FIN 3 0 1 – 0 0 2 Introduction to

Finance
EP 12
Today’s Agenda CH 8: Stock Valuation
CH 8
Why is it more difficult to price stocks than
bonds?
1. Cash flows (dividends) are not known in advance
2. Life of the investment is assumed to be forever
•Suppose
  you are considering purchasing a share of stock today with the
following characteristics
• Receive a dividend at the end of the first year
• You are able to sell the stock for price at the end of the first year
 𝑃1
 𝐷 1

t=0 t=1

• In this case you would be willing to pay for the stock, where R is your
required rate of return

  Problem! We do not know what is equal to

•Now
  you consider keeping the stock for one additional year
• Receive a dividend at the end of the second year
• You are able to sell the stock for price at the end of the second year
 𝑃2
 𝐷 2

t=1 t=2

• Now we can solve for

Can continue to repeat for ∞ time periods (forever)

• 

The price of a stock today is equal to the present value of all future
dividends.

Problem! We do not know the value of future dividends

To avoid this problem we can make assumptions about future
dividends – 4 options
Dividend Assumptions
(1) Zero growth dividends

(2) Constant growth

(3) Non-constant growth

(4) Two-stage growth

Option 1: Zero Growth Dividends

𝐷1=𝐷2=𝐷3=𝐷=𝐶𝑜𝑛𝑠𝑡𝑎𝑛𝑡
• 

This is an ordinary perpetuity!

Option 1: Zero Growth Dividends (Example)
 
If the required return is 10% and a company pays an annual
dividend of $1.50 that is not expected to grow, how much is the
stock worth?
Option 2: Constant Growth
•Dividends
  grow at a constant rate

This is a growing perpetuity!

Option 2: Constant Growth (Example)

 
A company has just paid a dividend of $1.50 per share. The dividend
is expected to grow at a constant rate of 4% per year. If the required
return is 10%, what is the stock worth today?
Option 2: Constant Growth
 
Also known as the Dividend Growth Model

Can be generalized to any time period

Option 2: Constant Growth (Example)
 

Using the previous example, what is the value of the stock in five
years (
Option 3: Non-constant Growth
Allows for “supernormal” growth rates over some finite length of time
(assume they begin growing at a constant rate at some point in the future)

Example: A firm will pay the below dividends for their first three years.
After the three years, the dividends will grow at a constant rate of 5%
per year. If the required return is 10%, what is the value of the stock
today?
Year Expected Dividend
1 $1.00
2 $2.25
3 $3.00
Option 3: Non-constant Growth (Example)
Example: A firm will pay the below dividends for their first three years.
After the three years, the dividends will grow at a constant rate of 5%
per year. If the required return is 10%, what is the value of the stock
today?
Year Expected Dividend
1 $1.00
2 $2.25
3 $3.00
Non-constant Growth Constant Growth

0 1 2 3 4 5 6

$1.00 $2.25 $3.00 $  3.00(1+.05) $  3.00 ( 1+.05 )2 $  3.00 ( 1+.05 )3

Step 1: Find the value of the Constant Growth portion
Constant Growth
  = 𝐷 3 ∗(1+𝑔) 3.00 ∗(1+.05)
𝑃 3 = = $ 63 3 4 5 6
( 𝑅 − 𝑔) (.10 −.05)

$  3.00(1+.05) $  3.00 ( 1+.05 )2 $  3.00 ( 1+.05 )3

Step 2: Find the present value of each of the cash flows

0 1 2 3
  0 = $ 1.00 + $ 2.25 + $ 3.00+$ 63.00 = $ 52.35
𝑃
( 1+.10 )1 ( 1+.10 )2 ( 1.10 )3
$1.00 $2.25 $3.00
$63
 Option 4: Two-Stage Growth
 
Stock grows at a rate for a given number of years (Stage 1) and then grows
at a rate forever (Stage 2).

Stage 1 Stage 2

0 1 2 3 4 5 6

3 2
$
1
  1.00 ( 1+ 𝑔1 ) $
2
  1.00 ( 1+ 𝑔1 ) $
  1.00 ( 1+ 𝑔1 )
3 $
  1.00 ( 1+ 𝑔1 ) ( 1+ 𝑔2 )
3 3 3
$
  1.00 ( 1+ 𝑔1 ) ( 1+ 𝑔2 ) $
  1.00 ( 1+ 𝑔1 ) ( 1+ 𝑔2 )

Example: Suppose a dividend of $1 is expected to grow at a rate of 5% for

the next three years, and then continue to grow at 4% forever. If the
required rate of return is 10%, what is the value of the stock?
Option 4: Two-Stage Growth (Example)
Example: Suppose a dividend is $1 today, and is expected to grow at a rate of 5% for the
next three years, and then continue to grow at 4% forever. If the required rate of return
is 10%, what is the value of the stock?
Stage 1 Stage 2

0 1 2 3 4 5 6

1 3 2
$  1.00 ( 1+.05 ) $  1.00 ( 1+.05 )
3 $
  1.00 ( 1+.05 ) ( 1+.04 )
2
$  1.00 ( 1+.05 ) 3
$  1.00 ( 1+.05 ) ( 1+.04 ) $  1.00 ( 1+.05 )3 ( 1+.04 )3
Stage 1 Stage 2

