CHAPTER 9

Stocks and Their Valuation

 Features of common stock

 Determining common stock values
 Preferred stock

9-1
Facts about common stock
 Represents ownership
 Ownership implies control
 Stockholders elect directors
 Directors elect management
 Management’s goal: Maximize the
stock price

9-2
 Intrinsic Value and Stock Price
 Outside investors, corporate insiders, and
analysts use a variety of approaches to
estimate a stock’s intrinsic value (P0).
 In equilibrium we assume that a stock’s price
equals its intrinsic value.
 Outsiders estimate intrinsic value to help

determine which stocks are attractive to

buy and/or sell.
 Stocks with a price below (above) its

intrinsic value are undervalued

(overvalued).
9-3
Determinants of Intrinsic Value
and Stock Prices (Figure 1-1)

9-4
Different approaches for estimating the
intrinsic value of a common stock

 Dividend growth model

 Corporate value model
 Using the multiples of comparable
firms

9-5
 Dividend growth model
 Value of a stock is the present value of the
future dividends expected to be generated by
the stock.

^ D1 D2 D3 D
P0  1
 2
 3
 ... 
(1  rs ) (1  rs ) (1  rs ) (1  rs ) 

9-6
Constant growth stock
 A stock whose dividends are expected to
grow forever at a constant rate, g.

D1 = D0 (1+g)1
D2 = D0 (1+g)2
Dt = D0 (1+g)t

 If g is constant, the dividend growth formula

converges to:
^ D 0 (1  g) D1
P0  
rs - g rs - g
9-7
 Future dividends and their
present values
$ D t  D0 ( 1  g ) t

0.25 Dt
PVD t  t
(1  r )

P0   PVD t

0 Years (t)
9-8
What happens if g > rs?
 If g > rs, the constant growth formula
leads to a negative stock price, which
does not make sense.
 The constant growth model can only be
used if:
 rs > g
 g is expected to be constant forever

9-9
If rRF = 7%, rM = 12%, and b = 1.2,
what is the required rate of return on
the firm’s stock?
 Use the SML to calculate the required
rate of return (rs):

rs = rRF + (rM – rRF)b

= 7% + (12% - 7%)1.2
= 13%

9-10
 If D0 = $2 and g is a constant 6%,
find the expected dividend stream for
the next 3 years, and their PVs.

0 1 2 3
g = 6%

D0 = 2.00 2.12 2.247 2.382

1.8761
rs = 13%
1.7599
1.6509

9-11
What is the stock’s intrinsic value?
 Using the constant growth model:

ˆP  D1  $2.12
0
rs - g 0.13 - 0.06
$2.12

0.07
 $30.29

9-12
What is the expected market price
of the stock, one year from now?
 D1 will have been paid out already. So,
P1 is the present value (as of year 1) of
D2, D3, D4, etc.
^ D2 $2.247
P1  
rs - g 0.13 - 0.06
 $32.10

 Could also
^
find expected P1 as:
P1  P0 (1.06)  $32.10
9-13
What are the expected dividend yield,
capital gains yield, and total return
during the first year?
 Dividend yield
= D1 / P0 = $2.12 / $30.29 = 7.0%
 Capital gains yield
= (P1 – P0) / P0
= ($32.10 - $30.29) / $30.29 = 6.0%
 Total return (rs)
= Dividend Yield + Capital Gains Yield
= 7.0% + 6.0% = 13.0%
9-14
What would the expected price
today be, if g = 0?
 The dividend stream would be a
perpetuity.

0 1 2 3
rs = 13%
...
2.00 2.00 2.00
^ PMT $2.00
P0    $15.38
r 0.13

9-15
Supernormal growth:
What if g = 30% for 3 years before
achieving long-run growth of 6%?
 Can no longer use just the constant growth
model to find stock value.
 However, the growth does become
constant after 3 years.

9-16
 Valuing common stock with
nonconstant growth

0 r = 13% 1 2 3 4
s
...
g = 30% g = 30% g = 30% g = 6%
D0 = 2.00 2.600 3.380 4.394 4.658
2.301
2.647
3.045
4.658
46.114 P 3   $66.54
^ 0.13  0.06
54.107 = P0
9-17
Find expected dividend and capital gains
yields during the first and fourth years.
 Dividend yield (first year)
= $2.60 / $54.11 = 4.81%
 Capital gains yield (first year)
= 13.00% - 4.81% = 8.19%
 During nonconstant growth, dividend yield
and capital gains yield are not constant,
and capital gains yield ≠ g.
 After t = 3, the stock has constant growth
and dividend yield = 7%, while capital
gains yield = 6%.
9-18
 Nonconstant growth:
What if g = 0% for 3 years before long-
run growth of 6%?

