Fundamentals of Corporate Finance

by Robert Parrino, Ph.D. & David S. Kidwell, Ph.D.

Chapter 9 Stock Valuation

Copyright 2008 John Wiley & Sons

CHAPTER 9 Stock Valuation

Chapter 9 Stock Valuation

Copyright 2008 John Wiley & Sons

Quick Links
The Market for Stocks
Types of Equity Securities

Equity Valuation

Chapter 9 Stock Valuation

Copyright 2008 John Wiley & Sons

The Market for Stocks

Basic Facts Equity securities are a corporations certificates of ownership.
Households dominate holdings of equity

securities, owning >36% of outstanding corporate equities.

Pension funds are largest institutional investors in

equities (21%), followed by mutual funds (20%), and foreign investors (10%).
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The Market for Stocks

Secondary Markets Outstanding shares of a stock are bought and sold among investors.
From investors perspective, secondary markets

provide marketability at a fair price for shares of securities they own.

Active secondary market enables firms to sell

their new debt or equity issues at lower funding costs than can firms without secondary markets that sell similar securities.
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The Market for Stocks

The Efficiency of Secondary Markets
In US, most secondary market transactions are

done on one of the stock exchanges.

In terms of total volume of activity and total

capitalization of firms listed, NYSE is the worlds largest and NASDAQ is the second largest.
In terms of number of companies listed and

shares traded daily, NASDAQ is larger than NYSE.

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The Market for Stocks

The Efficiency of Secondary Markets
There are four types of secondary markets. Each differs according to amount of price

information available to investors, which in turn, affects markets efficiency.

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The Market for Stocks

The Efficiency of Secondary Markets - Direct Search
Secondary markets farthest from our ideal of

complete price information are those in which buyer and seller must seek each other out directly.
A thorough search among all possible partners is

seldom done to locate the best price.

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The Market for Stocks

The Efficiency of Secondary Markets - Direct Search
Securities that sell in direct search markets are

usually bought and sold infrequently. Thus no third party (broker or dealer) has incentive to serve the market. Good examples of direct search markets: Sales of small private companies common stock and private placement transactions.
Direct search is the least efficient type of

secondary market.
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The Market for Stocks

The Efficiency of Secondary Markets - Brokered
Brokers bring buyers and sellers together to earn

a fee, called a commission.

Brokers extensive contacts provide a pool of

price information that individual investors could not economically duplicate themselves.
By charging a commission less than cost of direct

search, they give investors incentives to utilize information by hiring them as brokers.
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The Market for Stocks

The Efficiency of Secondary Markets - Dealer
Market efficiency is improved if someone in

marketplace can provide continuous bidding (selling or buying) for the security.
Dealers provide this service by holding

inventories of securities, which they own, then buying and selling from inventory to earn profit.

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The Market for Stocks

The Efficiency of Secondary Markets - Dealer
Advantage of dealer over brokered market is that

brokers cannot guarantee an order will be executed promptly. Dealers can offer guarantee, because they have inventory of securities.
A dealer market eliminates need for time-

consuming search for fair deal by buying and selling immediately from dealers inventory of securities.
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The Market for Stocks

The Efficiency of Secondary Markets - Dealer
NASDAQ is best-known example of dealer

market.
Electronic communications network (ECN)

systems provide additional price information to investors. Increase marketability and competition, which should improve NASDAQ efficiency.

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The Market for Stocks

The Efficiency of Secondary Markets - Auction In an auction market, buyers and sellers confront each other directly and bargain over price.
NYSE is best-known example of auction market. In NYSE, auction for a security takes place at a

specific location on the floor of the exchange, called a post.

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The Market for Stocks

The Efficiency of Secondary Markets - Auction
The auctioneer is the specialist designated by

exchange and allowed to act as dealer to represent orders placed by public customers.
NYSE is the most efficient equity market in US.

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The Market for Stocks

Reading the Stock Market Listings
The Wall Street Journal, The New York Times,

and other newspapers in large metropolitan areas provide stock listings for major stock exchanges, such as NYSE and relevant regional exchanges.
Exhibit 9.1 shows a section of NYSE listing in the

Wall Street Journal.