0 1 2 3 4 5 6

1 2
$  1.00 ( 1+.05 ) $  1.00 ( 1+.05 )
3  𝐷 3 (1+.04 )   Where
2
$  1.00 ( 1+.05 )  𝐷 3 (1+.04 )
3
 𝐷 3 (1+.04 )
 Option 4: Two-Stage Growth (Example)
Example: Suppose a dividend is $1 today, and is expected to grow at a rate of 5% for the
next three years, and then continue to grow at 4% forever. If the required rate of return
is 10%, what is the value of the stock?
Stage 1 Stage 2

0 1 2 3 4 5 6

1 2
$  1.00 ( 1+.05 ) $  1.00 ( 1+.05 )
3  𝐷 3 (1+.04 )   Where
2
$  1.00 ( 1+.05 )  𝐷 3 (1+.04 )
3
 𝐷 3 (1+.04 )

  Step 1: Calculate the value of Stage 2 as a growing perpetuity

 Option 4: Two-Stage Growth (Example)
Example: Suppose a dividend is $1 today, and is expected to grow at a rate of 5% for the
next three years, and then continue to grow at 4% forever. If the required rate of return
is 10%, what is the value of the stock?
Stage 1

0 1 2 3

1
$  1.00 ( 1+.05 ) $  1.00 ( 1+.05 )
3

$  1.00 ( 1+.05 ) $  20.11

2

 
Step 2: Calculate the present value of the cash flows
 Option 4: Two-Stage Growth (Example)
Example: Suppose a dividend is $1 today, and is expected to grow at a rate of 5% for the
next three years, and then continue to grow at 4% forever. If the required rate of return
is 10%, what is the value of the stock?

  Book Formula Method (t = # years continues for)

= = $17.84
Where does the dividend money come from?
• At fiscal year end, firms construct financial statements and calculate
net income
• From net income
• Part  reinvested into the firm as retained earnings
• Rest  handed out to shareholders as dividends

• Small, growing firms prefer to keep as much money in the firm as possible to
fund their investments in R&D activities
Taxes
• Corporations: dividends are not considered a business expense and are
not tax deductible
• Investors: dividends are taxed at a lower rate than ordinary income if
investor has held stock for more than 60 days

• Capital gains tax – you will be taxed if you sell the security for a higher
amount than the purchase price. Tax rate is lower if you hold the
security for > 1 year
• Capital loss deduction – if capital losses exceed capital gains then you
can deduct up to $3,000 per year to reduce taxable income
Common Stock Definitions and
Features
Types of Stock
• Common Stock
• No special preference with regards to dividends or bankruptcy

• Preferred Stock
• Dividend Priority
• Other Priority (sometimes Fixed dividend promised aswell)
 Classes of Stock
• Some firms have more than one class of common stock
• Often different classes have different voting rights

Example: Google – 3 classes

• Class A – held by regular investors
• Class B – superior-voting shares carry 10 times as may votes for the founders
• Class C – no voting rights – held by employees granted stock and Class A
stockholders

Founders control the direction of the business without majority economic ownership

https://blogs.wsj.com/cfo/2015/08/12/googles-multi-class-stock-structure-made-alphabet-move-unique/
Types of Stock
• Growth Stocks
• Earning Growth Potential (faster than competitors)
• Traditionally: High capital gains (high stock price) + future dividends
• Many times these firms do not pay out dividends in the beginning years
• They need to retain earnings to fund growth projects
• Example: Facebook

• Value Stocks
• Trade at a lower price relative to their fundamentals, such as dividends, earnings, and sales
• Traditionally: Dividends + maybe some capital gain
• These firms are mature and do not have many growth options left
• Example: Comcast
Proxy Fights
• Proxy – a grant of authority by a shareholder to someone else to vote
his or her shares

• Proxy Fight – shareholders vote by proxy in an attempt to replace

management
Shareholder Rights
• Shareholders elect directors

• Elected at annual meetings

• Staggered Elections – only a fraction of directorships are up for

election at one time
• Makes takeover attempts less likely to be successful, because it is more
difficult to vote in a majority of new directors
Market Indices
• Major Markets in US:
1) NYSE (Since 1792)
2) NASDAQ (Since 1971)

• Index: Representative of a market or sector

• Well known indices

• NASDAQ
• S&P 500
• DJIA (Dow Jones Industrial Average) – top 30
NASDAQ (NASDAQ Composite)
• Index:
• All Nasdaq domestic and international based common type stocks
listed on The Nasdaq Stock Market
• Must be exclusively listed on the Nasdaq exchange

• Weighting – Market Capitalization

Source: Nasdaq Composite Fact Sheet

NASDAQ (NASDAQ Composite)

Source: Nasdaq Composite Fact Sheet

S&P 500

Source: S&P Dow Jones Indices

S&P 500

Source: S&P Dow Jones Indices

S&P 500

Source: S&P Dow Jones Indices

Source: WSJ