Stock valuation

Types of stock
How shares are sold
Stock Valuation Techniques

Types of stock
Common stock
provides the permanent long-term financing of a firm
represents the true residual ownership of a firm
carries the right to vote on corporate policy and the
composition of the board of directors

Preferred stock
carries no voting rights
has preference over common stock in the payment of
dividends and claims on assets
usually has a fixed dividend.

Cash flows to 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

The price of the stock is the present

value of these expected cash flows.

One period example

Suppose you are thinking of purchasing the stock of
Union Capital Limited. You expect it to pay a 20 Taka
dividend in one year, and you believe that you can
sell the stock for 140 Taka 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?
Compute the PV of the expected cash flows
Price = (140 + 20) / (1.2) = Taka 133.33

Two period example

Now, what if you decide to hold the stock for two
years? In addition to the 20 Taka dividend in one
year, you expect a dividend of 21 Taka and a stock
price of 147 Taka both at the end of year 2. Now how
much would you be willing to pay?
Compute the PV of the expected cash flows
Price = 20 / (1.2) + (21 + 147) / (1.2)2 = Taka 133.33

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
Taka 22.05 and a stock price of Taka 154.35 both at the
end of year 3. Now how much would you be willing
to pay?
Compute the PV of the expected cash flows
Price = 20/ 1.2 + 21 / (1.2)2 + (22.05 + 154.35) / (1.2)3
= Taka 133.33

Developing the model

You could continue to push back when you would
sell the stock
You would find that the price of the stock is really
just the present value of all expected future dividend
payments
So, how can we estimate all future dividend
payments?

Constant dividend/zero growth

If dividends are expected at regular intervals
forever, then this is valued as a perpetuity.
P0 = D / R
A stock pays 50 Taka dividend every quarter. The
required rate of return is 10% with quarterly
compounding. What is the price?
P0 = 50 / (0.10/4)
= 50 / 0.025
= 2000 Taka

Valuation of Preferred stock

Most preferred stock pays a fixed dividend at regular intervals.
It has no stated maturity date and given the fixed nature of its
payments, is similar to a perpetual bond. Thud the present value
of preferred stock is
P0 = DivP / kP
If Khan Plc had a 9%, $100 face value preferred stock and the
required rate of return is 14%, then calculate the value of this
stock.
P0 = $9 / 0.14
= $64.29

Dividend growth model

If dividends are expected to grow at a constant
percent per period, then this is valued as follows.
P0
= D0 (1+g) / (R-g)
Suppose CS Capital just paid a dividend of 50 Taka.
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+0.02) / (0.15 0.02)
= 392 Taka

Dividend growth model

If dividends are expected to grow at a constant
percent per period, then this is valued as follows.
P0
= D1 / (R-g)
Suppose CS Capital is expected to pay a 20 Taka
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 = 20 / (0.20 0.05)
= 133 Taka

Finding the required return

You can use the DGM to find the value of R.
R
= (D1 / P0) + g
Suppose a firms stock is selling for 105 Taka. It just
paid a 10 Taka dividend and dividends are expected
to grow at 5% per year. What is the required return?
R

= [10*(1.05) / 105] + 0.05

= 15%

Dividend yield, cap gains yield

You can use the DGM to find the value of R.
R
= (D1 / P0) + g
(D1 / P0) is known as the dividend yield.
g is the capital gains yield.
In the last example:
R

= [10*(1.05) / 105] + 0.05

= 15%
Dividend yield
= 10 *1.05 / 105 = 10%
Capital gains yield = 0.05
= 5%

Self-assessment problems
A stock currently sells for 500 Taka per share. The
next expected annual dividend is 20 Taka, and the
growth rate is 6%. What is the expected rate of return
on this stock?
If the required rate of return on this stock were 12%,
what would the stock price be, and what would the
dividend yield be?

Formula sheet

Growth Phases Model

The growth phases model assumes that dividends
for each share will grow at two or more different
growth rates.

V =

t=1

D0(1+g1)
(1 + ke)

Dn(1+g2)t

t=n+1

(1 + ke)

Growth Phases Model

Note that the second phase of the growth phases
model assumes that dividends will grow at a
constant rate g2. We can rewrite the formula as:

D0(1+g1)

t=1

(1 + ke)t

V =

Dn+1
+
(1 + ke)n (k - g2)
1

Growth Phases
Model Example
Stock GP has an expected growth rate of 16% for
the first 3 years and 8% thereafter. Each share of
stock just received an annual $3.24 dividend per
share. The appropriate discount rate is 15%.
What is the value of the common stock under this
scenario?

Growth Phases
Model Example
0

D1

D2

D3

D4

D5

D6

Growth of 16% for 3 years

Growth of 8% to infinity!

Stock GP has two phases of growth. The first, 16%, starts at

time t=0 for 3 years and is followed by 8% thereafter starting at
time t=3. We should view the time line as two separate time
lines in the valuation.

Growth Phases
Model Example
0

D1

D2

D3

Growth Phase
#1 plus the infinitely
long Phase #2

D4

D5

D6

Note that we can value Phase #2 using the Constant

Growth Model

Growth Phases
Model Example
Finally, we calculate the intrinsic value by summing
all the cash flow present values.
V = $3.27 + $3.30 + $3.33 + $51.32

V=

t=1

V = $61.22
1
t
D0(1+.16)

+
t

(1 + .15)

D4

(1+.15)n (.15-.08)