Class 5 - Stocks

We want to attempt to value a stock. Stocks often provide dividends, and also provide the
sale price when the stock is sold.

If Pt represents the value of the stock [it may be the value of all the shares, or the value/share,
depending on the context] at time t, Divt represents the dividend at time t, and r is the appropriate
discount rate, then:

P0 = Div1/(1+r) + P1/(1+r)

P1 = Div2/(1+r) + P2/(1+r)

 P0 = Div1/(1+r) + Div2/(1+r)2 + P2/(1+r)2

 Continuing we get: P0 = Div1/(1+r) + Div2/(1+r)2 + Div3/(1+r)3 + …

In the case of constant dividends, Div1 = Div2 = … and P0 = Div/r (using the
perpetuity formula)

In the case of constant growth Div1 = Div0(1+g), Div2 = Div1(1+g) etc.

P0 = Div1/(r-g) *

The above model, *, is called the dividend discount model, or the Gordon model, named
after Professor Myron Gordon of the University of Toronto.

Exercise: Differential growth – growth at rate g1 for the first T years and growth at rate g2
after that. Draw a picture describing the series of dividends (start from Div1 in 1 year) and
derive the formula for the price, P, of the stock.

Where does the g come from in the Gordon model?

The theory is:

Earnings next year = Earning this year + Retained Earnings this year x Return on Retained earnings

Therefore, dividing both sides by “earning this year”, we get:

Earnings next year/Earnings this year = 1 + Retained Earnings this year/Earnings this year x Return on
Retained earnings

1
The left hand side of the above equation is 1+g. The ratio of retained earnings to earnings
is called the retention ratio.

Therefore:

1+g = 1 + Retention Ratio x Return on Retained Earnings

The return on retained earnings is usually estimated by the firm’s historical return on
equity (ROE)

Thus g = Retention ratio x ROE *

Example:

ABC Company just reported earnings of $1.6 million, and plans to retain 28% of its
earnings. If ABC has ROE of 12%, what is its expected growth rate?

g = .28 x .12 = .0336 = 3.36%

If it expects to continue to retain 28% of its earnings in the future, and if its ROE of 12%
can be maintained, find the value of ABC company, if the appropriate discount rate is
11%.

Next year, the company will earn 1.6 x (1.0336) and payout 72% of that.

Therefore P0 = (1.6 x 1.0336 x .72)/(.11 - .0336) = 1.1907/.0764 = 15,585,100

The Gordon formula can be rearranged to: r = Div1/P0 + g

The first term on the right hand side is the dividend yield. If we can estimate g from *
above, or otherwise, we can estimate the discount rate r.

Growth Opportunities:

Another approach to valuing a firm, or the shares of a firm is to consider growth

opportunities.

To start, imagine a company with no growth opportunities, and a level stream of earnings
in perpetuity. Since it has no growth opportunities, it has no reason to retain any of its
earnings, so it pays them all out as dividends.

EPS = Div, and P0 = EPS/r = Div/r where r is the discount rate on the firm’s stock.

2
Suppose the firm (at time t = 0) discovers a growth opportunity – a “worthwhile”
opportunity to invest some amount at time t=1, to receive a cash flow at time t=2.

The net present value at time t=0 of this growth opportunity is called PVGO.

Because of this opportunity P0 = EPS/r + PVGO.

Example:

Canadian Electronics expects to earn $100 million per year in perpetuity, if it does not
take on any new projects. The firm has an opportunity to invest $15 million today and
another $5 million in 1 year, in order to generate an additional $10 million/year in
perpetuity starting in 2 years. The firm has 20 million shares outstanding, and the
required rate of return on the stock is 15%.

What is the price of the stock without the growth opportunity?

Answer: 100/.15 = 666.667 million is the value of the firm
666.667/20 = $33.33 is the value per share without the growth opportunity

What is the value of the growth opportunity?

Answer: PVGO = -15 –5/1.15 + 1/(1.15)[10/.15] = $38.623 million

What is the price per share of the stock with the growth opportunity?
Answer: The additional value per share of taking on this opportunity is 38.623/20 =
$1.93, so the price per share is $33.33 + $1.93 = $35.26

In class exercise:

Consider a firm that expects a $2/share dividend in 1 year, with dividends growing after
that at 5% annually forever. Suppose r= 12%.

a) Find the price/share now

b) Find the price/share in exactly 10 years (just after the expected dividend is paid)
c) Find the value of the investment in exactly 10 years
d) How much of the investment is capital gain and how much is due to the
dividends?