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ACCT-702

Chapter 7 Stock Valuation


How do we value common stock? Dividends currently being paid are one of the primary factors
we look at when we attempt to value common stock. We look at dividends, stock values, and the
connection between the two. Common stock is more difficult to value in practice than a bond
because:
1. The promised cash flows are not known in advance.
2. The life of the investment is forever.
3. There is no way to easily observe the rate of return that the market requires. We determine
the value or price of the stock by calculating the present value of the future cash flows for a
stock.

Q: What determines the price of a stock?


A: current earnings, current dividend, future dividend, anticipated growth OR the present value
of all future cash flows.
P0 = D1/(1+R)1 + D2/(1+R)2 + D3/(1+R)3 + D4/(1+R)4 +
The price of the stock is = the present value of all future dividends indefinitely so we need to
modify this equation.
KEY EQUATIONS:
1. The General Case.
In general, the price today of a share of stock, P 0 is the present value of both its dividend and
price in one period for different growth:
P0 = ( D1 + P1 ) / ( 1 + R ); where R is the required return

2. Constant Growth Case:


If the dividend is constant and equal D, then the price can be written as:
P0 = D / R where the dividend is the same year after year but there is no growth as with
preferred stock.

If the dividend grows at a steady rate, g, then the price can be written as:
Dividend Growth Model:
Po = Do x (1 + g) / (R g) or
Pt = Dt x ( 1 + g) / ( R g ) where P is the price of the stock; D is the dividend; g is the growth; R
is the required return.

3. The Required Return.


The required return can be written as: R = ( D 1 / P0 ) + g
Other Variations of the above.
D1 is the same as D0 x (1 + g)
D2, is the same as D1 x (1 + g)
P4 = D5 / R g
P0 = P 4 / ( 1 + R ) 4
P0 = D1 / (R g)
Dividend Yield or = (D1 / P0)
PVa = PMT; P/Yr; xP/Yr
What is the practical use of the above equations?
Compare the P0 to market value of the security and determine if the price is a good deal or a
bust.
The goal of the financial manager is to maximize stock price (shareholder value).
We are learning what determines value.

Q: A stock will sell for $70 in one year and will pay $10 dividend at the end of the year. What is
the price of the stock. Assume a 25% return.
P0 price of the stock or PV; D1 is the dividend at the end of year 1; P1 is the price at the end of
year 1.
A: P0 = (D1 + P1) / (1 + R); P0 = (10 + 70) / 1.25; Price = $64
P0 = D1/(1+R)1 + D2/(1+R)2 + D3/(1+R)3 + D4/(1+R)4 +

The price of the stock is = the present value of all future dividends indefinitely so we need to
modify this equation.
Q: If growth is zero, in other words the dividend is constant at $10 and the required return is
20%. Calculate the price of the stock. P0 = D / R
A: Current price of the stock = 10/.2 = $50 per share

Q: If a dividend is currently $3 and is expected to grow 8% per year, how much will the dividend
be in 5 years.
A: 3 x (1.08)5 = $4.41

Q: If dividend growth is expected to be 5%, dividend payment is $10 at the end of this year and
the required return is 20%. Calculate the new price of the stock. P 0 = D1 / R g
A: Current price of the stock = 10 / .2 - .05 = $66.67

Q: Use the dividend growth model to calculate the price per share if D 0 = $2.30, R = 13, g = 5%.
P0 = D0 x (1 + g) / R g
A: P0 = 2.30 x 1.05 / ( .13 - .05); P 0 = $30.19

Q: Refer to the previous question. Use the dividend growth model and assuming constant
growth calculate the price of the stock at the end of year 5.
Pt = Dt x (1 + g) / (R g)
A: P5 = 2.30 x (1.05)5 / .13 - .05; P5 = 2.935 x 1.05 / .08 = 3.0822/.08 = $38.53
Q: Assume a company pays a dividend of $4 at the END of the year. D 1 = 4. Investors require a
16% return and the dividend increases by 6% every year. Based on the dividend growth model
what is the value of the stock today? What is the value of the stock in 4 years?
A: P0 = D1 / (R g). P0 = 4 / 0.16 - 0.06. P0 = $40.
Dividend in 4 years D4 = D1 x (1 + g )3. D4 = 4 x 1.063. D4 = $4.764
Price of the stock in 4 years P4 = D4 x ( 1 + g) / (R g). P4 = 4.764 x 1.06 / 0.16 - 0.06
P4 =
$50.50
Q: Assume a company is not currently paying dividends but intends on paying a dividend of
$0.50 per share in 5 years. At that time it is expected the dividend to grow by 10% annually.
The required rate of return is expected to be 20%. What is the price of the stock today?

