Brigham Ch9 Stock Edited 97 2003

9-1
Stocks and Their Valuation

(Ref: Brigham, E.F., and J.F. Houston. 2001. Fundamentals of
Financial Management, 9th Ed, Harcourt College Publishers, Ch. 9)
Features of common stock

Determining common stock values
Efficient markets
Preferred stock
Copyright 2002 by Harcourt, Inc.
All rights reserved.
9-2
Facts about Common Stock
Represents ownership.
Ownership implies control.
Stockholders elect directors.
Directors elect management.
Managements goal: Maximize the
stock price.
9-3
Social/Ethical Question
Should management be equally
concerned about employees,
customers, suppliers, and the
public, or just the stockholders?
In an enterprise economy,
management should work for
stockholders subject to constraints
(environmental, fair hiring, etc.) and
competition.
9-4
When is a stock sale an initial public

offering (IPO)?
A firm goes public through
an IPO when the stock is first
offered to the public.
9-5
Biggest IPOs of 2000 in the USA

Issuer
Proceeds from sale
AT&T Wireless
$9.03 billion
Infineon Technologies
$2.72 billion
Metropolitan Life Ins. Co.
$2.50 billion
TyCom
$2.88 billion
Genuity
$1.91 billion
9-6
Average Initial Returns on IPOs in

Various Countries
100%
75%
50%
a
C
an
ad
U
St nit
at ed
es
Ja
pa
n
Sw
ed
en
al
il
B
ra
z
Po
rt
ug
al
ay
si
a
25%
9-7
Different Approaches for Valuing

Common Stock
1. Dividend growth model:
- Constant Growth (Gordon) Model
- Supernormal (Non-constant) Growth Stock
- Erratic Growth Stock
2. Free cash flow method

3. Using the multiples of comparable
firms
9-8
When to use the models?

Constant growth model: most
appropriate for mature companies w
stable history of growth, and stable
future dividends.
Free cash flow method: good for the
large number of companies that dont
pay a dividend, or for whom it is hard to
forecast dividends.
9-9
Definitions of Terms
Dt = Dividend the stockholder expects to
receive at the end of Year t. D0 is the

most recent dividend, which has
already been paid; D1 is the first
dividend expected, and will be paid at
the end of this year; D2 is the dividend
expected at the end of two years, and
so forth. D1 represents the first cash
flow a new purchaser of the stock will
receive. Note that D0, the dividend that
has been paid, is known with certainty.
But all future dividends are expected
values, so the estimate of Dt may differ
among investors.
P0 = Actual market price of the stock today
9 - 10
P0 = Expected price of the stock at the end of

Year t (pronounced P hat t). P0 is the
intrinsic, or theoretical, value of the stock
today as seen by the particular investor
doing the analysis; P1 is the price
expected at the end of one year; and so on.
Note that P0 is the intrinsic value of the stock
today based on a particular investors
estimate of the stocks expected dividend
stream and the
riskiness of that stream.
Hence, whereas
the market price P0 is
fixed and is identical for all investors, P0
could differ among investors depending on
how
optimistic they are about the
company.
The caret, or hat is used to
indicate that Pt is an estimated value.
cont
9 - 11
cont
P0, the individual investors estimate of the
intrinsic value today, could be above or
below P0, the current stock price, but an
investor would buy the stock only if
his/her estimate of P0 were equal or
greater than P0. Since they are many
investors in the market, there can be many
values for P0. However, we can think of an
average or marginal investors whose
actions actually determine the market
price. For these marginal investors, P0
must = P0; otherwise a disequilibrium
would exist, and buying and selling in the
market would change P0, until P0 = P0 for
the marginal investor.
9 - 12
Market Price, P0 = the price at which

the stock sell in the market
Intrinsic Value, P0 = the value of an
asset that, in the mind of a particular
investor, is justified by the facts; P 0
may be different from the assets
current market price.
Growth Rate, g = The expected rate of
growth in dividends per share.
9 - 13
g = expected growth rate in dividends

as predicted by a marginal investor.
If dividends are expected to grow at
a constant rate, g is also equal to the
expected rate of growth in earnings
and in the stocks price. Different
investors may use different gs to
evaluate a firms stock, but the
market price, P0, is set on the basis
of the g estimated by marginal
investors.
9 - 14
Required Rate of Return, ks = The

minimum rate of return on a common
stock that a stockholder considers
acceptable.
ks = minimum acceptable, or required,
rate of return on the stock,
considering both its riskiness and
the returns available on other
investments. Again, this term
generally relates to marginal
investors. The determinants of ks
include the real rate of return,
expected inflation, and risk.
9 - 15
Expected Rate of Return, ks = The rate

