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Stocks and Their Valuation

Photographer: Scott Rothstein

Chapter 9
Features of common stock
Determining common stock values
Preferred stock
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Common Stock & Intrinsic Value

Represents ownership
Ownership implies control
Stockholders elect directors
Directors hire management
Managements goal
Maximize the stock price
Outside investors, corporate insiders, and analysts use a variety of
approaches to estimate a stocks intrinsic value (P0)
In equilibrium we assume that a stocks price equals its intrinsic
value.
Outsiders estimate intrinsic value to help determine which
stocks are attractive to buy and/or sell.
Stocks with a price below (above) its intrinsic value are
undervalued (overvalued).
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Determinants of Intrinsic Value and Stock Prices

Graphic shows that managerial actions, economic environment and political climate influence stocks intrinsic value and its perceived or market price. When the Market is in equilibrium, Intrinsic value = Stock price

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Ways to Estimate the Intrinsic Value of Stock

Dividend growth model

Corporate value model

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Dividend Growth Model

Key Concept:
Value of a stock is the present value of the
future dividends expected to be generated by
the stock
D3
D
D2
D1
+
+ ... +
+
P0 =
3
1
2
(1 + rs )
(1 + rs )
(1 + rs )
(1 + rs )
^

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Future Dividends and Their Present Values

Graph depicts dividends with a constant growth of g increase every year in a step function. However, the present value of future dividends gets smaller every year. If the value of a stock is the dividends that investors receive over time, then
the value of a stock is the sum of PV of its dividends over time.

D t = D0 ( 1 + g )

Dt
PVD t =
( 1 + r )t

0.25

P0 = PVD t
0

Years (t)
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Constant Growth Stock

A stock whose dividends are expected to grow forever at a constant
rate, g.
D1 = D0 (1+g)1
D2 = D0 (1+g)2
Dt = D0 (1+g)t
The value of the stock is the sum of the PV of its dividends
^

P0 =

D3
D
D2
D1
+
+
+
+
...
(1 + rs )
(1 + rs )1 (1 + rs )2 (1 + rs )3

If g is constant, the dividend growth formula converges to:

P0 =D1 / (rs g)

D0 (1 + g)
D1
=
P0 =
rs - g
rs - g
^

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What Happens If g > rs?

If g > rs, the constant growth formula leads to a

negative stock price, which does not make
sense
The constant growth model can only be used if:
rs > g
g is expected to be constant forever

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To Use Dividend Growth Model, First Need to Find rs

Example: rRF = 7%, rM = 12%, and b = 1.2, what is the
required rate of return on the firms stock?

Use the CAPM to calculate the required rate of return (rs):

rs = rRF + (rM rRF)b

= 7% + (12% - 7%)1.2
= 13%

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What Is the Stocks Intrinsic Value?

Assume the companys last dividend per share was $2.00 and the
company has a constant growth rate of 6%

Determine the value per share, using the constant

growth model:

P0 = D1 / (rs g)
= $2.12 / (.13 - .06)
= $2.12 / .07
= $30.29

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What Is the Expected Market Price One Year From Now?

D1 will have been paid out already. So, P1 is the
present value (as of year 1) of D2, D3, D4, etc.
P1 = D1(1+g) / (rs g)
P1 = [$2.12(1+ .06)]/ (.13 - .06)
= $2.247 / .07
= $32.10

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Expected Market Price One Year From Now Continued

Could also find expected P1 as:
PN = P0 (1+g)N
= $30.29 (1+ .06)1
= $32.10
Or by using financial calculator:
N
=
1
I

PV

-30.29

PMT =

FV

32.10
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First Year Expected Dividend Yield, Capital Gains Yield,

and Total Return
Dividend Yield
DY = D1 / P0
= $2.12 / $30.29
= 7.0%
Capital Gains Yield
CGY = (P1 P0) / P0
= ($32.10 - $30.29) / $30.29
= 6.0%
Total Return (rS)
rS = Dividend Yield + Capital Gains Yield
= 7.0% + 6.0%
= 13.0%

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What Would the Expected Price Today Be, if g = 0?

