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Stock

Valuation

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Learning Objectives
 Understand the investor required return

 Understand how stock prices depend on


future dividends and dividend growth

 Be able to compute stock prices using the


dividend growth model

 Understand the Two stage model growth


and Three stage model valuation
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Chapter Outline

 Computation of investor required return


 Dividend Discount Model
 Zero Growth Model
 Constant Growth Model
 Super Normal Growth Model

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Focus on Principles

 Stock Valuation

A process through which we determine the intrinsic value of per share.

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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
 The price of the stock is the present
value of its expected future cash
flows.
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Common and Preferred Stock Evaluation

 Common stock valuation is the process of determining the


value of a share of stock in a company. The holder of one share
in a company that has one million shares outstanding is actually
the owner of one-millionth of the company; the value of that
share should represent that percentage of the company's worth.
 The value of a preferred stock equals the present value of its
future dividend payments discounted at the required rate of
return of the stock. In most cases the preferred stock is
perpetual in nature, hence the price of a share of preferred
stock equals the periodic dividend divided by the required rate
of return.
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Comparison between common and proffered stock

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The Time Line
End of Start of
second year third year
Today

t=0 t =1 t=2 t=3 t=4


Po D1 D2 D3 D4 + P4

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Important symbols
Do = Current dividend/ Just paid dividend

D1 = Dividend at year 1

D2 = Dividend at year 2

D3 = Dividend at year 3

And so on…

Po = Current price/ Intrinsic value/ fundamental value

P1 = Price at year 1 (end)

P2 = Price at year 2 (end)

And so on …

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Investor Required Return
Investor required return based on two components, 1) Dividend
yield, 2) Capital gain/ growth

Required Return Dividend yield Capital Gain


of Investor (DY)
+ (CG/ Growth)

Symbols

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Investor Required Return
Q1: Waterworks has a dividend yield of 8 percent. If its dividend is
expected to grow at a constant rate of 5 percent, what must be the
expected rate of return on the company’s stock?

Data
DY CG
Dividend Yield = 8%
Capital Growth = 5%

Required Return
of Investor
8% + 5%

Required Return 13%


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of Investor
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Q2: Current price of stock is $20 and expected price after one year is
22.5. If investor required return is 18%. What percentage of dividend
should company pay?
Data

Po = $20 +
P1 = $22.5
Ri = 18%

18% DY +

DY 5.5%

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Stock Price Valuation Concept

Zero Growth Constant Growth Super normal growth


D1 D1
P0  P0  P0 = PV of all future inflows
r r -g
When companies at its Companies are Companies having
peek and no further growing at a constant multi growth stage
growth intact going growth rate, denoted
forward. with g
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Zero Growth Model
Q1: You own a stock that will start paying $0.50 annually at the
end of the year. It has zero growth in future. If the required rate of
return is 14%, what should you pay per share?

Data D1
P0 
r
D1 = $0.50 0.50
P0 
P0 = ? 14%
Ri = 14% P0  3.57 / share
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Q2: You own a stock that will start paying $3 annually at the end
of the year. It has zero growth in future. If the current price of
share $50, then what will be the implied required return of
investor?
Data D1
P0 
r
D1 = $3 3
50 
P0 = 50 r
Ri = ? r  6%

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Q3: You bought a stock today at $40 per share while implied
required return of investor 12%, then what dividend you will
receive from this stock?

Data D1
P0 
r
D1 = ? D1
40 
P0 = $40 12%
Ri = 12% D1  4.8 / share

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Constant Growth Model
Below given formula we use to calculate the intrinsic value per
share in constant growth model
D 0 (1  g) D1
For Intrinsic Value P0  
r -g r -g

For Required Return D 0 (1  g) D1


r g g
of investor P0 P0

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Q1: 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?
D 0 (1  g) D1
Data P0  
D0 =$0.5 r -g r-g
r = 15% 0.5(1  2%)
g = 2% P0 
15% - 2%
Po = ?
P0  3.92
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Q2: EXON company just paid a dividend of $2 while analyst
project constant growth rate around 5% and stock currently trading
at $21, what is the implied required return investor will get from
this investment?
Data D 0 (1  g) D1
r g g
D0 =$2 P0 P0
r=? 2(1  5%)
g = 5% r  5%
Po = $21 21
r  15%
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Q3: XYZ company expected to pay year end dividend $3, stock
currently trades at $40, Investor required return from this
investment is 15%, while this stock is being considered as a growth
stock. What is the implied growth rate?
Data D 0 (1  g) D1
D1 =$3 r g g
r = 15%
P0 P0

g=? 3
Po = $40 15%   g  g  7.5%
40
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Q4: XYZ company expected to pay year end dividend $3, stock
currently trades at $40, Investor required return from this
investment is 15%, while this stock is being considered as a growth
stock. What is the implied growth rate?