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Exhibit 9.1: NYSE Stock Listings from WSJ

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Types of Equity Securities

Common Stock and Preferred Stock Two types of equity securities 1) Common stock 2) Preferred stock
Common stock represents basic ownership claim

in a corporation. One of the owners rights is to vote on all important matters that affect life of company, such as vote to elect board of directors, capital budget, or proposed merger or acquisition.
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Types of Equity Securities

Common Stock and Preferred Stock
Owners of common stock are not guaranteed any

dividend payments; have lowest priority claim on firms assets in event of bankruptcy.
Legally, common stockholders enjoy limited

liability.

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Types of Equity Securities

Common Stock and Preferred Stock
Preferred stock also represents ownership

interest in corporation, but gets preferential treatment over common stock in certain matters.
Preferred dividend payments are firms fixed

obligations, similar to interest payments on corporate bonds.

Dividend payments are paid with after-tax dollars

subject to taxation.
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Types of Equity Securities

Common Stock and Preferred Stock
Preferred stock owners are given priority over

common stock owners with respect to dividends payments and claims against firms assets in event of bankruptcy or liquidation.
Even though preferred stock is equity, owners

have no voting privileges.

Preferred stocks are generally viewed as

perpetuities because they have no maturity.

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Types of Equity Securities

Preferred Stock: Debt or Equity?
Legally, preferred stock is equity. Like dividends on common stock, preferred-stock

dividends are taxable.

A strong case can be made that preferred stock is

really a special type of bond. 1) Regular preferred stock confers no voting powers.

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Types of Equity Securities

Preferred Stock: Debt or Equity? 2) Preferred stockholders receive fixed dividend regardless of firms earnings; if firm is liquidated, they receive a stated value (usually par)not residual value. 3) Preferred stocks often have credit ratings similar to those issued to bonds.

4) Preferred stock is sometimes convertible into common stock.

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Types of Equity Securities

Preferred Stock: Debt or Equity? 5) Most preferred stock issues today are not true perpetuities. Increasingly, preferred-stock issues have the sinking fund feature, which requires mandatory annual retirement schedules.
Valuation of common and preferred stock is done

by using same basic methodology discussed for bond valuations in Chapter 6.

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Types of Equity Securities

Preferred Stock: Debt or Equity?
Applying valuation procedure to common stocks

is more difficult than applying it to bonds for various reasons.

1) In contrast to coupon payments on bonds, size and timing of dividend cash flows are less certain. 2) Common stocks are true perpetuities in that they have no final maturity date.
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Types of Equity Securities

Preferred Stock: Debt or Equity?
Applying valuation procedure to common stocks

is more difficult than applying it to bonds for various reasons.

3) Unlike rate of return, or yield, on bonds, rate of return on common stock cannot be observed directly.

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Equity Valuation
A One-Period Model
This provides estimate of market price. Value of an asset is present value of its future

cash flowsthe future dividend and the end-ofperiod stock price.

D1+P1 P0 = 1+R

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Equity Valuation
A Two-Period Model
This can be viewed as two one-period models

strung together.
D1 D2 +P2 P0 = + 1+R (1+R)2

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Equity Valuation
A Perpetuity Model
Comprised of a series of one-period stock pricing

models strung together.

Although theoretically sound, this model is not

practical to apply. The number of dividends could be infinite.

Dt Pt D1 D2 P0 = + +...+ + 1+R (1+R)2 (1+R)t (1+R)t

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Equity Valuation
The General Dividend Valuation Model Equation 9.1 is a general expression for the value of a share of stock. Price of a share of stock is the present value of all expected future dividends.
D3 Dt D1 D2 D P0 ... (9.1) 2 3 t 1 R (1 R) (1 R) (1 R) t 1 (1 R)
Formula does not assume any specific pattern for

future cash dividends, such as a constant growth rate.

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Equity Valuation
The General Dividend Valuation Model
Makes no assumptions about when the share of

stock is going to be sold in future.

Finally, the model says that to compute a stocks

current value, we need to forecast an infinite number of dividends.

Equation 9.1 implies that the underlying value of a

share of stock is determined by markets expectations of firms future cash flows.

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Equity Valuation
The General Dividend Valuation Model
Remember, in efficient markets stock prices

change constantly as new information becomes available and is incorporated into firms market price. For publicly traded companies, a constant stream of information about the firm reaches the market, some having impact on stock price while other information has no effect.