A: P4 = D5 / (R - g);
P4 = .5 / .2 - .1;
P4 = $5. P0 = P4 / (1 + R)4;
P0 = 5 / 1.24;
P0 = $2.41
Dividend Yield = D1 / P0. The dividend growth rate (g) can be interpreted as the capital gains
yield.
P0 = D1 / (R g) OR R g = D1 / P0 OR R = (D1 / P0 )+ g
Q: A stock is selling for $20 per share. The next dividend will be $1 per share. Dividend growth
will be 10%. What is the return (R) on this stock?
A: R = Dividend yield + Capital gains yield;
R = (D1 / P0 ) + g;
R = 1 / 20 + 10%;
R = 5% + 10%;
R = 15%

Do: Question 1, 2, 3, 4, 5, 7, 8, and 11 page 226.

Chapter 7 Stock Valuation Assignment


Question 1 page 226. Money Inc., just paid a dividend of $2.50 per share on its stock. The
dividends are expected to grow at a constant rate of 5% per year, indefinitely. If investors
require an 11% return on Money stock, what is the current price? What will the price be in 3
years? In 15 years?
_______________________________________________________________________________________________
_______________________________________________________________________________________________
_______________________________________________________________________________________________
_______________________________________________________________________________________________
_______________________________________________________________________________________________
Question 2. The next dividend payment by the Bank of Labrador will be $1.80 per share. The
dividends are anticipated to maintain a 6.5% growth rate, forever. If the Bank of Labrador stock
currently sells for $47.00 per share, what is the required return?
_______________________________________________________________________________________________
_______________________________________________________________________________________________
_______________________________________________________________________________________________
_______________________________________________________________________________________________
_______________________________________________________________________________________________
Question 3. For the company in the previous problem, what is the dividend yield? What is the
expected capital gains yield?
_______________________________________________________________________________________________
_______________________________________________________________________________________________
_______________________________________________________________________________________________
_______________________________________________________________________________________________
_______________________________________________________________________________________________
Question 4. Canadian Rockies Corporation will pay a $4.50 per share dividend next year. The
company pledges to increase its dividend by 4% per year, indefinitely. If you require a 12%
return on your investment, how much will you pay for the companys stock today?
_______________________________________________________________________________________________
_______________________________________________________________________________________________
_______________________________________________________________________________________________
_______________________________________________________________________________________________
_______________________________________________________________________________________________
Question 5. Niagara Falls, Inc. is expected to maintain a constant 6% growth rate in its
dividends, indefinitely. If the company has a dividend yield of 4.1%, what is the required return
on the companys stock?
_______________________________________________________________________________________________
_______________________________________________________________________________________________
_______________________________________________________________________________________________
_______________________________________________________________________________________________
_______________________________________________________________________________________________

Question 7. Moose Corp. pays a constant $15 dividend on its stock. The company will maintain
this dividend for the next 8 years and will then cease paying dividends forever. If the required
return on this stock is 11%, what is the current share price?
_______________________________________________________________________________________________
_______________________________________________________________________________________________
_______________________________________________________________________________________________
_______________________________________________________________________________________________
_______________________________________________________________________________________________
Question 8. Lacrosse, Inc. has an issue of preferred stock outstanding that pays a $7 dividend
every year, in perpetuity. If this issue currently sells for $90.21 per share, what is the required
return?
_______________________________________________________________________________________________
_______________________________________________________________________________________________
_______________________________________________________________________________________________
_______________________________________________________________________________________________
_______________________________________________________________________________________________
Question 11. The stock price of York Co. is $70. Investors require a 12% rate of return on similar
stocks. If the company plans to pay a dividend of $4.25 next year, what growth rate is expected
for the companys stock price?
_______________________________________________________________________________________________
_______________________________________________________________________________________________
_______________________________________________________________________________________________
_______________________________________________________________________________________________
_______________________________________________________________________________________________

ACCT-702
Chapter 7 Stock Valuation
How do we value common stock? ____________________________________________________________
are one of the primary factors we look at when we attempt to value common stock. We look at
_____________________________________________, and the connection between the two. Common
stock is more difficult to value in practice than a bond because:
1. _______________________________________________________________________________________
2. _______________________________________________________________________________________
3._______________________________________________________________________________________
We determine the value or price of the stock by calculating the _________________________ of the
_____________________________________________________________.
Q: What determines the price of a stock?
A: ______________________________________________________________________________________
_________________________________________________________________________________________
P0 = D1/(1+R)1 + D2/(1+R)2 + D3/(1+R)3 + D4/(1+R)4 +
The price of the stock is = the present value of all future dividends indefinitely so we need to
modify this equation.
KEY EQUATIONS:
1. The General Case.
In general, the price today of a share of stock, P 0 is the present value of both its dividend and
price in one period for different growth:
___________________________________________________________________________________________
2. Constant Growth Case:
If the dividend is constant and equal D, then the price can be written as:
___________________________________________________________________________________________
If the dividend grows at a steady rate, g, then the price can be written as:
Dividend Growth Model:
__________________________________________________________________________________________
__________________________________________________________________________________________
3. The Required Return.
The required return can be written as: _________________________________________________________
Other Variations of the above.
D1 is the same as _________________________________________________________________________
D2, is the same as _________________________________________________________________________
P4 = D5 / R g
P0 = P 4 / ( 1 + R ) 4
P0 = D1 / (1 + R ) 1
Dividend Yield = ________________________________________________________________________
PVa = PMT; P/Yr; xP/Yr
What is the practical use of the above equations?
Compare the P0 to market value of the security and determine if the price is a
__________________________