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Super Normal Growth Model

Below given formula we use to calculate the intrinsic value per


share by using “Super Normal Growth Model”

P0 = PV of all future inflows

Present Dividend payments and


Values price of horizon period

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The 3-step solution
• Step 1 – Forecast the dividends during the non-constant growth period up to the first year at which dividends grow at a
constant rate.
• Step 2 – Once a constant growth rate is reached, use the constant growth pricing model to forecast the stock price. This
stock price represents the PV of all dividends beyond the non-constant growth period.
• Step 3 – Discount the cash flows (dividends found in step one and price found in step two) back to year zero at the
appropriate discount rate. This is the current value of the stock.

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Q1: XYZ company paid last year $2 as dividend, further investors
expected dividend growth 20% for next two years and then 10%
next 3 years and 5% forever thereafter. Calculate future dividend
payments?
Do D1 D2 D3 D4 D5 D6

2 2.4 2.88 3.17 3.48 3.83 4.02


D1  2(1  20%)  2.4 D4  3.17(1  10%)  3.48
D2  2.4(1  20%)  2.88 D5  3.48(1  10%)  3.83
D3  2.88(1  10%)  3.17 D6  3.83(1  5%)  4.02
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Q1: SMR Inc. last year paid dividend of $1 and investors believe
that dividend would grow by 15% for next 2 years and in the 3 year
company will pay 10%, while after third year dividend would grow
by 5% thereafter. What is the maximum value investor can pay for
this stock if the required rate of return 15%? Using
D0 = 1 GGM
D1 = 1*(1+15%) = 1.15 P3 = 15.30
1.45 * (1  5%)
P3 
D2 = 1.15*(1+15%) = 1.32 (15%  5%)

D3 = 1.32*(1+10%) = 1.45
1.15 1.32 1.45  15.30
D4 = 1.45*(1+5%) = 1.53 Po   
(1  15%)^1 (1  15%)^ 2 (1  15%)^3

Part 3 of 3 Po  13.01
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Do D1 D2 D3 D4

1 1.15 1.32 1.45 1.53

(Due to constant growth after 3rd year) => P3 = ?

D4 1.53
Using GGM => P3    15.30
r  g 15%  5%

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Do D1 D2 D3  P3

1 1.15 1.32 1.45  15.30


D1 D2 D3  P3
P0  1
 2
 3
(1  r ) (1  r ) (1  r )
1.15 1.32 1.45  15.30
P0  1
 2

(1  15%) (1  15%) (1  15%)3
P0  13.01
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Concept of Growth (g)

g = ROE x b

ROE = Return on equity

b = Retention ratio = (1 - DPR)

DPR = Dividend Payout Ratio

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Question: A stock sells for $40. The next dividend will be $4 per
share. If the rate of return earned on reinvested funds is 15 percent
and the company reinvests 40 percent of earnings in the firm, what
must be the discount rate?
Date: 1st Step: 2nd Step:
P0 = $40 Formula for growth: Formula for discount rate (r):
D1 = $4 g = ROE x b r = (D1/ P0) + g
ROE = 15% g = 15% x 40% r = (4/ 40) + 0.06
b = 40% g = 6% r = 0.16 = 16%

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Dividend from Earning Per Share
(Concept of DPR)

DPR = Dividend Payout Ratio = DPS / EPS

Where;
DPS = Dividend Per Share = Dividend / No. of Shares
EPS = Earning Per Share = Net Income / No. of Shares

DPS = DPR x EPS


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Question: Assume a company has earnings per share of $5 and pays
out 40% in dividends. The earnings growth rate for the next 3 years
will be 20% and after third year, the earnings will increase at an
annual rate of 5% thereafter. If a 12% rate of return required then what
will be the value of the company stock?
Eo E1 E2 E3 E4

5 6 7.2 8.64 9.07


E1 = 5*(1+20%) = 6
E2 = 6*(1+20%) = 7.2
E3 = 7.2*(1+20%) = 8.64
Part 3 of 3 E4 = 8.64*(1+5%) = 9.07
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Using; DPS = EPS x DPR
E0 = 5
E1 = 5*(1+20%) = 6 D1 = 6*40% = 2.4
E2 = 6*(1+20%) = 7.2 D2 = 7.2*40% = 2.88
E3 = 7.2*(1+20%) = 8.64 D3 = 8.64*40% = 3.46
E4 = 8.64*(1+5%) = 9.07 D4 = 9.07*40% = 3.63
3.63
Using CGM=> P3  = 51.86
(12%  5%)

32 Part 3 of 3
2 .4 2.88 3.46  51.86
Po  1
 2
 3
(1  12%) (1  12%) (1  12%)

Po  2.14  2.30  39.38

Po  43.82

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References

1) Richard A. Brealey, Stewart C. Myers and Franklin Allen (2011),


Principles of Corporate Finance 10th edition, McGraw Hill.
2) Brigham, E. F., & Houston, J. F. (2013) Fundamentals of Financial
Management. (13 Ed).
3) Ross S, Trayler, R, Bird, R, Westerfield R & Jordan B 2011,
Essentials of Corporate Finance, 2nd Edition, McGraw Hill, Sydney.
4) Brigham, E. F., & Ehrhardt, M. C. (2016) Financial Management
Theory and Practice. (14 Ed).

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