratio for the sample of
comparable firms often has a wide
range.
– For example, the average P/E ratio might be
20, but the range could be from 10 to 50.
How do you know whether your firm should
be compared to the low, average, or high
performers?

8-31
 Preferred Stock
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• Hybrid security.
• Similar to bonds in that preferred
stockholders receive a fixed dividend
which must be paid before dividends
can be paid on common stock.
• However, unlike bonds, preferred
stock dividends can be omitted
without fear of pushing the firm into
bankruptcy.
8-32
 Preferred Stock Valuation
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• Similar to the valuation of perpetual

bonds DPS
VPS 
rPS
• A preferred stock pays a quarterly
dividend of $1.25 ($5 per year) with
a required return of10%. Its value
is DPS 4($1.25) $5
VPS     $50
rPS 0. 1 0.1
8-33
 Expected return: given Vps = $50
and annual dividend = $5
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$5
Vps = $50 =
^
rps

^ $5
rps = = 0.10 = 10.0%
$50

8-34
 Stock Price Volatility for
changes in rS and g
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• Are volatile stock prices consistent with

rationing pricing?
• Small changes in expected g and rs
cause large changes in stock prices.
• As new information arrives, investors
continually update their estimates of g
and rs.
• If stock prices are not volatile, then this
means there is not a good flow of
information.
8-35
 Stock Market Equilibrium
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• In equilibrium, stock prices are

stable. There is no general
tendency for people to buy versus
to sell.
• The expected price, P, must equal
the actual price, P. In other words,
the fundamental value must be the
same as the price.

8-36
 In equilibrium, expected returns
must equal required returns:
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^
rs = D1/P0 + g = rs = rRF + (rM - rRF)b

8-37
 How is equilibrium
established?
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^ D^
If rs = 1 + g > rs, then P0 is “too low.”
P0
If the price is lower than the fundamental
value, then the stock is a “bargain.” Buy
orders will exceed sell orders, the price
will be bid up until:
^
D1/P0 + g = rs = rs
8-38
 Efficient Market Hypothesis
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• Securities are normally in equilibrium

and are “fairly priced.”
• Investors cannot “beat the market”
except through good luck or inside
information.
• The prices of securities fully reflect
available information. They will adjust
immediately to any new
development.
8-39
 Weak-form EMH
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• Investors buying bonds and stocks

cannot profit by looking at past
trends. A recent decline is no
reason to think stocks will go up (or
down) in the future. Evidence
supports weak-form EMH, but
“technical analysis” is still used.

8-40
 Semistrong-form EMH
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• All publicly available information is

reflected in stock prices, so it does
not pay to pore over annual reports
looking for undervalued stocks.
Largely true.

8-41
 Strong-form EMH
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• All information, even inside

information, is embedded in stock
prices. Not true--insiders can gain
by trading on the basis of insider
information, but that is illegal!

8-42
 Markets are generally
efficient because:
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• 100,000 or so trained analysts--

MBAs, CFAs, and PhDs--work for
firms like Fidelity, Merrill, Morgan,
and Prudential.
• These analysts have similar access
to data and megabucks to invest.
• Thus, news is reflected in P0 almost
instantaneously.
8-43