Chapter 6

Stock Valuation

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 Key Concepts and Skills
 Understand how stock prices depend on future
dividends and dividend growth
 Be able to compute stock prices using the
dividend growth model
 Understand how growth opportunities affect
stock values
 Understand the PE ratio
 Understand how stock markets work

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 Chapter Outline
6.1 The Present Value of Common Stocks
6.2 Estimates of Parameters in the Dividend-
Discount Model
6.3 Growth Opportunities
6.4 The Dividend Growth Model and the NPVGO
Model
6.5 Price-Earnings Ratio
6.6 Some Features of Common and Preferred
Stock
6.7 The Stock Markets
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 6.1 The PV of Common Stocks
 The value of any asset is the present value of its
expected future cash flows.
 Stock ownership produces cash flows from:
 Dividends
 Capital Gains
 Valuation of Different Types of Stocks
 Zero Growth
 Constant Growth
 Differential Growth

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 Case 1: Zero Growth
 Assume that dividends will remain at the same level forever

Div 1  Div 2  Div 3  

 Since future cash flows are constant, the value of a zero
growth stock is the present value of a perpetuity:

Div 1 Div 2 Div 3

P0  1
 2
 3

(1  R ) (1  R) (1  R )
Div
P0 
R
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 Case 2: Constant Growth
Assume that dividends will grow at a constant rate, g,
forever, i.e.,
Div 1  Div 0 (1  g )
Div 2  Div 1 (1  g )  Div 0 (1  g ) 2
Div 3  Div 2 (1  g )  Div 0 (1  g ) 3
Since future cash flows grow at a constant rate forever,
the value of a constant growth stock is the present value
of a growing perpetuity:
Div 1
P0 
Rg
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 Constant Growth Example
 Suppose Big D, Inc., just paid a dividend of
$.50. It is expected to increase its dividend by
2% per year. If the market requires a return of
15% on assets of this risk level, how much
should the stock be selling for?
 P0 = .50(1+.02) / (.15 - .02) = $3.92

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 Case 3: Differential Growth
 Assume that dividends will grow at different rates
in the foreseeable future and then will grow at a
constant rate thereafter.
 To value a Differential Growth Stock, we need to:
 Estimate future dividends in the foreseeable future.
 Estimate the future stock price when the stock
becomes a Constant Growth Stock (case 2).
 Compute the total present value of the estimated
future dividends and future stock price at the
appropriate discount rate.

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 Case 3: Differential Growth
 Assume that dividends will grow at rate g1 for N
years and grow at rate g2 thereafter.
Div 1  Div 0 (1  g1 )
Div 2  Div 1 (1  g1 )  Div 0 (1  g1 ) 2
..
.
Div N  Div N 1 (1  g1 )  Div 0 (1  g1 ) N

Div N 1  Div N (1  g 2 )  Div 0 (1  g1 ) N (1  g 2 )

.
..
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 Case 3: Differential Growth
Dividends will grow at rate g1 for N years and grow
at rate g2 thereafter
Div 0 (1  g1 ) Div 0 (1  g1 ) 2
…
0 1 2
Div N (1  g 2 )
N
Div 0 (1  g1 )  Div 0 (1  g1 ) N (1  g 2 )
… …
N N+1
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 Case 3: Differential Growth
We can value this as the sum of:
 an N-year annuity growing at rate g1

C  (1  g1 ) 
T
PA  1  T 
R  g1  (1  R) 
 plus the discounted value of a perpetuity growing at
rate g2 that starts in year N+1
 Div N 1 
 
 R  g2 
PB  N
(1  R)
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 Case 3: Differential Growth
Consolidating gives:

 Div N 1 
 
C  (1  g1 )T   R  g 2 
P 1  T 
 N
R  g1  (1  R)  (1  R )

Or, we can “cash flow” it out.

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 A Differential Growth Example
A common stock just paid a dividend of $2. The
dividend is expected to grow at 8% for 3 years,
then it will grow at 4% in perpetuity.
What is the stock worth? The discount rate is 12%.

