Chapter 9: Valuation of

Common Stocks

Objective
Explain equity evaluation
using discounting

1
Copyright Prentice Hall Inc. 1999. Author: Nick Bagley

Dividend policy
and wealth

Chapter 9 Contents
9.1 Reading stock listings
9.2 The discounted dividend model
9.3 Earning and investment opportunity
9.4 A reconsideration of the price
multiple approach
9.5 Does dividend policy affect
shareholder wealth?
2

9.1 Reading Stock Listings

The following newspaper stock
listing is usually printed as a
horizontal string of information
The listing is for IBM, which is
traded on the New York Stock
Exchange
3

Reading Stock Listings

Yr Hi
Yr Lo
123 1/8 93 1/8

Stock
IBM

Sym
IBM

Div
4.84

PE
16

Vol 100
14591

Yld %
4.2

Day Hi Day Lo Close

115

113

Net Chg

114 3/4 +1 3/8

4

9.2 The Discounted

Dividend Model
A discounted dividend model is any
model that computes the value of a
share of a stock as the present
value of the expected future cash
dividends

Present Value of Dividends

P0 = D1/(1+k)+ D2/(1+k)2+ D3/(1+k)3
+...+
With constant growth rate
D2 = D1(1+g), D3 = D2(1+g), etc.
Hence, P0 = D1/(k-g)
6

Present Value of Dividends

P0 = D1/(1+k)+ D2/(1+k)2+ D3/(1+k)3
+...+
P1 = D2/(1+k)+ D3/(1+k)2+ D4/(1+k)3
+...+
Using the above equations P0 = (P1 + D1)/(1+k)
7

Capital gain yield = g =

dividend growth rate
P0 = D1/(k-g)
P1 = D2/(k-g)
D2 = D1(1+g)
Using the above equations (P1 - P0)/P0 = g
8

Discount rate k = rate of

return on the stock =
market capitalization rate

Recall
P0 = (P1 + D1)/(1+k)
on
thethat
stock
Subtracting P0/(1+k) from both sides
of the above equation and
simplifying we get:
k = (P1 + D1 - P0)/ P0 =
rate of return on the stock = market
capitalization rate on the stock
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Discount rate k =
Dividend yield plus capital
gain yield

k = (P1 + D1 - P0)/ P0 = annual rate of

return on the stock, or
k = D1/ P0 + (P1 - P0)/ P0

This relationship tells you that next

years expected dividend yield + the
expected capital gain yield is equal to
the required rate of return
10

Solving for k
k = D1/ P0 + (P1 - P0)/ P0

g = (P1 - P0)/ P0

Hence, k = D1/ P0 + g
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9.3 Earning and

Investment Opportunity
A second approach to DCF valuation
focuses on future earnings and
investment opportunities
This focus, rather than the earlier
dividend focus, concentrates the
analysts attention on the core
business determinants of value
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Earning and Investment

Opportunity
To simplify the analysis, suppose that
no new shares are issued, and no taxes
Dividends = earnings - net new investment
D = E - I. The formula for valuing stock is

Dt
Et
It
p0

t
t
t
t 1 1 k
t 1 1 k
t 1 1 k
13

Interpretation
The value of a company is not equal
to the present value of its expected
earnings
The value of a company is equal to
the present value of its expected
earnings net of new investments
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Nogrowth
Nogrowth Co has a policy of no net new
investments
This does not mean the firm does not invest
in new plant and equipment--only that
purchases match the loss of value of the
existing assets (as measured by
depreciation)
If we assume everything is in real terms, it
is reasonable to assume that Nogrowth will
pay a constant (say) $15/share each year
15

Nogrowth
If the real capitalization rate is 15%,
then the value of Nogrowth is
15/0.15 = $100

16

Growth Stock
Growthstock Co initially has the
same earnings as Nogrowth, but
reinvests 60% of its earnings each
year into new investments that yield
a real rate of return of 20% per year

17

Growth Stock
The management of Growthstock may
be thought of as taking 60% of the
shareholders value, and reinvesting it
on behalf of the shareholders.
The earnings retention rate is 60%
and the dividend payout ratio is 40%

18

Growth Stock
The first year dividend is $15*0.4 = $6
At the end of first period $9 is invested at 20% rate, which gives a
perpetuity of $1.8 beginning second period.
The total earnings at the end of the second year are equal to $15 + $1.8 =
$16.8
Second year dividend is $16.8*0.4=$6.72

in year 1 to obtain $15*0.6*0.20 = $1.8 forever

In year 1 this has a value of $1.8/0.15 = $12
There is a second, third, fourth, flow starting in year 3, 4, 5, also $12
The present value of these streams is 12/0.15 = $80