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Equity Valuation
The Growth Stock Pricing Paradox
Growth stocks

Stocks of companies whose earnings are growing at above-average rates and are expected to continue to do so for some time.

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The Growth Stock Pricing Paradox
Fast-growing companies typically pay no dividends

on their stock during the growth phase.

Management believes the company has a number

of high-return investment opportunities; both company and its investors will be better off if earnings are reinvested.
Equation 9.1 predictsand common sense saysif

you own stock in a company that will never pay you any cash, market value of those shares of stock are worth absolutely nothing.
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Equity Valuation
The Growth Stock Pricing Paradox
In reality, these firms will eventually pay out

dividends in distant future.

If internal investments succeed, stocks price

should go up significantly.
Investors can then sell their stock at much higher price than what they paid.

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Equity Valuation
Stock Valuation: Some Simplifying Assumptions
To make Equation 9.1 more applicable, some

simplifying assumptions about the pattern of dividends are necessary.

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Equity Valuation
Stock Valuation: Some Simplifying Assumptions
Three different assumptions can cover most

growth patterns. 1) Dividend payments remain constant over time; i.e., they have growth rate of zero. 2) Dividends have constant growth rate. 3) Dividends have mixed growth rate pattern; i.e., they have one payment pattern then switch to another.
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Equity Valuation
Zero Growth Dividend Model
The dividend payment pattern remains constant

over time: D1 = D2 = D 3 = . . . = D
In this case the dividend-discount model

(Equation 9.1) becomes:

D D D D P0 = + + ...+ 1+R (1+R)2 (1+R)3 (1+R)

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Equity Valuation
Zero Growth Dividend Model
This cash flow pattern essentially describes a

perpetuity with a constant cash flow.

In Chapter 6 we developed the present value of a

Chapter 9 Stock Valuation

perpetuity with a constant cash flow as CF/i, where CF is the constant cash flow and i is the interest rate. Similarly, equation 9.2 gives the valuation model for a zero growth stock. D P0 = (9.2) R
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Equity Valuation
Zero Growth Dividend Model Example Del Mar Corporation pays $5 dividend per year, and the board of directors has no plans to change the dividend. The firms investors expect a 20 percent return on investment. What should be the price of the firms stock?
D $5 P0 = = = $25 per share R 0.20

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Equity Valuation
Constant Growth Dividend Model
Cash dividends do not remain constant but

instead grow at some average rate g from one period to next forever.
Constant dividend growth is appropriate

assumption for mature companies with history of stable growth.

While an infinite horizon is hard to comprehend,

far-distant dividends have small present value and contribute very little to price of stock.
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Exhibit 9.2: Impact on Stock Prices

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Equity Valuation
Constant-Growth Dividend Model
Deriving the constant-growth dividend model is

fairly straightforward. We must build a model to compute value of dividend payments for any time period.
The constant-growth dividend model is easy to do

because it is just an application of Equation 6.6 from Chapter 6.

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Equity Valuation
Constant-Growth Dividend Model
Recall that equation for a growing perpetuity in

Chapter 6 is equation 6.6: PVA = CF1/(i g)

The constant-growth dividend model tells us that

the current price of a share of stock is the next period dividend divided by the difference between the discount rate and the dividend growth rate.

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Equity Valuation
Constant-Growth Dividend Model
With the constant-growth dividend model, the

general formula for dividend values is as follows:

Dt = D0(1+g)t

(9.3)

Equation 9.4 shows how to value a constant-

growth stock :

D1 P0 = R-g
Chapter 9 Stock Valuation

(9.4)
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Equity Valuation
Constant-Growth Dividend Model Example This years dividend will be $4.81 for Big Red Automotive. The dividends will grow at a constant 4 percent and investors who own stock in similar types of firms expect to earn a return of 18 percent. What is the value of the firms stock?
D1 = D0 (1+g) = $4.81(1+0.04) = $4.811.04 = $5.00 D1 $5.00 $5.00 P0 = = = = $35.71 R-g 0.18-0.04 0.14
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Equity Valuation
Computing Future Stock Prices
The constant-growth dividend model (Equation

9.4) can be generalized to determine value, or price, of share of stock at any point in time.
Equation 9.5 shows price of share of stock at any

time t as follows:

Dt+1 Pt = R-g

(9.5)

