CH 5 P.

129

How to value Bonds and stocks

presented by:
yazan maani
murad abo-ghoush
 Key Concepts and Skills

 Know the important bond features and bond types

 Understand bond values and why they fluctuate
 Understand how stock prices depend on future
dividends and dividend growth
 Be able to compute stock prices using the dividend
growth model
 Understand how growth opportunities affect stock
values
 Chapter Outline
5.1 Definitions and Example of a Bond
5.2 How to Value Bonds
5.3 Bond Concepts
5.4 The Present Value of Common Stocks
5.5 Estimates of Parameters in the Dividend- Discount Model
5.6 Growth Opportunities
5.7 The Dividend Growth Model and the NPVGO (net present
value of the growth opportunity) Model

5.8 Price-Earnings Ratio

5.9 Stock Market Reporting
 Definition and Example of Bond 5.1
 A bond is a legally binding agreement between a borrower and a
lender that specifies the:
 Par (face) value
 Coupon rate
 Coupon payment
 Maturity Date
 The yield to maturity is the required market interest rate on the
bond.

 Others Definitions:

 A Bond is a fixed interest financial asset issued by governments,

companies, banks, public utilities and other large entities.
Type of Bonds
- Secured Bond
- Callable Bond
- Convertible Bond
 Agency Bonds
 Municipal Bonds
 corporate Bonds
 Zero Coupon Bond
- This bonds used in United States bonds markets and is the
biggest in the world.
 How to Value Bonds 5.2
 Primary Principle:
 Value of financial securities = PV of expected
future cash flows
 Bond value is, therefore, determined by the
present value of the coupon payments and par
value.
 Interest rates are inversely related to present
(i.e., bond) values.
The Bond Pricing Equation

 1 
1 -
 (1 + R) T  FV
Bond Value = C  +
 (1 + R )
T
 R
 
 Pure Discount Bonds
 Make no periodic interest payments (coupon rate = 0%).
pure discount bond that will make only one payment of
principal and interest.
 Entire Yield maturity = Purchase price – par value (FV)
 Cannot sell for more than par value
 Sometimes called zeroes, deep discount bonds, or
original issue discount bonds (OIDs)
 Treasury Bills and principal-only Treasury strips are good examples
of zeroes.
 How to value Bonds 5.2
 1- Pure Discount Bonds: ( Fixed future date )

• pure discount bond that will make only one payment of principal and interest.
Also called a zero-coupon bond or a single-payment bond. And It Is the
simplest kind of bond.  coupon rate = 0
• Zero- coupon bonds are bonds that do not pay interest during the life of
the bonds.
• The Bond is said to mature or expire on the date of its final payment.
• Face value ( par value ): is the payment at maturity or expire bond.
 Pure Discount Bonds
Information needed for valuing pure discount bonds:

 Time to maturity (T) = Maturity date - today’s date

 Face value (F)
 Discount rate (r)
Value of pure Discount Bond
Present value of a pure discount bond at time 0:

FV
PV =
(1 + R ) T

Where:
FV= face value
R= interest rate
T= years
:Example
 The present value formula can produce some
surprising results, suppose that the interest
rate 10 %. Consider bond with a face value of
$1 million that matures in 20 years, find the
value of bond, its PV is given by:

 PV = FV  PV= _$1 Million_

(1 + R ) T
( 1+10%)^20

= $ 148, 644
Level Coupon Bonds
 Coupon bonds are a type of bond issue that offers the
benefit of receiving an interest payment on a semi-
annual basis.
 The coupon is paid every six months and is the same
throughout the life of the bond.
 The face value of the bound is paid at maturity in end
the final year.
 Value of a level Coupon Bonds
 Typically, F = 1000

