Stock Valuation
Corporate Finance
Dr. A. DeMaskey
1
Learning Objectives

Questions to be answered:







What are the rights and privileges of stock
ownership?
What types of common stock exist?
How can stock market transactions be
classified?
How are stocks valued?
What is the total return on stocks?
What does stock market equilibrium mean
and how is it established?
What is preferred stock and how is it valued?
2
Facts About Common Stock
Represents ownership.
 Ownership implies control.
 Stockholders elect directors.
 Directors hire management.
 Management’s goal: Maximize stock
price.

3
Basics of Common Stock

Preemptive Right


Right to purchase new shares in
proportion to current holdings.
Classified Stock
Founders’ shares, with voting rights but
dividend restrictions.
 New shares might be called “Class A”
shares, with voting restrictions but full
dividend rights.

4
The Market for Common
Stock

Secondary Market

Primary Market

Initial Public Offering (IPO) Market
5
The Dividend Valuation
Model

Stock Value = PV of Expected Dividends
Pˆ0 
D1
D2
D

 ... 
1
2

1  ks  1  ks 
1  ks 

Dt

t
t 1 1  k s 
6
Return on Stocks

Total return = Dividend yield +
Capital gains yield
Dividend yield = D1/P0
 Capital gains yield = (P1 – P0)/P0


If dividends are paid quarterly, the
annual return is
(1 + quarterly return)4 – 1.0
7
Zero Growth Model
Dividends are not expected to grow
over time.
 Value of a zero growth stock:

D
ˆ
P0 
ks

The expected rate of return:
D
ks 
P0
8
Constant Growth Model
Dividends are expected to grow at
some normal, or constant rate
forever.
 For a constant growth stock,
Dt = D0(1 + g)t
 If g is constant, then

D0 1  g 
D1
ˆ
P0 

ks  g
ks  g
9
$
D t  D 0 1  g
t
Dt
PVDt 
t
1

k


0.25
P0   PVDt
0
If g > k, P0  !
Years (t)
What happens if g > ks?
D
1

P0 
requires k s  g.
ks  g


If ks< g, get negative stock price, which
is nonsense.
We cannot use the model unless (1) g 
ks and (2) g is expected to be constant
forever. Because g must be a longterm growth rate, it cannot be  ks.
11
Growth Rate of Dividends

The growth rate, g, can be stated in
terms of the dividend payout ratio:

D1 

g  k s 1 
 EPS1 


The greater ks, the higher the expected
growth rate of dividends.
The greater the dividend payout ratio, the
lower the expected growth rate of dividends.
12
Total Expected Return on a
Constant Growth Stock

Rearrange the constant growth
model to rate of return form:
 
P
0
D1
D1

to ks 
 g.
ks  g
P0
13
Nonconstant Growth Model


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Find the present value of the dividends during
the period of non-constant growth.
Find the price of the stock at the end of the nonconstant growth period, at which point it has
become a constant growth stock, and discount
this price back to the present.
Add these two components to find the stock’s
present value.
P0 = PV of DIV during constant growth period +
PV of DIV after the constant growth period to
infinity
14
Summary of Dividend
Valuation Model


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The greater the current dividend, the
grater the value of a share of stock.
The greater the expected growth in
dividends, the greater the value of a
share of stock.
The greater the uncertainty of dividends,
the greater the discount rate and the
lower the value of a share of stock.
15
Stock Market Equilibrium


In equilibrium, stock prices are
stable. There is no general
tendency for people to buy versus
to sell.
^
The expected price, P, must equal
the actual price, P. In other words,
the fundamental value must be the
same as the price.
16
Stock Market Equilibrium



If the expected rate of return is less than the
required rate of return, investors will desire to
sell the stock.
If the expected rate of return is greater than the
required rate of return, investors will try to
purchase the stock.
Only at the equilibrium price, where the
expected returns and the required returns are
equal, will the stock be stable.
^
ks = D1/P0 + g = ks = kRF + (kM kRF)b.
17
How is stock market
equilibrium established?



^
^
If ks = (D1/P0) + g > ks, then P0 is “too
low.”
If the price is lower than the fundamental
value, then the stock is a “bargain.”
Buy orders will exceed sell orders, the
price will be bid up, and D1/P0 falls until
^
D1/P0 + g = ks = ks.
18
Why do stock prices
change?
D1
P0 
ki  g
^

ki = kRF + (kM - kRF)bi could change



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Inflation expectations
Risk aversion
Company risk
g could change
19
Preferred Stock

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Hybrid security.
Similar to bonds in that preferred
stockholders receive a fixed dividend
which must be paid before dividends can
be paid on common stock.
However, unlike bonds, preferred stock
dividends can be omitted without fear of
pushing the firm into bankruptcy.
20
Valuation of Preferred Stock

The value of preferred stock is found as:
Vp 


Dp
kp
The greater the preferred dividend, the
greater the value of a share of preferred
stock.
The greater the required rate of return, the
lower the value of preferred stock.
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