Principles of

Chapter 4 Corporate Finance

Tenth Edition

The Value of
Common Stocks

Slides by
Matthew Will

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
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Topics Covered
➢How Common Stocks Are Traded
➢How Common Stocks Are Valued
➢Estimating The Cost Of Equity Capital
➢The Link Between Stock Price and Earnings
per Share
➢Valuing a Business by Discounted Cash
Flow
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How Common Stocks Are Traded

(Self-study)

➢ Primary market: When new shares of common stocks are sold in the market to raise capital,
it is called a primary market transaction. A good example of a primary market transaction is
the IPO (Initial Public Offering).
➢ Secondary market: When already issued stocks are traded in the market, it is called a
secondary market transaction. Most transactions in the stock market are secondary market
transactions.
➢ There are two types of exchanges that are prevalent in the USA. They are auction markets
and dealer markets. The New York Stock Exchange is an example of an auction market.
Here specialists act as auctioneers and match up would-be buyers and sellers. The Nasdaq is
an example of a dealer market. In the case of a dealer market, all trades take place between a
group of dealers and the investors. Dealer markets are also active in trading many other types
of financial instruments such as bonds.
➢ Market capitalization rate: The rate of return expected by the investors in common stocks is
called the market capitalization rate. It is also called the cost of equity capital. For a constant
growth stock, it is the dividend yield plus the growth rate in dividends.
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How Common Stocks Are Traded

(Self-study)

➢ The major secondary market for GE shares is: New York Stock Exchange
➢ The following are foreign companies that are traded on the New York Stock Exchange:
Toyota, Brazil Telecom, Nokia, Endesa.
➢ The dividend yield reported as Yld. % in The Wall Street Journal quotation is calculated
as follows: dividends/close
➢ The exchange-traded fund (EFT) that tracks the Nasdaq 100 index is called: QQQQ
➢ The following are auction markets are: New York Stock Exchange, London Stock
Exchange, Tokyo Stock Exchange.
➢ An example of a dealer market: Nasdaq
➢ In New York Stock Exchange, specialists act as the auctioneers.
➢ In the following exchanges (London Stock Exchange, Tokyo Stock Exchange,
Frankfurt Stock Exchange), a computer acts as the auctioneer.
➢ Income stocks: Dow Chemicals, Cummins, Inc
➢ Growth stocks: Starbucks, e2v Technologies, Microsoft, Starbucks
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How Common Stocks Are Valued

(Self-study)

Book Value - Net worth of the firm according to the balance

sheet.
Dividend - Periodic cash distribution from the firm to the
shareholders.
P/E Ratio - Price per share divided by earnings per share.
Market Value Balance Sheet - Financial statement that uses
market value of assets and liabilities.
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How Common Stocks Are Valued

RATE OF RETURN (r%)
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How Common Stocks Are Valued

RATE OF RETURN (r%)

Return Measurements
Div1
Restated P0 =
r−g
Div1
Dividend Yield = Div1
P0 r= +g
P0

Return on Equity = ROE

EPS
ROE =
Book Equity Per Share
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How Common Stocks Are Valued

PRICE (P)

Dividend Discount Model - Computation of

today’s stock price which states that share
value equals the present value of all expected
future dividends.
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How Common Stocks Are Valued

DIVIDEND GROWTH RATE (g)

➢ Constant dividend growth formula: There are two important assumptions that are
necessary for the formula to work correctly. First assumption is that the growth rate in
dividends is constant. The second assumption is that the discount rate is greater than
the growth rate in dividends

➢ Dividend growth rate for a stable firm can be estimated as:

g = plow back rate x the return on equity (ROE)

➢ The growth rate in dividends is a function of two ratios: ROE and the Retention Ratio
➢ Generally high growth stocks pay Low or no dividends
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How Common Stocks Are Valued

PRICE-EARNING RATIO (P/E) & EARNING PER SHARE (EPS)

➢ The P/E ratio is a widely used financial indicator, but is also quite ambiguous. Generally, a
high P/E ratio indicates that the investors think a firm has good growth potential. It is the
ratio of current market price and earnings of a stock.
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How Common Stocks Are Valued

Present Value of the Growth Opportunities (PVGO)

➢ A high proportion of the value of a growth stock comes from PVGO (Present Value of the
Growth Opportunities)
➢ Example: Why Microsoft experienced a significant drop in price when it announced its first
ever regular dividend along with huge profits: Under the concept of PVGO, Microsoft was
converting form a company with significant growth to a company with no growth. An
increase in the dividend for a growth company is often a sign of reduced growth. Thus,
the market would have reacted negatively to the news.
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Stock Price and Earnings Per Share

➢ If a firm elects to pay a lower dividend, and
reinvest the funds, the stock price may
increase because future dividends may be
higher.

