CHAPTER

4 4-1

The Value of Common Stocks

Brealey, Myers, and Allen

Principles of Corporate Finance

12th Edition

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4-1 how common stocks are traded
4-2

• Primary Market
• New securities
• Secondary Market
• Previously-issued securities
• Common Stock
• Ownership shares in publicly-held
corporation

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4-1 how common stocks are traded
4-3

• Electronic Communication Networks (ECNs)

• Computer networks that allow electronic trading
• Exchange-Traded Funds (ETFs)
• Stock portfolios bought/sold in single trade
• SPDRs (Standard & Poor’s Depository Receipts
or “spiders”)
• ETFs tracking several S&P indexes

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 Stock Listings
4-4

Source: Refinitiv

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4-2 How common stocks are valued
4-5

• Book Value
• Net worth of firm according to balance sheet
• Market Value Balance Sheet
• Financial statement that uses market value of
assets and liabilities
• Dividend
• Periodic cash distribution from firm to the
shareholders
• P/E Ratio
• Price per share divided by earnings per share
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4-2 How common stocks are valued
4-6

• Discounted Cash Flow (DCF) Formula

• Value of a stock = present value of future cash
flows

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4-2 How common stocks are valued
4-7

• Expected Return
• Percentage yield forecast from specific investment
over time period
• Sometimes called market capitalization rate

Div1  P1  P0
Expected return  r 
P0

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4-2 How common stocks are valued
4-8

• Example
• Fledgling Electronics sells for $100 per share
today; they are expected to sell for $110 in one
year. What is expected return if dividend in one
year is forecasted to be $5.00?

5  110  100
Expected return   .15
100
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4-2 How common stocks are valued
4-9

• Price of share of stock is present value of future

cash flows
• For a stock, future cash flows are dividends and
ultimate sales price

Div1  P1
Price  P0 
1 r

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4-2 How common stocks are valued
4-10

• Example
• Fledgling Electronics price

5  110
Price  P0   100
1.15

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4-2 How common stocks are valued
4-11

But in a similar way we can write next year’s price as a

function of the expected dividend and the price one year
later. Then the price can be written as:

Continuing this reasoning we have:

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4-2 How common stocks are valued
4-12

• Dividend Discount Model

• Computation of today’s stock price: share value
equals present value of all expected future
dividends
• H: Time horizon for investment

Div1 Div2 DivH  PH

P0  1
 2
 ...  H
(1  r ) (1  r ) (1  r )

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4-2 How common stocks are valued
4-13

• Modified Formula

Div1 Div2 DivH  PH

P0  1
 2
 ... 
(1  r ) (1  r ) (1  r ) H

Divt
H
PH
P0   t
 H
t 1 (1  r ) (1  r )

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4-2 How common stocks are valued
4-14

• Example
• Fledgling Electronics forecasted to pay $5.00
dividend at end of year 1 and $5.50 dividend at
end of year 2. End-of-second-year stock will be
sold for $121. Discount rate is 15%. What is the
price of stock?

5.00 5.50  121

PV  1
 2
(1  .15) (1  .15)
PV  $100.00
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4-2 How common stocks are valued
4-15

• Example
• XYZ Company will pay dividends of $3, $3.24, and
$3.50 over next three years. After three years,
stock sells for $94.48. What is the price of stock
given 12% expected return?

3.00 3.24 3.50  94.48

PV  1
 2
 3
(1  .12) (1  .12) (1  .12)
PV  $75.00
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4-2 How common stocks are valued
4-16

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 4-2 How common stocks are valued 4-17

Dividend Discount Model – What if H goes to infinity?

PV(stock)  PV(expected future dividends)

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 4-2 How common stocks are valued 4-18

Dividend Discount Model – We will make some

simplifying assumptions.
What if the dividend always stays the same?

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4-2 How common stocks are valued
4-19

If we forecast no growth, and plan to hold out stock

indefinitely, we will then value the stock as a
PERPETUITY.

Div1 EPS1
Perpetuity  P0  or
r r
Assumes all earnings are
paid to shareholders.

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 4-2 How common stocks are valued 4-20

Constant Growth DDM - A version of the dividend

growth model in which dividends grow at a constant
rate (Gordon-Shapiro Growth Model).

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4-2 How common stocks are valued
4-21

• Valuing Non-Constant Growth

Div1 Div2 Div H PH

PV ( EquityValu e)  1
 2
 ...  H

(1  r ) (1  r ) (1  r ) (1  r ) H

DivH 1
PH 
rg

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4-2 How common stocks are valued
4-22

Example – Phoenix produces dividends in three consecutive

years of 0, .31, and .65 per share, respectively. The dividend in
year four is estimated to be .67 and should grow in perpetuity
at 4%. Given a discount rate of 10%, what is the price of the
stock?

