Chapter 5

INVESTING IN
COMMON STOCK
PN. ROSLINA BT AMEERUDIN
Med (technical), BBA (Hons) Finance,
Dip. In Banking 1
 Course Outline

5.1 Acquire the concepts of common stocks

5.1.1 Explain common stocks
5.1.2 Discuss the characteristics of common stocks
a. Claim on income
b. Claim on assets
c. Limited liability
d. Voting rights
e. Preemptive rights
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 Course Outline
5.2 Calculate common stock’s value
5.2.1 Compute the value of common stock
a. Single holding period
b. Multiple holding periods
5.2.2 Compute the value of different types of stocks using
Dividend Growth Models
a. Zero growth
b. Constant growth
c. Differential growth
5.2.3 Compute the value of stock using Price Earnings
(P/E) ratio approach
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 COMMON STOCKS/SHARES
• Also known as ordinary shares, are part of the
shareholders’ equity of a company
• Usually purchased for potential capital appreciation
• If the company makes money you will share in the profits
either by seeing the value of your shares rise, by being
paid dividends, or both; if the company suffers a poor year
or the market decline, your share values may fall and
dividends are unlikely (resulting in a potential capital
loss).

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 COMMON STOCKS/SHARES
• Represents ownership in a corporation.
• Have a right for electing a board of directors and voting on
corporate policy.
• Shareholders are owners of the business.
• In the event of liquidation, common shareholders have
rights to a company’s assets but only after bondholders,
preferred shareholders and other debt holders has been
settled.

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 Characteristics of common stock

a. Claim on income
Shareholders are often said to have a residual claim to the income of the
business. Entitle to receive a dividend.
b. Claim on assets
If the company goes bankrupt, you get some portion of the asset after
paying the company’s payables to the preferred stockholders of the
company.

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 c. Limited liability
Shareholders have limited liability (the portion you have purchased
from the stock market is actually the total liability)
Ex : If you are holding 10 share of the company , if company goes
bankrupt , maximum amount you can lose is the value of 10 shares.
d. Voting rights
Shareholder have the capability of casting the vote while selecting
board of directors
e. Preemptive rights
Allow common shareholders to maintain their proportional ownership
in the company in the event that the company issues another offering
of stock. Have the right but not the obligation to purchase as many
new shares of the stock

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 Terms used in common stock
a) Par Value
• The par value is the issue price per share of the common
stock.

(b) Prospectus
• A prospectus is a brochure that is distributed to would-be
investors. It provides information on the company such as
the activities of the firm, the board of directors, past year
financial statements, summary of material risk factors,
utilization of proceeds, and financial impact from
utilization of proceeds. 8
(c) Board Lots
• Shares are traded on the stock exchange in units of board
lots. Previously one board lot traded in the Bursa Malaysia
is equivalent to 1,000 units of shares but in the year 2003,
the Bursa Malaysia implemented the standardisation of
board lots at 100 shares per lot.
• The exercise was carried out in four stages; starting with
the Second Board counters in April 2003 and followed by
the Main Board counters which concluded in June 2003.
With the standardisation of board lots at 100 shares per lot
instead of 1,000 shares.

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(d)Dividends

• Earnings of a company are distributed to shareholders in

the form of dividends and the dividend can be paid in the
form of cash or additional stocks allotted to existing
shareholders.

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 Analyzing common stock
• The Dividend Discount Model (DDM)
• Dividends are the foundation of valuation for common stocks.
• To value common stock. i.e the cash flows are the dividends
expected to be paid in each future period.
• Investors must be carefully study the future prospects for a
company and estimate the likely dividends to be paid.
• Estimate an appropriate required rate of return or discount rate
based on the risk foreseen in the dividends.
• Discount to the present value of the future dividends to be
expected.
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 Types of DDM
1. The Zero-Growth Model
(The fixed dollar dividend model).
• Assuming a constant dollar dividend
• (no growth model).
Formula :-
Po = Do/Kcs

• where:-
Do is the constant dollar dividend expected for all future time periods.
Kcs is the opportunity cost or required rate of return for this particular
common share.
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Example :
The common stock of Syarikat Excellence is
expected to pay an annual dividend of
RM0.22 per share and this dividend is expected to
remain constant for an indefinite period.
Compute the value of this stock if the required
rate of return is 10%.
P =RM0.22
0.10
=RM2.20
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2. The Constant –Growth Model

Dividends are expected to grow at a constant rate over

time.
Formula:-

Po = Do(1 + g)1 /(1 + Kcs)1 + Do(1 + g )2 /(1 + Kcs)2 +

Do(1 + g)3/(1 + Kcs)3 + …. Do(1 + g) ∞ / (1 + Kcs) ∞

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• Where :-
Do = the current dividend being paid.
g = constant growing rate.
Kcs = discount rate.

Simplified equation :-

Po = D1 / (K – g)

Where :-
D1 = the dividend expected to be received at the
end of year 1.

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Example :
The common stock of Syarikat Excellence is
expected to pay an annual dividend of
RM0.22 per share next year and this dividend is
expected to grow at a rate of 5% annually.
Compute the value of this stock if the required
rate of return is 10%.

P= 0.22
0.10 – 0.05
=RM4.40 16
3. The Multiple-Growth Model

Where the expected future growth in dividends must be

described using two or more growth rates.
Formula:-

t=n
Po = ∑ Do(1 + g1)t / (1 + K)t +
t=1 [Dn(1 + gc)/(K – g) x 1/(1 + K)n ]
•

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Where:-
Po = the intrinsic value of the stock today.
Do = the current dividend.
g1 = the supernormal growth rate for dividends.
gc = the constant- growth rate for dividends.
K = the required rate of return.
n = the number of periods of supernormal growth.
Dn= the dividend at the end of the abnormal growth period.

