ch09 Fin202

Fundamentals of Corporate Finance
Fifth Edition, International Adaptation

Robert Parrino, Ph.D.; David S. Kidwell, Ph.D.;
Thomas W. Bates, Ph.D.; Stuart Gillan, Ph.D.
Chapter 9
Stock Valuation
Copyright ©2022 John Wiley & Sons, Inc.
Chapter 9: Stock Valuation
Copyright ©2022 John Wiley & Sons, Inc. 2

Learning Objectives (1 of 2)
1. List and describe the four types of secondary markets

2. Describe the two types of stock securities, and explain
why many financial analysts treat preferred stock as a
special type of bond rather than as an equity security
3. Describe how expected future cash flows, discounted
at the required rate of return, determine the value of
common stock
4. Describe how the general dividend-valuation model
values a share of stock

Learning Objectives (2 of 2)
5. Discuss the assumptions that are necessary to make the

general dividend-valuation model easier to use, and
use the model to compute the value of a firm’s stock
6. Explain why g must be less than R in the constant-
growth dividend model
7. Explain how valuing preferred stock with a stated
maturity differs from valuing preferred stock with no
maturity, and calculate the price of a share of preferred
stock under both conditions

9.1 The Market for Stocks
LEARNING OBJECTIVE
List and describe the four types of secondary markets
• Secondary markets
• Major secondary markets
• Efficiency of secondary markets
• Stock market indexes
• Reading stock market quotes
L.O. 9.1 Copyright ©2022 John Wiley & Sons, Inc. 5

The Market for Stocks
• Stocks are equity securities; they represent an

ownership interest in a corporation
• Today, more than half of U.S. households have some
investment in the stock market
• Pension funds are the largest institutional investors in
equities, followed by mutual funds and foreign
investors

Secondary Markets
• The New York Stock Exchange (NYSE) and National Association of

Securities Dealers Automated Quotation (NASDAQ) rank one and two in
total volume and total capitalization
• The NASDAQ is larger than the NYSE in terms of number of companies
listed and shares traded daily
• Most secondary market transactions in the U.S. occur on a stock exchange
• Investors buy and sell previously issued securities among themselves in
secondary markets
o Secondary markets provide marketability and fair prices for shares of stock
o Firms receive higher prices for securities they issue in primary markets because
investors are more willing to buy securities that are easy to resell in a secondary
market

Efficiency of Secondary Markets
• In an efficient market, stock prices are updated

constantly as new information reaches the market and
is immediately incorporated into estimates of market
values
• Secondary markets bring us closer to the ideal of a
perfectly efficient market
o Provide information about security pricing
o Give buyers and sellers access to each other
o Make it easier to complete transactions
o Low transaction costs
Types of Secondary Markets
• Secondary markets differ in the amount of information

about prices available to investors, which influences
each market’s efficiency
• There are four types of secondary markets, these are
ranked in the order from least to most efficient:
o Direct search
o Broker
o Dealer
o Auction

Direct Search
• Least efficient
o A buyer and seller must find each other without assistance. A
search among all possible partners to locate the best price is
seldom done
o Transactions are so infrequent that no third party (broker or
dealer) has incentives to serve the market
o Is the least efficient market - farthest from the ideal that provides
complete price information
• Most common instances where direct search is used:
o Sale of small private firm’s common stock
o Private placement of common stock

Broker
• Using a broker increases market efficiency

o Brokers earn a fee (commission) for bringing buyers and
sellers together
o Dealing with buyers and sellers provides brokers with
extensive information about prices at which investors are
willing to trade shares
o A commission that is less than the cost of direct search gives
an investor the incentive to pay a broker for price
information

Dealer (Over-the-Counter Markets)
• Dealer, higher level of market efficiency

o Market efficiency is improved if someone provides continuous
bidding (selling or buying) for a security, so no time is lost
searching for a partner
o Dealers provide this service by owning inventories of securities
from which they buy and sell to earn profit
o A dealer has an advantage over a broker because a broker cannot
guarantee prompt execution of an order; a dealer holds an
inventory of securities and can provide the guarantee
o NASDAQ is the best-known dealer market, electronic
communications network (ECN) systems provide price
information which increases marketability and competition