of return on a common stock that a
stockholder expects to receive in the
future.
ks = Expected rate of return that an
investor who buys the stock expects
to receive in the future. Ks
(pronounced k hat s) could be
above or below ks, but one would
buy the stock only if ks were equal or
greater than ks.
9 - 16
Actual, Realized Rate of Return, ks = The rate

of return on a common stock actually
received by stockholders in some past
period. Ks may be greater, or less than,
and/or ks.
ks = actual, or realized, after-the fact rate of
return (pronounce k bar s). You may
expect to obtain a return of ks= 15% if you
buy Exxon today, but if the market goes
down, you may end up next year with an
actual realized return that is much lower,
perhaps even negative.
9 - 17
Dividend Yield = The expected

dividend divided by the current price
of a share of stock.
D1/P0 = Expected dividend yield on the
stock during the coming year. If the
stock is expected to pay a dividend
of D1 = $1 during the next 12 months,
and its current price is P0 = $10, then
the expected dividend yield is $1/$10
= 0.10 = 10%
9 - 18
Capital Gains Yield = The capital gain

during a given year divided by the
beginning price.
(P1-P0)/P0 = Expected capital gains
yield on the stock during the coming
year. If the stock sells for $10 today,
and if it is expected to rise to $10.50
at the end of one year, the expected
capital gain is P1- P0 = $0.50.
Expected capital gain yield =
$0.50/$10 = 5%
9 - 19
Expected Total Return = The sum of

the dividend yield and the expected
capital gains yield.
Expected total return = ks = Expected
dividend yield (D1/P0) + expected
capital gains yield (P1-P0)/P0. In our
example, the expected total return is
10% + 5% = 15%
9 - 20
Stock Value = PV of Dividends

P 0
D1
1 k
s
D2
1 k
s
D3
1 k
s
. . .
1 k
What is a constant growth stock?

A stock whose dividends are expected to
grow forever at a constant rate, g.
9 - 21
For a Constant Growth Stock

D1 = D0(1 + g)1
D2 = D0(1 + g)2 = D1(1+g)1
Dt = D0(1 + g)t
If g is constant, then:
D0(1 + g)
D1
P0 =
=
ks g
ks g
^
9 - 22
D t D0 1 g
Dt
PVD t
t
1 k
0.25
P0 PVD t
0
If g > k, P0 !
Years (t)
9 - 23
What happens if g > ks?
P0 =
D1
ks g
requires ks > g
If ks< g, get negative stock price,

which is nonsense.
We cant use model unless (1) k s > g
and (2) g is expected to be constant
forever.
9 - 24
Assume beta = 1.2, kRF = 7%, and kM =

12%. What is the required rate of
return (ks) on the firms stock?
Use the SML to calculate ks:

ks= kRF + (kM kRF) Firm
= 7% + (12% 7%) (1.2)
= 13%
9 - 25
D0 was $2.00 and g is a constant 6%.

Find the expected dividends for the
next 3 years, and their PVs (ks = 13%)
0
g = 6%
D0 = 2.00 2.12
13%
$1.8761
$1.7599
$1.6509
2
2.247
3
2.382
9 - 26
Whats the stocks market value?

D0 = 2.00, ks = 13%, g = 6%
Constant growth model:
D1
$2.12
P0 =
=
ks g
0.13 0.06
=
$2.12
0.07
= $30.29
9 - 27
What is the stocks market value one

^ ?
year from now, P
1
D1 will have been paid, so expected
dividends are D2, D3, D4 and so on.
With P0= $30.29, D2=D1(1+g)=$2.12(1.06)=$2.247;
D2
$2.247
P1 =
=
ks g
0.13 0.06
= $32.10
^
Could^also find P1 as follows:
P1= P0(1.06)=30.29(1.06)=$32.10
9 - 28
Find the expected dividend yield,

capital gains yield, and total return
during the first year.
D1
$2.12
Dividend yld =
=
= 7.0%
P0
$30.29
^
P 1 P0
$32.10
$30.29
Cap gains yld =
=
$30.29
P0
= 6.0%
Total return = 7.0% + 6.0% = 13.0%
9 - 29
Rearrange model to rate of return form:
D
D
1
1
g
P0
to
k
s
k s g
P0
^
Then, ks = $2.12/$30.29 + 0.06