C C C F
 PV = ‫ــــــــــــــــــ‬+ ‫ــــــــــــــــــ‬+ ..… + ‫ـــــــــــــــ‬+ ‫ـــــــــــــــــ‬
1+ R (1+ R)^2 (1+R)^t (1+R)^t
Where:
C = Coupon value
F = face value
T = number of years
To calculate value of level coupon bond:
C F
PV = 1 ‫ــــــــــــــ‬ ______
r (1+r)^t
1‫ـــ ــــــــــــــ‬
where: (1+r)^t
C= coupon value
 Exampel
US government bond called ”13s of November 2009” that means the annual coupon rate =13%

− a face value of 1,000

− an annual coupon of 1000 × 13% = 130
− coupons are paid in May and November 130 / 2 = 65
Suppose that today is (( November 2005 )) and the bond is redeemed in (( November
2008 )). The stated annual rate is 10%. What is the price of the bond? The semi-annual
rate is 5%. The payments are shown in the table below.

Date 2006-5 / 2006-11 / 2007-5 / 2007-11 / 2008-5 / 2008-11 / 2009-5 / 2009-11

Payment 65 65 65 65 65 65 65 65 + 1000

Solution: c 1 F
PV= ‫ــــــــــــــــ ـــــــــــــــــ‬- 1 ‫ـــــــــــــ‬
r (1+r )^ t ( 1+r )^t

P = PV
65 1 1000
PV= ‫ــــــــــــــــــــ‬ ‫ـــــــــــــــــــــ‬- 1 ‫ــــــــــــــــــــ‬  1300 * 1 1096$ = 0.68* 1000+ 0.68 ‫ــ‬
0.05 (1.05)^8 (1.05 )^8
:NOTE

 if C > r then P > F (bond sells at premium), if C < r

then P < F (bond sells at discount)

 Where:
c = coupon value
P= PV
F= face value
r = interest rate
 The distinguished between the stated annual interest rate and the
effective annual interest rate:

 The effective annual interest rate is:

( 1 + R / M) ^m – 1
Where:
R= stated annual interest rate
M= number of compounding intervals

In the previous example R = 10% , M= 2 , the effective annual interest

rate is:

( 1 + R / M ) ^m -1  ( 1 + 10% / 2 )^2 – 1 = 10.25 %

** because the bond is paying interest twice a year, the bondholder earns
a 10.25% return.
2- Consols

The conslos Are:

 bonds that never stop paying a coupon.
 have no final maturity date.
 and therefore never mature.
- Called: preferred stock.
Preferred stock is stock that is issued by corporation
and that provides that holder a fixed dividend in
perpetuity.
Example
 If the markwide interest rate is 10%, a consol
with a yearly interest payment on $ 50, the
consol is valued at:

C $ 50
PV= ‫ ــــــــــــــ‬ 500$ = ‫ــــــــــــــ‬
R 0.10
C = consol value with interest payment
R = interest rate
Bond concepts 5.3

 Interest rates and bond prices:

The relationship between interest rates and
bond prices is negative relationship

Interest rate the bonds prices

What is the relationship between interest
?rate, bonds and stock prices? And why
Bond price goes up when interest rate down, and bond
price goes down when interest rates goes up.
Why?
 you have a bond that is worth $1000 and pays 5% coupon
interest. You then decide to sell that bond when interest rates
increased. You will now have to sell that bond for less than
$1000. Since interest rates increased, investors can now get a
bond that is worth $1000 and pays 6%. So in order to make
your bond appealing to investors you will have to lower the price
of your bond so that they can make up for the difference in
interest that your bond is paying. (Remember your bond is
paying 5% and they can easily get one that pays 6%)
 Let's say you are still holding the same 5%
bond and interest rates dropped to 4%. If you
decide to sell your bond now you can charge
more for it because the investors can only
find bonds paying 4% while you have one for
sale offering 5%. The investors will be willing
to pay more for that bond to have the higher
coupon rate.
 The relationship between stocks
and interest rates
 The relationship between stocks and interest rates
are a little more complicated because it has more
variables but the relationship is usually inverse as
well. If interest rates rise stock prices tend to fall.
Interest rates drop stock prices increase.

