7- 1

CHAPTER 8 (Ch. 7 in 4 th edition)

The Valuation and

Characteristics of Stock
 7- 2

Common Stock

Background
Stockholders own the corporation, but in
many instances the corporation is
widely held
Stock ownership is spread among a
large number of people
Because of this, most stockholders are
only interested in how much money
they will receive as a stockholder
Most equity investors arent
interested in a role as owners
 7- 3
The Return on an Investment in
Common Stock
The future cash flows associated with stock ownership consists
of
Dividends and
The eventual selling price of the shares
If you buy a share of stock for price P0, hold it for one year during
which time you receive a dividend of D1, then sell it for a price P1,
your return, k, would be:

D1+ P1-P0
k=
P0 A capital gain (loss) occurs
or if you sell the stock for a
price greater (lower) than
D1 P1-P0
k= + you paid for it.
P0 P0
dividend yield capital gains yield
 7- 4
The Intrinsic (Calculated) Value and
Market Price

A stocks intrinsic value is based on

assumptions made by a potential investor
Must estimate future expected cash flows
Need to perform a fundamental
analysis of the firm and the industry
Different investors with different cash flow
estimates will have different intrinsic
values
 7- 5
Price versus Earnings
 7- 6

Developing Growth-Based Models

Realistically most people tend to forecast growth rates rather
than cash flows
A stocks value today is the sum of the present values of the
dividends received while the investor holds it and the price for
which it is eventually sold

An Infinite Stream of Dividends

Many investors buy a stock, hold for awhile, then sell, as
represented in the above equation
However, this is not convenient for valuation purposes

D1 D2 Dn Pn
P0 =
1 k 1 k 2
1 k
n
1 k
n
 7- 7

Developing Growth-Based Models

A person who buys stock at time n will hold it

until period m and then sell it
Their valuation will look like this:
Dn + 1 Dm Pm
Pn = ++ +
1 + k 1 + k
m-n
1 + k
m-n

Repeating this process until infinity results in:

Di
P0
1 + k
i
i=1

Conceptually its possible to replace the final

selling price with an infinite series of dividends
 7- 8

Stock Value = PV of Dividends:

D1 D2 D3 D
P0 ...
1 k s 1 k s 1 k s
1 2 3
1 k s

What is a constant growth stock?

One whose dividends are expected to

grow forever at a constant rate, g.
 7- 9
The Constant Growth Model
If dividends are assumed to be growing at a constant rate forever
and we know the last dividend paid, D0, then the model simplifies
to:

Which represents a series of fractions as follows

D0 1 g D0 1 g D0 1 g
2 3

P0 =
1 k 1 k
2
1 k
3

If k>g the fractions get smaller (approach zero) as the exponents get
larger
If k>g growth is normal
If k<g growth is supernormal
Can occur but lasts for limited time period
 7- 10

Constant Normal Growth

Constant growth model can be simplified to

D1 1 K must be
P0 D1 greater
k g ks g than g.

D1 = D0(1+g)
The constant growth model is a simple
expression for forecasting the price of a
stock thats expected to grow at a constant,
normal rate
 7- 11

The discount rate (ki) is the opportunity

cost of capital, i.e., the rate that could
be earned on alternative investments of
equal risk.
For Bonds:
ki = k* + IP + LP + MRP + DRP.

For Stocks:
Ks = KRF + (KM KRF)s
 7- 12
Constant Normal GrowthExample

Q: Atlas Motors is expected to grow at a constant rate of 6% a year

into the indefinite future. It recently paid a dividends of $2.25 a
share. The rate of return on stocks similar to Atlas is about 11%.
What should a share of Atlas Motors sell for today?

A: D1
Example

P0
k-g
$2.25 (1.06)

.11 - .06
$47.70
 7- 13

What happens if g > ks?

If ks< g, get negative stock price, which is

nonsense.

D1
P0 requires k s g.
ks g

We cant use model unless (1) ks> g and

(2) g is expected to be constant forever.
 7- 14

The Zero Growth Rate CaseA Constant

Dividend

If a stock is expected to pay a constant,

non-growing dividend, each dollar
dividend is the same
Gordon model simplifies to:
D
P0
k
A zero growth stock is a perpetuity to the
investor
 7- 15

The Expected Return

Can recast Constant Growth model to focus on
the return (k) implied by the constant growth
assumption
D1
k g
P0
g is the expected capital gains (%)

The higher the expected growth in dividends the

faster the price is expected to grow

Would this apply to farmland? How?

