Stocks and Stock Valuation

Chapter 7
Stocks and
Stock Valuation
Learning Objectives
1. Explain the basic characteristics of common

stock.
2. Define the primary market and the secondary
market.
3. Calculate the value of a stock given a history of
dividend payments.
4. Explain the shortcomings of the dividend pricing
models.
5. Calculate the price of preferred stock.
6. Understand the concept of efficient markets.
Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-2

7.1 Characteristics of Common
Stock
• Major financing vehicle for corporations

• Provides holders with an opportunity to
share in the future cash flows of the issuer.
• Holders have ownership in the company.
• Unlike bonds, no maturity date and
variable periodic income.

7.1 (A) Ownership
• Share in the residual profits of the company.

• Claim to all its assets and cash flow once
the creditors, employees, suppliers, and
taxes are paid off.
• Voting rights
– participate in the management of the company
– elect the board of directors which selects the
management team that runs the company’s day-
to-day operations.

7.1 (B) Claim on Assets and
Cash Flow (Residual Claim)
• In case of liquidation…
Shareholders have a claim on the residual assets
and cash flow of the company.
Known as “residual” rights.

7.1 (C) Vote (Voice in
Management)
• Standard voting rights: Typically, one vote

per share provided to shareholders to vote
in board elections and other key changes to
the charter and bylaws.
• Can be altered by issuing several classes of
stock.
– Non-voting stock, which is usually for a
temporary period of time,
– Super voting rights, which provide the holders
with multiple votes per share, increasing their
influence and control over the company.

7.1 (D) No Maturity Date
• Considered to be permanent financing

• Infinite life, i.e. no maturity date
• No promised date when investment is
returned.

7.1 (E) Dividends and Their Tax
Effect
• Companies pay cash dividends periodically (usually every
quarter) to their shareholders out of net income.
• Unlike coupon interest paid on bonds, dividends cannot be
treated as a tax-deductible expense by the company.
• For the recipient, however, dividends are considered to be
taxable income.
• More material on dividends and dividend policy is covered in
Chapter 17.

7.1 (F) Authorized, Issued, and
Outstanding Shares
Authorized shares:maximum number of shares that

the company may sell, as per
charter.
Issued shares: the number of shares that has

already been sold by the company
and are either currently available
for public trading (outstanding
shares) or held by the company
for future uses such as rewarding
employees (treasury stock).

7.1 (G) Treasury Stock
• Non-dividend paying, non-voting shares

being held by the issuing firm right from the
time they were first issued
OR
• Shares that have been later repurchased by
the issuing firm in the market.

7.1 (H) Preemptive Rights
• Privileges that allow current shareholders to

buy a fixed percentage of all future issues
before they are offered to the general
public.
• Enables current common stockholders to
maintain their proportional ownership in the
company.

7.2 Stock Markets
Stocks are traded in two types of markets:

1. primary or “first sale” market
2. secondary or “after-sale” market

7.2 (A) Primary Markets
First issue market where issuing

firm is involved.
• Initial public offering (IPO)

• Prospectus
• Due diligence
• Firm commitment
• Best efforts

7.2 (B) Secondary Markets:
How Stocks Trade
• Forum where common stock can be traded among

investors themselves.
• Provides liquidity and variety.
• In the United States, 3 well-known secondary stock
markets:
• NYSE
• AMEX
• NASDAQ
Specialist
Ask price
Bid price
Bid-ask spread

7.2 (C) Bull Markets and Bear
Markets
• A Bull market: prolonged rising stock

market, coined on the analogy that a bull
attacks with his horns from the bottom up.
• A Bear market: prolonged declining market,

based on the analogy that a bear swipes
with his paws from the top down.

7.3 Stock Valuation
• Value of a share of stock the present

value of its expected future cash flow…
– Cash dividends paid (if any).
– Future selling price of the stock.
– The discount rate i.e. risk-appropriate rate of
return to be earned on the investment.
• No guaranteed cash flow information.
• No maturity date.
• Valuation is more of an “art” than a science.

