Chapter 7

Stock Valuation
Chapter Outline
7.1 Stock Basics
7.2 The Mechanics of Stock Trades
7.3 The Dividend-Discount Model
7.4 Estimating Dividends in the Dividend-Discount
Model
7.5 Limitations of the Dividend-Discount Model
7.6 Share Repurchases and the Total Payout Model
7.7 Putting It All Together

7-2
Learning Objectives
• Describe the basics of common stock, preferred
stock, and stock quotes
• Compare how trades are executed on the NYSE and
NASDAQ
• Value a stock as the present value of its expected
future dividends
• Understand the tradeoff between dividends and
growth in stock valuation
• Appreciate the limitations of valuing a stock based
on expected dividends
• Value a stock as the present value of the company’s
total payout

7-3
7.1 Stock Basics

• Stock Market Reporting: Stock Quotes

– Common Stock
– Ticker Symbol

7-4
Figure 7.1
Stock Price
Quote for Nike
(NKE)

7-5
7.1 Stock Basics

• Common Stock
– Shareholder Voting
• Straight Voting
• Cumulative Voting
• Classes of Stock
– Shareholder Rights
• Annual Meeting
• Proxy
– Proxy Contest

7-6
7.1 Stock Basics

• Preferred Stock
– Cumulative versus Non-Cumulative Preferred
Stock
– Preferred Stock: Equity or Debt

7-7
7.2 The Mechanics of Stock Trades

• Market Order
• Limit Order
• Round Lot
• Super Display Book
system
• Floor Broker
• Dealer

7-8
7.3 The Dividend-Discount Model

• A One Year Investor

– Two potential sources of cash flows from owning
a stock:
• Dividends
• Selling Shares

7-9
7.3 The Dividend-Discount Model

• A One Year Investor

– Since the cash flows are not risk-less, they
must be discounted at the equity cost of capital

7-10
7.3 The Dividend-Discount Model

• Dividend Yields, Capital Gains, and Total

Returns
– Dividend Yield
– Capital Gain
• Capital Gains Rate
– Total Return

7-11
7.3 The Dividend-Discount Model

• Dividend Yields, Capital Gains, and Total

Returns
– The expected total return of the stock should
equal the expected return of other investments
available in the market with equivalent risk

7-12
Example 7.1 Stock Prices and
Returns

Problem:
• Suppose you expect Longs Drug Stores to pay an
annual dividend of $.56 per share in the coming
year and to trade $45.50 per share at the end of
the year. If investments with equivalent risk to
Longs’ stock have an expected return of 6.80%,
what is the most you would pay today for Longs’
stock? What dividend yield and capital gain rate
would you expect at this price?

7-13
Example 7.1 Stock Prices and
Returns

Solution:
Plan:
• We can use Eq. 7.1 to solve for the beginning
price we would pay now (P0) given our
expectations about dividends (Div1=$0.56) and
future price (P1=$45.50) and the return we need
to expect to earn to be willing to invest
(rE=0.068%).
• We can then use Eq. 7.2 to calculate the dividend
yield and capital gain rate
Div1  P1 (Eq. 7.1)
P0 
1  rE 7-14
Example 7.1 Stock Prices and
Returns

Execute:
Div1  P1 $0.56  $45.50
P0    $43.13
1  rE 1.0680
• Referring to Eq. 7.2 we see that at this price,
Longs’ dividend yield is Div1/P0 = 0.56/43.13 =
1.30%. The expected capital gain is $45.50 -
$43.13 = $2.37 per share, for a capital gain rate
of 2.37/43.13 = 5.50%.

7-15
Example 7.1 Stock Prices and
Returns

Evaluate:
• At a price of $43.13, Longs’ expected total return
is 1.30% + 5.50% = 6.80%, which is equal to its
equity cost of capital (the return being paid by
investments with equivalent risk to Longs’). This
amount is the most we would be willing to pay for
Longs’ stock. If we paid more, our expected
return would be less than 6.8% and we would
rather invest elsewhere.

7-16
Example 7.1a Stock Prices and
Returns

Problem:
• Suppose you expect Koch Industries to pay an
annual dividend of $2.31 per share in the coming
year and to trade $82.75 per share at the end of
the year. If investments with equivalent risk to
Koch’s stock have an expected return of 8.9%,
what is the most you would pay today for Koch’s
stock? What dividend yield and capital gain rate
would you expect at this price?

