Chapter Eight

Stock Valuation

Allen Zhu BFIN350 Advanced Corporate Finance 1

 You should know
1. The price of a stock is the
present value of all future
expected dividends
2. There are three approaches
to valuing the stock price,
depending on the growth
rate(s) of the dividends
3. The rights of common and
preferred shareholders

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 Chapter Outline
• Common Stock Valuation
• Common Stock Features
• Preferred Stock Features
• Stock Market Reporting
• Summary and Conclusions
• Appendix A – Corporate Voting

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 Key Concepts and Skills
• Understand how stock prices depend on
future dividends and dividend growth
• Understand the characteristics of
common and preferred stocks
• Understand the different ways corporate
directors are elected to office
• Understand how stock prices are quoted
and the basics of stock market reporting

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 LO1
Cash Flows for Shareholder
• 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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 LO1
One Period Example
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

© 2016 McGraw-Hill Education Limited

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 LO1
Two Period Example
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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 LO1
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 $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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 LO1
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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 LO1
Estimating Dividends: Special Cases
• Constant dividend (zero growth)
• The firm will pay a constant dividend forever
• This is like preferred stock
• The price is computed using the perpetuity
formula
• Constant dividend growth (constant growth)
• The firm will increase the dividend by a constant
percent every period
• Supernormal growth (two-stage growth)
• Dividend growth is not consistent initially, but
settles down to constant growth eventually

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 LO1 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 = .50 / (.1 / 4) = $20

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 LO1
Dividend Growth Model
• 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:

D 0 (1 + g) D1
P0 = =
R -g R -g

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 LO1
DGM – Examples
1. 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 = .50(1+.02) / (.15 - .02) = $3.92
2. 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 / (.2 - .05) = $13.33
• Why isn’t the $2 in the numerator multiplied by (1.05) in this
example?

© 2016 McGraw-Hill Education Limited

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Stock Price Sensitivity to Dividend Growth, g
LO1

D1 = $2; R = 20%
250

200
Stock Price

150

100

50

0
0 0.05 0.1 0.15 0.2
Growth Rate

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Stock Price Sensitivity to Required Return, R
LO1

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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 LO1
Gordon Growth Company – Example
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%.
1. What is the current price?
• P0 = 4 / (.16 - .06) = $40
• Remember that we already have the dividend expected next year, so we don’t
multiply the dividend by 1+g
2. What is the price expected to be in year 4?
• P4 = D4(1 + g) / (R – g) = D5 / (R – g)
• P4 = 4(1+.06)4 / (.16 - .06) = 50.50
3. What is the implied return given the change in price during the four
year period?
• 50.50 = 40(1+return)4; return = 6%
• 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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 Example – Non-constant Dividend Growth
LO1

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.
• 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 / (.2 - .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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 LO1

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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 LO1 Using the Constant DGM to Find R
• Start with the constant DGM:

D 0 (1 + g) D
P0 = = 1
R -g R -g
rearrange and solve for R
D 0 (1 + g) D1
R= +g= +g
P0 P0

• This shows the components of the required return

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 Example – Finding the Required Return
LO1

• 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] + .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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 LO1

Table 8.1 - Summary of Stock Valuation

The General Case
In general, the price today of a share of stock, P0, is the present value of all of its future dividends, D1, D2, D3, …
D1 D2 D3
P0 = 1
+ 2
+ +!
(1 + r ) (1 + r ) (1 + r )3

where r is the required return.

Zero Growth Case
If there is no growth in dividends, the price can be written as
D1
P0 =
r
Constant Growth Case
If the dividend grows at a steady rate, g, the price can be written as:
D1
P0 =
(r - g )
This result is called the dividend growth model.

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Table 8.1
LO1- Summary of Stock Valuation continued
Supernormal Growth Case
If the dividend grows steadily after t periods, the price can be written as:
D1 D2 Dt Pt
P0 = 1
+ 2
+ !+ t
+
(1 + r ) (1 + r ) (1 + r ) (1 + r )t

where
Dt ´ (1 + g )
Pt =
(r - g )

Valuation using Multiples

For stocks that don’t pay dividends (or have erratic dividend growth rates), we can value them using the PE ratio
and/or the Price-sales ratio:
Pt = Benchmark PE ratio ´ EPSt
Pt = Benchmark Price-sales ratio ´ Sales per share
The Required Return
The required return, r, can be written as the sum of two things:
r = D1/P0 + g
where D1/P0 is the dividend yield and g is the capital gains yield (which is the same thing as the growth rate in the
dividends for the steady growth case).
 LO2 Common Stock Features 8.2
• 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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 LO2
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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 LO2 Preferred Stock Features 8.3
• 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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 LO4
Stock Market Reporting
• Stock market quotations are published in the
newspapers and are also available on-line (usually
with 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
• Click on the web surfer to go to the site

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 LO4 Work the Web Example
• Information on a large number of stocks
in several different markets can also be
found at the Globe & Mail website
• Click on the web surfer to go to the site

• Also, publicly traded companies usually

have an investor relations section on
their web pages

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 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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 LO3

Appendix A – 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
• 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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