Chapter 4

THE VALUE OF COMMON

STOCKS

Brealey, Myers, and Allen

Principles of Corporate Finance
11th Global Edition
4-1 HOW COMMON STOCKS ARE TRADED

• Primary Market
• New securities
• Secondary Market
• Previously-issued securities
• Common Stock
• Ownership shares in publicly-held
corporation

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4-1 HOW COMMON STOCKS ARE TRADED
• Electronic Communication Networks
(ECNs)
• Computer networks that allow electronic trading

• Exchange-Traded Funds (ETFs)

• Stock portfolios bought/sold in single trade

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4-2 HOW COMMON STOCKS ARE VALUED
• Book Value
• Net worth of firm according to balance sheet
• Dividend
• Periodic cash distribution from firm to the
shareholders
• P/E Ratio
• Price per share divided by earnings per share
• Market Value Balance Sheet
• Financial statement that uses market value of
assets and liabilities
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4-2 HOW COMMON STOCKS ARE VALUED
• Discounted Cash Flow (DCF) Formula
• Value of a stock = present value of future cash
flows

PV(stock)  PV(expected future dividends)

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4-2 HOW COMMON STOCKS ARE VALUED
• Expected Return
• Percentage yield forecast from specific
investment over time period
• Sometimes called market capitalization rate

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4-2 HOW COMMON STOCKS ARE VALUED
• Example
• Fledgling Electronics sells for $100 per share
today; they are expected to sell for $110 in one
year. What is expected return if dividend in one
year is forecasted to be $5.00?

5  110  100
Expected return   .15
100

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4-2 HOW COMMON STOCKS ARE VALUED
• Price of share of stock is present value of
future cash flows
• For a stock, future cash flows are dividends
and ultimate sales price

Div1  P1
Price  P0 
1 r

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4-2 HOW COMMON STOCKS ARE VALUED

• Example
• Fledgling Electronics price

5  110
Price  P0   100
1.15

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4-2 HOW COMMON STOCKS ARE VALUED
• Market Capitalization Rate
• Estimated using perpetuity formula
• Also called cost of equity capital

Div1
Capitalization rate  P0 
rg
Div1
r g
P0
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4-2 HOW COMMON STOCKS ARE VALUED
• Dividend Discount Model
• Computation of today’s stock price: share value
equals present value of all expected future
dividends
• H: Time horizon for investment

Div1 Div2 DivH  PH

P0    ... 
(1  r ) (1  r )
1 2
(1  r ) H

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4-2 HOW COMMON STOCKS ARE VALUED
• Modified Formula

Div1 Div2 DivH  PH

P0    ... 
(1  r ) (1  r )
1 2
(1  r ) H

H
Divt PH
P0   
t 1 (1  r ) (1  r )
t H

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4-2 HOW COMMON STOCKS ARE VALUED
• Example
• Fledgling Electronics forecasted to pay $5.00
dividend at end of year 1 and $5.50 dividend at
end of year 2. End-of-second-year stock will be
sold for $121. Discount rate is 15%. What is the
price of stock?

5.00 5.50  121

PV  
(1  .15)1
(1  .15) 2

PV  $100.00
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4-2 HOW COMMON STOCKS ARE VALUED
• Example
• XYZ Company will pay dividends of $3, $3.24,
and $3.50 over next three years. After three
years, stock sells for $94.48. What is the price
of stock given 12% expected return?

3.00 3.24 3.50  94.48

PV   
(1  .12) (1  .12)
1 2
(1  .12) 3

PV  $75.00
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4-2 HOW COMMON STOCKS ARE VALUED

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4-3 ESTIMATING COST OF EQUITY CAPITAL

• Dividend Yield
• Expected return on stock investment plus
expected dividend growth
• Similar to capitalization rate

Div1
Price  P0 
rg
Div1
Dividend yield  r  g
P0
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4-3 ESTIMATING COST OF EQUITY CAPITAL
• Example
• Northwest Natural Gas shares sold for $47.30
at start of 2012. Dividend payments for 2013
were $1.86 a share with no growth. What is
dividend yield?
Dividend Yield  r
1.86
r
47.30
r  .039
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4-3 ESTIMATING COST OF EQUITY CAPITAL
• Example
• Northwest Natural Gas shares sold for $47.30 at
start of 2012. Dividend payments for 2013 were
$1.86 a share with 4.6% growth. What is r?