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Growth Stock
At the end of second year $16.8*0.6 =
$10.08 is invested at 20% rate, which gives
a perpetuity of $2.016 beginning third
period.
The total earnings at the end of the third
year are equal to $15 + $1.8 + $2.016 =
$18.816
Third year dividend is
$18.816*0.4=$7.5264
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Growth Stock
First year dividend = $6
Second year dividend = $6.72 = $6(1.12)
Third year dividend = $7.5264 = $6.72(1.12)
The dividend growth rate of 12% is not a
coincidence - it is equal to the earnings
retention rate of 60% times the 20% rate of
return of new investments.
g = 20% * 60% = 0.20 * 0.60 = 0.12=12%
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Generalize
Let the
g = dividend growth rate
b = earnings retention rate
R = ROE on new investments
Then g = b * R

22

A Reconsideration of the
Price Multiple Approach
Recall the
P0 = e1/k + NPV of future investments

In terms of P/E
P0/ E1 = 1/k + NPV/ E1 of future investments
Firms with high PE ratios are then interpreted
as having low capitalization rates or
excellent future investment opportunities
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Does Dividend Policy

Affect Shareholder
Wealth?

Dividend policy of a corporation

The policy regarding paying out cash to
its shareholders, holding constant its
investment and borrowing decisions

24

9.4 Reconsideration of the

P/E Multiple Approach
The formula for a growing perpetuity is:
E1
E1 g Po
E1
Po
Po

NPVfurure investment
kg
k
k
k

25

9.5 Does Dividend Policy

Affect Shareholder
Wealth?

In a frictionless world where there are

no taxes nor transaction costs, the
dividend policy (as defined in the last
slide) will have no affect on the wealth
of stock holders
We shall examine: tax, regulations, cost
of external financing, and information
content of dividends
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Cash Dividends and Share

Repurchases
A corporation may distribute cash
By paying dividends
All shareholders are paid the same per share

By repurchasing its own stock

Shareholders choosing to liquidate some or
all of their holdings sell the shares at market
price (as they normally do), and the
company makes market purchases
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Illustration: Dividend
Payment
The following table shows a
simplified balance sheet of Cashrich
Co
Assume
Number of shares outstanding =
500,000
Share price = $20
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Illustration: Dividends
Assets
Cash

Liab\ Equ
2

Debt

Other

10

Equity

10

Total

12

Total

12

29

Illustration: Dividend
Payment
If Cashrich declares a dividend of $2 /
share it will pay 500,000 * $2 =
$1,000,000
Given its level of risk, the payment will
reduce the market value of the shares by
$1,000,000 to $20 * 500,000 - $1,000,000
= $9,000,000, so each share will be worth
$9,000,000 / 500,000 = $18 / share
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Illustration: Dividend
Payment
Was 2
Assets
Cash

Was 10

Liab\ Equ
1

Debt

2
9

Other

10

Equity

Total

11

Total

31

11
Were 12

Illustration: Dividend
Payment
Before the dividend, every share
was worth $20
After the $2 / share dividend, every
share was worth $18
Conclusion
Shareholders wealth is unchanged
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Illustration: Share
Repurchase
The original balance is shown below
Share price is still $20
Number of shares outstanding is
500,000

33

Illustration: Share
Repurchase
Assets
Cash

Liab\ Equ
2

Debt

Other

10

Equity

10

Total

12

Total

12

34

Illustration: Share
Repurchase
The company repurchases 50,000
shares at $20 per share = $1,000,000
The market value of the firm is now
$10,000,000 less the loss of $1,000,000
cash, or $9,000,000
The number of shares outstanding is now
500,000 - 50,000 = 450,000

35

Illustration: Share
Repurchase
The share price is then
$9,000,000/450,000 = $20

The wealth of the shareholders who

sold out is unchanged
The wealth of the shareholders who
held the stock is unchanged
36

Illustration: Share
Repurchase Was 2
Assets
Cash

Was 10

Liab\ Equ
1

Debt

2
9

Other

10

Equity

Total

11

Total

37

11
Were 12

Stock Dividends
Corporations sometimes declare a stock
split and distribute stock dividends
These activities do not distribute cash to the
shareholders
They increase the number of issued shares,
but do not change the % of the company
each shareholder owns

They do not affect shareholder wealth

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Modigliani and Miller

In a frictionless environment, where
there are no costs of issuing new
shares of stock, nor costs of
repurchasing existing shares, a
firms dividend policy can have no
effect on the wealth of current
shareholders
39

The Real World: Share

Repurchase
Smart Co has had a good year, and
is considering repurchasing some
outstanding stock in order to prevent
some of its shareholders paying
personal income tax on the dividend
There are restrictions on this kind of
practice in many countries, including
the USA
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The Real World:

Asymmetric Information
The management of Cryptic Co is
concerned that the investment
community does not understand its
business
It has decided to finance projects using
cheaper retained earnings rather than
issuing more stock at a discount from
its true market value
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The Real World: Signaling

The management of Trip Co has had a
single bad year, but has decided not
to reduce its dividend
Reducing the dividend may send a signal
to the investment community saying
The fundamentals of Trip have changed:
consider decreasing future dividend
estimates and/or consider increasing the
cost of capital to compensate for
additional risk
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