 Interest rate , the stock price

Level coupon bond is sells in
:following ways
 At the face value of $1000 If coupon rate
equal marketwide interest rate  C = R
 Discount if the coupon rate is below the
marketwide interest rate  C < R
 Premium if the coupon rate is above the
marketwide interest rate.  C > R
 Example 5.2, P.133 Bond valuation
 The interest rate is 10%. A two year bond with a 10% coupon
pays interest of $100
( $100 / 10% = $1000), for simplicity we assume that the
interest is paid annually.

The face value = 1000

C F+C $100 $1000+$100
PV= ‫ـــــــــــــــــــــــــ‬+ ‫ ــــــــــــ‬  = 1000= ‫ــــــــــــــــــــــــــ‬+ ‫ــــــــــــــــــ‬
1+R (1+R)^t 1.10 (1.10)^2

Where: C= coupon value F= face value

If the interest rate unexpectedly
: rises to 12%, the bond sells at

$100 $1000+$100
 = ‫ ــــــــــــــــــ‬+ ‫ــــــــــــــــــــــــــ‬
1+12% (1+12%)^2

= 966.20

Because 966.20 is less than 1000 the bond is

said sell at a discount
 If interest rate fell to 8%, the bond
:would sell at

100 1000+100
= 1035.67 = ‫ ـــــــــــــــــــــــ‬+ ‫ــــــــــــــــ‬
1+8% (1+8%)^2

Because $ 1035.67 more than 1000 the bond is

said to sell at a premium
Yield to maturity
 Yield to maturity is the rate implied by the current
bond price.

 The yield to maturity is the interest rate that equates

the PV of the payments on the bond to the current
bond price.

Spot rate: the theoretical yield on a zero-coupon

Treasury (discount bond).
 If your bond is selling at $1035.67 what return is a
bondholder receiving?
C = 100 Fv = 1000 ( previous example)

100 1000+100
1035.67 = ‫ ـــــــــــــــــــــــــ‬+ ‫ـــــــــــــــــــ‬
1+r (1+r)^2

R = 8% If R= yield maturity
Then a yield maturity = 8%
* The bond with its 10% coupon is priced to yield 8% at 1035.67
 Example
spot rate on one-year discount bond is 8% and on
two year bond is 10%. Find the yield to maturity of a
two-year 5% coupon bond with annual payments and
face value 1,000.

C= 1000 * 5% = 50
C F+C
Bond price  P =‫ــــــــــــــــــ‬+ ‫ــــــــــــــ‬
1+ R (1+R)^t

50 1000+50
= 914 = ‫ ــــــــــــــــــــــــــ‬+ ‫ــــــــــــــــ‬
1+ 0.08 ( 1+ 0. 1)^2
‫‪ Yield to maturity :‬‬

‫‪50‬‬ ‫‪1050‬‬
‫‪  r = 9.95%‬ــــــــــــــــ ‪ +‬ـــــــــــــــــــ = ‪914‬‬
‫)‪(1+r‬‬ ‫‪(1+r)^2‬‬
The present value formulas for Bonds
 Pure discount Bonds
F
PV = ‫ـــــــــــــــ‬
(1+R)^t
 Level coupon Bonds
C 1 F
PV = ‫ـــــــــــــــ ــــــــــــــــ‬- 1 ‫ــــــــــ‬
r (1+R)^t (1+R)^t

where F is typically $1000 for level coupon bond

 Consols
C
PV= ‫ــــــــــــ‬
R
STOCKS
The present value of common 5.4
stocks
 Dividends versus capital gains:
- Stock provides two kinds of cash flow:
1- stocks often pay dividends on regular basis.
2- the stockholder receives the sale price when
selling the stock.
To value of stocks
 We need to answer, which of the following is
the value of a stock equal to?
1- The discounted present value of the sum of
next period’s dividend plus next period’s
stock price.
2- The discounted present value of all future
dividends.
Individual is willing to buy the stock and hold it for one year,
:so P0 for the stock today is equal

Div1 P1
P0 = ‫ــــــــــــــــــ‬+ ‫ــــــــــــــ‬ ( 5.1 )
1+R 1+R

Where: Div1 = dividend paid at year’s end

P1 = price at year’s end
P0 = PV common stock investment
R = discount rate for the stock

