Stocks and Their Valuation

Features of Common Stock

Determining Common Stock Values
Preferred Stock

9-1
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 Stock Certificate

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 Facts about Common Stock

• Represents ownership
• Ownership implies control
• Stockholders elect directors
• Directors elect management
• Management’s goal: Maximize the stock price

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 Intrinsic Value and Stock Price

• Outside investors, corporate insiders, and analysts

use a variety of approaches to estimate a stock’s
intrinsic value (P0).
• In equilibrium we assume that a stock’s 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

Managerial Actions, the Economic Environment,

Taxes, and the Political Climate

“True” Investor “Perceived” Investor “Perceived”

“True” Risk
Cash Flows Cash Flows Risk

Stock’s Stock’s
Intrinsic Value Market Price

Market Equilibrium:
Intrinsic Value = Stock Price
9-5
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 Different Approaches for Estimating the Intrinsic
Value of a Common Stock

• Discounted dividend model

• Corporate valuation model
• P/E multiple approach
• EVA approach

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 Discounted Dividend Model

• Value of a stock is the present value of the future

dividends expected to be generated by the stock.

D1 D2 D3 D
P̂0     ... 
(1  rs ) (1  rs ) (1  rs )
1 2 3
(1  rs )

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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
• If g is constant, the discounted dividend formula
converges to:
D0 (1  g) D1
P̂0  
rs  g rs  g

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 Future Dividends and Their Present Values

$ Dt  D0 (1  g)t

0.25 Dt
PVDt 
( 1  r )t

P0  PVDt

0 Years (t)
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Pop Quiz
A stock is expected to pay a dividend of $0.75 at the end of the year. The
required rate of return is rs = 10.5%, and the expected constant growth
rate is g = 6.4%. What is the stock's current price?

a. $17.39
b. $17.84
c. $18.29
d. $18.75
e. $19.22

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Solution

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Pop Quiz
A stock just paid a dividend of D0 = $1.50. The required rate of return is rs
= 10.1%, and the constant growth rate is g = 4.0%. What is the current
stock price?

a. $23.11
b. $23.70
c. $24.31
d. $24.93
e. $25.57

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Solution

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Pop Quiz
A share of common stock just paid a dividend of $1.00. If the expected
long-run growth rate for this stock is 5.4%, and if investors' required rate
of return is 11.4%, what is the stock price?

a. $16.28
b. $16.70
c. $17.13
d. $17.57
e. $18.01

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Solution

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Pop Quiz
If D1 = $1.25, g (which is constant) = 4.7%, and P0 = $26.00, what is the
stock’s expected dividend yield for the coming year?

a. 4.12%
b. 4.34%
c. 4.57%
d. 4.81%
e. 5.05%

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Solution

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Pop Quiz
If D0 = $2.25, g (which is constant) = 3.5%, and P0 = $50, what is the
stock’s expected dividend yield for the coming year?

a. 4.42%
b. 4.66%
c. 4.89%
d. 5.13%
e. 5.39%

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Solution

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Pop Quiz
If D1 = $1.25, g (which is constant) = 5.5%, and P0 = $44, what is the
stock’s expected total return for the coming year?

a. 7.54%
b. 7.73%
c. 7.93%
d. 8.13%
e. 8.34%

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Solution

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Pop Quiz
If D0 = $1.75, g (which is constant) = 3.6%, and P0 = $32.00, what is the
stock’s expected total return for the coming year?

a. 8.37%
b. 8.59%
c. 8.81%
d. 9.03%
e. 9.27%

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Solution

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Pop Quiz
Gay Manufacturing is expected to pay a dividend of $1.25 per share at
the end of the year (D1 = $1.25). The stock sells for $32.50 per share,
and its required rate of return is 10.5%. The dividend is expected to grow
at some constant rate, g, forever. What is the equilibrium expected
growth rate?

a. 6.01%
b. 6.17%
c. 6.33%
d. 6.49%
e. 6.65%

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Solution

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Pop Quiz
Reddick Enterprises' stock currently sells for $35.50 per share. The
dividend is projected to increase at a constant rate of 5.50% per year.
The required rate of return on the stock, rs, is 9.00%. What is the stock's
expected price 3 years from today?

a. $37.86
b. $38.83
c. $39.83
d. $40.85
e. $41.69

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Solution

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Pop Quiz
Goode Inc.'s stock has a required rate of return of 11.50%, and it sells for
$25.00 per share. Goode's dividend is expected to grow at a constant
rate of 7.00%. What was the last dividend, D0?

a. $0.95
b. $1.05
c. $1.16
d. $1.27
e. $1.40

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Solution

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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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 Find the Expected Dividend Stream for the Next
3 Years and Their PVs

D0 = $2 and g is a constant 6%.