0 r = 13% 1 2 3 4
s
...
g = 0% g = 0% g = 0% g = 6%
D0 = 2.00 2.00 2.00 2.00 2.12
1.77
1.57
1.39
2.12
20.99 P 3   $30.29
^ 0.13  0.06
25.72 = P0
9-19
Find expected dividend and capital gains
yields during the first and fourth years.
 Dividend yield (first year)
= $2.00 / $25.72 = 7.78%
 Capital gains yield (first year)
= 13.00% - 7.78% = 5.22%
 After t = 3, the stock has constant
growth and dividend yield = 7%,
while capital gains yield = 6%.

9-20
If the stock was expected to have
negative growth (g = -6%), would anyone
buy the stock, and what is its value?
 The firm still has earnings and pays
dividends, even though they may be
declining, they still have value.

^ D1 D0 ( 1  g )
P0  
rs - g rs - g
$2.00 (0.94) $1.88
   $9.89
0.13 - (-0.06) 0.19

9-21
Find expected annual dividend and
capital gains yields.
 Capital gains yield
= g = -6.00%
 Dividend yield
= 13.00% - (-6.00%) = 19.00%

 Since the stock is experiencing constant

growth, dividend yield and capital gains
yield are constant. Dividend yield is
sufficiently large (19%) to offset a negative
capital gains.
9-22
Corporate value model
 Also called the free cash flow method.
Suggests the value of the entire firm
equals the present value of the firm’s
free cash flows.
 Remember, free cash flow is the firm’s
after-tax operating income less the net
capital investment
 FCF = NOPAT – Net capital investment
9-23
 Applying the corporate value model
 Find the market value (MV) of the firm,
by finding the PV of the firm’s future
FCFs.
 Subtract MV of firm’s debt and preferred
stock to get MV of common stock.
 Divide MV of common stock by the
number of shares outstanding to get
intrinsic stock price (value).
9-24
Issues regarding the
corporate value model
 Often preferred to the dividend growth model,
especially when considering number of firms
that don’t pay dividends or when dividends are
hard to forecast.
 Similar to dividend growth model, assumes at
some point free cash flow will grow at a
constant rate.
 Terminal value (TVN) represents value of firm
at the point that growth becomes constant.
9-25
 Given the long-run gFCF = 6%, and
WACC of 10%, use the corporate value
model to find the firm’s intrinsic value.

0 r = 10% 1 2 3 4
...
g = 6%
-5 10 20 21.20
-4.545
8.264
15.026 21.20
398.197 530 = = TV3
0.10 - 0.06
416.942
9-26
If the firm has $40 million in debt and
has 10 million shares of stock, what is
the firm’s intrinsic value per share?
 MV of equity = MV of firm – MV of debt
= $416.94 - $40
= $376.94 million
 Value per share = MV of equity / # of
shares
= $376.94 / 10
= $37.69

9-27
Firm multiples method
 Analysts often use the following multiples
to value stocks.
 P/E
 P / CF
 P / Sales
 EXAMPLE: Based on comparable firms,
estimate the appropriate P/E. Multiply this
by expected earnings to back out an
estimate of the stock price.
9-28
What is market equilibrium?
 In equilibrium, stock prices are stable and
there is no general tendency for people to
buy versus to sell.
 In equilibrium, two conditions hold:
 The current market stock price equals its
^
intrinsic value (P0 = P0).
 Expected returns must equal required returns.
^ D1
rs  g  rs  rRF  (rM  rRF )b
P0
9-29
Market equilibrium
 Expected returns are determined by
estimating dividends and expected
capital gains.
 Required returns are determined by
estimating risk and applying the CAPM.

9-30
How is market equilibrium
established?
 If price is below intrinsic value …
 The current price (P0) is “too low” and
offers a bargain.
 Buy orders will be greater than sell
orders.
 P0 will be bid up until expected return
equals required return.

9-31
How are the equilibrium
values determined?
 Are the equilibrium intrinsic value and
expected return estimated by
managers or are they determined by
something else?
 Equilibrium levels are based on the
market’s estimate of intrinsic value and
the market’s required rate of return, which
are both dependent upon the attitudes of
the marginal investor.

9-32
Preferred stock
 Hybrid security.
 Like bonds, preferred stockholders
receive a fixed dividend that must be
paid before dividends are paid to
common stockholders.
 However, companies can omit preferred
dividend payments without fear of
pushing the firm into bankruptcy.

9-33
If preferred stock with an annual
dividend of $5 sells for $50, what is the
preferred stock’s expected return?

Vp = D / rp
$50 = $5 / rp

^
rp = $5 / $50
= 0.10 = 10%

9-34