Stock Valuation

(Chapter 9)

PV of common stocks
The value of any asset is the present value of its
expected future cash flows.
Stock ownership produces cash flows from:

Dividends
Capital Gains

Valuation of Different Types of Stocks

Zero Growth
Constant Growth
Differential Growth

Case 1: zero growth

Assume that dividends will remain at the same level

forever

Div 1 = Div 2 = Div 3 =

Since future cash flows are constant, the value

of a zero growth stock is the present value of a

perpetuity:

Div 3
Div 1
Div 2
+
+
+
P0 =
1
2
3
(1 + R ) (1 + R ) (1 + R )
Div
P0 =
R

Case 2: Constant Growth

Assume that dividends will grow at a constant rate, g,

forever, i.e.,

Div 1 = Div 0 (1 + g )

Div 2 = Div 1 (1 + g ) = Div 0 (1 + g ) 2

Div 3 = Div 2 (1 + g ) = Div 0 (1 + g )

Since future cash flows grow at a constant rate

forever, the value of a constant growth stock is the
present value of a growing perpetuity:

Div 1
P0 =
Rg

Constant Growth Example

Suppose Big D, Inc., just paid a dividend

of $.50. It is expected to increase its
dividend by 2% per year. If the market
requires a return of 15% on assets of this
risk level, how much should the stock be
selling for?
P0 = .50(1+.02) / (.15 - .02) = $3.92

Case 3: Differential Growth

Assume that dividends will grow at different

rates in the foreseeable future and then will
grow at a constant rate thereafter.
To value a Differential Growth Stock, we need
to:
Estimate future dividends in the foreseeable
future.
Estimate the future stock price when the stock
becomes a Constant Growth Stock (case 2).
Compute the total present value of the estimated
future dividends and future stock price at the
appropriate discount rate.

Differential Growth

Assume that dividends will grow at rate g1 for

N years and grow at rate g2 thereafter.
Div 1 = Div 0 (1 + g1 )
Div 2 = Div 1 (1 + g1 ) = Div 0 (1 + g1 ) 2
.
.

Div N = Div N 1 (1 + g1 ) = Div 0 (1 + g1 ) N

Div N +1 = Div N (1 + g 2 ) = Div 0 (1 + g1 ) (1 + g 2 )
N

.
.

Differential Growth
Dividends will grow at rate g1 for N years and grow
at rate g2 thereafter
Div 0 (1 + g1 ) Div 0 (1 + g1 ) 2

Div 0 (1 + g1 ) N

Div N (1 + g 2 )
= Div 0 (1 + g1 ) N (1 + g 2 )

N+1

Differential Growth
We can value this as the sum of:
a T-year annuity growing at rate g1

C (1 + g1 )T
PA =
1
T
R g1 (1 + R )
plus the discounted value of a perpetuity

growing at rate g2 that starts in year T+1

Div T +1

R g2

PB =
T
(1 + R )

Differential Growth

Consolidating gives:

Div T +1

T
C (1 + g1 ) R g 2
+
P=
1
T
T
R g1 (1 + R ) (1 + R )

A Differential Growth Example

A common stock just paid a dividend of $2. The
dividend is expected to grow at 8% for 3 years,
then it will grow at 4% in perpetuity.
What is the stock worth? The discount rate is 12%.

Apply the formula

$2(1.08) 3 (1.04)

3
.12 .04
$2 (1.08) (1.08)

P=
+

.12 .08 (1.12) 3

(1.12) 3

(
$32.75)
P = $54 [1 .8966] +
3
(1.12)

P = $5.58 + $23.31

P = $28.89

Using Cash flow to calculate price

$2(1.08)
0

$2.16
0

$2(1.08)

$2(1.08) $2(1.08) (1.04)

$2.33
2

The constant
$2.62
$2.52 +
growth phase
.12 .04beginning in year 4

can be valued as a
growing perpetuity
at time 3.

$2.16 $2.33 $2.52 + $32.75

P0 =
+
+
= $28.89
2
3
1.12 (1.12)
(1.12)

$2.62
P3 =
= $32.75
.08

Estimate of parameters

The value of a firm depends upon its

growth rate, g, and its discount rate, R.
Where does g come from?
g = Retention ratio

Where does R come from

The discount rate can be broken into two

parts.
The dividend yield
The growth rate (in dividends)

In practice, there is a great deal of

estimation error involved in estimating R.

Using DGM to find R

Start with the DGM:

D 0 (1 + g)
D1
=
P0 =
R -g
R -g
D 0 (1 + g)
D1
+g=
+g
R=
P0
P0

Growth Opportunities

Growth opportunities are opportunities to

invest in positive NPV projects.
The value of a firm can be conceptualized
as the sum of the value of a firm that pays
out 100% of its earnings as dividends plus
the net present value of the growth
opportunities.
EPS
P=
+ NPVGO
R

Example of NPVGO
Consider a firm that has forecasted EPS of $5, a discount
rate of 16%, and is currently priced at $75 per share.
We can calculate the value of the firm as a cash cow.

EPS $5
P0 =
=
= $31.25
R
.16
So, NPVGO must be: $75 - $31.25 = $43.75

How Retention Rate affect Firm

value

An increase in the retention rate will:

Reduce the dividend paid to shareholders
Increase the firms growth rate

These have offsetting influences on stock

price
Which one dominates?
If ROE>R, then increased retention increases
firm value since reinvested capital earns more
than the cost of capital.

Suggested Exercise

Chapter 9: 4,7,10