PV = P0
The buyer who is willing to purchase
the stock for P1

Div 2 P2
 P1 = ‫ ـــــــــــــــــ‬+ ‫ ــــــــــــــ‬ (5.2)
1+R 1+R
P1  end year’s P0

 ** there must be buyer at the end of year 1.

‫‪ Substituting the value of P1 in Equation 5.1‬‬

‫‪1‬‬ ‫‪Div2 + P2‬‬

‫‪ Div1 +‬ـــــــــــــــ = ‪P0‬‬ ‫ــــــــــــــــــ‬ ‫)‪(5.3‬‬
‫‪1+R‬‬ ‫‪1+R‬‬

‫‪Div1‬‬ ‫‪Div2‬‬ ‫‪P2‬‬

‫ـــــــــــــ ‪ +‬ــــــــــــــ ‪ +‬ـــــــــــــــــــــ =‬
‫‪1+R‬‬ ‫‪(1+R)^2 (1+R)^2‬‬
 ?Where does P2 come from
 Investor at the end of year 2 is willing to pay P2 because
of the dividend and stock price at year 3.

Div1 Div2 Div3

 P0 = ‫ـــــــــــــــ‬+ ‫ــــــــــــــــ‬+ ‫ ـــــــــــــــ‬+ …
1+R (1+R)^2 (1+R)^3

** The investor may want to cash out early , he must find

another investor who is willing to buy. The price this
second investor pays is dependent on dividends after
his date of purchase.
The Present Value of Common Stocks 5.4

 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
 Valuation of different types of stocks
 Case 1 : Zero Growth
Value of stocks with a constant dividend
Div1 Div2 Div1
P0 = ‫ =ـــــــــــــ‬.… + ‫ــــــــــــــ‬+ ‫ــــــــــــــ‬
1+R (1+R)^2 R

Div 1 = div 2 =… = Div

 Case 2 : constant growth
 Dividends grow at rate (g), as follows:

End of year dividend:

1 2 3 4
Div1 Div1 (1+g) Div1(1+g)^2 Div1(1+g)^3

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 =
R−g
Note: Div1 is the dividend at the end of the first period
Zero Growth, constant Growth and
differential Growth patterns
diff erential
grow th g1> g2
Dividends per share

low growth g2
constant
grow th

high growth 91

zero growth G = 0

1 2 3 4 5 6 7 8 9 10
YEAR

 Dividend growth models:

zero growth: P0 = Div1 / R

constant growth: P0 = Div / ( R-g )

 Div N +1 
 
C  (1 + g1 )T   R − g 2 
Deferential growth: P= 1 − +
R − g1  (1 + R)T  (1 + R) N
 Example 5.3 P.138
 Hampshire products will pay a dividend of $4 per
share a year from now. Financial analysts believe
that dividend will raise at 6% per year for the
foreseeable future, what is the dividend per share at
the end of each of the first 5 years? With 6% growth
we have this:
End of year dividend:
1 2 3 4 5
$4 4*(1.06) 4*(1.06)^2 4*(1.06)^3 4*(1.06)^4

= $ 4.24 =$ 4.4944 =$ 4.7641 = $ 5.0499

Value of common stock with
:dividends growing at constant rate

Div1 Div1(1+g) Div(1+g)^2 DIV(1+g)^3 Div1

P0= ‫…=ــــــــــــــــــ‬+ ‫ـــــــــــــــــ‬+ ‫ــــــــــــــــــ‬+ ‫ــــــــــــــــ‬+ ‫ـــــــــــ‬
1+R (1+R)^2 (1+R)^3 (1+R)^4 R-g

Where:
G = growth rate.
Div1 = Dividend on the stock at the end of the first period.
 Example 5.4, P.138
 Investor is considering the purchase of share of the X company. The
stock will pay a $3 dividend a year from today. This dividend is
expected to grow at 10% per year. The investor thinks that the required
return on this stock is 15%, what is the value of share of X company’s
stock?