7-17
Example 7.1a Stock Prices and
Returns
Solution:
Plan:
• We can use Eq. 7.1 to solve for the beginning price we
would pay now (P0) given our expectations about dividends
(Div1=2.31) and future price (P1=$82.75) and the return we
need to expect to earn to be willing to invest (rE=8.9%).
• We can then use Eq. 7.2 to calculate the dividend yield and
capital gain.

Div1  P1
P0  (Eq. 7.1)
1  rE
7-18
Example 7.1a Stock Prices and
Returns

Execute:
Div1  P1 $2.31  $82.75
P0    $78.11
1  rE 1.089
• Referring to Eq. 7.2 we see that at this price,
Koch’s dividend yield is Div1/P0 = 2.31/78.11 =
2.96%. The expected capital gain is $82.75 -
$78.11 = $4.64 per share, for a capital gain rate
of 4.64/78.11 = 5.94%.

7-19
Example 7.1a Stock Prices and
Returns

Evaluate:
• At a price of $78.11, Koch’s expected total return
is 2.96% + 5.94% = 8.90%, which is equal to its
equity cost of capital (the return being paid by
investments with equivalent risk to Koch’s). This
amount is the most we would be willing to pay for
Koch’s stock. If we paid more, our expected
return would be less than 8.9% and we would
rather invest elsewhere.

7-20
Example 7.1b Stock Prices and
Returns

Problem:
• Suppose you expect Harford Industries to pay an
annual dividend of $5.35 per share in the coming
year and to trade $63.32 per share at the end of
the year. If investments with equivalent risk to
Harford’s stock have an expected return of 12.5%,
what is the most you would pay today for
Harford’s stock? What dividend yield and capital
gain rate would you expect at this price?

7-21
Example 7.1b Stock Prices and
Returns
Solution:
Plan:
• We can use Eq. 7.1 to solve for the beginning price we
would pay now (P0) given our expectations about dividends
(Div1=5.35) and future price (P1=$63.32) and the return we
need to expect to earn to be willing to invest (rE=12.5%).
• We can then use Eq. 7.2 to calculate the dividend yield and
capital gain.

Div1  P1
P0  (Eq. 7.1)
1  rE
7-22
Example 7.1b Stock Prices and
Returns

Execute:
Div1  P1 $5.35  $63.32
P0    $61.04
1  rE 1.125

• Referring to Eq. 7.2 we see that at this price,

Harford’s dividend yield is Div1/P0 = 5.35/61.04 =
8.76%. The expected capital gain is $63.32 -
$61.04 = $2.28 per share, for a capital gain rate
of 2.28/61.04 = 3.74%.

7-23
Example 7.1b Stock Prices and
Returns

Evaluate:
• At a price of $61.04 Harford’s expected total
return is 8.76% + 3.74% = 12.50%, which is
equal to its equity cost of capital (the return being
paid by investments with equivalent risk to
Harford’s). This amount is the most we would be
willing to pay for Harford’s stock. If we paid more,
our expected return would be less than 12.50%
and we would rather invest elsewhere.

7-24
7.3 The Dividend-Discount Model

• A Multiyear Investor
– Suppose we planned to hold the stock for two
years
• Then we would receive dividends in both year 1 and
year 2 before selling the stock, as shown in the
following timeline:

7-25
7.3 The Dividend-Discount Model

• A Multiyear Investor
– As a two-year investor, we care about the
dividend and stock price in year 2.

Div1 Div2  P2
P0   (Eq. 7.3)
1  rE 1  r 
2
E

7-26
 7.3 The Dividend-Discount Model

• Dividend-Discount Model Equation

Div1 Div2 Div N PN
P0   L   (Eq. 7.4)
1  rE   1  r  1  r 
2 N N
1  rE E E

– The price of the stock is equal to the present
value of all of the expected future dividends it
will pay, along with the cash flow from the sale
in year N

7-27
7.3 The Dividend-Discount Model

• Dividend-Discount Model Equation

– The price of a stock is equal to the present
value of all of the expected future dividends it
will pay)

Div1 Div2 Div3

P0    L (Eq. 7.5)
1  rE 1  r  1  r 
2 3
E E


7-28
7.4 Estimating Dividends in the
Dividend-Discount Model

• Constant Dividend Growth

– Assumes that dividends will grow at a constant
rate, g, forever
– The value of the firm depends on the dividend
level of next year, divided by the equity cost of
capital adjusted by the growth rate

Div1
P0  (Eq. 7.6)
rE  g
7-29
Example 7.2 Valuing a Firm with
Constant Dividend Growth

Problem:
• Consolidated Edison, Inc. (Con Edison), is a
regulated utility company that services the New
York City area. Suppose Con Edison plans to pay
$2.30 per share in dividends in the coming year.
If its equity cost of capital is 7% and dividends are
expected to grow by 2% per year in the future,
estimate the value of Con Edison’s stock.

