CHAPTER 8

Stocks and Their Valuation

 Features of common stock

 Determining common stock
values
 Efficient markets
 Preferred stock
8-1
Facts about common stock
 Represents ownership
 Ownership implies control
 Stockholders elect directors
 Directors elect management
 Management’s goal: Maximize the
stock price

8-2
Social/Ethical Question
 Should management be equally
concerned about employees,
customers, suppliers, and “the
public,” or just the stockholders?
 In an enterprise economy,
management should work for
stockholders subject to constraints
(environmental, fair hiring, etc.) and
competition.
8-3
Types of stock market
transactions
 Secondary market
 Primary market
 Initial public offering market
(“going public”)

8-4
Different approaches for
valuing common stock
 Dividend growth model
 Corporate value model
 Using the multiples of
comparable firms

8-5
 Dividend growth model
 Value of a stock is the present value of
the future dividends expected to be
generated by the stock.

^ D1 D2 D3 D∞
P0 = + + + ...+ ∞
(1+ ks ) (1+ ks ) (1+ ks )
1 2 3
(1+ ks )

8-6
Constant growth stock
 A stock whose dividends are expected
to grow forever at a constant rate, g.

D1 = D0 (1+g)1
D2 = D0 (1+g)2
Dt = D0 (1+g)t

 If g is constant, the dividend growth

formula converges to:
^ D0 (1 + g) D1
P0 = =
ks - g ks - g
8-7
 Future dividends and their
present values
$ Dt = D0 ( 1 + g ) t

Dt
0.25 PVDt =
(1+ k ) t

P0 = ∑ PVDt

0 Years (t)
8-8
What happens if g > ks?
 If g > ks, the constant growth
formula leads to a negative stock
price, which does not make sense.
 The constant growth model can
only be used if:
 ks > g
 g is expected to be constant forever

8-9
If kRF = 7%, kM = 12%, and β = 1.2,
what is the required rate of return
on the firm’s stock?
 Use the SML to calculate the
required rate of return (ks):

ks = kRF + (kM – kRF)β

= 7% + (12% - 7%)1.2
= 13%

8-10
 If D0 = $2 and g is a constant 6%,
find the expected dividend
stream for the next 3 years, and
their PVs.

0 1 2 3
g = 6%

D0 = 2.00 2.12 2.247 2.382

1.8761
ks = 13%
1.7599
1.6509

8-11
What is the stock’s market
value?
 Using the constant growth model:

D1 $2.12
P0 = =
ks - g 0.13- 0.06
$2.12
=
0.07
= $30.29

8-12
What is the expected market
price of the stock, one year
from now?
 D1 will have been paid out already.
So, P1 is the present value (as of
year 1) of D2, D3, D4, etc.
^
D2 $2.247
P1 = =
ks - g 0.13- 0.06
= $32.10

 Could also
^
find expected P1 as:
P1 = P0 (1.06)= $32.10
8-13
What is the expected dividend
yield, capital gains yield, and total
return during the first year?
 Dividend yield
= D1 / P0 = $2.12 / $30.29 = 7.0%
 Capital gains yield
= (P1 – P0) / P0
= ($32.10 - $30.29) / $30.29 = 6.0%
 Total return (ks)
= Dividend Yield + Capital Gains Yield
= 7.0% + 6.0% = 13.0%

8-14
What would the expected
price today be, if g = 0?
 The dividend stream would be a
perpetuity.

0 1 2 3
ks = 13%
...
2.00 2.00 2.00
^ PMT $2.00
P0 = = = $15.38
k 0.13

8-15
Supernormal growth:
What if g = 30% for 3 years before
achieving long-run growth of 6%?
 Can no longer use just the constant
growth model to find stock value.
 However, the growth does become
constant after 3 years.

8-16
 Valuing common stock with
nonconstant growth

0 k = 13% 1 2 3 4
s
...
g = 30% g = 30% g = 30% g = 6%
D0 = 2.00 2.600 3.380 4.394 4.658
2.301
2.647
3.045
4.658
46.114 P 3 = = $66.54
^ 0.13 − 0.06
54.107 = P0
8-17
Find expected dividend and capital
gains yields during the first and
fourth years.
 Dividend yield (first year)
= $2.60 / $54.11 = 4.81%
 Capital gains yield (first year)
= 13.00% - 4.81% = 8.19%
 During nonconstant growth, dividend
yield and capital gains yield are not
constant, and capital gains yield ≠ g.
 After t = 3, the stock has constant
growth and dividend yield = 7%, while
capital gains yield = 6%.
8-18
 Nonconstant growth:
What if g = 0% for 3 years before
long-run growth of 6%?

0 k = 13% 1 2 3 4
s
...
g = 0% g = 0% g = 0% g = 6%
D0 = 2.00 2.00 2.00 2.00 2.12
1.77
1.57
1.39
2.12
20.99 P 3 = = $30.29
^ 0.13 − 0.06
25.72 = P0
8-19
Find expected dividend and capital
gains yields during the first and
fourth years.
 Dividend yield (first year)
= $2.00 / $25.72 = 7.78%
 Capital gains yield (first year)
= 13.00% - 7.78% = 5.22%
 After t = 3, the stock has constant
growth and dividend yield = 7%,
while capital gains yield = 6%.