0 g = 6%
1 2 3

2.12 2.247 2.382

1.8761
rs = 13%
1.7599
1.6509

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 What is the stock’s intrinsic value?

Using the constant growth model:

D1 $2.12
P̂0  
rs  g 0.13  0.06
$2.12

0.07
 $30.29

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 What is the stock’s expected value, one year
from now?

• D1 will have been paid out already. So, expected P1

is the present value (as of Year 1) of D2, D3, D4, etc.

D2 $2.247
P̂1  
rs  g 0.13  0.06
 $32.10

• Could also find expected P1 as:

P̂1  P0 (1.06)  $32.10

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 Find Expected Dividend Yield, Capital Gains Yield, and
Total Return During First Year

• Dividend yield
= D1/P0 = $2.12/$30.29 = 7.0%
• Capital gains yield
= (P1 – P0)/P0
= ($32.10 – $30.29)/$30.29 = 6.0%
• Total return (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.

0 rs = 13% 1 2 3

2.00 2.00 2.00

PMT $2.00
P̂0    $15.38
r 0.13

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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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 Valuing Common Stock with Nonconstant Growth

D0 = $2.00.
0 rs = 13% 1 2 3 4

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

2.600 3.380 4.394 4.658
2.301
2.647
3.045
4.658
46.114 P̂3   $66.54
54.107 = P̂0 0.13  0.06

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 Find Expected Dividend and Capital Gains Yields
During the First and Fourth Years

• Dividend yield (first year)

= $2.60/$54.11 = 4.81%
• Capital gains yield (first year)
= 13.00% – 4.81% = 8.19%
• During nonconstant growth, dividend yield and
capital gains yield are not constant, and capital
gains yield ≠ g.
• After t = 3, the stock has constant growth and
dividend yield = 7%, while capital gains yield = 6%.

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 Nonconstant Growth: What if g = 0% for 3 years
before long-run growth of 6%?

D0 = $2.00.
0 r = 13% 1 2 3 4
s

g = 0% g = 0% g = 0% g = 6%
2.00 2.00 2.00 2.12
1.77
1.57
1.39
2.12
20.99 P̂3   $30.29
0.13  0.06
25.72 = P̂0
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 Find Expected Dividend and Capital Gains Yields
During the First and Fourth Years

• Dividend yield (first year)

= $2.00/$25.72 = 7.78%
• Capital gains yield (first year)
= 13.00% – 7.78% = 5.22%
• After t = 3, the stock has constant growth and
dividend yield = 7%, while capital gains yield = 6%.

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If the stock was expected to have negative growth (g = -6%),
would anyone buy the stock, and what is its value?

• Yes. Even though the dividends are declining, the stock

is still producing cash flows and therefore has positive
value.

D1 D (1  g)
P̂0   0
rs  g rs  g
$2.00 (0.94) $1.88
   $9.89
0.13  (-0.06) 0.19

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 Find Expected Annual Dividend and Capital
Gains Yields

• Capital gains yield

= g = -6.00%
• Dividend yield
= 13.00% – (-6.00%) = 19.00%
• Since the stock is experiencing constant growth,
dividend yield and capital gains yield are constant.
Dividend yield is sufficiently large (19%) to offset
negative capital gains.

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Pop Quiz
Nachman Industries just paid a dividend of D0 = $1.32. Analysts expect
the company's dividend to grow by 30% this year, by 10% in Year 2, and
at a constant rate of 5% in Year 3 and thereafter. The required return on
this low-risk stock is 9.00%. What is the best estimate of the stock’s
current market value?

a. $41.59
b. $42.65
c. $43.75
d. $44.87
e. $45.99

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Solution

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 Corporate Valuation Model

• Also called the free cash flow method. Suggests the

value of the entire firm equals the present value of
the firm’s free cash flows.
• Remember, free cash flow is the firm’s after-tax
operating income less the net capital investment.

FCF  EBIT(1  T) 
Depr. and   Capital
   NOWC
 amortization expenditures 

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 Applying the Corporate Valuation Model

• Find the market value (MV) of the firm, by finding

the PV of the firm’s future FCFs.
• Subtract MV of firm’s debt and preferred stock to
get MV of common stock.
• Divide MV of common stock by the number of
shares outstanding to get intrinsic stock price
(value).

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 Issues Regarding the Corporate Valuation Model

• Often preferred to the discounted dividend model,

especially when considering number of firms that
don’t pay dividends or when dividends are hard to
forecast.
• Similar to discounted dividend model, assumes at
some point free cash flow will grow at a constant
rate.
• Horizon value (HVN) represents value of firm at the
point that growth becomes constant.

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 Use the Corporate Valuation Model to Find the
Firm’s Intrinsic Value

Given: Long-Run gFCF = 6% and WACC = 10%

0 r = 10% 1 2 3 4

g = 6%
-5 10 20 21.20
-4.545
8.264
15.026
21.20
398.197 530   HV3
0.10  0.06
416.942

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 What is the firm’s intrinsic value per share?