Auction
• Auction, highest level of market efficiency

o In an auction market, buyers and sellers interact with each
other in a group and bargain over price
o The auctioneer, or specialist, is designated by the exchange
to be a dealer for certain securities and fill orders by public
customers
o The NYSE is the best-known auction market and is the most
efficient equity market in the U.S.
o The auction for a security on the NYSE takes place at a
specific post on the floor of the exchange

Stock Market Indexes
• A stock market index is a select group of stocks whose

performance is used to estimate the performance of a larger
group of stocks, they are watched closely not only to track
economic activity but also to measure the performance of
specific firms. Examples are:
o Dow Jones Industrial Average
o NASDAQ Composite Index
o New York Stock Exchange Index
o Standard & Poor’s 500 Index

The Most Widely Followed Stock
Market Indexes
• The most widely quoted stock market index is the Dow
Jones Industrial Average (DJIA), it consists of 30
companies that represent about 20 percent of the market
value of all U.S. stocks
• Standard and Poor’s 500 Index consists of 500 stocks and
is regarded as the best index for measuring the
performance of the largest companies in the U.S. economy
• NASDAQ Composite Index consists of all the common
stocks listed on the NASDAQ stock exchange

Reading Stock Market Quotes
• The Wall Street Journal, The New York Times, and other
major newspapers provide stock listings for the NYSE,
NASDAQ, and relevant regional exchanges
• Stock price quotes and other market information are also
readily available online from reliable websites such as
Yahoo! Finance, MSN Money, and CNBC, just to name a
few

Exhibit 9.1: Stock Quotes and Other
Financial Market Data
This exhibit features stock
quotes and other financial
market data for Nike Inc.,
provided by CNBC.com
on February 11, 2021

9.2 Common and Preferred Stock
LEARNING OBJECTIVE
Describe the two types of stock securities, and explain
why many financial analysts treat preferred stock as a
special type of bond rather than as an equity security
• Common stock
• Preferred stock

Common Stock and Preferred Stock
• Common Stock and Preferred Stock

o Represent ownership interest in a corporation
o Are the two most frequently used types of equity securities
o Dividend payments do not affect a firm’s taxes
o Have limited liability, so claims made against the corporation
cannot include a stockholder’s personal assets
o Are generally viewed as perpetuities because they do not have
maturity dates
o Are not “guaranteed” dividends, but dividends are “promised” to
preferred stockholders

Common Stock
• Common stock is the basic ownership claim on a

corporation
• Common stockholders have the right to vote on
o Electing the board of directors
o Capital budgeting
o Proposed mergers and acquisitions
• Common stockholders have the right to a firm’s residual
assets after creditors, preferred stockholders, and others
with higher priority claims have been satisfied

Preferred Stock
• Preferred stock represents ownership in a corporation

• Preferred stockholders
o Do not have the right to vote
o Have priority over common stockholders with respect to dividends and
liquidation of assets
o Must be paid a fixed dividend before funds are distributed to common
stockholders
• Preferred stock is equity, but a strong case can be made that it is a
special type of debt
o Dividends are due regardless of earnings
o It frequently has a credit rating
o It may be convertible or callable
9.3 Common Stock Valuation
LEARNING OBJECTIVE
Describe how expected future cash flows, discounted at the
required rate of return, determine the value of common stock
• A one-period model
• A perpetuity model

Valuation of Equity Securities
• The value of common and preferred stock is estimated

using the methodology employed for bond valuation,
although valuing common stock is more difficult than
valuing bonds or preferred stock
o The size and timing of dividends are less certain
compared to coupon payments
o The rate of return on common stock cannot be observed
directly from the market
o Common stock is a true perpetuity because it has no
maturity date

One-Period Model for Market Value
• The market value of a share of stock today equals the combined
present value of two future cash inflows, the expected end-of-
period dividend and the expected end-of-period stock price
D1  P1
P0 
1 R

Two-Period Model for Market Value
• The two-period model can be viewed as a combination of two
one-period models:
D1 D 2  P2
P0  
1  R  1  R 
1 2

Multi-period Model
• The ultimate result is the following equation:
D1 D2 D3 Dt Pt
P0       
1  R 1  R 2 1  R 3 1  R  1  R 
t t
• Here, t is the time period, which can be any number from one
to infinity (∞). We will use t, instead of n, to denote the time
period from this point forward because it is more commonly
used in pricing equations; n will still be used to denote the
number of periods.