Div1 $3
P0 = ‫ ـــــــــــــــ‬ P0= 60$ = ‫ــــــــــــــــــــــ‬
R-g 0.15 - 0.1

If g estimated to be 12.5%, what is the value of share?

$3
P0= 120$ = ‫ـــــــــــــــــــــــــ‬.
0.15 – 0.125
 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.
 Example 5.5

The dividend for a share of stock a year from today will be $ 1.15. during the
following four years the dividend will grow (g1) at 15% per year.
After that growth will equal (g2) 10% per year. Calculate the present value of the
stock if the required return is 15%? Calculate the present value of the dividends
at the end of each the first five year.

End of year 1 2 3 4 5

Dividends 1.15 1.3225 1.5209 1.7490 2.0114

 Div1 Div1(1+g) Div1(1+g)^2
PV= ‫ـــــــــــــــــــــــــــــ‬+ ‫ ــــــــــــــــــــــ‬+ ‫ ـــــــــــــــــــ‬+…. To calculate PV
1+R (1+R)^2 (1+R)^3 in (g1) = 15%

Future year Growth rate Expected Present value

Dividend
1 0.15 $ 1.15 $1

2 0.15 $ 1.3225 1

3 0.15 $ 1.5209 1

4 0.15 $ 1.7490 1

5 0.15 $ 2.0114 1

Years 1-5 PV of dividends

=5
calculate PV of dividend Beginning at
end for year 6
 End of year dividend in g2 = 10%

End of year 5 6 7 8 9

Dividends 2.0114 )Div5 (1+g Div5(1+g)^2 Div5(1+g)^3Div5(1+g)^4

2.2125 2.4338 2.6772 2.9449

We use Div5 because it’s the beginning year, ( end of the first period )
The price at the end of year 5 :
Div6 $2.2125
P5 = 44.25$ = ‫ـــــــــــــــــــ =ــــــــــــــــــــــ‬
R-G2 0.15 - 0.1

The present value of P5 today

P5 $44.25
22$ = ‫ــــــــــــــــــــ = ــــــــــــــــــــ‬
(1+R)^5 (1.15)^5

The present value of all dividends today is

22+5 = $27
 : Differential growth equation
 an N-year annuity growing at rate g1

C  (1 + g1 )T 
PA = 1 − 
R − g1  (1 + R )T 

 plus the discounted value of a perpetuity growing at rate g2

that starts in year N+1
D iv N + 

R −g 
1

PB = 2 

(1 +R ) N

 Consolidating give:
 Div N +1 
 
C  (1 + g1 )   R − g 2 
T
P= 1 − T 
+
R − g1  (1 + R )  (1 + R ) N
 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%.

 Div N +1 
 
C  (1 + g1 )   R − g 2 
T
P= 1 − T 
+
R − g1  (1 + R )  (1 + R ) N

 $2(1.08)3 (1.04) 
 
$2 × (1.08)  (1.08) 3
  . 12 − .04 
P= 1 −  +
.12 − .08  (1.12) 3  (1.12) 3

P = $54 × [1 − .8966] +
( $32.75) P = $5.58 + $23.31
3
(1.12)
P = $28.89
Estimates of Parameters 5.5
 The value of a firm depends upon its growth rate, g, and its discount
rate, R.

Net investment = investment – Depreciation

Net investment = zero when total investment equal Depreciation.  No
growth in earning.
Net investment could be Positive only if some earnings are not paid out as
dividends, that is occur if some earnings are retained.

g = Retention ratio × Return on retained earnings

Where: g : is growth rate in dividends

 Earnings Growth
 X company Enterprises just reported earning of $ 2million, it plans to retain 40%
of its earnings. The historical return on equity (ROE) has been 16%, a figure that is
expected to continue into the future. How much will earning grow over the coming
year?
We have two method:
First: estimate for future returns
firm retain  40% × 2 million = 800,000

the increase in earning :

$ 800,000 × 0.16 = 128,000

The percentage growth in earning :