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Computing Future Stock Prices Example A firm has a current dividend (D0) of $2.50, R is 15 percent, and g is 5 percent. What is the price of the stock today (P0) and what will it be in five years (P5)?
D1=D0 (1+g)=$2.501.05=$2.625 D1 $2.625 $2.625 P0 = = = =$26.25 R-g 0.15-0.05 0.10 D6 =D0 (1+g)6 =$2.50(1.05)6 =$2.501.34=$3.35 D6 $3.35 $3.35 P5 = = = =$33.50 R-g 0.15-0.05 0.10 48

Chapter 9 Stock Valuation

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Equity Valuation
The Relationship between R and g
Constant-growth dividend model yields solutions

that are invalid whenever dividend growth rate equals or exceeds discount rate (g R).
If g = R, the value of the denominator is zero and

the value of the stock is infinitewhich makes no sense.

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The Relationship between R and g
If g > R, the present value of the dividend gets

bigger and bigger rather than smaller and smaller as it should. This implies that a firm that is growing at a very fast rate does so forever.

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Equity Valuation
Supernormal-Growth Dividend Model
During the early part of their lives, very successful

firms experience a supernormal rate of growth in earnings.

To value a share of stock for a firm with

supernormal dividend growth patterns, we can apply Equation 9.1, our general dividend model, and Equation 9.5, which gives the price of share of stock with constant dividend growth at any point in time.
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Exhibit 9.3: Dividend Growth Rate Patterns

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Exhibit 9.4: Timeline for Nonconstant-Dividend Pattern

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Equity Valuation
Supernormal-Growth Dividend Model
Thus, our valuation model is:

P0 = PV (Mixed dividend growth) + PV (Constant dividend growth)

Dt Pt D1 D2 P0 = + +...+ + 1+R (1+R)2 (1+R)t (1+R)t

(9.6)

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Supernormal-Growth Dividend Model Example Find the value of the stock described in Exhibit 9.4.
D4 = D3 (1+g) = $3.001.06 = $3.18 D4 $3.18 $3.18 P3 = = = = $35.33 R-g 0.15-0.06 0.09 $1.00 $2.00 $3.00 $35.33 P0 = + + + 2 3 1.15 (1.15) (1.15) (1.15)3 = $0.87 + $1.51 + $1.97 + $23.23 = $27.58
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Valuing Preferred Stock In computing the value of preferred stock, one must know whether preferred stock has an effective maturity because of a sinking-fund option or call option.
Most significant difference between preferred

stock with a fixed maturity and a bond is risk of default.

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Valuing Preferred Stock
Since preferred-stock dividends are declared by

the board of directors, failure to pay dividends does not result in default.
Failure to pay a preferred-stock dividend as

promised is a serious financial breach and signals to the market that firm is in serious financial difficulty.

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Preferred Stock with a Fixed Maturity
We can use the bond valuation model developed

in Chapter 8 to determine its price, or value.

Equation 8.2 in chapter 8 can be restated as the

price of a share of preferred stock (PS0).

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Preferred Stock with a Fixed Maturity
Preferred stock price = PV (Dividend payments) +

PV (Par value)
D/m Pmn D/m D/m D/m PS0 ... (9.7) 1 i/m (1 i/m) 2 (1 i/m) 3 (1 i/m) mn
Since most preferred stocks make quarterly

dividend payments, m equals 4.

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Preferred Stock with a Fixed Maturity Example A utility companys preferred stock has an annual dividend payment of $10 (paid quarterly), a stated (par) value of $100, and an effective maturity of 20 years. If similar preferred stock issues have market yields of 8 percent, what is the value of the preferred stock? $2.50 $2.50 PS 0 = + +...+ $102.50 1.02 (1.02)2 (1.02)80
= $119.87
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Preferred Stock with a Fixed Maturity Example The financial calculator solution of this problem is as follows:
Enter Answer
80 2 2.50 1,00

PV
-119.87

PMT

FV

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Perpetual Preferred Stock Some preferred-stock issues have no maturity.
Dividends are constant over time (g = 0). Fixed dividend payments go on forever. We can use Equation 9.2 to value such preferred-

stock issues.

D P0 = R
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Perpetual Preferred Stock Example Northwest Airlines has a perpetual preferred stock issue that pays a dividend of $5 per year. Investors require an 18 percent return on such an investment. What should be the value of the preferred stock?
D $5.00 P0 = = = $27.78 R 0.18

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