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 With the Formula
 $2(1.08) 3 (1.04) 
 
$2  (1.08)  (1.08) 3   .12  .04 

P 1  3
 3
.12  .08  (1.12)  (1.12)

P  $54  1  .8966
$32.75
3
(1.12)

P  $5.58  $23.31 P  $28.89

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 With Cash Flows
$2(1.08) $2(1.08) 2 $2(1.08) 3 $2(1.08) 3 (1.04)
…
0 1 2 3 4
$2.62 The constant
$2.16 $2.33 $2.52  growth phase
.08 beginning in year 4
can be valued as a
0 1 2 3 growing perpetuity
at time 3.
$2.16 $2.33 $2.52  $32.75
P0     $28.89
1.12 (1.12) 2
(1.12) 3 $2.62
P   $32.75 3
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 6.2 Estimates of Parameters
 The value of a firm depends upon its growth
rate, g, and its discount rate, R.
 Where does g come from?
g = Retention ratio × Return on retained earnings

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 Where does R come from?
 The discount rate can be broken into two parts.
 The dividend yield
 The growth rate (in dividends)

 In practice, there is a great deal of estimation

error involved in estimating R.

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 Using the DGM to Find R
 Start with the DGM:
D 0 (1  g) D1
P0  
R -g R -g
Rearrange and solve for R:
D 0 (1  g) D1
R g  g
P0 P0

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 6.3 Growth Opportunities
 Growth opportunities are opportunities to
invest in positive NPV projects.
 The value of a firm can be conceptualized as
the sum of the value of a firm that pays out
100-percent of its earnings as dividends and
the net present value of the growth
opportunities. EPS
P  NPVGO
r
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 6.4 The NPVGO Model
 We have two ways to value a stock:
 The dividend discount model
 The sum of its price as a “cash cow” plus the per
share value of its growth opportunities

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 The NPVGO Model: Example
Consider a firm that has EPS of $5 at the end of the
first year, a dividend-payout ratio of 30%, a discount
rate of 16%, and a return on retained earnings of
20%.
 The dividend at year one will be $5 × .30 = $1.50 per share.
 The retention ratio is .70 ( = 1 -.30), implying a growth rate in
dividends of 14% = .70 × 20%.
From the dividend growth model, the price of a share is:
Div 1 $1.50
P0    $75
R  g .16  .14
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 The NPVGO Model: Example
First, we must calculate the value of the firm as a cash cow.
EPS $5
P0    $31.25
R .16
Second, we must calculate the value of the growth
opportunities.
 3.50  .20 
 3.50  .16  $.875
P0    $43.75
Rg .16  .14

Finally, P0  31.25  43.75  $75

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 6.5 Price-Earnings Ratio
 Many analysts frequently relate earnings per share to
price.
 The price-earnings ratio is calculated as the current
stock price divided by annual EPS.
 The Wall Street Journal uses last 4 quarter’s earnings
Price per share
P/E ratio 
EPS

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 6.6 Features of Common Stock
 Voting rights (Cumulative vs. Straight)
 Proxy voting

 Classes of stock

 Other rights
 Share proportionally in declared dividends
 Share proportionally in remaining assets during
liquidation
 Preemptive right – first shot at new stock issue to
maintain proportional ownership if desired

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 Features of Preferred Stock
 Dividends
 Stated dividend must be paid before dividends can be
paid to common stockholders.
 Dividends are not a liability of the firm, and
preferred dividends can be deferred indefinitely.
 Most preferred dividends are cumulative – any
missed preferred dividends have to be paid before
common dividends can be paid.
 Preferred stock generally does not carry voting
rights.
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 6.7 The Stock Markets
 Dealers vs. Brokers
 New York Stock Exchange (NYSE)
 Largest stock market in the world
 Members
 Own seats on the exchange
 Commission brokers

 Specialists

 Floor brokers

 Floor traders

 Operations
 Floor activity
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 NASDAQ
 Not a physical exchange – computer-based
quotation system
 Multiple market makers
 Electronic Communications Networks
 Three levels of information
 Level 1 – median quotes, registered representatives
 Level 2 – view quotes, brokers & dealers
 Level 3 – view and update quotes, dealers only
 Large portion of technology stocks

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 Stock Market Reporting
52 WEEKS YLD VOL N ET
HI LO STOCKSYM DIV % PE 100s CLOSE CHG
25.72 18.12 Gap Inc GPS 0.18 0.8 18 39961 21.35 …
Gap pays a
dividend of 18
Gap has cents/share. Gap ended trading at
been as high $21.35, which is
as $25.72 in unchanged from
the last year. Given the current yesterday.
price, the dividend
yield is .8%.

3,996,100 shares traded

Gap has been as Given the current hands in the last day’s
low as $18.12 in price, the PE ratio is trading.
the last year. 18 times earnings.
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 Quick Quiz
 What determines the price of a share of stock?
 What determines g and R in the DGM?

 Decompose a stock’s price into constant

growth and NPVGO values.
 Discuss the importance of the PE ratio.

 What are some of the major characteristics of

common and preferred stock?

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