Stock Valuation

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Common Stock

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Intrinsic vs. Market Value

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Present Value of Common Stocks
We can think of value of a stock as the present value
of future dividends (D = DPS: Dividend per share):
D1 P1
P0 = +
(1 + R) (1 + R)1
1

D1 D2 P2
P0 = + +
(1 + R) (1 + R) (1 + R)
1 2 2

...
D1 D2 D3
P0 = + + +
(1 + R) (1 + R) (1 + R)
1 2 3

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Present Value of Common Stocks
The value of any asset is the present value of its
expected future cash flows
Stock ownership produces cash flows from
Dividends
Capital Gains
Valuation of different types of stocks
Zero Growth
Constant Growth
Differential Growth

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 Equity Valuation

Three Scenarios

Differential
Zero Growth Constant Growth
Growth

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Equity Valuation:
Three Scenarios

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 Case 1: Zero Growth
Assume that dividends will remain at the same level
forever
D1 = D2 = D3 =

Since future cash flows are constant, value of a

zero growth stock is present value of perpetuity:
D1 D1 D1
P0 = + + +
(1 + R) (1 + R) (1 + R)
1 2 3

D1
P0 =
R
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 Case 2: Constant Growth
Assume that dividends will grow at a constant rate (g)
forever, i.e.
D2 = D1 (1 + g)
D3 = D2 (1 + g) = D1 (1 + g)2
...
Value of a constant growth stock is the present value of
a growing perpetuity (Gordon Model)
D1
P0 =
R g

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 Constant Growth Example
Big D, Inc., will pay a dividend of $0.50 per
share a year from today. It is expected to
increase its dividend by 2% per year. If
investors require a return of 15%, what is the
stock value?
0.5
P0 = = 3.846
0.15 0.02

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 Case 3: Differential Growth
Assume that dividends will grow at rate g1 for T
years and grow at rate g2 thereafter

D1 D1 (1 + g1 )

0 1 2
D T (1 + g2 )
T 1
D1 (1 + g1 ) = D1 (1 + g1 )T 1 (1 + g2 )

T T+1
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 Case 3: Differential Growth
We can value this as the sum of:
an T-year annuity growing at rate g1
D1 1 + g1
T

1
R g1 1 + R

present value of a perpetuity growing at rate g2 that

starts in year T+1
D T +1

R g2
(1 + R)T

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 A Differential Growth Example
A stock will pay a dividend of $2 a year from
today. The dividend is expected to grow at
8% for 2 years (after year 1), then it will
grow at 4% in perpetuity.

What is the stock worth? The discount rate

is 12%.

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 With Cash Flows
2 2
2 2(1.08) 1 2(1.08) 2(1.08) (1.04)

0 1 2 3 4
2.43
2 2.16 2.333 + Constant growth phase
0.12 0.04 beginning in year 4 is a
growing perpetuity
0 1 2 3 D4 = 2.333 x 1.04 = 2.43
D5 = 2.333 x 1.042
2 2.16 2.333 30.375
P0 = + 2
+ 3
+ 3
= 26.8 D6 = 2.333 x 1.043 ...
1.12 (1.12) (1.12) (1.12)

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 With the Formula

2(1.08)2 (1.04)

2 (1.08) 0.12 0.04
3
P0 = 1 3
+ 3
0.12 0.08 (1.12) (1.12)

30.326
P0 = 50 (1 0.89664) +
(1.12)3

P0 = 5.168 + 21.585 = 26.8

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 Estimates of Parameters
The value of a stock depends upon its growth
rate (g) and its discount rate (R)

Where does g come from?

g = Retention ratio Return on Equity (ROE)
g = (1 Payout) Return on Equity (ROE)

where Payout = DPS/EPS, Retention ratio (plowback) = 1 - Payout

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 Where does R come from?
Discount rate can be broken into two parts.
Dividend yield (D1 / P0)
Growth rate (in dividends)

D1 D1
P0 = R = +g
R g P0

Later, CAPM to estimate discount rate

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 Growth Opportunities
Growth opportunities are opportunities to
invest in positive NPV projects
Value of a firm can be the sum of the value of
a firm that pays out 100% of its earnings (EPS)
as dividends and the net present value of the
growth opportunities (NPVGO)
EPS1
P0 = + NPVGO
R

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 DGM and NPVGO
We have two ways to value a stock:
Dividend growth model (DGM)
Sum of its value as a cash cow plus the per share
value of its growth opportunities (NPVGO)

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 NPVGO Model: Example
Firm has EPS of $5 at the end of the first year, payout
ratio of 30%, discount rate of 16%, and ROE of 20%
Dividend year 1: D1 = 5 0.3 = 1.5
Growth rate in dividends: g = (1 0.3) 20% = 14%

From dividend growth model, stock value is:

D1 1.50
P0 = = = 75
R g 0.16 0.14

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 NPVGO Model: Example
First, we must calculate the value of the firm as a
cash cow
EPS1 5
P0 = = = 31.25
R 0.16
Second, we calculate the value of the growth
opportunities

EPS1 = 5 Retained EPS1 = 5 0.7 = 3.5

3.5 0.20
NPV1 = 3.5 + = 0.875
0.16

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 NPVGO Model: Example
EPS2 = 5 1.14 = 5.7 Retained EPS2 = 5.7 0.7 = 3.99
3.99 0.20
NPV2 = 3.99 + = 0.9975
0.16
NPV growths at 14% rate (0.9975/0.875 1)

NPV1 0.875 0.9975 0.875

NPVGO0 = = + + ... = = 43.75
R g 1.16 1.16 2
0.16 0.14

Finally, P0 = 31.25 + 43.75 = 75

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 Price-Earnings Ratio
Analysts frequently relate earnings per share to price
Price-earnings ratio is calculated as the current stock
price divided by next year (annual) EPS (i.e., number
of years to recover investment)
P0
P/E =
EPS1

Using constant dividend growth model:

D1 EPS1 Payout P0 Payout
P0 = = P /E = =
R g R g EPS1 R g

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 Price-Earnings Ratio
Increases with:
payout
growth
Decreases with:
discount rate (riskless interest rate + risk premium)
Compare P/E across firms to assess if:
stock is cheap - low P/E
stock is expensive - high P/E

but firms must be comparable in payout, growth and

risk (for example, firms in the same industry)

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Stock Quotes

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Dividends

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Price-Earnings Ratio

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