7-30
Example 7.2 Valuing a Firm with
Constant Dividend Growth

Solution:
Plan:
• Because the dividends are expected to grow
perpetually at a constant rate, we can use Eq. 7.6
to value Con Edison. The next dividend (Div1) is
expected to be $2.30, the growth rate (g) is 2%
and the equity cost of capital (rE) is 7%.

7-31
Example 7.2 Valuing a Firm with
Constant Dividend Growth

Execute:

Div1 $2.30
P0    $46.00
rE  g 0.07  0.02

7-32
Example 7.2 Valuing a Firm with
Constant Dividend Growth

Evaluate:
• You would be willing to pay 20 times this year’s
dividend of $2.30 to own Con Edison stock
because you are buying claim to this year’s
dividend and to an infinite growing series of future
dividends.

7-33
Example 7.2a Valuing a Firm with
Constant Dividend Growth

Problem:
• Suppose Target Corporation plans to pay $0.68
per share in dividends in the coming year. If its
equity cost of capital is 10% and dividends are
expected to grow by 8.4% per year in the future,
estimate the value of Target’s stock.

7-34
Example 7.2a Valuing a Firm with
Constant Dividend Growth

Solution:
Plan:
• Because the dividends are expected to grow
perpetually at a constant rate, we can use Eq. 7.6
to value Target. The next dividend (Div1) is
expected to be $0.68, the growth rate (g) is 8.4%
and the equity cost of capital (rE) is 10%.

7-35
Example 7.2a Valuing a Firm with
Constant Dividend Growth

Execute:

Div1 $0.68
P0    $42.50
rE  g .10  .084

7-36
Example 7.2a Valuing a Firm with
Constant Dividend Growth

Evaluate:
• You would be willing to pay 62.5 times this year’s
dividend of $0.68 to own Target stock because you
are buying claim to this year’s dividend and to an
infinite growing series of future dividends.

7-37
Example 7.2b Valuing a Firm with
Constant Dividend Growth

Problem:
• Suppose The Walt Disney Company plans to pay
$0.38 per share in dividends in the coming year.
If its equity cost of capital is 10.6% and dividends
are expected to grow by 9.5% per year in the
future, estimate the value of Disney’s stock.

7-38
Example 7.2b Valuing a Firm with
Constant Dividend Growth

Solution:
Plan:
• Because the dividends are expected to grow
perpetually at a constant rate, we can use Eq. 7.6
to value Disney. The next dividend (Div1) is
expected to be $0.38, the growth rate (g) is 9.5%
and the equity cost of capital (rE) is 10.6%.

7-39
Example 7.2b Valuing a Firm with
Constant Dividend Growth

Execute:

Div1 $0.38
P0    $34.55
rE  g .106  .095

7-40
Example 7.2b Valuing a Firm with
Constant Dividend Growth

Evaluate:
• You would be willing to pay 90.9 times this year’s
dividend of $0.38 to own Disney stock because
you are buying claim to this year’s dividend and to
an infinite growing series of future dividends.

7-41
7.4 Estimating Dividends in the
Dividend-Discount Model

• Dividends Versus Investment and Growth

– A Simple Model of Growth
• The dividend each year is equal to the firm’s earnings
per share (EPS) multiplied by its dividend payout rate

(Eq. 7.8)

7-42
7.4 Estimating Dividends in the
Dividend-Discount Model

• Dividends Versus Investment and Growth

– A Simple Model of Growth
• The firm can increase its dividend in three ways:
– It can increase its earnings
– It can increase its dividend payout rate
– It can decrease its number of shares outstanding

7-43
 7.4 Estimating Dividends in the
Dividend-Discount Model

• Dividends Versus Investment and Growth

– A Simple Model of Growth
• If all increases in future earnings result exclusively
from new investment made with retained earnings,
then:

Change in Earnings = New Investment  Return on New Investment (Eq. 7.9)

7-44
7.4 Estimating Dividends in the
Dividend-Discount Model

• Dividends Versus Investment and Growth

– A Simple Model of Growth
• New investment equals the firm’s earnings multiplied
by its retention rate, or the fraction of current
earnings that the firm retains:

New Investment  Earnings  Retention Rate (Eq. 7.10)

7-45
7.4 Estimating Dividends in the
Dividend-Discount Model

• Dividends Versus Investment and Growth

– A Simple Model of Growth
• Substituting Eq. 7.10 into Eq. 7.9 and dividing by
earnings gives an expression for the growth rate of
earnings:

Change in Earnings
Earnings Growth Rate =
Earnings
 Retention Rate  Return on New Investment
(Eq. 7.11)

7-46
7.4 Estimating Dividends in the
Dividend-Discount Model

• Dividends Versus Investment and Growth

– A Simple Model of Growth
• If the firm chooses to keep its dividend payout rate
constant, then the growth in its dividends will equal
the growth in its earnings:

g  Retention Rate  Return on New Investment (Eq. 7.12)

7-47
Example 7.3 Cutting Dividends for
Profitable Growth

Problem:
• Crane Sporting Goods expects to have earnings
per share of $6 in the coming year. Rather than
reinvest these earnings and grow, the firm plans
to pay out all of its earnings as a dividend. With
these expectations of no growth, Crane’s current
share price is $60.

7-48
Example 7.3 Cutting Dividends for
Profitable Growth

Problem (cont'd):
• Suppose Crane could cut its dividend payout rate
to 75% for the foreseeable future and use the
retained earnings to open new stores. The return
on investment in these stores is expected to be
12%. If we assume that the risk of these new
investments is the same as the risk of its existing
investments, then the firm’s equity cost of capital
is unchanged. What effect would this new policy
have on Crane’s stock price?

7-49
Example 7.3 Cutting Dividends for
Profitable Growth

Solution:
Plan:
• To figure out the effect of this policy on Crane’s
stock price, we need to know several things. First,
we need to compute its equity cost of capital.
Next we must determine Crane’s dividend and
growth rate under the new policy.
• Because we know that Crane currently has a
growth rate of 0 (g = 0), a dividend of $6 and a
price of $60, we can use Eq. 7.7 to estimate rE.

7-50
Example 7.3 Cutting Dividends for
Profitable Growth

Plan (cont'd):
• Next, the new dividend will simply be 75% of the
old dividend of $6. Finally, given a retention rate
of 25% and a return on new investment of 12%,
we can use Eq. 7.12 to compute the new growth
rate (g). Finally, armed with the new dividend,
Crane’s equity cost of capital, and its new growth
rate, we can use Eq. 7.6 to compute the price of
Crane’s shares if it institutes the new policy.

7-51
Example 7.3 Cutting Dividends for
Profitable Growth

Execute:
• Using Eq. 7.7 to estimate rE we have

Div1 $6
rE  g  0%  0.10 0  10%
P0 $60
• In other words, to justify Crane’s stock price under
its current policy, the expected return of other
stocks in the market with equivalent risk must be
10%.

7-52
Example 7.3 Cutting Dividends for
Profitable Growth

Execute (cont’d):
• Next, we consider the consequences of the new
policy. If Crane reduces its dividend payout rate
to 75%, then from Eq. 7.8 its dividend this coming
year will fall to Div1 = EPS1 x 75% = $6 x 75% =
$4.50.
• At the same time, because the firm will now retain
25% of its earnings to invest in new stores, from
Eq. 7.12 its growth rate will increase to:
g  Retention Rate  Return on New Investment  25%  12%  3%

7-53
Example 7.3 Cutting Dividends for
Profitable Growth

Execute (cont’d):
• Assuming Crane can continue to grow at this rate,
we can compute its share price under the new
policy using the constant dividend growth model of
Eq. 7.6

Div1 $4.50
P0    $64.29
rE  g 0.10  0.03

7-54
Example 7.3 Cutting Dividends for
Profitable Growth

Evaluate:
• Crane’s share price should rise from $60 to $64.29
if the company cuts its dividend in order to
increase its investment and growth, implying that
the investment has positive NPV. By using its
earnings to invest in projects that offer a rate of
return (12%) greater than its equity cost of capital
(10%), Crane has created value for its
shareholders.

7-55
Example 7.3a Cutting Dividends for
Profitable Growth

Problem:
• Pittsburgh & West Virginia Railroad (PW) expects
to have earnings per share of $0.48 in the coming
year. Rather than reinvest these earnings and
grow, the firm plans to pay out all of its earnings
as a dividend. With these expectations of no
growth, PW’s current share price is $10.

7-56
Example 7.3a Cutting Dividends for
Profitable Growth

Problem (cont'd):
• Suppose PW could cut its dividend payout rate to
67% for the foreseeable future and use the
retained earnings to expand. The return on
investment in the expansion is expected to be
11%. If we assume that the risk of these new
investments is the same as the risk of its existing
investments, then the firm’s equity cost of capital
is unchanged. What effect would this new policy
have on PW’s stock price?