128,000
Change in earning = 0.064= ‫ــــــــــــــــــــــــــــــ‬
total earnings 2 million
Second:

G= retention × ROE  = 40% × 16% = 0.064

?Where does R come from
 The discount rate can be broken into two
parts.
 The dividend yield
 The growth rate (in dividends)
 Using the dividend Growth model -(DGM) to Find R

 Start with the DGM:

D 0 (1 +g) D1
P0 = =
R -g R -g
Rearrange and solve for R:
D 0 (1 +g) D1
R= +g = +g
 That mean, the total return (R) has tow components:
 1- Div1 / P0  called dividend yield.

P0 P0
 Growth rate (g)  the dividend growth rate is also the rate at which the stock price grows  capital gains yield
 :Example
 Suppose, the stock selling for $25 per share, the next
dividend will be $1 per share, you think the dividend will
grow by 10% per year. What return does this stock offer
you if this is correct?

 R= Div1 / P0 + g  R = 1 / $25 + 10%

= 4% + 10%
= 14%

we expected return of 14% percent

Where: R= return
 To calculate the price in one year P1,
Div1 × (1+g) 1 × (1+10%)
P1=‫ــــــــــــــــــــــــــــ =ـــــــــــــــــــــــــــــــــــ‬
( R-g ) ( 14% - 10% )

= 1.10 ÷ 0.04
= $ 27.5 ~ $ 28
Stock selling in $25 and stock price grown 10%
If you will pay $25 for the stock today, you will get $1 dividend at the end year,

Dividend yield = 1 ÷ 25 = 4 %

you have a gain equal  $28 – $25 = $3

And you capital gain yield equal  3 ÷ 25 = 10%

total return  4% + 10 % = 14%

Where : R = dividend yield + Capital gains yield

R= Div1 / P0 + g
 Growth Opportunities 5.6
 Growth opportunities are opportunities to invest in positive NPV
projects.

 When company will pay all earnings out to stockholder as

dividends,
 EPS = Div  that called cash cow

Where :
EPS : earnings per share
Div : Dividends per share

*value of share of stock when firm acts as a cash cow:

EPS = Div
R R

Where: R = discount rate on stock

 Stock price after firm commits to new project:

EPS
P= + NPVGO
R
 Where:
NPVGO = net present value of the growth opportunity
This equation : indicate that the price of stock can be sum of two different items:
1- ( EPS / R )  is the value of the firm if it rested , simply ( distributed all
earning to the stockholders).
2- the additional (NPVGO) value if the firm retains earning to fund new projects.
 Example
 X company expected to earn $1miliion per year. And no new investment opportunities. There are 100,000 shares of
stock outstanding, the firm will have an opportunity at date 1 to spend $ 1 million on a new marketing campaign. The
new campaign will increase earnings in every subsequent period by $ 210,000. this is a 21% return per year on the
project. The firm’s discount rate is 10%.
 What is the value per share before and after deciding to accept the marketing campaign?

Solution: - we must find the earnings per share (EPS), and NPVGO.

expects earn = 1million , stock outstanding = 100,000

earning per share (EPS) = 1 million / 100,000 = $ 10.
now we will calculate value of share of X company before the campaign:
Firstly : value of share when firm acts as a cash cow:
EPS = $ 10 . = $100
R 10%
To find NPVGO:
Secondly: Value of marketing campaign at date 1: ( investment is made at date 1)
- 1 million + 210,000 = 1,100,000 ( the cash inflow occur at date 2)
10%
Thirdly: we determine the value at date 0  ( 1+r)
1,100,000 / 1.1 = 1.000.000
So NPVGO = 1 million / 100,000 = $10
Finally: price per share = EPS / R + NPVGO  100 + 10 = $110
 Summary of the example:
All the earnings at date 1 are spent on the marketing effort, and no
dividends are paid to stockholder at that date.
- Dividends in all periods are equal 1million (annual dividend when X
company is cash cow) + 210,000 (dividends from marketing) =
1210000
- Dividends per share are equal Dividends in all period (1210000)/ stock
outstanding (100,000) = $ 12.1
- Because the Dividends are start ate date 2, the price per share at date1
= 12.1 / 10% = 121.
- The price per share at date 0 = 121 / 1+10% = 110.
We have tow condition must be in
:order to increase value
1- Earnings must be retained so that projects
can be funded
2- the projects must have positive NPV.

