Stock Valuation

Learning Module

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Stock Valuation
 Firms obtain their long-term sources of equity
financing by issuing common and preferred stock.
 The payments of the firm to the holders of these
securities are in the form of dividends.
 The common stockholders are the owners of the firm
and have the right to vote on important matters to the
firm, such as the election of the Board of Directors.
 Preferred stock, on the other hand, is a hybrid form of
financing, sharing some features with debt and some
with common equity.
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Stock Valuation
 The value of these securities, as with other assets, is
based upon the discounted value of their expected
future cash flows. The value of a share of stock is
often calculated as the present value of the stream of
dividends the stock is expected to provide in the
future.
 We will illustrate the valuation of a constant growth
stock, i.e., a stock whose dividends are growing at a
rate.
 Preferred stock is a perpetuity and is a little easier to
value than common stock. 3
Equations

 Constant Growth Stock Price:

P0 = [D0(1+g)]/(r – g) = D1/(r-g)
 You can also solve for the expected return:
r = (D1/P0) + g
 Preferred Stock:
Pp = Dp / r

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Equations
 where:
 P0 = the stock price at time 0
 D0 = the current dividend
 D1 = the next dividend (i.e., at time 1)
 g = the growth rate of the dividends
 r = the required return on the stock
 Note that g < r.
 Pp = the preferred stock price
 Dp = the preferred dividend
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Constant Growth Stocks
 A constant growth stock is a stock whose dividends
are expected to grow at a constant rate in the
forseeable future.

 This condition fits some established firms, which tend

to grow over the long run at the same rate as the
economy.

 There are numerous, more complicated models

which we will not discuss in this learning module.
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An Example
 Find the stock price given that the current dividend is
$2 per share, dividends are expected to grow at a
rate of 5% in the forseeable future, and the required
return is 10%
 Step 1 – Draw Timeline
$5 g = 5%

0 r = 10% Infinity

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An Example
 Step 2 – Write equation
P0 = D0(1+g)/(r – g) = D1/(r – g)
 Step 3 – Fill in equation
P0 = $2 (1 + 5%)/(10% - 5%)
 Step 4 – Solve equation
P0 = $2.10/5% = $2.10/0.05 = $42
 This means that the value of the stock at time zero
is $42 dollars given a required rate of return of
10%, a growth rate of 5% and a dividend at time
zero of $2.
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Preferred Stock
 Preferred stock is defined as equity with priority over
common stock with respect to the payment of dividends and
the distribution of assets in a liquidation.
 Preferred stock has the following features:
 Par Value - The par value represents the claim of the preferred
stockholder against the value of the firm.
 Preferred Dividend / Preferred Dividend Rate - The preferred
dividend rate is expressed as a percentage of the par value of the
preferred stock. The annual preferred dividend is determined by
multiplying the preferred dividend rate times the par value of the
preferred stock.
 Since preferred dividends are generally fixed, preferred stock
can be valued as a constant growth stock with a dividend
growth rate equal to zero.
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An Example
 Find the price of a share of preferred stock given that the
par value is $100 per share, the preferred dividend rate is
10%, and the required return is 12%.
 A timeline is not really needed, because the dividends of
preferred stock are fixed. However, you can always draw
one if it helps.
 Step 2 – Write equation
Pp = Dp/r

Note: The formula is the same as a constant growth stock with g = 0, so

P0 = D1/(r – g) = Pp = Dp/r when g = 0.
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An Example
 Step 3 – Fill In Equation
Pp = $10/12%
 Step 4 – Solve Equation
Pp = $83.33

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