Chapter 9

Stock Valuation

9-0
Chapter
Outline
1. The Present Value of Common Stocks
2. Estimates of Parameters in the Dividend
Discount Model
3. Growth Opportunities
4. Price-Earnings Ratio
5. The Stock Markets

9-1
 9.1 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

9-2
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 Div 3

P0    
(1
2 R) 1
(1 R) (1
2

R)3
Div
P  R
0

9-3
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  Div2 (1 g)  Div0 (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: Di
P0 R
v1 
9-4
 Constant Growth
•Example
Suppose Big D, Inc., just paid a dividend of $0.50. 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

9-5
 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.

9-6
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  Div1 (1 g1 )  Div0 (1 g )2
1 .

Div N  N 1(1
. g1 )  Div 0 (1 g1 ) N

Div
Div  Div .(1 g )  Div (1 g ) N (1 g )
N N 2 0
1 1 2
.
.
9-7
Case 3: Differential
Growth
Dividends will grow at rate g for N years and grow
1
at rate g2 thereafter

Div (1 g ) Div (1 g )2

0 1 0 1

…
0 1 2
Div N (1 g 2 )
Div (1 g ) N
0  Div 0 (1 g1 ) N (1 g2 )
1
… …
N N+1 9-8
Case 3: Differential
Growth
We can value this as the sum of:
 a T-year annuity growing at rate g1

C 
PA  (1
 1 g ) T

 1  
R  g  (1
1

 plus the discounted R)value

T of a perpetuity growing at
rate g that starts in year T+1
2

 Div T1 
 R  g2 
PB 
(1 R)T 9-9
Case 3: Differential
Growth
Consolidating gives:

 Div T1 
 R  g2 
P C  (1 g )  
1 T

 1 (1 R)T (1 R) T

R  g1  

Or, we can “cash flow” it

out.

9-10
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%.

9-11
With the
Formula
 $2(1.08)3 (1.04) 
$2 (1.08) .12
P (1.08)  
3

 1   .04
(1.12) 3
 .12 .08 (1.12)3
 

P  $541 .8966
 $32.753
(1.12)

P  $5.58  P
$23.31 $28.89 9-12
 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 $2.3 $2.52 growth phase
3  .12 beginning in year
4 can be valued as
.04 a growing
0 1 2 3
perpetuity
at time 3.
$2.16 $2.33 $2.52  $32.75
P0  1.12  (1.12)2  (1.12)3  $28.89
$2.62
P3  
.08 9-13
9.2 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

9-14
 Using the DGM to Find
•RThe discount rate can be broken into two
parts.
• The dividend yield
• The capital gains yield/The growth rate
• Start with the DGM:
P0 D 0 ( 1  g)
 

Rearrange and solve for R:

D 0 D( 11  Rg) -g D1
R  P0 g  P0  g
R -g
In practice, there is a great deal of estimation error
involved
in estimating R.
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9.3 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% of its earnings as
dividends plus the net present value of the growth
opportunities.

EPS
P  R  NPVGO

9-16
NPVGO Model:
Example
Consider a firm that has forecasted EPS of $5, a discount rate
of 16%, and is currently priced at $75 per share.
• We can calculate the value of the firm as a cash cow.

EPS $5
P0  R  .16 $31.25
• So, NPVGO must be: $75 - $31.25 = $43.75

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 Retention Rate and Firm
•Value
An increase in the retention rate will:
• Reduce the dividend paid to shareholders
• Increase the firm’s growth rate
• These have offsetting influences on
stock price
• Which one dominates?
• If ROE>R, then increased retention increases firm value
since reinvested capital earns more than the cost of capital.

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9.4 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.

Price per share

P/E ratio 
EPS

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PE and
NPVGO
EPS
• Recall, P  NPVGO
R
• Dividing every term by EPS provides the following
description of the PE ratio:

1 NPVGO
PE  
R EPS
• So, a firm’s PE ratio is positively related to
growth opportunities and negatively related to risk
(R) 9-20
 9.5 The Stock
•Markets
Dealers vs. Brokers
Dealer: maintains an inventory and stands ready to
trade; Broker: matches buyers and sellers.
• New York Stock Exchange (NYSE)
• Largest stock market in the world
• License Holders (formerly “Members”)
• Entitled to buy or sell on the exchange floor
• 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
• Large portion of technology stocks

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Stock Market
Reporting
52 WEEKS YLD VOL NET
HI LO STOCK DIV % PE 100s CLOSE CHG
SYM 0.34 3.1 8 88298 11.06
21.89 9.41Gap
Gappays
Inc a 0.45
GPS dividend of 34
Gap has cents/share. Gap ended trading at
been as high $11.06, which is up 45
as $21.89 cents from yesterday.
in the last Given the current
year. price, the dividend
yield is 3.1%.

8,829,800 shares traded

Gap has been as Given the current hands in the last
low as $9.41 in price, the PE ratio is day’s trading.
the last year. 8 times earnings.
9-23
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 NYSE
and Nasdaq?

9-24