7.3 Stock Valuation (continued)
Table 7.1 Differences between Bonds and

Stocks

Example 1: Stock price with known

dividends and sale price.
Agnes wants to purchase common stock of New

Frontier Inc. and hold it for 4 years. The
directors of the company just announced that
they expect to pay an annual cash dividend of
$4.00 per share for the next 5 years. Agnes
believes that she will be able to sell the stock
for $40 at the end of four years. In order to
earn 12% on this investment, how much should
Agnes pay for this stock?

Example 1 Answer
 1 
 1 
Price = Future Price 
1
 Dividend Stream   1  r n

1 r n  r 
 
 
 1 
 1  
1  1 0.124 
Price = $40.00  $4.00   
1 0.124

0.12

 
 
Price = $40.00 x 0.635518 + $4.00 x 3.03734

Price = $25.42 + $12.149 = $37.57

Example 1 Answer (continued)

Method 2. Using a financial calculator
Mode: P/Y=1; C/Y = 1
Input: N I/Y PV PMT FV

Key: 4 12 ? 4 40
Output -37.57

4 variations of a dividend pricing model have

been used to value common stock
1. The constant dividend model with an infinite

horizon
2. The constant dividend model with a finite
horizon
3. The constant growth dividend model with a
finite horizon
4. The constant growth dividend model with an
infinite horizon

7.3 (A) The Constant Dividend
Model with an Infinite Horizon
Assumes that the firm is paying the same dividend
amount in perpetuity.
i.e. Div1 = Div2 = Div3 = Div4 = Div5 = Div∞
For perpetuities,
PV = PMT/r
where r the required rate and PMT is the cash flow.
Thus, for a stock that is expected to pay the same

dividend forever,
Price = Dividend/Required rate of return

7.3 (A) The Constant Dividend Model
with an Infinite Horizon (continued)
Example 2. Quarterly dividends forever
Let’s say that the Peak Growth Company is paying a

quarterly dividend of $0.50 and has decided to pay the
same amount forever. If Joe wants to earn an annual
rate of return of 12% on this investment, how much
should he offer to buy the stock at?
Answer
Quarterly dividend = $0.50
Quarterly rate of return = Annual rate/4= 12%/4 = 3%
PV = Quarterly dividend/Quarterly rate of return
Price = 0.50/.03 = $16.67

7.3 (B) The Constant Dividend
Model with a Finite Horizon
• Assumes that the stock is held for a finite period of time
and then sold to another investor.
• Constant dividends received over the investment
horizon.
• Price estimated as the sum of the present value of an
annuity (constant dividend) and that of a single sum
(the selling price).
• Similar to a typical non-zero coupon, corporate bond.
• Have to estimate the future selling price, since that is
not a given value, unlike the par value of a bond

7.3 (B) The Constant Dividend Model
with a Finite Horizon (continued)
Example 3. Constant dividends with finite

holding period.
Let’s say that the Peak Growth Company is
paying an annual dividend of $2.00 and has
decided to pay the same amount forever.
Joe wants to earn an annual rate of return of
12% on this investment, and plans to hold the
stock for 5 years, with the expectation of selling
it for $20 at the end of 5 years.
How much should he offer to buy the stock at?

7.3 (B) The Constant Dividend Model
with a Finite Horizon (continued)
Example 3 Answer
Annual dividend = $2.00 = PMT
Selling Price = $20 = FV
Annual rate of return = 12%
PV = PV of dividend stream over 5 years + PV of Year 5
price

Key: 5 12 ? 2 20
Output -18.56

7.3 (C) The Constant Growth Dividend
Model with an Infinite Horizon
Known as the Gordon model (after its

developer, Myron Gordon).
Estimate is based on the discounted value of
an infinite stream of future dividends that
grow at a constant rate, g.