The goal of the financial manager is to _________________________________________________________


We are learning what determines value.

Q: A stock will sell for $70 in one year and will pay $10 dividend at the end of the year. What is
the price of the stock. Assume a 25% return.
P0 price of the stock or PV; D1 is the dividend at the end of year 1; P1 is the price at the end of
year 1.
A: ______________________________________________________________________________
P0 = D1/(1+R)1 + D2/(1+R)2 + D3/(1+R)3 + D4/(1+R)4 +
The price of the stock is = ___________________________________________________________.
Q: If growth is zero, in other words the dividend is constant at $10 and the required return is
20%. Calculate the price of the stock.
A: Current price of the stock _________________________________________________________
Q: If a dividend is currently $3 and is expected to grow 8% per year, how much will the dividend
be in 5 years.
A: Dividend in 5 years = ______________________________________________________________
Q: If dividend growth is expected to be 5%, dividend payment is $10 at the end of this year and
the required return is 20%. Calculate the new price of the stock.
A: Current price of the stock = ________________________________________________________
Q: Use the dividend growth model to calculate the price per share if D 0 = $2.30, R = 13, g = 5%.
A: ______________________________________________________________________________
________________________________________________________________________________
Q: Use the dividend growth model and assuming constant growth calculate the price of the stock
at the end of year 5.
A: ______________________________________________________________________________
________________________________________________________________________________
Q: Assume a company pays a dividend of $4 at the END of the year. D 1 = 4. Investors require a
16% return and the dividend increases by 6% every year. Based on the dividend growth model
what is the value of the stock today? What is the value of the stock in 4 years?
A: Value of the stock today _________________________________________________________
________________________________________________________________________________
Dividend in 4 years ________________________________________________________________
________________________________________________________________________________
Price of the stock in 4 years P4 = D4 x ( 1 + g) / (R g). ____________________________________
________________________________________________________________________________
Q: Assume a company is not currently paying dividends but intends on paying a dividend of
$0.50 per share in 5 years. At that time it is expected the dividend to grow by 10% annually.
The required rate of return is expected to e 20%. What is the price of the stock today?
A: P4 = D5 / (R - g) _________________________________________________________________
________________________________________________________________________________
Dividend Yield = D1 / P0. The dividend growth rate (g) can be interpreted as the capital gains
yield.

P0 = D1 / (R g) OR R g = D1 / P0 OR R = (D1 / P0 )+ g
Q: A stock is selling for $20 per share. The next dividend will be $1 per share. Dividend growth
will be 10%. What is the return (R) on this stock?
A: R = Dividend yield + Capital gains yield; R = _________________________________________
_______________________________________________________________________________

Question 1. page 226. Money Inc., just paid a dividend of $2.50 per share on its stock. The
dividends are expected to grow at a constant rate of 5% per year, indefinitely. If investors
require an 11% return on Money stock, what is the current price? What will the price be in 3
years? In 15 years?
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
Question 2. The next dividend payment by the Bank of Labrador will be $1.80 peer share. The
dividends are anticipated to maintain a 6.5% growth rate forever. If the Bank of Labrador stock
currently sells for $47.00 per share, what is the required return?
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
Question 3. For the company in the previous problem, what is the dividend yield? What is the
expected capital gains yield?
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
Question 4. Canadian Rockies Corporation will pay a $4.50 per share dividend next year. The
company pledges to increase its dividend by 4% per year indefinitely. If you require a 12% return
on your investment, how much will you pay for the companys stock today?
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
Question 5. Niagara Falls, Inc., is expected to maintain a constant 6% growth rate in its
dividends, indefinitely. If the company has a dividend yield of 4.1%, what is the required return
on the companys stock?
___________________________________________________________________________________
___________________________________________________________________________________
___________________________________________________________________________________
Question 8. Lacrosse, Inc., has an issue of preferred stock outstanding that pays a $7 dividend
every year, in perpetuity. If this issue currently sells for $90.21 per share, what is the required
return?
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________________________________________________