9.4 The General Dividend-Valuation Model
LEARNING OBJECTIVE
Describe how the general dividend-valuation model values a share
of stock
• The General Dividend-Valuation Model

• The Growth Stock Pricing Paradox

The General Dividend Valuation
Model
• The perpetuity model for market value can be viewed as an
infinite series of one-period stock pricing models as shown in
Equation 9.1:
D1 D2 D3 D4 D5 D
P0      
1  R 1  R  1  R  1  R  1  R 
2 3 4 5
1  R 

∞
D𝑡
P0 =∑
𝑡 =1 ( 1+ R )𝑡
• Although theoretically sound, it is not practical to add an infinite
number of terms
• Equation 9.1 is a general model for valuing a share of stock
Details of the Dividend Valuation
Model
• The value of a share of stock is the present value of all
expected future cash dividends. The model
o Requires dividend forecasts for an infinite number of
periods
o Implies the intrinsic value of a share of stock is determined
by the market’s expectations of a firm’s future cash flows
• The model does not include specific assumptions, such as:
o Whether the growth rate is constant, which is important in
estimating expected future cash dividends
o Forecasting dividends or when a share of stock might be
sold
Growth Stock Pricing Paradox
• Growth stock: stock of a company whose earnings are growing at an
above-average rate and are expected to continue to do so for some
time
• Rapidly-growing firms
o Typically pay no dividends on common stock in the growth phase
o Have many high-return investment opportunities, making investors are
better off if firms reinvest earnings
• But Equation 9.1 and common sense predict that the shares of a
company that will never pay cash to investors are worthless
o In reality, high-growth firms will eventually pay dividends
o If investments made with reinvested funds succeed, a firm’s net cash
inflows should increase significantly and investors can sell their stock at
a much higher price than what they paid
9.5 Stock Valuation: Some Simplifying Assumptions
LEARNING OBJECTIVE
Discuss the assumptions that are necessary to make the general
dividend-valuation model easier to use, and use the model to compute
the value of a firm’s common stock
• Some simplifying assumptions

• Zero-growth dividend model
• Constant-growth dividend model
• Computing future stock prices

Some Simplifying Assumptions on
Equity Valuation
• To make Equation 9.1 more applicable, a simplifying
assumption about the pattern of dividends is necessary
in each of the following cases
• The dividend has a zero-growth rate and is always the
same, or
• The dividend has a constant growth rate, or
• The dividend has a mixed growth rate, higher in some
periods and lower in others

Zero-Growth Dividend Model
• Model assumes the dividend is constant

o This cash flow pattern describes a perpetuity with a constant cash
flow, similar to the perpetuity model
Equation 9.2
D
P0 
R

Example: Zero-Growth Dividend
Model
• Del Mar Corporation pays $5 dividend per year, and the board
of directors has no plans to change the dividend. The firm’s
investors require a 20% return on investment. What is the
expected market price on the stock?
D $5
P0    $25
R 0.20

Constant Growth Dividend Model
• Model assumes cash dividends increase at the rate g from one

period to the next forever, which is a reasonable assumption for
mature companies with a history of stable growth
o Equation 9.3: the dividend at any time in the future
D t  D 0  1  g 
t
• Equation 9.4: the current price of a share of stock is next

period’s dividend divided by the difference between the
discount rate and the dividend growth rate
D1
P0 
Rg

Example: Constant-Growth Dividend
Model
• Big Red Automotive paid a dividend of $4.81 this year. The
dividend is expected to increase by 4% annually and investors
who own stock in similar firms require a return of 18%. What is
the market value of the firm’s stock?
D1  D0  1  g   $4.81 1.04   $5.00

1
D1 $5.00
P0    $35.71
R  g 0.18  0.04

Exhibit 9.2: Impact on Stock Prices of
Near and Distant Future Dividends

Computing Future Stock Prices
• The constant-growth dividend model can be generalized to

value a share of stock at any point in time
Equation 9.5
Dt 1
Pt 
Rg

Example: Future Price in Constant-
Growth Dividend Model
• Ace, Inc. paid a dividend of $2.50 today. Similar stocks yield
15% and g is 5%. Estimate the stock price five years from today.
D6  D 0  1  g   $2.50  1.05   $3.35

6 6
D6 $3.35
P5    $33.50
R  g 0.15  0.05

9.6 The Relation between R and g
LEARNING OBJECTIVE
Explain why g must be less than R in the constant-growth
dividend model
• The relation between R and g
• Mixed (Supernormal) Growth Dividend Model