Div  1 g Div 1 g Div 1 g Div 1 g
1 2 3
Price  0  0  0  0

0
1 r 1
1 r 2
1 r 3 1  r 
where r is the required rate of return

Model with an Infinite Horizon (cont’d)
• With some algebra, this can be simplified

to….
Div  1 g
Price  0
0 r  g
• And since Div0 x (1+g) = Div1
Div
Price  1
0 r  g
• Or more generally Pn = Divn+1/(r-g)

Example 4: Constant growth rate, infinite

horizon (with growth rate given).
Let’s say that the Peak Growth Company just paid
its shareholders an annual dividend of $2.00 and
has announced that the dividends would grow at an
annual rate of 8% forever. If investors expect to
earn an annual rate of return of 12% on this
investment how much would they offer to buy the
stock for?

Example 4 Answer
Div0 = $2.00; g=8%; r=12%

Div1=Div0*(1+g)
Div1=$2.00*(1.08)Div1=$2.16
P0 = Div1/(r-g)$2.16/(.12 - .08)$54
Price0 = $54
Note: r and g must be in decimals.

EXAMPLE 5: Constant growth rate, infinite

horizon (with growth rate estimated from past
history).
Let’s say that you are considering an investment in
the common stock of QuickFix Enterprises and are
convinced that its last paid dividend of $1.25 will
grow at its historical average growth rate from here
on. Using the past 10 years of dividend history and
a required rate of return of 14%, calculate the price
of QuickFix’s common stock.

QuickFix Enterprises’ Annual Dividends

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
$0.50 $0.55 $0.61 $0.67 $0.73 $0.81 $0.89 $0.98 $1.08 $1.25
Required rate of return = 14%

Compound growth rate “g” = (FV/PV)1/n -1
Where FV = $1.25; PV = 0.50; n = 9
g = (1.25/0.50)1/9 – 1 10.72%
Div1 = Div0(1+g)$1.25*(1.1072)$1.384
P0 = Div1/(r-g)  $1.384/(.14-.1072)$42.19

7.3 (D) The Constant Growth
Dividend Model with a Finite Horizon
Investor expects to hold a stock for a limited number of years,
Company’s dividends are growing at a constant rate.
Following formula is used to value the stock…
Div  1 g   1 g n  Pricen

Price  0  1   +
0 r  g   1 r  

1 r n

Note: This formula would lead to the same  as the Gordon model, if it is
price estimate
assumed that the growth rate of dividends and the required rate of return of the next owner,
(after n years) remain the same.

7.3 (D) The Constant Growth Dividend
Model with a Finite Horizon (continued)
Example 6: Constant growth, finite horizon.

The QuickFix Company just paid a dividend of
$1.25 and analysts expect the dividend to grow at
its compound average growth rate of 10.72%
forever.
If you plan on holding the stock for just 7 years,
and you have an expected rate of return of 14%,
how much would you pay for the stock?
Assume that the next owner also expects to earn
14% on his or her investment.

Example 6 Answer
We can solve this in 2 ways.
Method 1: Use the constant growth, finite
horizon formula
Method 2: Use the Gordon Model since g is

constant forever, and both investors have
the same required rates of return


Method 1 Use the following equation:
Div  1 g   1 g n 
Price  0  1    + Price
0 r  g   1 r 
 
n
  1 r n
Price in year 7 = Div8/(r-g)

Div0 = $1.25; g =10.72%; r=14%;  Div8 = D0(1+g)8
Div81.25*(1.1072)8 = 2.25844
P7=2.25844/(.14-.1072)$86.07
1.25  1.1072    1.1072   86 .07

7
Price 0   1   +
.14  .1072    1.14   1.14 7

 = $42.195 *0.184829 + 34.40 = $42.19


Method 2: Use the Gordon Model
P0 = D0(1+g)/(r-g)
P0 = $1.25*(1.1072)/(.14-.1072)
P0 = $42.19

7.3 (E) Non-constant Growth
Dividends
• The above 4 models work if a firm is either
expected to pay a constant dividend amount
indefinitely, or is expected to have its dividends
grow at a constant rate for long periods of time.
• For most firms, the dividend growth patterns of
most firms tend to be variable, making the
valuation process complicated.
• However, if we can assume that at some point in
the future, the dividend growth rate will become
constant, we can use a combination of the Gordon
Model and present value equations to calculate the
price of the stock.

