Stock VALUATION
Dr. Doaa El-Diftar
Lecture 11
Chapter Outline
■ Introduction
■ Preferred stock valuation
■ Common stock valuation
– Zero-Growth Model
– Constant Growth Model
– Supernormal Growth Model
Introduction
■ Represents ownership in a firm
■ Earn a return in two ways
– Price of the stock rises over time (Capital Gains)
– Dividends are paid to the stockholder (Dividends Yield)
■ Stockholders have the right of residual claimant
■ Stocks do not mature
■ Types of stocks
– Common stock
– Right to vote for BOD and other important issues.
– Receive dividends
– Share in assets remaining after liabilities have been paid
in case of liquidation
– Preferred stock
– Receive a fixed dividend (this feature makes it more like a
bond).
– This makes its price relatively stable.
– Do not usually vote unless the firm fails to pay them the
promised dividend.
– Have claims on assets but after all debt holders are paid.
But has priority before common stockholders.
Stock Valuation Models
As was discussed in the previous chapters, assets are valued as
follows:
– Estimate the future cash flows
– Determine the required rate of return or discount rate which
depend on the risks of cash flows
– Compute the present value of the future cash flows to
determine what the asset is worth
Preferred Stock Valuation
■ Preferred stocks are quite straightforward.
■ A preferred stock has fixed dividends and usually an indefinite
maturity (paid forever), so a share of preferred stock is essentially a
perpetuity.
■ Preferred stock valuation: P0 = D / R
P0 the current value or price of the share
D Dividends
R required rate of return
Example:
A Company’s stock pays $5 annual dividends and has a required
return of 8%. Calculate the value of the preferred stock.
Common Stock Valuation
1) Zero Growth Model common stocks with fixed dividends over
time; dividends don’t grow with time (growth rate is zero).
– Valued exactly like preferred stocks:
P0 = D / R
– Here, the required rate of return is higher than preferred
stocks because they are riskier.
2) Constant Growth Model (Gordan Growth Model) common stocks
with dividends that grow at a constant rate. The growth rate is
constant, but dividends are growing.
– Valuation:
P0 = D 1 / R – g
P0 Current stock value
R required rate of return
G constant growth rate
D1 = D0 x (1 +g); where, D0 is the most recent dividend paid.
■ NOTE: If you want to estimate the stock’s value in two years
P2 = D3 / R – g D3 = D2 (1+g) or D3 = D0 (1+g)3
Example 1:
Huskie Motor’s just paid an annual dividend of $1.00 per
share. Management has promised shareholders to increase
dividends a constant rate of 5%. If the required return is 12%,
what is the current value per share? If the share is currently
traded in the market at $20, should you buy or not?
Example 2:
Consider a stock with current dividend of $2 and expected growth
rate of 5%. If the required return is 10%, what is the expected
price today? In 4 years?
3) Supernormal Growth Model
– Dividend's growth is not consistent initially but settles down
to constant growth.
– Firms typically go through life cycles and, as a result, exhibit
different dividend patterns over time
– Prepare a timeline whenever you solve a problem with a
complex dividend pattern so that you can be sure the cash
flows are placed in the proper time periods.
Valuation:
P = PV (Mixed dividend growth) + PV (Constant dividend growth)
P = PV (Mixed dividend growth) + PV (Constant dividend growth)
Rule:
Mixed Dividend Growth:
ˆP D1 D2 D3 . . . D
0
1 R 1 R 1 R 1 R
1 2 3
Constant Dividend Growth: ˆ Dt 1
Pt
R g
Example 1:
A Corporation is expected to pay the following dividends over the
next four years: $3, $10, $15, and $3.08. Afterwards, the company
pledges to maintain a constant 5% growth rate in dividends, forever.
If the required return on the stock is 11%, what is the current
share’s value?
Example 2:
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?
