Stock Valuation

Valuation

• The determination of what a stock

is worth; the stock's intrinsic value
• If the price exceeds the valuation,
buy the stock.
• If the price is less than the
valuation, short the stock.

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 Cash Flows for Stockholders

If you buy a share of stock, you can

receive cash in two ways
– The company pays dividends
– You sell your shares, either to another
investor in the market or back to the
company

• As with bonds, the price of the stock

is the present value of these expected
cash flows
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 Dividend Characteristics

• Dividends are not a liability of the firm until

a dividend has been declared by the Board
• A firm is not default for not declaring
dividends
• Dividends and Taxes
– Dividend payments are not considered a business
expense, therefore, they are not tax deductible
– Dividends received by individuals are taxed as
ordinary income
– Dividends received by corporations have a
minimum 70% exclusion from taxable income 4
 Dividend Valuation Model

If the dividend is fixed, valuation is:

D
V
k
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 Dividend Growth Model

Value depends on the

– the required return,
– the dividend, and
– the growth in the dividend.

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 Valuing Common Stock Using the Discounted Dividend Model

 Similar to bonds, the value of common

stock is equal to the present value of all
future cash flows that the stockholder
expects to receive from owning the
shares of stock.
 Unlike bonds, the future cash flows in
the form of dividends are not fixed.
Thus, the value of common stock is
derived from discounting “expected
dividend.” 7
 Three Step Procedure for Valuing Common Stock

1. Estimate the amount and timing of future cash

flows the common stock is expected to provide.

2. Evaluate the riskiness of the future dividends,

and determine the rate of return an investor
might expect to receive from a comparable risky
investment, which becomes the investor’s
required rate of return.

3. Calculate the present value of the expected

dividends by discounting them back to the
present at the investor’s required rate of return.
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 Stock Pricing: Example
There is a share of common stock you plan to hold for
only one year. What will be the value of the stock
today if it pays a dividend of $2.00, is expected to have
a price of $75 and the investor’s required rate of return
is 12%?

Value of Common stock

= Present Value of future cash flows
N: 1 = Present Value of (dividend +
PMT: 2 expected selling price)
FV: 75
= ($2 + $75) ÷ (1.12)1
I/Y: 12
= $68.75
PV = − 68.75
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 Stock Pricing: Example
What will be the value of common stock if you
hold the stock for two years and sell it for $82?
Assume the dividend payment is fixed at $2 per
year.
Value of Common stock
= Present Value of future cash flows
N: 2
= Present Value of (dividends + expected
PMT: 4
selling price)
FV: 82
I/Y: 12 = {($2) ÷ (1.12)1 } + {($2+$82) ÷ (1.12)2 }
PV = − 72.1301
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 One Period Example
Suppose you are thinking of purchasing
the stock of Ford Motor Company and you
expect it to pay a $2 dividend in one year
and you believe that you can sell the stock
for $14 at that time. If you require a return
of 20% on investments of this risk, what is
the maximum you would be willing to pay?
N: 1
PMT: 0 – Compute the PV of the expected cash flows
FV: 16 – Price = (14 + 2) ÷ (1.2)
I/Y: 20
PV = −13.3333
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 Two Period Example

Now what if you decide to hold the

stock for two years? In addition to
the dividend in one year, you expect
a dividend of $2.10 in and a stock
price of $14.70 at the end of year 2.
CF0: 0 Now how much would you be willing
C01: 2
F01: 1
to pay?
C02: 16.80 – PV = 2 ÷ (1.2) + (2.10 + 14.70) ÷ (1.2)2
F02: 1
I = 20
NPV = −13.3333
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 Three Period Example

Finally, what if you decide to hold the

stock for three periods? In addition to
the dividends at the end of years 1
and 2, you expect to receive a
dividend of $2.205 at the end of year
CF0: 0
C01: 2 3 and a stock price of $15.435. Now
F01: 1
C02: 2.10
how much would you be willing to
F02: 1 pay?
CO3: 17.64
F03: 1
I = 20
– PV = 2 / 1.2 + 2.10 / (1.2)2 + (2.205
NPV = −13.3333 + 15.435) / (1.2)3
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 Stock Valuation: Constant Dividends

 Since stocks do not have a maturity period,

we can consider the value of stock to be
equal to the present value of future
expected dividends over a certain period
and an expected selling price.
 Valuing common stocks using general
discounted cash flow model is made difficult
as analyst has to forecast each of the future
dividends. This problem is greatly simplified
if we assume that dividends grow at a fixed
or constant rate.
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Constant Dividend Growth Model

If the dividend grows at a constant rate,

valuation is:

(1  g )
V  D0
(k  g )
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Constant Dividend Growth Rate Model

 Vcs = Value of a share of common stock

 D0 = Annual cash dividend in the year of
valuation (paid already)
g = annual growth rate in the dividend
 rcs = the common stockholder’s required rate
of return
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 Constant Dividend Growth Rate Model

Mattco common stock paid a $2 dividend at the

end of last year and is expected to pay a cash
dividend every year in perpetuity. Each year, the
dividends are expected to grow at a rate of 10%.
Based on an assessment of the riskiness of the
common stock, the investor’s required rate of
return is 15%. What is the value of this common
stock?

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 Zero Growth Model

If dividends are expected at regular

intervals forever, then this is like preferred
stock and is valued as a perpetuity

P0 = D ÷ R
Suppose stock is expected to pay a $0.50
dividend every quarter and the required
return is 10% with quarterly
compounding. What is the price?
→ P0 = .50 ÷ (0.1 ÷ 4) = $20
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 Zero Growth Model: Example

Suppose Y-Corp. just paid a dividend

of $.50. It is expected to increase its
dividend by 2% per year. If the
market requires a return of 15% on
assets of this risk, how much should
the stock be selling for?
P0 = .50(1+.02) ÷ (.15 - .02) =
$3.92
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 Zero Growth Model: Example

Z-Corp. is expected to pay a $2

dividend in one year. If the dividend
is expected to grow at 5% per year
and the required return is 20%, what
is the price?

