Stocks and Their Valuation: Features of Common Stock Determining Common Stock Values Preferred Stock

10 - 1
CHAPTER 10
Stocks and Their Valuation
 Features of common stock

 Determining common stock
values
 Preferred stock
Copyright © 2002 Harcourt, Inc. All rights reserved.

10 - 2
Facts about Common Stock
 Represents ownership.
 Ownership implies control.
 Stockholders elect directors.
 Directors hire management.
 Management’s goal: Maximize
stock price.
10 - 3
When is a stock sale an initial public

offering (IPO)?
 A firm “goes public” through an IPO

when the stock is first offered to the
public.
 Prior to an IPO, shares are typically
owned by the firm’s managers, key
employees, and, in many situations,
venture capital providers.

10 - 4
Stock Value = PV of Dividends
 = D1 D2 D3 D∞
P + + +. . .+
0
(1 + k ) (1 + k ) (1 + k )
s
1
s
2
s
3
(1 + k ) s
∞
What is a constant growth stock?
One whose dividends are expected to

grow forever at a constant rate, g.
10 - 5
For a constant growth stock,
D1 = D 0 (1 + g)
1
D 2 = D 0 (1 + g)
2
D t = D t (1 + g)
t
If g is constant, then:
P = D 0 (1 + g) =
D1
0
ks − g ks − g
10 - 6
What happens if g > ks?
 D
P0 = 1
requires k s > g.
ks − g
 If ks< g, get negative stock price,
which is nonsense.
 We can’t use model unless (1) g < ks
and (2) g is expected to be constant
forever. Because g must be a long-
term growth rate, it cannot be > ks.
10 - 7
Assume beta = 1.2, kRF = 7%, and kM =

12%. What is the required rate of
return on the firm’s stock?
Use the SML to calculate ks:
ks = kRF + (kM - kRF)bFirm

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

10 - 8
D0 was $2.00 and g is a constant 6%.

Find the expected dividends for the
next 3 years, and their PVs. ks = 13%.
0 g=6% 1 2 3 4
D0=2.00 2.12 2.2472 2.3820

1.8761 13%
1.7599
1.6508

10 - 9
What’s the stock’s market value?
D0 = 2.00, ks = 13%, g = 6%.
Constant growth model:
P 0 =
D 0 (1 + g) =
D1
ks − g ks − g
$2.12 $2.12
= = $30.29.
0.13 - 0.06 0.07
10 - 10
What is the stock’s market value one

^
year from now, P 1?
 D1 will have been paid, so expected

dividends are D2, D3, D4 and so on.
Thus,
D2
P̂1 =
ks − g
$2.2472
= = $32.10.
0.07

10 - 11
Find the expected dividend yield and

capital gains yield during the first year.
D1 $2.12
Dividend yield = = = 7.0%.
P0 $30.29
^
P1 - P 0 $32.10 - $30.29
CG Yield = =
P0 $30.29
= 6.0%.
10 - 12
Find the total return during the

first year.
 Total return = Dividend yield +

Capital gains yield.
 Total return = 7% + 6% = 13%.
Total return = 13% = ks.
 For constant growth stock:
Capital gains yield = 6% = g.
10 - 13
Rearrange model to rate of return form:
 D  D
P0 = 1
to k s = 1
+ g.
ks − g P0
^
Then, ks = $2.12/$30.29 + 0.06
= 0.07 + 0.06 = 13%.

10 - 14
What would P0 be if g = 0?
The dividend stream would be a

perpetuity.
0 k =13% 1 2 3
s
2.00 2.00 2.00
^ PMT $2.00
P0 = = = $15.38.
k 0.13
10 - 15
If we have supernormal growth of

30% for 3 years, then a long-run
^
constant g = 6%, what is P0? k is
still 13%.
 Can no longer use constant growth

model.
 However, growth becomes constant
after 3 years.

10 - 16
Nonconstant growth followed by constant

growth:
0 k =13% 1 2 3 4
s
g = 30% g = 30% g = 30% g = 6%

D0 = 2.00 2.60 3.38 4.394 4.6576
2.3009
2.6470
3.0453
$4.6576
P̂3 = = $66.5371
46.1135 0.13 − 0.06
^
54.1067 = P0
10 - 17
What is the expected dividend yield and

capital gains yield at t = 0? At t = 4?
At t = 0:
D1 $2.60
Dividend yield = = = 4.8%.
P0 $54.11
CG Yield = 13.0% - 4.8% = 8.2%.
(More…)
10 - 18
 During nonconstant growth, dividend

yield and capital gains yield are not
constant.
 If current growth is greater than g,
current capital gains yield is greater
than g.
 After t = 3, g = constant = 6%, so the t
t = 4 capital gains gains yield = 6%.
 Because ks = 13%, the t = 4 dividend
yield = 13% - 6% = 7%.
10 - 19
Is the stock price based on

short-term growth?
 The current stock price is $54.11.
 The PV of dividends beyond year 3 is
$46.11 (P
^ 3 discounted back to t = 0).
 The percentage of stock price due to
“long-term” dividends is:
$46.11
$54.11 = 85.2%.
10 - 20
Suppose g = 0 for t = 1 to 3, and then g

is a constant 6%. What is ^P0?
0 1 2 3 4
ks=13%
...
g = 0% g = 0% g = 0% g = 6%
2.00 2.00 2.00 2.12
1.7699
1.5663
P = 2.12 = 30.2857
1.3861
20.9895 3
25.7118 0.07
10 - 21
What is dividend yield and capital

gains yield at t = 0 and at t = 3?
D1 2.00
t = 0: P = $25.72= 7.8%.
0
CGY = 13.0% - 7.8% = 5.2%.
t = 3: Now have constant growth

with g = capital gains yield = 6% and
dividend yield = 7%.
10 - 22
If g = -6%, would anyone buy the

stock? If so, at what price?
Firm still has earnings and still pays

^
dividends, so P0 > 0:
D 0 ( 1 + g) D1
P̂0 = =
ks − g ks − g
$2.00(0.94) $1.88
= = = $9.89.
0.13 - (-0.06) 0.19
10 - 23
What are the annual dividend

and capital gains yield?
Capital gains yield = g = -6.0%.
Dividend yield = 13.0% - (-6.0%)

