Chapter 8
Stock Valuation
Slides Prepared By:
Larbi Hammami
Desautels Faculty of
Management
McGill University
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Learning Objectives
• How stock prices depend on future dividends and
dividend growth. (L01)
• The characteristics of common and preferred
stocks. (L02)
• The different ways corporate directors are elected to
office. (L03)
• The stock market quotations and the basics of
market reporting. (L04)
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Chapter Outline
8.1 Common Stock Valuation
8.2 Common Stock Features
8.3 Preferred Stock Features
8.4 Stock Market Reporting
Summary and Conclusions
Appendix A
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8.1 Common Stock Valuation
Cash Flows for Shareholders
• 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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8.1 Common Stock Valuation
Example - One Period
• Suppose you are thinking of purchasing the stock of
Moore Oil, Inc. 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?
− Compute the PV of the expected cash flows
Price = (14 + 2)/(1.2) = $13.33
Or FV = 16; I/Y = 20; N = 1; CPT PV = –13.33
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8.1 Common Stock Valuation
Period Example - Two Period
• Now what if you decide to hold the stock for two
years? In addition to the $2 dividend in one year, you
expect a dividend of $2.10 in two years and a stock
price of $14.70 at the end of year 2.
Now how much would you be willing to pay now?
PV = $2/(1.2) + ($2.10 + $14.70)/(1.2)2 = $13.33
Or CF0 = 0; C01 = 2; F01 = 1; C02 = 16.80; F02 = 1;
NPV; I = 20; CPT NPV = 13.33
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8.1 Common Stock Valuation
Example - Three Period
• 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 3 and a stock price of
$15.435.
Now how much would you be willing to pay?
PV = $2/1.2 + $2.10/(1.2)2 + ($2.205 $15.435)/(1.2)3
= $13.33
Or CF0 = 0; C01 = 2; F01 = 1; C02 = 2.10; F02 = 1;
C03 = 17.64; F03 = 1; NPV; I = 20; CPT NPV = 13.33
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8.1 Common Stock Valuation
Developing The Model
• You could continue to push back the date 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
dividends.
• So, how can we estimate all future dividend
payments?
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8.1 Common Stock Valuation
Estimating Dividends: Special Cases
• Constant dividend
− The firm will pay a constant dividend forever.
− This is like preferred stock.
− The price is computed using the perpetuity formula.
• Constant dividend growth
− The firm will increase the dividend by a constant
percent every period.
• Supernormal growth
− Dividend growth is not consistent initially, but settles
down to constant growth eventually.
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8.1 Common Stock Valuation
Zero Growth
• 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 = $0.50/(0.1/4) = $20
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8.1 Common Stock Valuation
Constant Dividend Growth
• Dividends are expected to grow at a constant
percent per period
P0 = D1/(1+R) + D2/(1+R)2 + D3/(1+R)3 + …
P0 = D0(1+g)/(1+R) + D0(1+g)2/(1+R)2
+ D0(1+g)3/(1+R)3 + …
• With a little algebra, this reduces to
D0 (1 + g) D1
P0 = =
R−g R−g
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8.1 Common Stock Valuation
Example - Constant Dividend Growth
• Suppose Big D, Inc. just paid a dividend of $0.50. 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 = [$0.50 × (1+.02)]/(0.15 - 0.02) = $3.92
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8.1 Common Stock Valuation
Example - Constant Dividend Growth
• Suppose TB Pirates, Inc. 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/(0.2 – 0.05) = $13.33
− Why isn’t the $2 in the numerator multiplied by
(1.05) in this example?
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8.1 Common Stock Valuation
Stock Price Sensitivity to Dividend Growth, g
D1==20%
D1 = $2; R $2; R = 20%
250
200
Stock Price
150
100
250
200
St ock Pri ce
150
100
50
0 0. 05 0. 1 0. 15 0. 2
G rowt h Rat e
50
0
0 0.05 0.1 0.15 0.2
Growth Rate
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8.1 Common Stock Valuation
Stock Price Sensitivity to Required Return, R
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
Required Return
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8.1 Common Stock Valuation
Example - Constant Dividend Growth
• Gordon Growth Company is expected to pay a
dividend of $4 next period and dividends are
expected to grow at 6% per year. The required
return is 16%.
What is the current price?
P0 = $4/(0.16 – 0.06) = $40
− Remember that we already have the dividend
expected next year, so we don’t multiply the
dividend by (1+g).
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8.1 Common Stock Valuation
Example - Constant Dividend Growth (cont.)
• What is the price expected to be in year 4?
P4 = D4(1 + g)/(R – g) = D5/R – g)
P4 = [$4 × (1+0.06)4]/(0.16 – 0.06) = $50.50
• What is the implied return given the change in price
during the four-year period?