 Basis for growth expectations 7- 16

Just looking at past dividend growth is not very

informative because it can be distorted
Growth in EPS is the fundamental driver of growth
in dividends (get data on EPS growth)
EPS growth greater than sales growth is not
sustainable over a long period (so get data on
sales growth)
Consider industry factors, including the general
economy, that affect growth and market share
ROE times the retention rate is the fundamental
driver of EPS growth (get data on ROE and
retention rate)
Also look for expert opinion
 7- 17

Whats the stocks market value?

D0 = 2.00, ks = 16%, g = 6%.

Constant growth model:

D1 $2.12
P0
k s g 0.16 0.06

$2.12
$21.20.
0.10
 7- 18

What is the stocks market value one

^
year from now, P1?
D1 will have been paid, so expected
dividends are D2, D3, D4 and so on. Then,

D2 $2.247
P1 $22.47.
k s g 0.16 0.06

D3 $2.382
P2 $23.82.
k s g 0.16 0.06
 7- 19

Constant Growth Implications

Ks = 16%; g = 6%; 1/(.16-.06) = 10

Year Dividend Multiple Stock Growth

Price Rate
0 $2.12 10 $21.20 6%

1 $2.247 10 $22.47 6%

2 $2.382 10 $23.82 6%
 7- 20

Find the expected dividend yield,

capital gains yield, and total return
during the first year.

D1 $2.12
Dividend yld 10%.
P0 $21.20

P1 P0 D1
Cap. gains yld k s 6%.
P0 P0

Total return 10% 6% 16%.

 7- 21
Why do the dividend and capital gains returns
add-up to the required rate of return?
Rearrange model to rate of return form:

D1 D1
P0 k s g.
ks g P0

Then, ks = $2.12/$21.20+ 0.06

= 0.10 + 0.06 = 16%.

Dividend yield+capital gain

 7- 22

What would P0 be if g = 0?
The dividend stream would be a perpetuity.

0 1 2 3
16%

2.00 2.00 2.00

PMT $2.00
P0 $12.50.
k 0.16
 7- 23

Two Stage Growth

At times a firms future growth may not be

expected to be constant
For example, a new product may lead to
temporary high growth
The two-stage growth model allows us to value a
stock that is expected to grow at an unusual rate
for a limited time
Use the Gordon model to value the constant
portion
Find the present value of the non-constant
growth periods
 7- 24

Problem 9 from lab

Frazier Inc. paid a dividend of $4 last year

(D0). The firm is expecting dividends to
grow at 21% in years 12 and 10% in Year
3. After that growth will be constant at
8% per year. Similar investments return
14%. Calculate the value of the stock
today.
a.$71.49b.$88.31c.$91.47d.$116.10
 7- 25

ANS: C
D1 = 4(1.21) = 4.84
D2 = D1(1.21) = 5.8564
D3 = D2(1.10) = 6.442
D4 = D3(1.08) = 6.9574032
P3 = [D4]/(.14 .08) = 115.95672
6.44 + 115.96 = 122.40
Calculator Steps:
CFo = 0, C01 = 4.84, C02 = 5.86, C03 = 122.40; I = 14
Solve for NPV = $91.37
 7- 26

Two Stage GrowthExample

Q: Zylon Corporations stock is selling for $48 a share according to
The Wall Street Journal. Weve heard a rumor that the firm will
make an exciting new product announcement next week. By
studying the industry, weve concluded that this new product will
support an overall company growth rate of 20% for about two
years. After that, we feel growth will slow rapidly and level off at
Example

about 6%. The firm currently pays an annual dividend of $2.00,

which can be expected to grow with the company. The rate of
return on stocks like Zylon is approximately 10%. Is Zylon a
good buy at $48?

A: Well estimate what we think Zylon should be worth given our

expectations about growth.
 7- 27

Two Stage GrowthExample

Well develop a schedule of expected dividend payments:
Expected
Year Dividend Growth
1 $2.40 20%
Example

2 $2.88 20%
3 $3.05 6%
Next, well use the constant growth model at the point in time
where the growth rate changes and constant growth begins.
Thats year 2, so:
D3 $3.05
P2 $76.25
k - g2 .10 - .06
 7- 28

Do time line and PV on the board

CF0 = 0
CF1 = 2.40
CF2 = 2.88 + 76.32 = 79.20
Ks = 10%
NPV =?= 67.64
 7- 29
Another example: If we have
supernormal growth of 30% for 3 yrs,
^
then a long-run constant g=6%, what is
P0? ks is still 16%.

Have to project out the

assumptions on a time line.
Apply the constant growth
model after 3 years.
 7- 30

High growth followed by constant lower growth:

0 4
ks=16% 1 2 3
g = 30% g = 30% g = 30% g = 6%
D0 = 2.00 2.60 3.380 4.394 4.658
CF0=0 46.58

CF1=2.6
CF2=3.38
4.658
CF3=50.97
P3 $46.58
I=16 0.16 0.06
NPV = 37.410 = P0
 7- 31

What is the expected dividend yield

and capital gains yield at t = 0?
At t = 4?