Dividends (continued)
Example 7: Non-constant dividend pattern
The Rapid Growth Company is expected to pay a
dividend of $1.00 at the end of this year.
Thereafter, the dividends are expected to grow at
the rate of 25% per year for 2 years, and then drop
to 18% for 1 year, before settling at the industry
average growth rate of 10% indefinitely.
If you require a return of 16% to invest in a stock
of this risk level, how much would you be justified
in paying for this stock?
D1=$1.00; g1=25%; n1=2; g2=18%; n2=1; gc=10%;
r=16%

Example 7 Answer
Step 1. Calculate the annual dividends expected
in Years 1-4, using the appropriate growth rates.
D1=$1.00; D2=$1.00*(1.25)=$1.25;
D3=$1.25*(1.25) = $1.56; D4=$1.56*(1.18) = $1.84;
Step 2. Calculate the price at the start of the constant
growth phase using the Gordon model.
P4 = D4*(1+g)/(r-g) = $1.84*(1.10)/(.16-.10)
= $2.02/.06 = $33.73

Step 3. Discount the annual dividends in Years 1-4 and the Price
at the end of Year 4, back to Year 0 using the required rate of
return as the discount rate, and add them up to solve for the
current price.
P0 = $1.00/(1.16) +
1.25/(1.16)2+$1.56/(1.16)3+$1.84/(1.16)4+$33.73/(1.16)4
P0 = $$0.862+0.928+$.999+$1.016+$18.63 = $22.44
Note: This uneven cash flow stream can also be discounted by

using the NPV function of the financial calculator….
CF0=0;CF1=1.00;CF2=1.25;CF3=1.56;CF4=1.84+33.73;I=16%;
NPV=$22.44

7.4 Dividend Model
Shortcomings
• Need future cash flow estimates and a required rate of return,
therefore difficult to apply universally.
– Erratic dividend patterns,
– Long periods of no dividends,
– Declining dividend trends
• Need a pricing model that is more inclusive than the dividend
model, one that can estimate expected returns for stocks
without the need for a stable dividend history.
• The capital asset pricing model (CAPM), or the security market
line (SML), which will be covered in Chapter 8, is one option.
• SML can be used to estimate expected returns for companies
based on their risk, the premium for taking on risk, and the
reward for waiting and not on their historical dividend
patterns.

7.5 Preferred Stock
Pays constant dividend as long as the stock is outstanding.
Typically has infinite maturity, but some are convertible into

common stock at some pre-determined ratio.
Have “preferred status” over common stockholders in the case

of dividend payments and liquidation payouts.
Dividends can be cumulative or non-cumulative
To calculate the price of preferred stock, we use the PV of a

perpetuity equation, i.e. Price0 = PMT/r
PMT = Annual dividend (dividend rate * par value); and

r = investor’s required rate of return.

7.5 Preferred Stock (continued)
Example 8: Pricing preferred stock.
The Mid-American Utility Company’s preferred

stock pays an annual dividend of 8% per year
on its par value of $60. If you want to earn
10% on your investment how much should you
offer for this preferred stock?
Answer
Annual dividend = .08*$60 = $4.80
Price = $4.80/0.10 = $48

7.6 Efficient Markets
Market in which security prices are current

and fair to all traders.
Transactions costs are minimal.
There are two forms of efficiency:
1. Operational efficiency and
2. Informational efficiency.

7.6 (A) Operational Efficiency
• Speed and accuracy with which trades are

processed.
• Ease with which the investing public can
access the best available prices.
– The NYSE’s SuperDOT computer system,
– NASDAQ’s SOES
• Match buyers and sellers very efficiently and
at the best available price.
• Therefore definitely very operationally
efficient markets.

7.6 (B) Informational Efficiency
• Speed and accuracy with which information is

reflected in the available prices for trading.
• Securities would always trade at their fair or
equilibrium value.
– Diverse information -- financial economists have
come up with three versions of efficient markets from
an information perspective:
– weak form,
– semi-strong form,
– strong form.
• These three forms make up what is known as
the efficient market hypothesis (EMH).

