LECTURE 8

S T O C K VA L U AT I O N

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 KEY CONCEPTS AND SKILLS

• Understand the features of both common and preferred stock.

• Understand the basic stock valuation, using zero growth,

constant growth and non-constant growth.

• Explain how stock prices depend on future dividends and

dividend growth.

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 COMMON STOCK

• Is the basic ownership claim in a corporation.

• Has the right to vote on matters such as electing a board of
directors, setting a capital budget, and proposed mergers or
acquisitions.
• Has the right to a firm’s residual assets after creditors,
preferred stockholders, and others with higher priority claims
have been satisfied.

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 PREFERRED STOCK

• Represents ownership in corporation.

• Does not have the right to vote.
• Has priority over common stock with respect to dividends and
liquidation of assets.
• Must be paid a fixed dividend before funds are distributed to
common stockholders.

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 PREFERRED STOCK

• Preferred Stock: Debt or Equity?

• Preferred stock is equity but a strong case can be made that it
is a special type of debt.
• Regular preferred has no voting rights.
• Dividends are due regardless of earnings.
• It may be convertible into common stock.
• Most preferred is not a “true perpetuity” – it may be called or
retired by a firm.

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 STOCK VALUATION

• Valuation of Equity Securities

• Valuing common stock is more difficult than valuing bonds or
preferred stock because:
1. Size and timing of dividends are less certain compared to
coupon payments.
2. The rate of return on common stock cannot be observed
directly from the market.
3. Common stock is a true perpetuity because it has no
maturity date.

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CASH FLOWS FOR STOCKHOLDERS

• If you buy a share of stock, you can receive cash in two ways:
 The company pays dividends.
 You sell your shares, either to another investor in the
market or back to the company.

• As with bonds, the price of the stock is the present value of

these expected cash flows.

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 ONE-PERIOD EXAMPLE

• Suppose you are thinking of purchasing the stock of Moore

Oil, Inc.
• You expect it to pay a $2 dividend in one year, and you
believe that you can sell the stock for $14 at that time.
• If you require a return of 20% on investments of this risk,
what is the maximum you would be willing to pay?

 Compute the PV of the expected cash flows.

 Price = (14 + 2) / (1.2) = $13.33

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 TWO-PERIOD EXAMPLE

• Now, what if you decide to hold the stock for two years?
• In addition to the dividend in first year, you expect a
dividend of $2.10 in second year and a stock price of
$14.70 at the end of year 2.
• Now how much would you be willing to pay?

 PV = 2 / (1.2) + (2.10 + 14.70) / (1.2)2 = $13.33

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 THREE-PERIOD EXAMPLE

• Finally, what if you decide to hold the stock for three years?
• In addition to the dividends at the end of years 1 and 2, you
expect to receive a dividend of $2.205 at the end of year 3
and the stock price is expected to be $15.435.
• Now how much would you be willing to pay?

 PV = 2 / 1.2 + 2.10 / (1.2)2 + (2.205 + 15.435) / (1.2)3 =

$13.33

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 DEVELOPING THE MODEL

• You could continue to push back the year in which you will
sell the stock.
• You would find that the price of the stock is really just the
present value of all expected future dividends.

D1 D2 D3 D
P0  1
 2
 3
 ...  
(1  R) (1  R) (1  R) (1  R)
• So, how can we estimate all future dividend payments?

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 ESTIMATING DIVIDENDS:
SPECIAL CASES
• Constant dividend (zero growth)
 The firm will pay a constant dividend forever.
 This is like preferred stock.
 The price is computed using the perpetuity formula.
• Constant dividend growth (constant growth)
 The firm will increase the dividend by a constant percent every
period.
 The price is computed using the growing perpetuity model.
• Supernormal growth (non-constant growth)
 Dividend growth is not consistent initially but settles down to
constant growth eventually.
 The price is computed using a multistage model.

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 ESTIMATING DIVIDENDS:
SPECIAL CASES
• Simplifying Assumptions:
• Three models or assumptions for describing growth patterns
of dividends:
1. The dividend has a zero growth rate and is always the same.
2. The dividend has a constant growth rate.
3. The dividend has a mixed growth rate; i.e., the rate is higher
in some periods and lower in others.

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 ZERO GROWTH

• If dividends are expected at regular intervals forever, then this

is a perpetuity, and the present value of expected future
dividends can be found using the perpetuity formula.
 P0 = D / R
• Suppose a stock is expected to pay a $0.50 dividend every
quarter and the required return is 10% with quarterly
compounding. What is the price?
 P0 = 0.50 / (0.1 / 4) = $20

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 DIVIDEND GROWTH MODEL

• Dividends are expected to grow at a constant percent per

period.
 P0 = D1 /(1+R) + D2 /(1+R)2 + D3 /(1+R)3 + …
 P0 = D0(1+g)/(1+R) + D0(1+g)2/(1+R)2 + D0(1+g)3/(1+R)3 +
…

• With a little algebra and some series work, this reduces to:
D 0 (1  g) D1
P0  
R -g R -g
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 DGM – EXAMPLE 1

• Suppose Big D, Inc., just paid a dividend of $0.50 per share.

• It is expected to increase its dividend by 2% per year.
• If the market requires a return of 15% on assets of this risk,
how much should the stock be selling for?

• P0 = 0.50(1+0.02) / (0.15 - 0.02) = $3.92

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TABLE 8.1 – STOCK VALUATION
SUMMARY (1)

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TABLE 8.1 – STOCK VALUATION
SUMMARY (2)

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 HOMEWORK

• XYZ stock currently sells for $50 per share. The next
expected annual dividend is $2, and the growth rate is 6%.
What is the expected rate of return on this stock?

• If the required rate of return on this stock were 12%, what

would the stock price be, and what would the dividend yield
be?

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 REFERENCE

• Ross, S.A., Westerfield, R.W., and Jordan, B.D.

(2019). Fundamentals of Corporate Finance, Chapter
8 Stock Valuation, 239 – 250, McGraw-Hill.

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