Lecture 4

Stock Valuations
 Dividends Discount Model
Calculating value for a one-period DDM
BuyBest shares are expected to pay a dividend
at the end of the year of €1.25. The analyst
estimates the required return to be 8% and
the expected price at the end of the year to
be €28.00. The current price is €26.00.
•Calculate the value of the shares today.
•Determine whether BuyBest is overvalued,
undervalued, or properly valued.
Calculating value for a one-period DDM
BuyBest shares are expected to pay a dividend at the end of the
year of €1.25. The analyst estimates the required return to be 8%
and the expected price at the end of the year to be €28.00. The
current price is €26.00. Calculate the value of the shares today.
Determine whether BuyBest is overvalued, undervalued, or
properly valued.

Answer:
The current value of the shares according to the DDM is
equal to:
V0 = ( €1.25 + €28.00) / 1.08 = €27.08

BuyBest is undervalued. We can draw that conclusion by

comparing the current price of €26.00 to the fundamental
value of €27.08.
Calculating value for a two-period DDM
Machines Unlimited shares are expected to pay
dividends of 1.55 Canadian dollars (C$) and C$1.72
at the end of each of the next two years,
respectively. The investor expects the price of the
shares at the end of this 2-year holding period to be
C$42.00. The investor’s required rate of return is
14%. Calculate the current value of Machines
Unlimited shares.
Calculating value for a two-period DDM
Machines Unlimited shares are expected to pay dividends of
1.55 Canadian dollars (C$) and C$1.72 at the end of each of
the next two years, respectively. The investor expects the
price of the shares at the end of this 2-year holding period to
be C$42.00. The investor’s required rate of return is 14%.
Calculate the current value of Machines Unlimited shares.
Calculating value for a three-period DDM
Example: Calculating value for a three-period
DDM Reliable Motors shares are expected to
pay dividends of $1.50, $1.60, and $1.75 at
the end of each of the next three years,
respectively. The investor expects the price of
the shares at the end of this 3-year holding
period to be $54.00. The investor's required
rate of return is 15%. Calculate the current
value of Reliable’s shares.
Calculating value for a three-period DDM
Example: Calculating value for a three-period DDM Reliable
Motors shares are expected to pay dividends of $1.50, $1.60,
and $1.75 at the end of each of the next three years,
respectively. The investor expects the price of the shares at
the end of this 3-year holding period to be $54.00. The
investor's required rate of return is 15%. Calculate the current
value of Reliable’s shares.
 Calculating the Value of
Fixed Rate Perpetual Preferred Stock

United Publishing has a fixe rate perpetual

preferred stock outstanding, with a dividend 6%
(based on Par Value of 100$). If the investor’s
required rate of return is 9.5%, calculate the
current value of these shares.
 Calculating the Value of
Fixed Rate Perpetual Preferred Stock
United Publishing has a fixe rate perpetual preferred
stock outstanding, with a dividend 6% (based on Par
Value of 100$). If the investor’s required rate of return is
9.5%, calculate the current value of these shares.
Calculating value with Gordon Growth Model
DownUnder Financial recently paid a dividend
of 1.80 Australian dollars (A$). An analyst has
examined the financial statements and
historical dividend policy of DownUnder and
expects that the firm’s dividend rate will grow
at a constant rate of 3.5% indefinitely. The
analyst also determines DownUnder beta is
1.5, the risk-free rate is 4%, and the expected
return on the market portfolio is 8%. Calculate
the current value of DownUnder shares.
Calculating value with Gordon Growth Model
DownUnder Financial recently paid a dividend of 1.80 Australian
dollars (A$). An analyst has examined the financial statements and
historical dividend policy of DownUnder and expects that the
firm’s dividend rate will grow at a constant rate of 3.5%
indefinitely. The analyst also determines DownUnder’s beta is 1.5,
the risk-free rate is 4%, and the expected return on the market
portfolio is 8%. Calculate the current value of DownUnder’s shares.
 Calculating the implied
Growth Rate using Gordon Growth Model

Assume that current price and most recent annual

dividend of Aurora Mining (AM) are 24.25$ and 1.1$
respectively. If required rate of return on AM stock is
8.5% then what is the implied growth rate?
 Calculating the implied
Growth Rate using Gordon Growth Model
Assume that current price and most recent annual
dividend of Aurora Mining (AM) are 24.25$ and 1.1$
respectively. If required rate of return on AM stock is
8.5% then what is the implied growth rate?
Calculating Present Value of Growth Opportunities
Reliable Inc Shares trade at 60 Swiss Francs with
expected earnings of 5 Swiss Francs per share and
required rate of return of 10%. Assume that Shares are
properly priced so price is equal to fundamental value.
Calculate the PVGO
Calculating Present Value of Growth Opportunities
Reliable Inc Shares trade at 60 Swiss Francs with
expected earnings of 5 Swiss Francs per share and
required rate of return of 10%. Assume that Shares are
properly priced so price is equal to fundamental value.
Calculate the PVGO.
Estimating Stock Value using Multiple Methods

Level Partners is expected to have earnings of 12 $ in 10

years, a dividend payout ratio of 50% and required rate
of return of 11%. At that time, dividend growth rate is
expected to fall to 4%, the trailing P/E is forecasted to be
eight times the earnings.

Estimate the terminal value at the end of ten years using

GGM and P/E Multiple.
Estimating Stock Value using Multiple Methods
Level Partners is expected to have earnings of 12 $ in 10
years, a dividend payout ratio of 50% and required rate
of return of 11%. At that time, dividend growth rate is
expected to fall to 4%, the trailing P/E is forecasted to be
eight times the earnings. Estimate the terminal value at
the end of ten years using GGM and P/E Multiple.
 Some Characteristics of
Gordon Growth Model (GGM)

•GGM is applicable on stable, mature and

dividend paying firms.
•GGM is appropriate for valuing market
indices.
•GGM can be used to determine price-
implied growth, required rate of returns and
PVGO.
 Some Limitations of Gordon Growth Model

•Valuations are very sensitive to estimates of growth

rates and required rates of return both of which are
difficult to estimate with precession.
•The model can not be easily applied to non-dividend
paying stocks.
•Unpredictable growth pattern of some firms would
make using the model difficult and resulting valuations
unreliable.
 Valuation Using Two Stage Model

•Two Stage DDM is the most basic multistage model in

which we assume that the company grows at a higher
rate for a relatively short period of time (the first stage).

•Then the growth rate reverts to long run stable rate (the
second stage)
Valuation Using Two Stage Model
Valuation Using Two Stage Model
Calculate the Stock Value Using Two Stage Model
Sea Island Recreation currently pays a dividend of 1$. An
Analyst forecasts growth of 10% for next three years
followed by the growth of 4% thereafter. The required
return is 12%. Calculate the value per share.
Calculate the Stock Value Using Two Stage Model
Sea Island Recreation currently pays a dividend of 1$. An
Analyst forecasts growth of 10% for next three years
followed by the growth of 4% thereafter. The required
return is 12%. Calculate the value per share.
Calculate the Stock Value Using Two Stage Model
Valuing Non-Dividend Paying Stock
Valuing Non-Dividend Paying Stock
Calculating Expected Return
Calculating Expected Return Using GGM