= 0.07 + 0.06 = 13%
9 - 30
^
What would P0 be if g = 0?
The dividend stream would be a
perpetuity.
0
13%
2.00
2.00
2.00
...
P0 = PMT = $2.00 = $15.38

k
0.13
9 - 31
If we have supernormal growth of 30%

for 3 years, then a long-run constant
g = 6%, what is P^0? ks is still 13%.
Can no longer use constant growth
model.
However, growth becomes constant
after 3 years.
9 - 32
Valuing a Supernormal/Non-constant
Growth Stock
Supernormal/non-constant growth is that
part of the firms life cycle in which it grows
faster than the economy as a whole.
Steps to Value Supernormal Growth Stock:
1. Compute the expected future cash
dividends
cont.
9 - 33
2. Compute the stocks price at a

future point in time, using constant
growth model Pt = Dt+1/(r-g). (You
must pick a point after the dividend
growth rate has become constant)
3. Compute the PV of the expected
future sale price and add that to the
PV of all the expected cash
dividends between now and then.
(Source: Emery, D.R., J.D. Finnerty and
J.D. Stowe.1998. Principles of Financial
Management. Prentice Hall, pp 172-173)
9 - 34
Nonconstant growth followed by

constant growth:
0 k = 13% 1
s
g = 30%
D0 = 2.00
2
g = 30%
2.600
3
g = 30%
3.380
4
g = 6%...
4.394
...
4.658
2.301
2.647
3.045
46.114
54.107
= P0
P 3
4.658
.
$66.54
0 .13 0.06
9 - 35
What is the expected dividend yield

and capital gains yield at t = 0?
At t = 4? (Div yield0=Div1/Price)
Div. yield0 = $2.60 = 4.81%.
$54.11
Cap. gain0 = (ks- div yield)
=13.00% 4.81% = 8.19%.
9 - 36
During nonconstant growth,

dividend yield (D/P) and capital
gains yield are not constant, and
capital gains yield is not equal to g.
After t = 3, g = constant = 6% =
capital gains yield; ks = 13%; so D/P
= 13% 6% = 7%.
9 - 37
Suppose g = 0% for t = 1 to 3, and then

^
g is a constant 6%. What is P0?
0
ks=13%
g = 0%
2.00
2
g = 0%
2.00
1.77
1.57
1.39
20.99
25.72
3
g = 0%
2.00
4
g = 6%
2.00
...
2.12
2.12

30.29.
P
3
0.07
9 - 38
What is D/P and capital gains yield at

t = 0 and at t = 3?
t = 0:
D1 $2.00
=
= 7.78% (D/P=div yield)
P0 $25.72
CGY = 13% 7.78% = 5.22%.
t = 3: Now have constant growth

with g = capital gains yield = 6% and
D/P = 7%. (CGY=capital gain yield)
9 - 39
What is the annual dividend yield (D/P)

and capital gains yield?
Capital gains yield = g = -6.0%,

Dividend yield= 13.0% (-6.0%) = 19%.
D/P and cap. gains yield are constant,
with high dividend yield (19%) offsetting
negative capital gains yield.
9 - 40
If g = -6%, would anyone buy the

stock? If so, at what price?
Firm still has earnings and still pays
dividends, so P0 > 0:
D
1
+
g
D
0
1
0 =
=
P
g
g
ks
ks
= $2.00(0.94) = $1.88 = $9.89.
0.13 (-0.06)
0.19
9 - 41
Further Example of Supernormal Growth

Stock
Netscape is operating in a new industry that has
recently caught on with the public. Sales are
growing at 80% per year. This high sales growth is
expected to translate into a 25% growth rate in cash
dividends for each of the next 4 years. After that, the
dividend growth rate is expected to be 5% forever.
Annual dividend paid yesterday is $0.75. The stocks
required return is 22%. What is Netscapes stocks
price?
(Source: Emery et al, Principles of Financial Management. 1998.
pp 172-173)
cont.
9 - 42
i) Compute the expected future cash dividends:
Time
Div($)
g(%)
0
1
2
3
4
5
6 ...
0.75
0.938
1.172
1.465 1.831
1.923
2.019
25%
25%
25%
25%
5%
5%
5%
ii) Find the stock price at a future time, a point after which the dividend growth rate has
become constant forever. That point is at year 5, thus:
P5 = D6/(r-g) = $2.019/(0.22-0.05) = $11.876
iii) Compute the PVs of all the future expected cash dividends found in step (i)
and add to the PV of the expected future sale price (P5) calculated in step (ii):
P0 = 0.938/1.221 + 1.172/1.222 + 1.465/1.223
+ 1.831/1.224 + 1.923/1.225 + 11.876/1.225
= $(0.768 + 0.787 + 0.807 + 0.827 + 0.711 + 4.394)
= $8.295
9 - 43
Valuing An Erratic-Growth Stock (EGS)