Payout Ratio - Fraction of earnings paid out as

dividends
Plowback Ratio - Fraction of earnings retained
by the firm
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Stock Price and Earnings Per Share

Example
Our company forecasts to pay a $8.33
dividend next year, which represents
100% of its earnings. This will provide
investors with a 15% expected return.
Instead, we decide to plowback 40% of
the earnings at the firm’s current return
on equity of 25%. What is the value of
the stock before and after the plowback
decision?
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Stock Price and Earnings Per Share

Example
Our company forecasts to pay a $8.33 dividend next year, which
represents 100% of its earnings. This will provide investors with
a 15% expected return. Instead, we decide to plowback 40% of
the earnings at the firm’s current return on equity of 25%. What
is the value of the stock before and after the plowback decision?

No Growth With Growth

8.33 g = .25  .40 = .10

P0 = = $55.56
.15
5.00
P0 = = $100.00
.15 − .10
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Stock Price and Earnings Per Share

Example - continued
If the company did not plowback some earnings, the
stock price would remain at $55.56. With the
plowback, the price rose to $100.00.

The difference between these two numbers is called

the Present Value of Growth Opportunities (PVGO).

PVGO = 100.00 − 55.56 = $44.44

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Stock Price and Earnings Per Share

Present Value of Growth Opportunities
(PVGO) - Net present value of a firm’s
future investments.

Sustainable Growth Rate - Steady rate at

which a firm can grow: plowback ratio X
return on equity.
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Valuing a Business
Valuing a Business or Project
The value of a business or Project is usually
computed as the discounted value of FCF out
to a valuation horizon (H).
The valuation horizon is sometimes called the
terminal value and is calculated like PVGO.

FCF1 FCF2 FCFH PV H

PV = + + ... + +
(1 + r ) (1 + r )
1 2
(1 + r ) H
(1 + r ) H
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Valuing a Business
Valuing a Business or Project

FCF1 FCF2 FCFH PV H

PV = + + ... + +
(1 + r ) (1 + r )
1 2
(1 + r ) H
(1 + r ) H

PV (free cash flows) PV (horizon value)

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Valuing a Business
Example
Given the cash flows for Concatenator Manufacturing Division,
calculate the PV of near term cash flows, PV (horizon value),
and the total value of the firm. r=10% and g= 6%

Year
1 2 3 4 5 6 7 8 9 10
Asset Value 10.00 12.00 14.40 17.28 20.74 23.43 26.47 28.05 29.73 31.51
Earnings 1.20 1.44 1.73 2.07 2.49 2.81 3.18 3.36 3.57 3.78
Investment 2.00 2.40 2.88 3.46 2.69 3.04 1.59 1.68 1.78 1.89
Free Cash Flow - .80 - .96 - 1.15 - 1.39 - .20 - .23 1.59 1.68 1.79 1.89
.EPS growth (%) 20 20 20 20 20 13 13 6 6 6
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Valuing a Business
Example - continued
Given the cash flows for Concatenator Manufacturing Division,
calculate the PV of near term cash flows, PV (horizon value),
and the total value of the firm. r=10% and g= 6%

1  1.59 
PV(horizon value) = 6   = 22.4
(1.1)  .10 − .06 
.80 .96 1.15 1.39 .20 .23
PV(FCF) = - − − − − −
1.1 (1.1) (1.1) (1.1) (1.1) (1.1)6
2 3 4 5

= − 3 .6
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Valuing a Business
Example - continued
Given the cash flows for Concatenator Manufacturing Division,
calculate the PV of near term cash flows, PV (horizon value),
and the total value of the firm. r=10% and g= 6%

PV(busines s) = PV(FCF) + PV(horizon value)

= -3.6 + 22.4
= $18.8
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Web Resources
Click to access web sites
Internet connection required

www.dividenddiscountmodel.com
www.valuepro.net
www.nyse.com
www.nasdaq.com
www.londonstockexchange.com
www.tse.or.jp
www.123world.com/stockexchanges
www.rba.co.uk
www.fibv.com