Firm value when invests in growth opportunities positive ( + ) NPVGO .

Firm value when opportunities negative (-) NPVGO

 The dividend Growth model and 5.7
the NPVGO model

 We have two ways to value a stock:

 The dividend discount model
 The sum of its price as a “cash cow” plus the per
share value of its growth opportunities
 Example when firm’s value fall  (NPVGO is
(negative
 Suppose, x company has EPS of $30 at the end of the first year, a dividend payout ratio of 50%, discount rate of 15%, and return on its
retained earning of 25%, calculate the price per share.
( using the Dividend growth model and NPVGO model )
Firstly: Dividend growth model:
dividends at date 1  50% × $30 = $15 per share.  EPS × payout ratio
retention ratio  1 – 50% = 0.5.  ( 1- payout ratio )
growth rate in dividends  0.25 × 0.5 = 0.13 return on retained earning × retention ratio

Price value of share of stock today  Div1 / (R-g) = $15 / (0.15 – 0.13) = 750

Secondly: The NPVGO model

1- value per share of a single growth opportunity:
EPS = $30 from Question
Firm retains  $30 × 0.5 = 15  EPS × retention ratio
Firm earns  15 × 0.25 = $3.75  firm retains on investment × return on retained earning

NPV from investment of date 1  ( - firm retains on investment + . Firm earn . ) - 15 + 3,75 = 10
R 0.15
2- value per share of all opportunities:
- Growth rate of earning and dividends = 0.13
- Return earning at date 2  15 × (1+0.13)  15 × 1.13 = $16.95  firm retains × (1+g)
- Firm earns  16.95 × 0.25 = 4.238  return earning at date 2 × return on retained earning
- NPV from investment of date 2  - 16.95 + 4.238 = - 478.9
0.15
NPVGO is negative ( so the value of firm will be fall)
 Example when value of firm’s increase 
(+(positive NPVGO
 Suppose, X company has EPS of $10 at the end of the first year, a dividend payout ratio of 40%, a discount rate of
16%, and a return on its retained earnings of 20%. Calculate the price per share.
( using the Dividend growth model and NPVGO model )

Firstly: the Dividend growth model:

Dividends at date 1  40% × $10 = $4 per share  dividend payout × EPS
Retention ratio  ( 1- 40%) = 0.6  (1 - dividend payout)
Growth rate in dividends  0,6 × 20% = 0.12  retention ratio × return on retained earning
Price of share of stock today  Div1 / ( R-g)  $4 / (0.16 – 0.12 ) = $100

Secondly: The NPVGO model:

1- value per share of a single growth opportunity
EPS = $10
Firm retains  0.6 × $10 = $6  EPS × retention ratio
Firm earns  $6 × 20% = 1.20  firm retains × return on retained earning
NPV from investment of date 1  -6 + 1.20 / 0.16 = 1.50  - firm retains on investment + ( firm earns /R )
2- value per share of all opportunities:
Growth rate of earning and dividends = 12%
Retained earning at date 2  $6 × ( 1+ 12% ) = $ 6.72  firm retains × ( 1+ g)
Firm earns  6.72 × 20% = 1.344 return earning at date 2 × return on retained earning
NPV from investment at date 2 (- 6.72 + 1.344 / 0.16) = 1.68  -firm retains on investment + firm earns
R
 ‫‪VPV from investment at date 3‬‬