The Relation between R and g
• The relation between R and g
o The constant-growth dividend model yields invalid
solutions when the dividend growth rate equals or
exceeds the discount rate
o If g = R, the denominator is zero and the value of the
stock is infinite, which cannot occur
o If g > R, the denominator is negative and the stock price
is negative, which also cannot occur
• The constant-growth dividend model is therefore only
valid when the required rate of return is larger than the
expected growth rate, R > g
Mixed (Supernormal) Growth
Dividend Model
• Some firms experience a supernormal rate of growth in dividends in
the early years
• If the supernormal growth occurs first and is followed by constant
dividend growth, we can combine Equations 9.1 and 9.5
P0  PVnon  constant dividend growth  PVconstant dividend growth
Equation 9.6
D1 D2 Dt Pt
P0      
1  R 1  R 2 1  R  1  R 
t t

Exhibit 9.3: Dividend Growth Rate
Patterns

Time Line for Nonconstant Dividend
Growth Pattern
Exhibit 9.4 The exhibit shows a timeline for a nonconstant dividend growth
pattern. The timeline makes it easy to see that we have two different dividend
growth patterns. For three years, the dividends are expected to grow at a mixed
rate; after that, they are expected to grow at a constant rate of 6 percent.

Example: Supernormal-Growth
Dividend Model
• Using the same example where a company’s expected dividends
are $1, $2, and $3 for the next three years and are expected to
grow at a constant rate of 6% per year thereafter. What should
the current price be if the required rate of return is 15%?
D 4  D3  1  g   $3.00  1.06   $3.18

1 1
D4 $3.18
P3    $35.33
R  g 0.15  0.06
$1.00 $2.00 $3.00 $35.33

P0      $27.58
1.15 1.15  1.15  1.15 
1 2 3 3

9.7 Valuing Preferred Stock
LEARNING OBJECTIVE
Explain how valuing preferred stock with a stated maturity differs
from valuing preferred stock with no maturity, and calculate the
price of a share of preferred stock under both conditions
• Valuing preferred stock

• Preferred stock with a fixed maturity
• Preferred stock with no maturity

Valuing Preferred Stock
• To value preferred stock, one must know if it has an
“effective maturity” because of a sinking fund or call option
• The most significant difference between preferred stock and
a bond is the stock has greater risk of not receiving the
promised payments
o Preferred stock dividends are payments to owners of the firm,
so failure to pay does not constitute default on an obligation
o Failure to pay a preferred-stock dividend as promised has
significant financial consequences because it signals to the
market that the firm has serious financial problems

Preferred Stock with a Fixed Maturity
• Preferred stock with a fixed maturity is priced using a
bond valuation model, adding the present value of the
dividend payments to the present value of the par value
Most preferred stocks make quarterly dividend
o
payments, so m = 4
Equation 9.7
D D D D
 Pmn
PS0  m  m  m  m
i  i
2
  i 
3
 i 
mn
1 1  1  1 
 
m  m  m    
 m

Example: Fixed Maturity Preferred
Stock
• E-Corp preferred has a par value of $100, a dividend of
$10 ($2.50 quarterly), and an effective maturity of 20
years. If similar stocks yield 8%, what is the value of
the stock?
$10 $10 $10
 $100
PS0  4  4  4
1 2 80
 0.08   0.08   0.08 
 1    1    1  
 4   4   4 
$2.50 $2.50 $2.50  $100
    $119.87
1.02  1.02  1.02 
1 2 80

Calculator Example: Fixed Maturity
Preferred Stock
• The previous problem involves quarterly compounding so
0.08
n  4  20 and i
4

Preferred Stock with No Maturity
• Perpetual preferred stock has no maturity date

Dividends are fixed, g = 0, and dividend payments go
o
on forever
o Equation 9.2, Zero-Growth Dividend Model, is used to
value perpetual preferred stock
Equation 9.2
D
P0 
R

Example: Perpetual Preferred Stock
• Suppose Delta Air Lines has perpetual preferred stock

that pays a dividend of $5 per year. Investors required
an 8% return on similar investments. What is the value
of Delta’s preferred?
D $5
P0    $62.50
R 0.08

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Copyright © 2022 John Wiley & Sons, Inc.