→P0 = 2 ÷ (.2 - .05) = $13.33

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 Stock Price Sensitivity to Dividend Growth

D1 = $2; R = 20%
250

200
Stock Price

150

100

50

0
0 0.05 0.1 0.15 0.2
Growth Rate

As the growth rate approaches the required return,

the stock price increases dramatically.
 Stock Price Sensitivity to Required Return

D1 = $2; g = 5%
250

200
Stock Price

150

100

50

0
0 0.05 0.1 0.15 0.2 0.25 0.3
Growth Rate

As the required return approaches the growth rate, the price

increases dramatically. This graph is a mirror image of the previous
one.
 The Cause of Stock Price Fluctuations

There are three variables that drive share value:

 The most recent dividend (D0): The more, the higher.

 Expected rate of growth in future dividends (g): The higher, the
higher.
 Investor’s required rate of return (rcs ): The higher, the lower.

Since most recent dividend (D0) has already been paid, it cannot be
changed. Thus, variations in the other two variables, r cs and g, can lead
to changes in stock prices.
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Determinants of the Investor’s Required Rate of Return

The investor’s required rate of return is

determined by two key factors:
• The level of interest rates in the
economy
• The risk of the firm’s stock.

If risk-free rate and/or systematic risk

(beta) rises, the investor’s required rate of
return will rise and the stock value will fall.
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 Required Return: Example

Suppose a firm’s stock is selling for

$10.50. They just paid a $1 dividend and
dividends are expected to grow at 5%
per year. What is the required return?
→ R = [1(1.05) ÷ 10.50] + .05 = 15%
• What is the dividend yield?
→ 1(1.05) ÷ 10.50 = 10%

• What is the capital gains yield?

→ g =5%
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 Determinants of Growth Rate of Future Dividends

Firm’s growth opportunities relate to:

 The rate of return the firm expects to earn when they
reinvest earnings (the return on equity, ROE), and
 The proportion of firm’s earnings that they reinvest. This is
known as the retention ratio, b, = 1- dividend payout ratio.
The growth rate can be formally expressed as follows:

 g = the expected rate of growth of dividends

 D1/E1 = the dividend payout ratio
 ROE = the return on equity earned when the firm reinvests
a portion of its earning back into the firm.

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 P/E Ratio Valuation Model

 Price/Earnings ratio (P/E ratio) is a popular

measure of stock valuation.
 P/E ratio is a relative value model because it tells
the investor how many dollars investors are willing
to pay for each dollar of the company’s earnings.

 Vcs = the value of common stock of the firm.

 P/E1 = the price earnings ratio for the firm based on the current price per
share divided by earnings for end of year 1.
 E1 = estimated earnings per share of common stock for the end of year 1.

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 Preferred Stock

Dividend:
 In general, size of preferred stock dividend is fixed, and it is either
stated as a dollar amount or as a percentage of the preferred stock’s
par value.

 Unlike common stockholders, preferred stockholders receive the same

fixed dividend regardless of how well the firm does.

Multiple Classes:
 If a company chooses, it can issue more than one class of preferred
stock, and each class can have different characteristics.

 For example, Public Storage (PSA) has 16 different issues of preferred

stock outstanding that vary in terms of dividend, convertibility,
seniority.
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 Preferred Stock

Claims on Assets and Income:

 In the event of bankruptcy, preferred
stockholders have priority over common
stock. However, they have lower priority than
the firm’s debt holders.
 Firm must pay dividends on preferred stock
prior to paying dividend on common stock.
 Most preferred stock carry a cumulative
feature. Cumulative feature requires that all
past unpaid dividends to be paid before any
common stock dividends can be declared.
 Thus, preferred stocks are less risky than
common stocks but more risky than bonds. 30
 Preferred Stock

Preferred Stock are a Hybrid Security

 Like common stocks, preferred stocks
do not have a fixed maturity date. Also,
like common stocks, nonpayment of
dividends does not lead to bankruptcy
of the firm.
 Like debt, preferred stocks have a fixed
dividend. Also, most preferred stocks
are periodically retired even though
there is no stated maturity date.
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 Features of Preferred Stock
Dividends
– Stated dividend that must be paid before
dividends can be paid to common stockholders

– Dividends are not a liability of the firm and

preferred dividends can be deferred indefinitely

– Most preferred dividends are cumulative – any

missed preferred dividends have to be paid
before common dividends can be paid

• Preferred stock generally does not carry

voting rights
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 Preferred Stock Valuation
Since preferred stockholders generally
receive a fixed dividend and the stocks are
perpetuities (non-maturing), it can be
valued using the present value of
perpetuity equation.

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 Yield on Preferred Stock: Example

What will be the yield on XYZ’s preferred

stock if the company has promised annual
dividend of $1.20 per share and each share
is currently selling for $32.50?

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 Pricing of Preferred Stock: Example

Consider Consolidated Edison’s preferred stock

issue, which pays an annual dividend of $5.00 per
share, does not have a maturity date, and on
which the market’s required yield or promised
rate of return (rps) for similar shares of preferred
stock is 6.02%. What is the value of the Con Ed’s
preferred stock?

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 Pricing of Preferred Stock: Example

What is the present value of a share

of preferred stock that pays a
dividend of $12 per share if the
market’s yield on similar issues of
preferred stock is 8%?

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