Pn = D(n + 1) / (K – gc)

Pn = the expected price of the stock derived from the constant-growth

model.
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Example :
Agrosearch Bhd. has recently discovered a new product
with huge potential. The company
is expected to experience a super growth rate in its
earnings thus paying generous dividends to its
shareholders. Its dividend is expected to grow at 40
percent this year, 30 percent next year, 20 percent the
following year, and 10 percent thereafter. Its current
dividend (Do) is RM0.20.
What is the value of the stock if the required rate of return
is 15 percent?

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 Solution
D0 = RM0.200
D1 = D0 (1+0.40) = RM0.20 (1.40)
= RM0.280
D2 = D1(1 + 0.30) = RM0.28 (1.30)
= RM0.364
D3 = D2 (1 + 0.20) = RM0.364 (1.20)
= RM0.437
D4 = D3 (1 + 0.10) = RM0.4368 (1.10)
= RM0.480
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Determine the price of the stock at the end of year three,
that is :

P3 = D4
k-g
= RM0.480
0.15 – 0.10

=RM9.60
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Then, discount and sum up the present value of D1
through D3 and P3 to find P0.
P0 = D1 / 1.15 + D2 / 1.152 + D3 / 1.153 + P3 / 1.153
P0 = 0.280 / 1.15 + 0.364 / 1.152 +0.437 / 1.153 + 9.60 / 1.153

P0 = RM7.12

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EXERCISE

Assume that the common stock of Syarikat

Excellence Bhd. is expected to pay a dividend of
RM0.22 at the end of year 1, RM0.21 at the end of
year 2 and RM0.33 at the end of year 3.
Compute the value of this stock if the price is
expected to be RM6.60 at the end of year 3 and
the required rate of return is 10%

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 SOLUTION

P = 0.22(PVIF ) + 0.21(PVIF ) +
0.33(PVIF ) + 6.60(PVIF )
P = 0.22(0.9091) + 0.21(0.8264) +
0.33(0.7513) + 6.60(0.7513)
= 0.20 + 0.17 + 0.23 + 4.96
= RM5.58

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 Problems arise in the valuation of equity
The Problems Occurred With DDM :_

1. The equation indicates the investors are dealing with

infinity. Investors must value a stream of dividends may be
paid forever since common share has no maturity date.

2. The dividend stream is uncertain. There is no specified

number of dividends. Dividends must be declared
periodically by the firm’s board of directors . Dividends
for most firms are expected to grow over time.

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 How To solve These Problems
• The infinite number of periods and dividends can
be solved by using a reasonable high discount
rates such as 12 %, 14.5% etc. Today’s value for
dividends to be received in 50/60 years in the
future are worth very little. e.g The present value
of RM 1 to be received 50 years from now; if
discount rate is 15% is RM 0.0009.
• Due to uncertainty. The solution is to make some
assumptions about the expected growth rate of
dividends over time. 26
 P/E RATIO MODEL
(EARNINGS MULTIPLIER)
• This is the most widely used method for valuing
the stock.
• Definition - P/E ratio is calculated by dividing the
current market price of the stock by the latest 12-
month earnings (EPS).

• P/E ratio = price/EPS

• EPS = Earning/share
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Example:
• An analyst has conducted some research on the
banking sector and found that the prevailing PE
ratio for next year will be 15. If you agree with the
evaluation, and estimate that the earnings per
share of Public Bank Bhd. for next year is going
to be RM0.25, then the prospective price of Public
Bank Bhd. will be:

• P1 = EPS1 x PE ratio = RM0.25 x 15

• = RM3.75
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 P= D
k-g
P/E1 = D1/E1
K-g

• Po = estimated earnings x justified

P/E ratio.

• Po = E1 x P/E ratio

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 Determinants of P/E ratio :-

• P/E ratio can be derived from DDM (based on

constant growth model).

• PE = D1 /(k-g)
• Devide by E1 (both sides)
• PE / E1 = (D1/E1) /(k – g)

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• Example

• E1 = Rm 3.00
• P/E ratio = 15
• Po = RM 45.00

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Factors that affect P/E ratio:-

• The dividend payout ratio (D/E)

• The required rate of return (k)
• The expected growth rate of dividends (g)

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The relationship between the P/E ratio and the
related factors :-

• When the payout ratio rise; the P/E ratio rise. i.e
direct relationship.
• When the value of g rise ; the P/E ratio rise . i.e
direct relationship.
• When the value of k rise; the P/E ratio declines. i.e
inverse relationship.

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Key factors in the valuation of equity
• i. Dividends
It is as the foundation of valuation of common
stocks because dividends are the only cash
payment a stockholder receives directly from a
firm.

• ii. The required rate of return

Investors must estimate an appropriate required
rate of return.
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• Intrinsic value

It is obtained through the present value analysis (DDM). It

is specify the relationship between intrinsic value (IV) and
the current market price (CMP).

• If IV > CMP – the asset is under-valued and should be

purchased or held if already hold.

• If IV < CMP – the asset is over-valued and should be

avoided or sold if held or sold short.

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• If IV = CMP – implies an equilibrium that asset is
correctly valued.

• IV may differ among investors due to different

estimations of future benefits and discount or
required rate of return.

• Therefore a particular asset on a particular day,

some investors are willing to buy and some are
willing to sell.
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