7.6 (B) Informational Efficiency
(continued)
• Weak-form efficient markets :

– Current prices reflect past prices and trading volume.
– Technical analysis – not useful
• Semi-strong-form efficient markets:
– Current prices reflect price and volume information and all
available relevant public information as well.
– Publicly available news or financial statement information not
very useful.
• Strong-form efficient markets:
– Current prices reflect price and volume history of the stock,
all publicly available information, and even all private
information.
– All information is already embedded in the price--no
advantage to using insider information to routinely
outperform the market.
• Jury is still out, evidence is not conclusive!

Additional Problems with Answers
Problem 1
Pricing constant growth stock, with finite
horizon: The Crescent Corporation just paid a
dividend of $2.00 per share and is expected to
continue paying the same amount each year for the
next 4 years.
If you have a required rate of return of 13%, plan
to hold the stock for 4 years, and are confident that
it will sell for $30 at the end of 4 years,
How much should you offer to buy it at today?

Problem 1 (Answer)
In this case, we have an annuity of $2 for 4

periods, followed by a lump sum of $30, to be
discounted at 13% for the respective number
of years.
Using a financial calculator

Key: 4 13 ? 2 30
Output -24.35

Problem 2
Constant growth rate, infinite horizon

(with growth rate estimated from past
history: Using the historical dividend
information provided below to calculate the
constant growth rate, and a required rate of
return of 18%, estimate the price of Nigel
Enterprises’ common stock.
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
$0.35 $0.45 $0.51 $0.65 $0.75 $0.88 $0.99 $1.10 $1.13 $1.30

Problem 2 (Answer)
First, estimate the historical average

growth rate of dividends by using the
following equation:
g = [(FV/PV)1/n – 1]
Where FV = Div2014 = $1.30

PV = Div2005 = $0.35
n = number of years in between =9
g = [(1.30/0.35)1/9 – 1]
 15.7%

Problem 2 (Answer) (continued)
Next, use the constant growth, infinite horizon

model to calculate price:
i.e. Price0 = Div0(1+g)/(r-g)
Div0 = Div2014= $1.30;
Div1= Div0*(1+g) =$1.30*(1.157)$1.504;
r = 18%; g = 15.7% (as calculated above)
Price0 = $1.504/(.18-.157)
Price0 = $65.40

Problem 3
Pricing common stock with multiple dividend

patterns: The Wonder Products Company is
expanding fast and therefore will not pay any
dividends for the next 3 years.
After that, starting at the end of year 4, it will pay a
dividend of $0.75 per share to its common
shareholders and increase it by 12% each year until
it pays $1.50 at the end of year 10.
After that it will pay $1.50 per year forever. If an
investor wants to earn 15% per year on this
investment, how much should he pay for the stock?

Problem 3 (Answer)
First lay out the dividends on a time line.

Expected Dividend Stream of The Wonder Products Co.
T0 T1 T2 T3 T4 T5 T6 T7 T8 T9 T10
… T∞
--- $0.00 $0.00 $0.00 $0.75 $0.84 $0.94 $1.05 $1.18 $1.32
$1.50 …$1.50
Note: There are 3 distinct dividend payment

patterns Years 1-3, no dividends; Years 4-
10, dividends grow at 12%; Years 11
onwards, zero-growth in dividends.

Next, Calculate the price at the end of Year

10, i.e. when the dividend growth rate is
zero.
Price10 = Div11/r = 1.50/.15 = $10;
Using the NPV function and the annual

cash flows calculate the price;
NPV(15,0,{0.00,0.00,0.00,0.75,0.84,0.94,1.0
5,1.18,1.32,1.50+10.00} $5.25
Price = $5.25

Problem 4
Pricing non-constant growth common stock: The

WedLink Corporation just paid a dividend of $1.25 to
its common shareholders.
It announced that it expects the dividends to grow by
25% per year for the next 3 years.
Then drop to a growth rate of 16% for an additional 2
years.
Finally the dividends will converge to the industry
median growth rate of 8% per year.
If investors are expecting 12% per year on WedLink’s
stock, calculate the current stock price.