7-57
Example 7.3a Cutting Dividends for
Profitable Growth

Solution:
Plan:
• To figure out the effect of this policy on PW’s stock
price, we need to know several things. First, we
need to compute its equity cost of capital. Next
we must determine PW’s dividend and growth rate
under the new policy.
• Because we know that PW currently has a growth
rate of 0 (g = 0), a dividend of $0.48 and a price
of $10, we can use Eq. 7.7 to estimate rE.

7-58
Example 7.3a Cutting Dividends for
Profitable Growth

Plan (cont'd):
• Next, the new dividend will simply be 67% of the
old dividend of $0.48. Finally, given a retention
rate of 33% and a return on new investment of
11%, we can use Eq. 7.12 to compute the new
growth rate (g). Finally, armed with the new
dividend, PW’s equity cost of capital, and its new
growth rate, we can use Eq. 7.6 to compute the
price of PW’s shares if it institutes the new policy.

7-59
Example 7.3a Cutting Dividends for
Profitable Growth

Execute:
• Using Eq. 7.7 to estimate rE we have

Div1 $0.48
rE  g  0  4.8%  0%  4.8%
P0 $10
• In other words, to justify PW’s stock price under
its current policy, the expected return of other
stocks in the market with equivalent risk must be
4.8%.

7-60
Example 7.3a Cutting Dividends for
Profitable Growth

Execute (cont’d):
• Next, we consider the consequences of the new
policy. If PW reduces its dividend payout rate to
67%, then from Eq. 7.8 its dividend this coming
year will fall to Div1 = EPS1 x 67% = $0.48 x
67% = $0.32.
• At the same time, because the firm will now retain
33% of its earnings to invest in new stores, from
Eq. 7.12 its growth rate will increase to
g  Retention Rate  Return on New Investment  33% 11%  3.63%

7-61
Example 7.3a Cutting Dividends for
Profitable Growth

Execute (cont’d):
• Assuming PW can continue to grow at this rate, we
can compute its share price under the new policy
using the constant dividend growth model of Eq.
7.6

Div1 $0.32
P0    $27.35
rE  g .048  .0363

7-62
Example 7.3a Cutting Dividends for
Profitable Growth

Evaluate:
• PW’s share price should rise from $10 to $27.35 if
the company cuts its dividend in order to increase
its investment and growth, implying that the
investment has positive NPV. By using its
earnings to invest in projects that offer a rate of
return (11%) greater than its equity cost of capital
(4.8%), PW has created value for its shareholders.

7-63
Example 7.4 Unprofitable Growth

Problem:
• Suppose Crane Supporting Goods decides to cut
its dividend payout rate to 75% to invest in new
stores, as in Example 7.3. But now suppose that
the return on these new investments is 8%, rather
than 12%. Give its expected earnings per share
this year of $6 and its equity cost of capital of
10% (we again assume that the risk of the new
investments is the same as its existing
investments), what will happen to Crane’s current
share price in this case?

7-64
Example 7.4 Unprofitable Growth

Solution:
Plan:
• We will follow the steps in Example 7.3, except
that in this case, we assume a return on new
investments of 8% when computing the new
growth rate (g) instead of 12% as in Example 7.3.

7-65
Example 7.4 Unprofitable Growth

Execute:
• Just as in Example 7.3, Crane’s dividend will fall to
$6 x 75% = $4.50. Its growth rate under the new
policy, given the lower return on new investment,
will now be g = 25% x 8% = 2%. The new share
price is therefore
Div1 $4.50
P0    $56.25
rE  g .10  .02

7-66
Example 7.4 Unprofitable Growth

Evaluate:
• Even though Crane will grow under the new policy,
the new investments have a negative NPV. The
company’s share price will fall if it cuts its dividend
to make new investments with a return of only
8%. By reinvesting its earnings at a rate (8%)
that is lower than its equity cost of capital (10%),
Crane has reduced shareholder value.

7-67
Example 7.4a Unprofitable Growth

Problem:
• Suppose Pittsburgh & West Virginia Railroad
decides to cut its dividend payout rate to 67% to
invest in new stores, as in Example 7.3a. But now
suppose that the return on these new investments
is 4%, rather than 11%. Give its expected
earnings per share this year of $0.48 and its
equity cost of capital of 4.8% (we again assume
that the risk of the new investments is the same
as its existing investments), what will happen to
PW’s current share price in this case?

7-68
Example 7.4a Unprofitable Growth

Solution:
Plan:
• We will follow the steps in Example 7.3a, except
that in this case, we assume a return on new
investments of 4% when computing the new
growth rate (g) instead of 11% as in Example
7.3a.