Price =

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4-3 Estimating cost of equity capital
4-23

• Market Capitalization Rate

• Estimated using perpetuity formula
• Also called cost of equity capital

Div1
Capitaliza tion rate  P0 
rg
Div1
r g
P0
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4-3 Estimating cost of equity capital
4-24

• Return Measurements

Div1
Dividend yield 
P0

Return on Equity  ROE

EPS
ROE 
Book equity per share

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4-3 Estimating cost of equity capital
4-25

• Dividend Growth Rate

• Derived by applying return on equity to
percentage of earnings reinvested in operations
• g = return on equity × plowback ratio

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 4-4 Stock price and earnings per share
4-26

• If firm pays lower dividend and reinvests funds,

stock price may increase due to higher future
dividends
• Payout Ratio
• Fraction of earnings paid out as dividends
• Plowback Ratio
• Fraction of earnings retained by firm

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 4-4 Stock price and earnings per share
4-27

• Example
• Company plans $8.33 dividend next year (100% of
earnings). Investors will get 15% expected return.
Instead, company plows back 40% of earnings at
firm’s current return on equity of 25%.
• What is the stock value before and after
plowback decision?

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 4-4 Stock price and earnings per share
4-28

• Example, continued
• No Growth
8.33
P0   $55.56
.15
• With Growth

g  .25  .40  .10

5.00
P0   $100.00
.15  .10

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 4-4 Stock price and earnings per share
4-29

• Example, continued
• Stock price remains at $55.56 with no earnings
plowed back
• With plowback, price is $100.00
• Difference is called present value of growth
opportunities (PVGO)

PVGO  100.00  55.56  $44.44

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 4-4 Stock price and earnings per share
4-30

• Present Value of Growth Opportunities (PVGO)

• Net present value of firm’s future investments
• Sustainable Growth Rate
• Steady rate at which firm can grow: plowback ratio
x return on equity

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 Exercise
4-31

Mexican Motors stock sells for 200 pesos per

share and next year’s dividend is 8.5 pesos.
Security analysts are forecasting earnings
growth of 7.5% per year for the next 5 years.
What rate of return are investors expecting if
earnings and dividends grow in perpetuity at
7.5%?

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 Exercise
4-32

Company Q’s current return on equity (ROE) is 14%. It

pays out one-half of earnings as cash dividends (payout-
ratio is 50%). Current book value per share is $50.
Assume that the ROE and payout ratio stay constant for
the next four years. After that, competition forces ROE
down to 11.5% and the payout ratio increases to 0.8. The
cost of equity is 11.5%
a) What are Q’s EPS and dividends the following years?
b) What is Q’s stock worth per share?

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 4-5 Valuing a business
4-33

• Valuing a Business or Project

• Usually computed as discounted value of FCF to
valuation horizon (H)
• Valuation horizon sometimes called terminal value
and calculated like PVGO

FCF1 FCF2 FCFH PVH

PV (Enterprise Value)  1
 2
 ...  H

(1  r ) (1  r ) (1  r ) (1  r ) H

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 4-5 Valuing a business
4-34

• Valuing a Business or Project

FCF1 FCF2 FCFH PVH

PV  1
 2
 ...  H
 H
(1  r ) (1  r ) (1  r ) (1  r )

PV (free cash flows) PV (horizon value)

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 4-5 Valuing a business 4-35

Valuing a Business or Project

The value of a company = the present value of
all future free cash flows
The value of the equity = the value of the
company – the value of the debt
The value of a share = the value of the equity
divided by the number of shares

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 Cash Flow
4-36

• Cash flow = the difference between the

money coming in and the money going out

• Free Cash Flow

= Cash Flow to Creditors
+ Cash Flow to Stockholders

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 Cash Flow from Assets
4-37

• Cash flow from assets

= Free Cash Flow
= Operating Cash Flow
- Net Capital Spending
- Change in Net Working Capital (NWC)

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 Cash Flow from Assets
4-38

• Operating Cash Flow

= EBIT * (1-Tc) + Depreciation – D NWC
• Capital Spending
= Ending Net Fixed Assets
- Beginning Net Fixed Assets
+ Depreciation
• D NWC = Change in Net Working Capital
= Ending NWC
- Beginning NWC

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 Cash Flow to Creditors and Stockholders
4-39

• Cash Flow to Creditors

= Interest paid
- Net new borrowing
• Cash Flow to Stockholders
= Dividends Paid
- Net New Equity Raised

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 4-40

INV

OCF
Interest paid
Debt
FCF
Amortisation
NFCF
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 4-5 Valuing a business
4-41

Example
Given the cash flows for Concatenator Manufacturing Division,
calculate the PV of near term cash flows, PV (horizon value), and the
total value of the firm. r=10% and g= 6%

Year
1 2 3 4 5 6 7 8 9 10

Operational CF 1.20 1.44 1.73 2.07 2.49 2.81 3.18 3.36 3.57 3.78
Investment 2.00 2.40 2.88 3.46 2.69 3.04 1.59 1.68 1.78 1.89
Free Cash Flow -.80 -.96 -1.15 -1.39 -.20 -.23 1.59 1.68 1.79 1.89
OpCF growth (%) 20 20 20 20 20 13 13 6 6 6

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 4-5 Valuing a business
4-42

• Example, Continued

1  1.59 
PV(horizon value)  6    22.4
1.1  .10  .06 

.80 .96 1.15 1.39 .20 .23

PV(FCF)       
1.1 1.12 1.13 1.14 1.15 1.16
 3.6

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 4-5 Valuing a business
4-43

• Example, Continued

PV(busines s)  PV(FCF)  PV(horizon value)

 -3.6  22.4
 $18.8

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