$50.50 = $40(1+return)4; return = 6%
Or PV = –40; FV = 50.50; N = 4; CPT I/Y = 6%
=> The price grows at the same rate as the dividends.
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8.1 Common Stock Valuation
Example - Nonconstant Dividend Growth
• Suppose a firm is expected to increase dividends by
20% in one year and by 15% in two years. After that
dividends will increase at a rate of 5% per year
indefinitely.
If the last dividend was $1 and the required return is
20%, what is the price of the stock?
• Remember that we have to find the PV of all
expected future dividends.
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8.1 Common Stock Valuation
Example - Nonconstant Dividend Growth (cont.)
• Compute the dividends until growth levels off
D1 = $1 × (1.2) = $1.20
D2 = $1.20 × (1.15) = $1.38
D3 = $1.38 × (1.05) = $1.449
• Find the expected future price
P2 = D3/(R – g) = $1.449/(0.2 – 0.05) = $9.66
• Find the present value of the expected future cash
flows
P0 = $1.20/(1.2) + ($1.38 + $9.66)/(1.2)2 = $8.67
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8.1 Common Stock Valuation
Quick Quiz - Part I
• What is the value of a stock that is expected to pay a
constant dividend of $2 per year if the required
return is 15%?
• What if the company starts increasing dividends by
3% per year, beginning with the next dividend?
Assume that the required return stays at 15%.
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8.1 Common Stock Valuation
Using the Constant Dividend Growth Model to Find R
• Start with the constant Dividend Growth Model
D0 (1 + g) D1
P0 = =
R−g R−g
rearrange and solve for R
D0 (1 + g) D1
R = +g = +g
P0 P0
• This shows the components of the required return.
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8.1 Common Stock Valuation
Example - Finding the Required Return
• 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 + 0.05 = 15%
• What is the dividend yield?
[$1 × (1.05)]/$10.50 = 10%
• What is the capital gains yield?
g =5%
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8.1 Common Stock Valuation
Table 8.1 - Summary of stock valuation
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8.1 Common Stock Valuation
Table 8.1 - Summary of stock valuation (cont.)
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8.1 Common Stock Valuation
Table 8.1 - Summary of stock valuation (cont.)
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8.2 Common Stock Features
• Shareholders’ Rights
• Other Rights
− Share proportionally in declared dividends
− Share proportionally in remaining assets during
liquidation
− Preemptive right - first shot at new stock issue to
maintain proportional ownership if desired
• Classes of stock
− Unequal voting rights
− Control of firm
− Coattail provision
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8.2 Common Stock Features
Dividend Characteristics
• Dividends are not a liability of the firm until a dividend has
been declared by the Board.
• Consequently, a firm cannot go bankrupt for not declaring
dividends.
• Dividends and Taxes
− Dividend payments are not considered a business
expense and are not tax deductible.
− Dividends received by individual shareholders are
partially sheltered by the dividend tax credit.
− Dividends received by corporate shareholders are not
taxed.
− This prevents double taxation of dividends.
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8.3 Preferred Stock Features
• Dividends
− Most preferreds have a stated dividend that must
be paid before common dividends can be paid.
− 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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8.4 Stock Market Reporting
• Stock market quotations are published in the
newspapers and are also available on-line (usually
with a 15-minute delays during trading hours)
• In Canada, large cap stocks trade on the TSX
• Quotes and corporate information on stocks that
trade on the TSX can be found at the exchange’s
website
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8.4 Stock Market Reporting
Work the Web Example
• Information on a large number of stocks in several
different markets can also be found at the Globe &
Mail website.
• Also, publicly traded companies usually have an
investor relations section on their web pages.
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8.4 Stock Market Reporting
Quick Quiz - Part II
• You observe a stock price of $18.75. You expect a
dividend growth rate of 5% and the most recent
dividend was $1.50.
What is the required return?
• What are some of the major characteristics of
common stock?
• What are some of the major characteristics of
preferred stock?
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Summary and Conclusions
• You should know:
− The price of a stock is the present value of all
future expected dividends.
− There are three approaches to valuing the
stock price, depending on the growth rate(s)
of the dividends.
− The rights of common and preferred
shareholders.
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Appendix 8A
Corporate Voting
• Cumulative Voting
− Designed for minority shareholders.
− Directors are elected all at once.
− A shareholder may cast all votes for one member
of the board of directors.
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Appendix 8A
Corporate Voting (cont.)
• Straight Voting
− Directors are elected one at a time.
− Majority shareholders can control the board.
• Proxy Voting
− Shareholder grants someone else authority to
vote on their behalf.
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