7-69
Example 7.4a Unprofitable Growth

Execute:
• Just as in Example 7.3a, PW’s dividend will fall to
$0.48 x 67% = $0.32. Its growth rate under the
new policy, given the lower return on new
investment, will now be g = 33% x 4% = 1.32%.
The new share price is therefore
Div1 $0.32
P0    $9.20
rE  g .048  .0132

7-70
Example 7.4a Unprofitable Growth

Evaluate:
• Even though PW will grow under the new policy,
the new investments have a negative NPV. The
company’s share price will fall if it cuts its dividend
to make new investments with a return of only
4%. By reinvesting its earnings at a rate (4%)
that is lower than its equity cost of capital (4.8%),
PW has reduced shareholder value.

7-71
7.4 Estimating Dividends in the
Dividend-Discount Model

• Changing Growth Rates

– If the firm is expected to grow at a long-term
rate g after year N + 1, then from the constant
dividend growth model:

Div N 1
PN  (Eq. 7.13)
rE  g

7-72
Example 7.5 Valuing a Firm with
Two Different Growth Rates
Problem:
• Small Fry, Inc., has just invented a potato chip that looks
and tastes like a french fry. Given the phenomenal market
response to this product, Small Fry is reinvesting all of its
earnings to expand its operations. Earnings were $2 per
share this past year and are expected to grow at a rate of
20% per year until the end of year 4. At that point, other
companies are likely to bring out competing products.
Analysts project that at the end of year 4, Small Fry will cut
its investment and begin paying 60% of its earnings as
dividends. Its growth will also slow to a long-run rate of
4%. If Small Fry’s equity cost of capital is 8%, what is the
value of a share today?

7-73
Example 7.5 Valuing a Firm with
Two Different Growth Rates

Solution:
Plan:
• We can use Small Fry’s projected earnings growth
rate and payout rate to forecast its future earnings
and dividends. After year 4, Small Fry’s dividends
will grow at a constant 4%, so we can use the
constant dividend growth model (Eq. 7.13) to
value all dividends after that point. Finally, we
can pull everything together with the dividend-
discount model.

7-74
Example 7.5 Valuing a Firm with
Two Different Growth Rates

Execute:
• The following spreadsheet projects Small Fry’s
earnings and dividends:

7-75
Example 7.5 Valuing a Firm with
Two Different Growth Rates

Execute (cont’d):
• Starting from $2.00 in year 0, EPS grows by 20%
per year until year 4, after which growth slows to
4%. Small Fry’s dividend payout rate is zero until
year 4, when competition reduces its investment
opportunities and its payout rate rises to 60%.
Multiplying EPS by the dividend payout ratio, we
project Small Fry’s future dividends in line 4.

7-76
Example 7.5 Valuing a Firm with
Two Different Growth Rates

Execute (cont’d):
• From year 4 onward, Small Fry’s dividends will
grow at the expected long-run rate of 4% per
year. Thus we can use the constant dividend
growth model to project Small Fry’s share price at
the end of year 3. Given its equity cost of capital
of 8%,
Div4 $2.49
P3    $62.25
rE  g 0.08  0.04

7-77
Example 7.5 Valuing a Firm with
Two Different Growth Rates

Execute (cont’d):
• We then apply the dividend discount model (Eq.
7.4) with this terminal value:

Div1 Div2 Div3 P3 $62.25

P0       $49.42
1  rE   1  r  1  r  1.08
2 3 3 3
1  rE E E

7-78
Example 7.5 Valuing a Firm with
Two Different Growth Rates

Evaluate:
• The dividend-discount model is flexible enough to
handle any forecasted pattern of dividends. Here
the dividends were zero for several years and then
settled into a constant growth rate, allowing us to
use the constant growth rate model as a shortcut.

7-79
Example 7.5a Valuing a Firm with
Two Different Growth Rates
Problem:
• Small Fry, Inc., has just invented a potato chip that looks
and tastes like a french fry. Given the phenomenal market
response to this product, Small Fry is reinvesting all of its
earnings to expand its operations. Earnings were $5 per
share this past year and are expected to grow at a rate of
30% per year until the end of year 3. At that point, other
companies are likely to bring out competing products.
Analysts project that at the end of year 3, Small Fry will cut
its investment and begin paying 75% of its earnings as
dividends. Its growth will also slow to a long-run rate of
5%. If Small Fry’s equity cost of capital is 9%, what is the
value of a share today?