The firm has $40 million total in debt and

preferred stock and has 10 million shares of
common stock.
MV of equity  MV of firm  MV of debt and preferred
 $416.94  $40
 $376.94 million

Value per share  MV of equity/# of shares

 $376.94/10
 $37.69

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Pop Quiz
Mooradian Corporation’s free cash flow during the just-ended year (t = 0)
was $150 million, and its FCF is expected to grow at a constant rate of
5.0% in the future. If the weighted average cost of capital is 12.5%, what
is the firm’s total corporate value, in millions?

a. $1,895
b. $1,995
c. $2,100
d. $2,205
e. $2,315

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Solution

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Pop Quiz
Suppose Boyson Corporation’s projected free cash flow for next year is
FCF1 = $150,000, and FCF is expected to grow at a constant rate of
6.5%. If the company’s weighted average cost of capital is 11.5%, what
is the firm’s total corporate value?

a. $2,572,125
b. $2,707,500
c. $2,850,000
d. $3,000,000
e. $3,150,000

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Solution

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Pop Quiz
Gupta Corporation is undergoing a restructuring, and its free cash flows
are expected to vary considerably during the next few years. However,
the FCF is expected to be $65.00 million in Year 5, and the FCF growth
rate is expected to be a constant 6.5% beyond that point. The weighted
average cost of capital is 12.0%. What is the horizon (or continuing)
value (in millions) at t = 5?

a. $1,025
b. $1,079
c. $1,136
d. $1,196
e. $1,259

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Solution

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Pop Quiz
You must estimate the intrinsic value of Noe Technologies’ stock. The
end-of-year free cash flow (FCF1) is expected to be $27.50 million, and it
is expected to grow at a constant rate of 7.0% a year thereafter. The
company’s WACC is 10.0%, it has $125.0 million of long-term debt plus
preferred stock outstanding, and there are 15.0 million shares of common
stock outstanding. What is the firm's estimated intrinsic value per share
of common stock?

a. $48.64
b. $50.67
c. $52.78
d. $54.89
e. $57.08

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Solution

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Pop Quiz
Kale Inc. forecasts the free cash flows (in millions) shown below. If the
weighted average cost of capital is 11.0% and FCF is expected to grow at
a rate of 5.0% after Year 2, what is the firm’s total corporate value, in
millions?

Year 1 2
Free cash flow -$50 $100

a. $1,456
b. $1,529
c. $1,606
d. $1,686
e. $1,770

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Solution

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Pop Quiz
Based on the corporate valuation model, Wang Inc.’s total corporate
value is $750 million. Its balance sheet shows $100 million notes
payable, $200 million of long-term debt, $40 million of common stock (par
plus paid-in-capital), and $160 million of retained earnings. What is the
best estimate for the firm’s value of equity, in millions?

a. $386
b. $406
c. $428
d. $450
e. $473

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Solution

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Pop Quiz
Based on the corporate valuation model, Morgan Inc.’s total corporate
value is $300 million. The balance sheet shows $90 million of notes
payable, $30 million of long-term debt, $40 million of preferred stock, and
$100 million of common equity. The company has 10 million shares of
stock outstanding. What is the best estimate of the stock’s price per
share?

a. $12.00
b. $12.64
c. $13.30
d. $14.00
e. $14.70

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Solution

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 Firm Multiples Method

• Analysts often use the following multiples to value

stocks.
– P/E
– P/CF
– P/Sales

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 EVA Approach

EVA = Equity capital(ROE – Cost of equity)

MVEquity = BVEquity + PV of all future EVAs

Value per share = MVEquity/# of shares

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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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 If preferred stock with an annual dividend of $5 sells for
$50, what is the preferred stock’s expected return?

D
Vp 
rp
$5
$50 
rp

$5
r̂p 
$50
 0.10  10%

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Pop Quiz
Molen Inc. has an outstanding issue of perpetual preferred stock with an
annual dividend of $7.50 per share. If the required return on this
preferred stock is 6.5%, at what price should the stock sell?

a. $104.27
b. $106.95
c. $109.69
d. $112.50
e. $115.38

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Solution

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Pop Quiz
Carter's preferred stock pays a dividend of $1.00 per quarter. If the price
of the stock is $45.00, what is its nominal (not effective) annual rate of
return?

a. 8.03%
b. 8.24%
c. 8.45%
d. 8.67%
e. 8.89%

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Solution

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Pop Quiz
Rebello's preferred stock pays a dividend of $1.00 per quarter, and it sells
for $55.00 per share. What is its effective annual (not nominal) rate of
return?

a. 6.62%
b. 6.82%
c. 7.03%
d. 7.25%
e. 7.47%

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Solution

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