Chapter 7

Equity Markets and

Stock Valuation

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McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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Chapter Outline
• Common Stock Valuation
• Some Features of Common and Preferred
Stocks
• The Stock Markets

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Stock Valuation
• As with bonds, the price of the stock is the
present value of these expected cash
flows
• If you buy a share of stock, you can
receive cash in two ways
– The company pays dividends
– You sell your shares, either to another
investor in the market or back to the company
(selling price)
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One Period Example

• Suppose you are thinking of purchasing
the stock of Moore Oil, Inc. and you
expect it to pay a $2 dividend in one year
and you believe that you can sell the stock
for $14 at that time. If you require a return
of 20% on investments of this risk, what is
the maximum you would be willing to pay?
– Compute the PV of the expected cash flows
– Price (P0) = (D1 + P1)/(1+r)
= (2 + 14) / (1.2) = $13.33

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Two Period Example

• Now what if you decide to hold the stock

for two years? In addition to the dividend
in one year, you expect a dividend of
$2.10 and a stock price of $14.70 at the
end of year 2. Now how much would you
be willing to pay?

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Three Period Example

• Finally, what if you decide to hold the stock for
three periods? In addition to the dividends at the
end of years 1 and 2, you expect to receive a
dividend of $2.205 at the end of year 3 and a stock
price of $15.435. Now how much would you be
willing to pay?

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Developing The Model

• You could continue to push back when
you would sell the stock
• Hold for N-period:
– P0=D1/(1+r)+D2/(1+r)2+...+(Dn+Pn)/(1+r)n
• You would find that the price of the stock
is really just the present value of all
expected future dividends
• So, how can we estimate all future
dividend payments?
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Estimate Div: Special Cases

• 1) Constant dividend
– The firm will pay a constant dividend forever
• 2) Constant dividend growth
– The firm will increase the dividend by a constant
percent every period, forever
• 3) Supernormal growth
– Dividend growth is not consistent initially, but
settles down to constant growth eventually

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1) Constant Div (zero growth)

• If dividends are expected at regular intervals
forever, then this is like preferred stock and is
valued as a perpetuity
• P0 = D / r
• Suppose stock is expected to pay a $0.50
dividend every quarter and the required return is
10% with quarterly compounding. What is the
price?

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2) Constant Dividend Growth

(Div Growth Model)
• Dividends are expected to grow at a
constant percent (g%) per period, forever.
– P0 = D1 /(1+r) + D2 /(1+r)2 + D3 /(1+r)3 + …
– P0 = D0(1+g)/(1+r) + D0(1+g)2/(1+r)2 +
D0(1+g)3/(1+r)3 + …
• With a little algebra, this reduces to:
D 0 (1 + g) D1
P0 = =
r -g r -g
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Example 1
• 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, how
much should the stock be selling for?

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Stock Price Sensitivity to

Dividend Growth, g
250
D1 = $2; r = 20%
200
Stock Price

150

100

50

0
0 0.05 0.1 0.15 0.2
Growth Rate

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Stock Price Sensitivity to

Required Return, r
250
D1 = $2; g = 5%
200
Stock Price

150

100

50

0
0 0.05 0.1 0.15 0.2 0.25 0.3
Required Rate of return

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Example 3

• Gordon Growth Company is expected to

pay a dividend of $4 next period and
dividends are expected to grow at 6% per
year. The required return is 16%.
• What is the current price?

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Continued…Example
• What is the price expected to be in year
4?

• What is the implied return given the

change in price during the four year
period?

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 3) Super Normal Growth 7-16
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(Non-constant Growth)
• Suppose a firm is expected to increase
dividends by 20% in one year and by 15%
in second year. 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?
• Remember that we have to find the PV of
all expected future dividends.
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Nonconstant Growth – Example

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Quick Quiz: Part 1

• What is the value of a stock that is
expected to pay a constant dividend of $2
per year if the required return is 15%?
(P0=$13.33)
• What if the company starts increasing
dividends by 3% per year, beginning with
the next dividend? The required return
stays at 15%. (P0 =$17.17)

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Using the DGM to Find r

• Start with the DGM:
D1
P0 =
r -g
rearrange and solve for r
D1
r= +g
P0

r = Dividend Yield + Capital gains Yield

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Finding the Required Return

• Suppose a firm’s stock is selling for
$10.50. They just paid a $1 dividend and
dividends are expected to grow at 5% per
year. What is the required return?

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Features of Common Stock

• Voting Rights
• Proxy voting
• Classes of stock
• Other Rights
– Share proportionally in declared dividends
– Share proportionally in remaining assets
during liquidation
– Preemptive right – first shot at new stock
issue to maintain proportional ownership if
desired
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Dividend Characteristics
• Dividends are not a liability of the firm until a
dividend has been declared by the Board
• Consequently, a firm cannot go bankrupt for not
declaring dividends
• Dividends and Taxes
– Dividend payments are not considered a
business expense, therefore, they are not tax
deductible
– Dividends received by individuals are taxed as
ordinary income

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Features of Preferred Stock

• Dividends
– Stated dividend that must be paid before
dividends can be paid to common
stockholders
– Dividends are not a liability of the firm and
preferred dividends can be deferred
indefinitely
– Most preferred dividends are cumulative – any
missed preferred dividends have to be paid
before common dividends can be paid
• Preferred stock generally does not carry
voting rights
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Stock Market
• Dealers vs. Brokers
– A Dealer maintains inventory and stands to
buy & sell at any time
• Dealers market
• NASDAQ
– A Broker brings buyer & seller together, but
does not maintain an inventory
• Auction market
• NYSE
• Bursa Malaysia

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Quick Quiz
• Suppose that sales and profits of ABC Bhd.
are growing at a rate of 30% per year. At the
end of four years the growth rate will drop to a
steady 6%. At the end of year 5, the company
will issue its first dividend in the amount of
RM3 per share. If the required return is 15%,
what is the value of a share of stock? Assume
dividends grow at the same rate as earnings
after year 4. (P0 = $19.06)

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Tutorial

• Problem 2, 4, 14, 16 & 18 from page 225

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