7-80
Example 7.5a Valuing a Firm with
Two Different Growth Rates

Solution:
Plan:
• We can use Small Fry’s projected earnings growth
rate and payout rate to forecast its future earnings
and dividends. After year 3, Small Fry’s dividends
will grow at a constant 5%, so we can use the
constant dividend growth model (Eq. 7.13) to
value all dividends after that point. Finally, we
can pull everything together with the dividend-
discount model.

7-81
Example 7.5a Valuing a Firm with
Two Different Growth Rates

Execute:
• The following spreadsheet projects Small Fry’s
earnings and dividends:

1 Year 0 1 2 3 4
2 Earnings
3 EPS Growth Rate (versus prior year) 30% 30% 30% 5%
4 EPS $5.00 $6.50 $8.45 $10.99 $11.54
5 Dividends
6 Dividend Payout Ratio 0% 0% 75% 75%
7 Div $0.00 $0.00 $8.24 $8.66

7-82
Example 7.5a Valuing a Firm with
Two Different Growth Rates

Execute (cont’d):
• Starting from $5.00 in year 0, EPS grows by 30%
per year until year 3, after which growth slows to
5%. Small Fry’s dividend payout rate is zero until
year 3, when competition reduces its investment
opportunities and its payout rate rises to 75%.
Multiplying EPS by the dividend payout ratio, we
project Small Fry’s future dividends in line 7.

7-83
Example 7.5a Valuing a Firm with
Two Different Growth Rates

Execute (cont’d):
• From year 3 onward, Small Fry’s dividends will
grow at the expected long-run rate of 5% per
year. Thus we can use the constant dividend
growth model to project Small Fry’s share price at
the end of year 3. Given its equity cost of capital
of 9%,
Div3 $8.24
P2    $206.00
rE  g .09  .05

7-84
Example 7.5a Valuing a Firm with
Two Different Growth Rates

Execute (cont’d):
• We then apply the dividend discount model (Eq.
7.4) with this terminal value:

Div1 Div2 P2 $206.00

P0      $173.39
1  rE (1  rE ) 2
(1  rE ) 2
1.09 2

7-85
Example 7.5a Valuing a Firm with
Two Different Growth Rates

Evaluate:
• The dividend-discount model is flexible enough to
handle any forecasted pattern of dividends. Here
the dividends were zero for several years and then
settled into a constant growth rate, allowing us to
use the constant growth rate model as a shortcut.

7-86
7.4 Estimating Dividends in the
Dividend-Discount Model

• Value Drivers and the Dividend-Discount

Model
– The dividend-discount model includes an
implicit forecast of the firm’s profitability which
is discounted back at the firm’s equity cost of
capital.

7-87
7.5 Limitations of the Dividend-
Discount Model

• Uncertain Dividend Forecasts

– The dividend-discount model values a stock
based on a forecast of the future dividends, but
a firm’s future dividends carry a tremendous
amount of uncertainty

7-88
Figure 7.2 NKE Stock Prices for
Different Expected Growth Rates

7-89
7.5 Limitations of the Dividend-
Discount Model

• Non-Dividend-Paying Stocks
– Many companies do not pay dividends, thus the
dividend-discount model must be modified.

7-90
7.6 Share Repurchases and the Total
Payout Model

• Share Repurchases
– The firm uses excess cash to buy back its own
stock
• Consequences:
• The more cash the firm uses to repurchase shares, the
less cash it has available to pay dividends
• By repurchasing shares, the firm decreases its share
count, which increases its earnings and dividends on a
per-share basis.

7-91
7.6 Share Repurchases and the Total
Payout Model

• Share Repurchases
– In the dividend-discount model, a share is
valued from the perspective of a single
shareholder, discounting the dividends the
shareholder will receive:

P0  PV  Future Dividends per Share  (Eq. 7.14)

7-92
7.6 Share Repurchases and the Total
Payout Model

• Total Payout Model

– Values all of the firm’s equity, rather than a
single share
• To use this model, discount the total payouts that the
firm makes to shareholders, which is the total amount
spent on both dividends and share repurchases

PV  Future Total Dividends and Repurchases  (Eq. 7.15)

P0 
Shares Outstanding 0

7-93
Example 7.6 Valuation with Share
Repurchases

Problem:
• Titan Industries has 217 million shares
outstanding and expects earnings at the end of
this year of $860 million. Titan plans to pay out
50% of its earnings in total, paying 30% as a
dividend and using 20% to repurchase shares. If
Titan’s earnings are expected to grow by 7.5% per
year and these payout rates remain constant,
determine Titan’s share price assuming an equity
cost of capital of 10%.