Problem 4 (Answer)
Determine the dividend per share in Years 1-5

using the stated annual growth rates:
D1=$1.25*(1.25)=$1.56;
D2=$1.56*(1.25)=$1.95;
D3=1.95*(1.25)=$2.44;
D4=$2.44*(1.16)=$2.83;
D5=$2.83*(1.16)=3.28
Next, Calculate the price at the end of Year 5;
using the Gordon Model.

Using r = 12% and g = 8% (constant

growth phase)
i.e. P5 = D5(1+g)/(r – g)
P5 = $3.28*(1.08)/(.12-.08)
3.54/.04=$88.56
Finally calculate the present value of all
the dividends in Years 1-5 and the price in
Year 5, by using the NPV function….(TI-83
keystrokes shown here)
NPV(12,0,{1.56, 1.95, 2.44, 2.83,
3.28+88.56} = $58.60

Problem 5 (A)
Pricing common stock with constant

growth and finite life versus infinite life.
The ANZAC Corporation plans to be in business
for 30 years.
They announce that they will pay a dividend of
$3.00 per share at the end of one year, and
continue increasing the annual dividend by 4%
per year until they liquidate the company at the
end of 30 years.
If you want to earn a rate of return of 12% by
investing in their stock, how much should you
pay for the stock?

Problem 5 (A) (Answer)
Div1 = $3.00; r = 12%; g = 4%; n = 30

Using the formula for a growing annuity we
can solve for the current price.
Div   1 g  30 
Price  1  1   
0 r  g   1 r  
 
 
$3.00   1.04 30 
Price0   1   
.12  .04   1.12  
Price0 = $37.5*0.89174 = $33.44

Problem 5 (B)
If the company was to announce that it

would continue increasing the dividend at
4% per year forever, how much more would
you be willing to pay for its stock, assuming
your required rate of return is still 12%?

Problem 5 (B) (Answer)
If the growth rate is 4% forever, the

price of the stock can be figured out by
using the Gordon Model:
D1=$3.00; r=12%
Div
Price  1
0 r  g
 $3.00/(.12 - .04) $37.50

Table 7.2 Coca-Cola Annual
Dividends

Table 7.3 Annual Dividend Growth for
Coca- Cola

Table 7.4 Recent Dividend
History of Five Firms

Table 7.5 Ranking of Stock Risk
Levels Based on Expected Returns

Table 7.6 Recent Annual
Dividends of Five Other Firms

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Chapter 7

1. Explain the basic characteristics of common

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-2

• Major financing vehicle for corporations

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-3

• Share in the residual profits of the company.

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• Standard voting rights: Typically, one vote

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• Considered to be permanent financing

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Authorized shares:maximum number of shares that

Issued shares: the number of shares that has

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• Non-dividend paying, non-voting shares

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• Privileges that allow current shareholders to

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Stocks are traded in two types of markets:

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First issue market where issuing

• Initial public offering (IPO)

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• Forum where common stock can be traded among

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• A Bull market: prolonged rising stock

• A Bear market: prolonged declining market,

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• Value of a share of stock the present

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Table 7.1 Differences between Bonds and

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Example 1: Stock price with known

Agnes wants to purchase common stock of New

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Price = $40.00 x 0.635518 + $4.00 x 3.03734

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Example 1 Answer (continued)

Mode: P/Y=1; C/Y = 1

Input: N I/Y PV PMT FV

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4 variations of a dividend pricing model have

1. The constant dividend model with an infinite

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Thus, for a stock that is expected to pay the same

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Example 2. Quarterly dividends forever

Let’s say that the Peak Growth Company is paying a

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Example 3. Constant dividends with finite

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Mode: P/Y=1; C/Y = 1

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Known as the Gordon model (after its

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• With some algebra, this can be simplified

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Example 4: Constant growth rate, infinite

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Div0 = $2.00; g=8%; r=12%