Definition: An EGS is a stock which is
expected to have an erratic dividend
growth for some finite time, followed by a
normal rate forever into the future.
P0=D1/( 1+r)1 + D2/(1+r)2 +Dn/(1+r)n + {(1+g)Dn)/[(1+r)n(r-g)]}
(Source: Emery et al., Principles of Financial Management. 1998.
pp 173-174)
cont..
9 - 44
Example:
Novells dividend was $1 last year and is to be $1 for
each of the next 3 years. After its projects have been
developed, earnings are expected to grow at a high rate
for 2 years as sales resulting from new projects are
realized. The higher earnings are expected to result in
40% increase in dividends for 2 years. After these 2
extraordinary increases in dividends, the dividend
growth rate is expected to be 3% per year forever.
Novells required rate of return is 12%. What is the worth
of its share today?
(i) First compute the expected future dividends:
Time
7 ..
Div($)
1.00
1.00
1.00
1.00
1.40
1.96
2.019
2.079
Growth
.
0%
0%
0%
40%
40%
3%
3%
cont
3%
9 - 45
(ii) D5 is where the growth rate in dividends is expected to
become constant forever and is the earliest point that
satisfies the constant-growth assumption. With D5 =$1.96,
g=3%, and r = 12%,
P0 = D1/( 1+r)1 + D2/(1+r)2 +Dn/(1+r)n + (1+g)Dn/{(1+r)n(r-g)}
P0 = 1.00/1.121
+ 1.00/1.122
+ 1.00/1.123
+1.40/1.124
+ 1.96/1.125
+ (1+0.03)1.96/{(1.12)5(0.12-0.03)}
= $17.13
9 - 46
Free Cash Flow Method/Total Company or

Corporate Valuation Model
The free cash flow method suggests

that the value of the entire firm
equals the present value of the firms
free cash flows (calculated on an
after-tax basis).
Recall that the free cash flow in any
given year can be calculated as:
NOPAT Net capital investment
(NOPAT= Net operating profit after taxes)
9 - 47
The Corporate Valuation Model (Text,pg 306)

Market Value=Vcompany= PV of expected future Free
cash flows of company
= FCF1/(1+r)1 +FCF2/(1+r)2+FCFn/(1+r)n
FCF
= (EBIT(1-T) + Dep + Amort)

- (Cap Exp + Change in NOWC);
or
FCF
= NOPAT New Investment in Operating Cap
9 - 48
Using the Free Cash Flow Method

Once the value of the firm is estimated,
an estimate of the stock price can be
found as follows:
MV of common stock (market
capitalization) = MV of firm MV of
debt and preferred stock.
^
P = MV of common stock/# of shares.

9 - 49
Issues Regarding the Free Cash Flow

Method
Free cash flow method is often
preferred to the dividend growth
model -- particularly for the large
number of companies that dont pay
a dividend, or for whom it is hard to
forecast dividends.
Cont..
9 - 50
FCF Method Issues (continued)

Similar to the dividend growth model,
the free cash flow method generally
assumes that at some point in time,
the growth rate in free cash flow will
become constant.
Terminal value represents the value of
the firm at the point in which growth
becomes constant.
9 - 51
FCF estimates for the next 3 years are
-$5, $10, and $20 million, after which the FCF is
expected to grow at 6%. The overall firm cost of
capital is 10%.
(r-g = 0.10-0.06 = 0.04)
0
k = 10%
4
g = 6%
-5
-4.545
8.264
15.026
398.197
$416.942
10
20
...
21.20
21.20
$530 = 0.04 = *TV3
*TV3 represents the terminal value of

the
firm,
at
t
=
3
9 - 52
If the firm has $40 million in debt and

has 10 million shares of stock, what is
the price per share?
Value of equity = Total value Value of debt
= $416.94 $40
= $376.94 million
Price per share = Value of equity/# of shares
= $376.94/10
= $37.69
9 - 53
Using the Multiples of Comparable

Firms to Estimate Stock Price
Analysts often use the following multiples to
value stocks:
P/E
P/CF
P/Sales
P/Customer
Example: Based on comparable firms,
estimate the appropriate P/E. Multiply this by
expected earnings to back out an estimate of
the stock price.
9 - 54
What is market equilibrium?(Text,pg310-312)
In equilibrium, stock prices are stable.