‫‪The retained earnings at date 3  6 × (1+12%)^2 = 7.5264‬‬

‫‪Firm earns  7.5264 × 20% = 1.5053‬‬
‫‪NPV from investment at date 3  -7.5264 + 1.5054 / 0.16 = 1.882‬‬
‫‪1.50‬‬ ‫‪1.68‬‬ ‫‪1.882‬‬
‫………‪ +‬ـــــــــــــ ‪+‬ـــــــــــــــــ ‪+‬ــــــــــــــــــ = ‪NPVGO‬‬
‫‪1.16‬‬ ‫‪(1.16)^2 (1.16)^3‬‬
‫‪We can write:‬‬
‫‪1.50‬‬ ‫)‪1.50 ( 1.12‬‬ ‫‪1.50 (1.12)^2‬‬
‫………‪ +‬ــــــــــــــــــ ‪ +‬ـــــــــــــــــــــــــــــ ‪ +‬ـــــــــــــــــــــــــــــ‬
‫‪1.16‬‬ ‫‪(1.16)^2‬‬ ‫‪(1.16)^3‬‬

‫‪1.50‬‬
‫ـــــــــــــــــــــــــــ = ‪NPVGO = 37.50$‬‬
‫‪0.16 – 0.12‬‬

‫‪NPVGO positive so value of firm will be increase‬‬

‫‪3- value per share if the firm is a cash cow:‬‬

‫‪Div‬‬ ‫‪$10‬‬
‫ــــــــــــــــــــ =ــــــــــــــــ =‪P0 = 62.5‬‬
‫‪R‬‬ ‫‪0.16‬‬

‫‪To find NPVGO when NPVGO positive ( + ): for more than one date‬‬

‫‪NPV date1‬‬ ‫‪NPVdate1 (1+g)^t‬‬

‫‪ + ………….‬ــــــــــــــــــــــــــــــــــ ‪ +‬ـــــــــــــــــــــــــــــــــــــــــــ‬
‫)‪(1+R‬‬ ‫‪( 1 + R )^t‬‬
)Price Earnings Ratio (PEr
 PEr is calculated as:
EPS
price per share = ‫ ــــــــــــــ‬+ NPVGO
R
Where :
EPS = earning per share
R = discount ratio
 Dividing by EPS yield
price per share 1 NPVGO
‫ ــــــــــــــــــــ‬+ ‫ـــــــــــــــــــــــــــــــــ = ـــــــــ‬
EPS R EPS
PE ratio is related to : NPVGO

Left side  is formula for the price earning ratio.

PE ratio= price per share / EPS

EX: consider two firm A , B  firm A has many valuable growth

opportunities, and firm B has no growth opportunities as all. each
having just reported earning per share of $1. the firm A should sell at a
higher price. Because an investor is buying both current income of $1
and growth opportunities. Suppose, firm A sells for $16, and firm B sells
for $8, the $1 earning per share number appears in the denominator of
the PE ratio for both firm, the PE (price earning) for firm A = $16 and for
firm B = $8
 Stock Market Reporting
 We can find this in financial newspaper.

52-week YDL VOL NET

HI LO stock (DIV) % PE 100s Close CHG
62.29 44.40 HarleyDav 0,64 1.2 16 70028 54.05 2.56

- The first two number { 62.29 and 44.40} are  highest and lowest prices for the stock over the
past 52 weeks.
- Stock (DIV) annual Dividends harley pays dividends quarterly, 0,64 is actually latest
quarterly dividend multiplied by 4, so cash dividend paid was $0,64 / 4 = $0.16 or 16 cent per
share.
- Close  is closing price of the day
- Net CHG  that the closing price of $54.05 is 2.56 higher than it was the day before so harely
was up 2.56 for the day
- YDL  the dividend yield based on the current dividend and the close price this is, $ 0.64 /
54.05 = 1.2%
- PE  price earning ratio closing price / annual earnings per share
- VOL tell us how many shares traded the day
Quick Quiz
 How do you find the value of a bond, and why do
bond prices change?
 What is a bond indenture, and what are some of the
important features?
 What determines the price of a share of stock?
 What determines g and R in the DGM?
 Decompose a stock’s price into constant growth and
NPVGO values.
 Discuss the importance of the PE ratio.