8-20
If the stock was expected to have
negative growth (g = -6%), would
anyone buy the stock, and what is its
value?
 The firm still has earnings and pays
dividends, even though they may be
declining, they still have value.

^ D1 D0 ( 1 + g )
P0 = =
ks - g ks - g
$2.00(0.94) $1.88
= = = $9.89
0.13- (-0.06) 0.19

8-21
Find expected annual dividend
and capital gains yields.
 Capital gains yield
= g = -6.00%
 Dividend yield
= 13.00% - (-6.00%) = 19.00%

 Since the stock is experiencing

constant growth, dividend yield and
capital gains yield are constant.
Dividend yield is sufficiently large
(19%) to offset a negative capital
gains. 8-22
Corporate value model
 Also called the free cash flow
method. Suggests the value of the
entire firm equals the present
value of the firm’s free cash flows.
 Remember, free cash flow is the
firm’s after-tax operating income
less the net capital investment
 FCF = NOPAT – Net capital investment
8-23
 Applying the corporate value
model
 Find the market value (MV) of the firm.
 Find PV of firm’s future FCFs
 Subtract MV of firm’s debt and preferred
stock to get MV of common stock.
 MV of = MV of – MV of debt and
common stock firm preferred
 Divide MV of common stock by the number
of shares outstanding to get intrinsic stock
price (value).
 P0 = MV of common stock / # of shares
8-24
Issues regarding the
corporate value model
 Often preferred to the dividend growth
model, especially when considering number
of firms that don’t pay dividends or when
dividends are hard to forecast.
 Similar to dividend growth model, assumes
at some point free cash flow will grow at a
constant rate.
 Terminal value (TVn) represents value of firm
at the point that growth becomes constant.

8-25
 Given the long-run gFCF = 6%, and
WACC of 10%, use the corporate
value model to find the firm’s
intrinsic value.

0 k = 10% 1 2 3 4
...
g = 6%
-5 10 20 21.20
-4.545
8.264
15.026 21.20
398.197 530 = = TV3
0.10 - 0.06
416.942

8-26
If the firm has $40 million in debt
and has 10 million shares of stock,
what is the firm’s intrinsic value per
share?
 MV of equity = MV of firm – MV of debt
= $416.94m - $40m
= $376.94 million
 Value per share = MV of equity / # of
shares
= $376.94m / 10m
= $37.69

8-27
Firm multiples method
 Analysts often use the following multiples
to value stocks.
 P/E
 P / CF
 P / Sales
 EXAMPLE: Based on comparable firms,
estimate the appropriate P/E. Multiply
this by expected earnings to back out an
estimate of the stock price.

8-28
What is market
equilibrium?
 In equilibrium, stock prices are stable
and there is no general tendency for
people to buy versus to sell.
 In equilibrium, expected returns must
equal required returns.
^
D1
ks = +g = ks = kRF + (kM − kRF )β
P0

8-29
Market equilibrium
 Expected returns are obtained by
estimating dividends and expected
capital gains.
 Required returns are obtained by
estimating risk and applying the
CAPM.

8-30
How is market equilibrium
established?
 If expected return exceeds
required return …
 The current price (P0) is “too low”
and offers a bargain.
 Buy orders will be greater than sell
orders.
 P0 will be bid up until expected
return equals required return
8-31
Factors that affect stock
price
 Required return (ks) could change
 Changing inflation could cause kRF to
change
 Market risk premium or exposure to
market risk (β) could change
 Growth rate (g) could change
 Due to economic (market) conditions
 Due to firm conditions
8-32
What is the Efficient Market
Hypothesis (EMH)?
 Securities are normally in
equilibrium and are “fairly priced.”
 Investors cannot “beat the market”
except through good luck or better
information.
 Levels of market efficiency
 Weak-form efficiency
 Semistrong-form efficiency
 Strong-form efficiency
8-33
Weak-form efficiency
 Can’t profit by looking at past
trends. A recent decline is no
reason to think stocks will go up
(or down) in the future.
 Evidence supports weak-form
EMH, but “technical analysis” is
still used.

8-34
Semistrong-form efficiency
 All publicly available information
is reflected in stock prices, so it
doesn’t pay to over analyze
annual reports looking for
undervalued stocks.
 Largely true, but superior
analysts can still profit by finding
and using new information
8-35
Strong-form efficiency
 All information, even inside
information, is embedded in
stock prices.
 Not true--insiders can gain by
trading on the basis of insider
information, but that’s illegal.

8-36
 Is the stock market
efficient?
 Empirical studies have been conducted to test the
three forms of efficiency. Most of which suggest
the stock market was:
 Highly efficient in the weak form.
 Reasonably efficient in the semistrong form.
 Not efficient in the strong form. Insiders could and did
make abnormal (and sometimes illegal) profits.
 Behavioral finance – incorporates elements of
cognitive psychology to better understand how
individuals and markets respond to different
situations.

8-37
Preferred stock
 Hybrid security
 Like bonds, preferred stockholders
receive a fixed dividend that must
be paid before dividends are paid
to common stockholders.
 However, companies can omit
preferred dividend payments
without fear of pushing the firm
into bankruptcy.
8-38
If preferred stock with an annual
dividend of $5 sells for $50, what is
the preferred stock’s expected
return?

Vp = D / kp
$50= $5 / kp

kp = $5 / $50
= 0.10 = 10%

8-39