$2.60
Div. yield0 6.95%.
$37.41

Therefore the capital gain must be :

Cap. gain0 16% 6.95% 9.055%.
 7- 32

During nonconstant growth,

dividend and cap. gains
yields are not constant, and
capital gains yield is less
than g.
After t = 3, g = constant = 6%
= capital gains yield; k =
16%; so D/P = 16 - 6 = 10%.
 7- 33

If g = -6%, would anyone buy the

stock? If so, at what price?
Firm still has earnings and still pays
dividends, so P0 > 0:

^ D1 D01 g
P0 .
ks g ks g
$2.00 0.94 $1.88
$8.55.
0.16 0.06 0.22
 7- 34

What is the annual D/P and capital

gains yield?

Capital gains yield = g = - 6.0%,

Dividend yield = 16.0% - (-6.0%) =
22%.
D/P and cap. gains yield are
constant, with high dividend yield
(22%) offsetting negative cap.
gains yield.
 7- 35
super normal growth example

The XYZ corporation has had annual

earnings and dividends increase at the rate
of 75% recently and recently paid
dividends of $4/share. The outlook is for
continued high growth at 50% per year for
the next three years, then a more modest
growth rate of 5% per year for all future
years.
The required return for a company of this
risk is 15%.
 7- 36

SUPER NORMAL GROWTH ANSWER

D1=6, D2=9, D3=13.50, D4=13.5(1.05)=14.175
P3=price of the stock at time 3, when the
constant growth begins
P3=14.175[1/.15-.05]=14.175(10)
=$141.75
Draw a time line.
Using the CFj part of your calculator:
CF0=0, CF1=6, CF2=9,
CF3=13.5+141.75=155.25, I=15
NPV=P0=$114.10
 Super Normal Growth 7- 37

Base Growth Num- Constant ks

Dividend rate ber of growth
years rate

$1 20% 5 3% 15%
$30 40% 3 4% 16%
$2 30% 2 5% 14%
2 30% 3 5% 14%
 7- 38

What is market equilibrium?

In equilibrium, stock prices are stable.

There is no general tendency for
people to buy versus sell.

In equilibrium, expected returns must

equal required returns:

k D1 P0 g k k RF k M k RF b.
 7- 39

How is equilibrium established?

If ^
k = (D1/ P0) + g > k, then

P0 is too low, a bargain.

Buy orders > sell orders;

P0 bid up; D1/P0 falls until

D1/P0 + g = ^k = k.
 7- 40
Why do stock prices change?
D1
P0
ki g
1. ki could change:
ki = kRF + (kM - kRF )bi
kRF = k* + IP

2. g could change due to economic or firm

situation

3. D could change usually due to earnings

4. Super-normal growth expectations could

be formed or change.
 7- 41

Feb. 4, 1994: Fed announced

increase in interest rates at 11 a.m.

Result: Dow Jones fell 95 points.

ki = kRF + (kM - kRF )bi

kRF = k* + IP

D1
P0
ki g
 7- 42

Securities Analysis

Securities analysis is the art and science of

selecting investments
Fundamental analysis looks at a company and its
business to forecast value
Technical analysis bases value on the pattern of
past prices and volumes
The Efficient Market Hypothesis says information
moves so rapidly in financial markets that price
changes occur immediately, so it is impossible to
consistently beat the market to bargains
 7- 43

Whats the Efficient

Market Hypothesis?

EMH: Securities are normally

in equilibrium and are fairly
priced, given what is currently
known. One cannot beat
the market except through
good luck or inside info.
 7- 44

1. Weak-form EMH:
Cant profit by looking at
past trends. A recent decline
is no reason to think stocks
will go up (or down) in the
future. Seems empirically
true, but technical analysis
is still used.
 7- 45

2. Semi-strong form EMH:

All publicly available info. is
reflected in stock prices, so
doesnt pay to pore over
annual reports looking for
undervalued stocks. Largely
true, but superior analysts
can still profit by finding and
using new information.

It is VERY hard to tell good luck from

superior stock picking/timing ability.
 7- 46

3. Strong-form EMH:
All information, even inside
info, is embedded in stock
prices. Not true--insiders
can gain by trading on the
basis of insider information,
but thats illegal.
 7- 47

Markets are efficient because:

1. 15,000 or so trained analysts; MBAs,

CFAs, Technical PhDs.
2. Work for firms like Merrill, Morgan,
Prudential, which have much money.
3. Have similar access to data.
4. Thus, news is reflected in P0 almost
instantaneously.