There is no general tendency for
people to buy versus to sell.
In equilibrium, expected returns must
equal required returns:
^
ks = (D1/P0) + g = ks = kRF + (kM kRF)firm

9 - 55
Expected returns are obtained by estimating

dividends and expected capital gains (which
can be found using any of the three
common stock valuation approaches).
^
Ks = (D1/P0) + g
Required returns are obtained from the
CAPM:
ks = kRF + (kM kRF)firm
9 - 56
How is equilibrium established?

If k^s = D1 + g > ks (CAPM) then
P0
P0 is too low (a bargain).
Buy orders > sell orders;
P0 bid up; D1/P0 falls until
^
(D1/P0) + g = ks = ks
9 - 57
Why do stock prices change?

D1
P0 =
.
ki g
^
1. ki could change:
ki = kRF + (kM kRF )bi.
kRF = k* + IP.
2. g could change due to
economic or firm situation.
9 - 58
Whats the Efficient Market Hypothesis

(EMH)?
EMH: Securities are normally in

equilibrium and are fairly priced.
One cannot beat the market
except through good luck or better
information.
9 - 59
1. Weak-form EMH:
Cant profit by looking at past
trends. A recent decline is no
reason to think stocks will go up
(or down) in the future.
Evidence supports weak-form
EMH, but technical analysis is
still used.
9 - 60
2. Semistrong-form EMH:
All publicly available
information is reflected in
stock prices, so doesnt pay to
pore over annual reports
looking for undervalued
stocks. Largely true, but
superior analysts can still
profit by finding and using new
information.
9 - 61
3. Strong-form EMH:
All information, even inside
information, is embedded in
stock prices. Not true--insiders
can gain by trading on the basis
of insider information, but thats
illegal.
9 - 62
Markets are generally efficient

because:
1. 15,000 or so trained analysts; MBAs,
CFAs, Technical PhDs.
2. Work for firms like Merrill, Morgan,
Prudential, which have a lot of money.
3. Have similar access to data.
4. Thus, news is reflected in P0 almost
instantaneously.
9 - 63
Preferred Stock
Hybrid security.
Similar to bonds in that preferred
stockholders receive a fixed dividend that
must be paid before dividends can be paid
on common stock.
However, unlike interest payments on
bonds, companies can omit dividend
payments on preferred stock without fear
of pushing the firm into bankruptcy.
9 - 64
Whats the expected return of

preferred stock with Vp = $50 and
annual dividend = $5?
$5
Vp $50
.
kp
k p $5 0.10 10.0%.
$50

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9-1

Stocks and Their Valuation

Features of common stock

Copyright 2002 by Harcourt, Inc.

All rights reserved.

Facts about Common Stock

All rights reserved.

All rights reserved.

When is a stock sale an initial public

Copyright 2002 by Harcourt, Inc.

All rights reserved.

Biggest IPOs of 2000 in the USA

Proceeds from sale

Metropolitan Life Ins. Co.

Copyright 2002 by Harcourt, Inc.

All rights reserved.

Average Initial Returns on IPOs in

Copyright 2002 by Harcourt, Inc.

All rights reserved.

Different Approaches for Valuing

2. Free cash flow method

Copyright 2002 by Harcourt, Inc.

All rights reserved.

When to use the models?

Copyright 2002 by Harcourt, Inc.

All rights reserved.

receive at the end of Year t. D0 is the

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P0 = Expected price of the stock at the end of

All rights reserved.

All rights reserved.

Market Price, P0 = the price at which

Copyright 2002 by Harcourt, Inc.

All rights reserved.

g = expected growth rate in dividends

All rights reserved.

Required Rate of Return, ks = The

All rights reserved.

Expected Rate of Return, ks = The rate

All rights reserved.

Actual, Realized Rate of Return, ks = The rate

All rights reserved.

Dividend Yield = The expected

All rights reserved.

Capital Gains Yield = The capital gain

All rights reserved.

Expected Total Return = The sum of

Copyright 2002 by Harcourt, Inc.

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Stock Value = PV of Dividends

What is a constant growth stock?

All rights reserved.

For a Constant Growth Stock

Copyright 2002 by Harcourt, Inc.

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What happens if g > ks?

If ks< g, get negative stock price,

Assume beta = 1.2, kRF = 7%, and kM =

Use the SML to calculate ks:

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D0 was $2.00 and g is a constant 6%.

All rights reserved.

Whats the stocks market value?

Copyright 2002 by Harcourt, Inc.