= 19.0%.
Both yields are constant over time, with

the high dividend yield (19%) offsetting
the negative capital gains yield.
Estimate Stock Price 10 - 24
 Dividend Valuation Model (DVM)
 P/E Multiple Value : วิธอี ัตราส่วนราคาต่อกำาไรต่อหุ้น
อัตราส่วนราคาต่อกำาไรต่อหุ้น(P/E Ratio) = ราคาตลาดต่อหุ้น / กำาไรต่อหุ้น = Price / EPS
ราคาตลาดต่อหุ้น (Price) = P/E Ratio x กำาไรต่อหุ้น
 Book Value : ราคาตามบัญชี
มูลค่าตามบัญชีของหุ้นสามัญรวม=สินทรัพย์รวม-หนี้สินทั้งหมดรวมหุ้นบุริมสิทธิ์
ราคาตามบัญชีต่อหุ้น = มูลค่าตามบัญชีของหุ้นสามัญรวม / จำานวนหุ้นสามัญ
หมายถึง: (สินทรัพย์รวม-หนี้สินทั้งหมดรวมหุ้นบุริมสิทธิ)์ / จำานวนหุ้นสามัญ
 Net Asset Value(NAV)หรือ Liquidation Value
วิธรี าคาตามมูลค่าสินทรัพย์สุทธิ
คล้ายวิธี BV. แต่คำานวณมูลค่าหุ้นสามัญจาก มูลค่าสินทรัพย์ตามราคาตลาด
10 - 25
What is market equilibrium?
In equilibrium, stock prices are stable.

There is no general tendency for
people to buy versus to sell.
^
The expected price, P, must equal the
actual price, P. In other words, the
fundamental value must be the same as
the price.
(More…)
10 - 26
In equilibrium, expected returns must

equal required returns:
^
ks = D1/P0 + g = ks = kRF + (kM - kRF)b.

10 - 27
How is equilibrium established?
^
^ D
If ks = 1 + g > ks, then P0 is “too low.”
P0
If the price is lower than the
fundamental value, then the stock is a
“bargain.”
Buy orders will exceed sell orders, the

^
price will be bid up, and D1/P0 falls until
D /P + g = k = k .
10 - 28
Why do stock prices change?
^ = D1
P0
ki − g
 ki = kRF + (kM - kRF )bi could change.

 Inflation expectations
 Risk aversion
 Company risk
 g could change.
10 - 29
Preferred Stock
 Hybrid security.
 Similar to bonds in that preferred
stockholders receive a fixed dividend
which must be paid before dividends
can be paid on common stock.
 However, unlike bonds, preferred
stock dividends can be omitted without
fear of pushing the firm into
bankruptcy.
10 - 30
What’s the expected return on

preferred stock with Vps = $50 and
annual dividend = $5?
$5
Vps = $50 = 
k
ps
 $5
k ps = = 0.10 = 10.0%.
$50

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10 - 1

 Features of common stock

Copyright © 2002 Harcourt, Inc. All rights reserved.

Facts about Common Stock

When is a stock sale an initial public

 A firm “goes public” through an IPO

Copyright © 2002 Harcourt, Inc. All rights reserved.

Stock Value = PV of Dividends

What is a constant growth stock?

One whose dividends are expected to

For a constant growth stock,

What happens if g > ks?

Assume beta = 1.2, kRF = 7%, and kM =

Use the SML to calculate ks:

ks = kRF + (kM - kRF)bFirm

Copyright © 2002 Harcourt, Inc. All rights reserved.

D0 was $2.00 and g is a constant 6%.

D0=2.00 2.12 2.2472 2.3820

Copyright © 2002 Harcourt, Inc. All rights reserved.

Constant growth model:

What is the stock’s market value one

 D1 will have been paid, so expected

Copyright © 2002 Harcourt, Inc. All rights reserved.

Find the expected dividend yield and

Find the total return during the

 Total return = Dividend yield +

Rearrange model to rate of return form:

Copyright © 2002 Harcourt, Inc. All rights reserved.

The dividend stream would be a

2.00 2.00 2.00

If we have supernormal growth of

 Can no longer use constant growth

Copyright © 2002 Harcourt, Inc. All rights reserved.

Nonconstant growth followed by constant

g = 30% g = 30% g = 30% g = 6%

What is the expected dividend yield and

CG Yield = 13.0% - 4.8% = 8.2%.

 During nonconstant growth, dividend

Is the stock price based on

Suppose g = 0 for t = 1 to 3, and then g

What is dividend yield and capital

CGY = 13.0% - 7.8% = 5.2%.

t = 3: Now have constant growth

If g = -6%, would anyone buy the

Firm still has earnings and still pays

What are the annual dividend

Capital gains yield = g = -6.0%.

Dividend yield = 13.0% - (-6.0%)

Both yields are constant over time, with

What is market equilibrium?

In equilibrium, stock prices are stable.

In equilibrium, expected returns must

Copyright © 2002 Harcourt, Inc. All rights reserved.

How is equilibrium established?

Buy orders will exceed sell orders, the

Why do stock prices change?

 ki = kRF + (kM - kRF )bi could change.

What’s the expected return on

Copyright © 2002 Harcourt, Inc. All rights reserved.

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