The dividend stream would be a perpetuity, with a
constant dividend of $2.00

rs = 13%

...
2.00

2.00

2.00

P0 = D0(1+g) / (rs g)
= D0(1+0) / (rs 0)
= D0 / rs
= $2.00 / .13
= $15.38
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Value of a Stock with Negative Growth?

Assume D0 = 2.00, = -6% rs = 13%
P0 = D0(1+g) / (rs g )
= $2.00(1 - .06) / .13 (.06)
= $1.88 / .19
= $9.89
The firm still has earnings and pays dividends, even
though they may be declining, they still have value

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Supernormal Growth

What if g = 30% for 3 years before achieving

long-run growth of 6%?
Can no longer use just the constant growth
model to find stock value
However, the growth does become constant after
3 years

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Supernormal Then Constant Growth Sum of PVs

Approach: Sum PV of Cash Flows + Terminal Value
Assume D0 = 2.00, g= 30% for 3 years, then 6% thereafter, rs = 13%
First find Dividends
DN+1 =0DrNs(1+g)
= 13%

...
D =2.00(1+.3) = 2.60, D =2.60(1+.3) = 3.38, D =3.38(1+.3) = 4.394, D
1

2
g
=
30%
g
=4.394(1+.06) = 4.658 = 30%

g = 30%3

3.380

2.600
0
Next calculate
TV
3

g = 6%

4.394

4.658

= D3(1+g) / (rs g)
TV32.301
= 4.658 / (.13 .06)
TV32.647
TV3 = $66.542

PV = FV /(1+rs)
PVD1 = 2.6/(1.13)1 =2.301
PVD2 = 3.38/(1.13)2 =2.647
PVD3+TV3 = (4.394 + 66.542)/(1.13)3 = 70.936
P0 = PV = 54.110
Next find PV of each of the cash flows:
PV = FV /(1+rs)
PVD1 = 2.6/(1.13)1 =2.301
PVD2 = 3.38/(1.13)2 =2.647
PVD3+TV3 = (4.394 + 66.542)/(1.13)3 = 70.936
P0 = PV = 54.110

49.162
54.110

=
P
3

4.394(1.06)
0.13

0.06

4.394

= $66.542
70.936

= P0
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Supernormal Then Constant Growth NPV on calculator

Approach: Calculate Dividends + TV; then find NPV
Assume D0 = 2.00, g= 30% for 3 years, then 6% thereafter, rs = 13%
Find Dividends and TV as you did in previous example
Next find NPV of cash flows, using your financial calculator:
I = 13%
CF0 = 0
CF1 = 2.6
CF2 = 3.38

0 r = 13% 1
s
3

...

CF3 = D3+TV =(4.394 + 66.542) = 70.936

NPV = 54.110

g = 30%

g = 30%

2.600

g = 30%

3.380

CF0= 0
CF1= 2.600
CF2= 3.380

4.394

4.658

4.394

P = 4.394(1.06) = $66.542
3
0.13 0.06
70.936

CF3= 70.936
I = 13
NPV = 54.11

g = 6%

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Non-constant Growth: No Growth Then Constant Growth

Assume D0 = 2.00, g= 0% for 3 years, then 6% thereafter, rs = 13%
First find Dividends
DN+1 = DN (1+g)
D1=2.00, D2= 2.00, D, D4 =2.00(1+.06) = 2.18

0 r = 13% 1
s

Next calculate TV3

TV3 = D3(1+g) / (rs g)

...