7-94
Example 7.6 Valuation with Share
Repurchases

Solution:
Plan:
• Based on the equity cost of capital of 10% and an
expected earnings growth rate of 7.5%, we can
compute the present value of Titan’s future payouts
as a constant growth perpetuity. The only input
missing here is Titan’s total payouts this year, which
we can calculate as 50% of its earnings. The present
value of all of Titan’s future payouts is the value of its
total equity. To obtain the price of a share, we divide
the total value by the number of shares outstanding
(217 million).
7-95
Example 7.6 Valuation with Share
Repurchases

Execute:
• Titan will have total payouts this year of 50% 
$860 million = $430 million. Using the constant
growth perpetuity formula, we have

7-96
Example 7.6 Valuation with Share
Repurchases

Execute (cont’d):
• This present value represents the total value of
Titan’s equity (i.e., its market capitalization). To
compute the share price, we divide by the current
number of shares outstanding:

7-97
Example 7.6 Valuation with Share
Repurchases
Evaluate:
• Using the total payout method, we did not need to know the
firm’s split between dividends and share repurchases. To
compare this method with the dividend-discount model, note
that Titan will pay a dividend of 30%  $860 million/(217
million shares) = $1.19 per share, for a dividend yield of
1.19/79.26 = 1.50%. From Eq. 7.7, Titan’s expected EPS,
dividend, and share price growth rate is g = rEDiv1/P0 =
8.50%. This growth rate exceeds the 7.50% growth rate of
earnings because Titan’s share count will decline over time
owing to its share repurchases.

7-98
Example 7.6a Valuation with Share
Repurchases

Problem:
• 3M Co. has 698 million shares outstanding and
expects earnings at the end of this year of $2.96
billion. 3M plans to pay out 50% of its earnings in
total, paying 25% as a dividend and using 25% to
repurchase shares. If 3M’s earnings are expected
to grow by 9.2% per year and these payout rates
remain constant, determine 3M’s share price
assuming an equity cost of capital of 12%.

7-99
Example 7.6a Valuation with Share
Repurchases

Solution:
Plan:
• Based on the equity cost of capital of 12% and an
expected earnings growth rate of 9.2% we can
compute the present value of 3M’s future payouts as
a constant growth perpetuity. The only input missing
here is 3M’s total payouts this year, which we can
calculate as 50% of its earnings. The present value of
all of 3M’s future payouts is the value of its total
equity. To obtain the price of a share, we divide the
total value by the number of shares outstanding (698
million).
7-100
Example 7.6a Valuation with Share
Repurchases

Execute:
• 3M will have total payouts this year of 50% x
$2.96 billion = $1.48 billion. Using the constant
growth perpetuity formula, we have
$1.48 billion
PV (Future Total Dividends and Repurchases)   $52.86 billion
.12 - .092
• This present value represents the total value of
3M’s equity (i.e. its market capitalization). To
compute the share price, we divide by the current
number of shares outstanding:
$52.86 billion
P0   $75.73 per share
698 million shares

7-101
Example 7.6a Valuation with Share
Repurchases
Evaluate:
• Using the total payout method, we did not need to know the
firm’s split between dividends and share repurchases. To
compare this method with the dividend-discount model, note
that 3M will pay a dividend of 25% x $2.96 billion/(698
million shares) = $1.06 per share, for a dividend yield of
$1.06/$75.73 = 1.40%. From Eq. 7.7, 3M’s expected EPS,
dividend, and share price growth rate g = rE – Div1/P0 =
12% – 1.4% = 10.6%. This growth rate exceeds the 9.2%
growth rate of earnings because 3M’s share count will
decline over time owing to its share repurchases.

7-102
7.7 Putting It All Together

• How would an investor decide whether to

buy or sell a stock?
– She would value the stock using her own
expectations
– If her expectations were substantially different,
she might conclude that the stock was over- or
under-priced
– Based on that conclusion, she would buy or sell
the stock

7-103
7.7 Putting It All Together

• How could a stock suddenly be worth more

or less after an earnings announcement?
– As investors digest the news, they update their
expectations and buying or selling pressure
would then drive the stock price up or down
until the buys and sells came into balance

7-104
7.7 Putting It All Together

• What should managers do to raise the

stock price further?
– The only way to raise the stock price is to make
value-increasing decisions

7-105
Chapter Quiz
1. What are some key differences between preferred
and common stock?
2. What is the role of a floor broker at the NYSE?
3. What discount rate do you use to discount the
future cash flows of a stock?
4. What are three ways that a firm can increase the
amount of its future dividend per share?
5. What are the main limitations of the dividend-
discount model?
6. How does the total payout model address part of
the dividend-discount model’s limitations?

7-106