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Fundamentals of Corporate Finance

Fifth Edition, International Adaptation

Copyright ©2022 John Wiley & Sons, Inc. 2

1. List and describe the four types of secondary markets

Copyright ©2022 John Wiley & Sons, Inc. 3

5. Discuss the assumptions that are necessary to make the

Copyright ©2022 John Wiley & Sons, Inc. 4

L.O. 9.1 Copyright ©2022 John Wiley & Sons, Inc. 5

• Stocks are equity securities; they represent an

L.O. 9.1 Copyright ©2022 John Wiley & Sons, Inc. 6

• The New York Stock Exchange (NYSE) and National Association of

L.O. 9.1 Copyright ©2022 John Wiley & Sons, Inc. 7

• In an efficient market, stock prices are updated

• Secondary markets differ in the amount of information

L.O. 9.1 Copyright ©2022 John Wiley & Sons, Inc. 9

L.O. 9.1 Copyright ©2022 John Wiley & Sons, Inc. 10

• Using a broker increases market efficiency

L.O. 9.1 Copyright ©2022 John Wiley & Sons, Inc. 11

• Dealer, higher level of market efficiency

L.O. 9.1 Copyright ©2022 John Wiley & Sons, Inc. 12

• Auction, highest level of market efficiency

L.O. 9.1 Copyright ©2022 John Wiley & Sons, Inc. 13

• A stock market index is a select group of stocks whose

L.O. 9.1 Copyright ©2022 John Wiley & Sons, Inc. 14

L.O. 9.1 Copyright ©2022 John Wiley & Sons, Inc. 15

L.O. 9.1 Copyright ©2022 John Wiley & Sons, Inc. 16

L.O. 9.1 Copyright ©2022 John Wiley & Sons, Inc. 17

L.O. 9.2 Copyright ©2022 John Wiley & Sons, Inc. 18

• Common Stock and Preferred Stock

L.O. 9.2 Copyright ©2022 John Wiley & Sons, Inc. 19

• Common stock is the basic ownership claim on a

L.O. 9.2 Copyright ©2022 John Wiley & Sons, Inc. 20

• Preferred stock represents ownership in a corporation

L.O. 9.3 Copyright ©2022 John Wiley & Sons, Inc. 22

• The value of common and preferred stock is estimated

L.O. 9.3 Copyright ©2022 John Wiley & Sons, Inc. 23

L.O. 9.3 Copyright ©2022 John Wiley & Sons, Inc. 24

L.O. 9.3 Copyright ©2022 John Wiley & Sons, Inc. 25

L.O. 9.3 Copyright ©2022 John Wiley & Sons, Inc. 26

• The General Dividend-Valuation Model

L.O. 9.4 Copyright ©2022 John Wiley & Sons, Inc. 27

• Some simplifying assumptions

L.O. 9.5 Copyright ©2022 John Wiley & Sons, Inc. 31

L.O. 9.5 Copyright ©2022 John Wiley & Sons, Inc. 32

• Model assumes the dividend is constant

L.O. 9.5 Copyright ©2022 John Wiley & Sons, Inc. 33

L.O. 9.5 Copyright ©2022 John Wiley & Sons, Inc. 34

• Model assumes cash dividends increase at the rate g from one

• Equation 9.4: the current price of a share of stock is next

L.O. 9.5 Copyright ©2022 John Wiley & Sons, Inc. 35

D1  D0  1  g   $4.81 1.04   $5.00

L.O. 9.5 Copyright ©2022 John Wiley & Sons, Inc. 36

L.O. 9.5 Copyright ©2022 John Wiley & Sons, Inc. 37

• The constant-growth dividend model can be generalized to

L.O. 9.5 Copyright ©2022 John Wiley & Sons, Inc. 38

D6  D 0  1  g   $2.50  1.05   $3.35

L.O. 9.5 Copyright ©2022 John Wiley & Sons, Inc. 39

L.O. 9.6 Copyright ©2022 John Wiley & Sons, Inc. 40

P0  PVnon  constant dividend growth  PVconstant dividend growth

L.O. 9.6 Copyright ©2022 John Wiley & Sons, Inc. 42

L.O. 9.6 Copyright ©2022 John Wiley & Sons, Inc. 43

L.O. 9.6 Copyright ©2022 John Wiley & Sons, Inc. 44

D 4  D3  1  g   $3.00  1.06   $3.18