TV3 = 2.12 / (.13 .06)

TV3 = $30.29

g = 0%

g = 0%

g = 0%

Next find NPV of cash flows, using your financial calculator:

I = 13%
CF0 = 0
CF1 = 2.00

2.00

2.00

g = 6%

2.00

2.12

CF2 = 2.00
CF3 = D3+TV3 =(2.00 + 30.29) = 32.29

CF0= 0
NPV = 25.71

CF1= 2.00
CF2= 2.00

2.00

P = 2.00(1.06) = $30.29
3
0.13 0.06
32.29

CF3= 32.29
I = 13
NPV = 25.71

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Corporate Value Model

Corporate Value Model

Suggests the value of the entire firm equals
the present value of the firms free cash flows
FCF = EBIT(1-T) + D&A CapEx - NOWC
A good way to evaluate firms that dont pay
dividends (technology companies, start-ups)
Also called the free cash flow method

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Corporate Value Model

3 Steps:
1. Find the ValueFIRM today by finding the NPV
of the firms future FCFs
If at constant growth now:
VFIRM_0 = FCF1 / (WACC g)

If at constant growth at year N:

VFIRM_0 = Sum of NPV of FCF1 through N

+ VFIRM_N

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Corporate Value Model Continued

2. Find Value of Equity

VFIRM_0 - Debt = VEQUITY

3. Find the Expected Stock Price today

VEQUITY / Shares = P0

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Step 1 Value of Firm

If the FCFs shown below grow at a constant rate of 6%
starting in year 3 and WACC is 10%, what is the value of
the firm today?
FCF0 = 0, FCF1 = -5, FCF2 = 10, FCF3 = 20;
TV3 = FCF3(1+g) / WACC- g

0 r = 10% 1

TV3 = 20(1+.06) / (.10 - .06) = 21.20 / .04 = 530

...

Solve for NPV, by entering CFs and I, then press NPV

CF0 = 0, CF1 = -5, CF2 = 10, CF3 = FCF3 + TV3 = 20 + 530 = 550
I = 10

g = 6%

NPV = ValueFIRM = $416.94

-5

10

20

21.20

CF0= 0
CF1= -5

20

CF2= 10

20.00(1.06)

TV3 =
= $ 530
0.10 0.06

CF3= 550
I = 10
NPV = ValueFIRM_0
= $416.94

$ 550
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Step 2: Value of Equity and

Step 3: Expected Stock Price, P0
If the firm has $40 million in debt and has 10 million
shares of stock, what is the firms value per share?

ValueEQUITY = ValueFIRM_0 Debt

= $416.94 - $40
= $376.94 million
Value /Share = P0
= ValueEQUITY / Shares
= $376.94 million / 10 million
= $37.69

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What Is Market Equilibrium?

In equilibrium, stock prices are stable and there is no general
tendency for people to buy versus to sell
In equilibrium, two conditions hold:
The current market stock price equals its intrinsic value
Expected returns must equal required returns

Expected returns are determined by estimating dividends and

expected capital gains
r^ = (D1 / P0) + g

Required returns are determined by estimating risk and applying

the CAPM
r = rRF + (rM rRF)b

In equilibrium, r^ = r
(D1 / P0) + g = rRF + (rM rRF)b

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How Market Equilibrium Works

Equilibrium levels are based on the markets

estimate of intrinsic value and the markets required
rate of return, which are both dependent upon the
attitudes of the marginal investor
If price is below intrinsic value
The current price (P0) is too low and offers a bargain
Buy orders will be greater than sell orders
P0 will be bid up until expected return equals required
return

If price is above intrinsic value, the opposite is true

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Preferred Stock
Hybrid security
Like bonds, preferred stockholders receive a fixed
dividend that must be paid before dividends are
paid to common stockholders
However, companies can omit preferred dividend
payments without fear of pushing the firm into
bankruptcy

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Expected Return on Preferred Stock

If preferred stock with an annual dividend of $5 sells
for $50, what is the preferred stocks expected return?
Vp = Dp / rp
$50 = $5 / rp
rp = $5 / $50
= 0.10
= 10%

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