1.86
r  .046
47.30
r  .085

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4-3 ESTIMATING COST OF EQUITY CAPITAL
• Return Measurements

Div1
Dividend yield 
P0

Return on Equity  ROE

EPS
ROE 
Book equity per share

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4-3 ESTIMATING COST OF EQUITY CAPITAL
• Dividend Growth Rate
• Derived by applying return on equity to
percentage of earnings reinvested in operations
• g = return on equity × plowback ratio

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4-3 ESTIMATING COST OF EQUITY CAPITAL
• Valuing Non-Constant Growth

Div1 Div2 DivH PH

PV    ...  
(1  r ) (1  r )
1 2
(1  r ) H
(1  r ) H

DivH 1
PH 
rg

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4-3 ESTIMATING COST OF EQUITY CAPITAL
• Example
• Phoenix pays dividends in three consecutive
years of 0, .31, and .65. Year-4 dividend is
estimated at .67 with perpetuity growth at 4%.
With 10% discount rate, what is stock price?

0 .31 .65  1 .67 

PV     
(1  .1) (1  .1) (1  .1)  (1  .1) (.10  .04) 
1 2 3 3

 9.13

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4-4 STOCK PRICE AND EARNINGS PER
SHARE
• If firm pays lower dividend and reinvests
funds, stock price may increase due to
higher future dividends
• Payout Ratio
• Fraction of earnings paid out as dividends
• Plowback Ratio
• Fraction of earnings retained by firm

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4-4 STOCK PRICE AND EARNINGS PER
SHARE
• Example
• Company plans $8.33 dividend next year (100%
of earnings). Investors will get 15% expected
return. Instead, company plows back 40% of
earnings at firm’s current return on equity of
25%. What is the stock value before and after
plowback decision?

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4-4 STOCK PRICE AND EARNINGS PER
SHARE
• Example, continued
• No Growth

8.33
P0   $55.56
.15
• With Growth

g  .25  .40  .10

5.00
P0   $100.00
.15  .10

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4-4 STOCK PRICE AND EARNINGS PER
SHARE
• Example, continued
• Stock price remains at $55.56 with no earnings
plowed back
• With plowback, price is $100.00
• Difference is called present value of growth
opportunities (PVGO)

PVGO  100.00  55.56  $44.44

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4-4 STOCK PRICE AND EARNINGS PER
SHARE
• Present Value of Growth Opportunities
(PVGO)
• Net present value of firm’s future investments

• Sustainable Growth Rate

• Steady rate at which firm can grow: plowback
ratio x return on equity

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4-5 VALUING A BUSINESS
• Valuing a Business or Project
• Usually computed as discounted value of FCF
to valuation horizon (H)
• Valuation horizon sometimes called terminal
value and calculated like PVGO

FCF1 FCF2 FCFH PVH

PV    ...  
(1  r )1 (1  r ) 2 (1  r ) H (1  r ) H

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4-5 VALUING A BUSINESS
• Valuing a Business or Project

FCF1 FCF2 FCFH PVH

PV    ...  
(1  r ) (1  r )
1 2
(1  r ) H
(1  r ) H

PV (free cash flows) PV (horizon value)

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4-5 VALUING A BUSINESS
• Example
• Given cash flows for Concatenator
Manufacturing Division, calculate PV of near-
term cash flows, PV (horizon value), and total
value of firm; r = 10% and g = 6%

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4-5 VALUING A BUSINESS
• Example, Continued

1  1.59 
PV(horizon value)  6    22.4
1.1  .10  .06 

.80 .96 1.15 1.39 .20 .23

PV(FCF)       
1.1 1.12 1.13 1.14 1.15 1.16
 3.6

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4-5 VALUING A BUSINESS
• Example, Continued

PV(business)  PV(FCF)  PV(horizon value)

 -3.6  22.4
 $18.8

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