Valuation of Common

Stocks and Corporations

1
 Topics in Chapter

 Features of common stock

 Valuing common stock
 Dividend Discount Model
 Constant growth stocks
 Non-constant growth stocks

2
Common Stock: Owners, Directors,
and Managers

 Represents ownership.
 Ownership implies control.
 Stockholders elect directors.
 Directors hire management.
 Since managers are “agents” of
shareholders, their goal should be:
Maximize stock price.

3
 Equity securities

 Equity securities represent ownership in a

corporation
 These securities represetn resibual claim
 There are two types of equities:
 Preferred stock
 Common stock
 Common Stock vs. Preferred Stock

1. When the company must liquidate and pay all

creditors and bond-holders, common
stockholders, will not receive any money until
after the preferred shareholders are paid out.
2. Dividends of preferred stocks are different from
those of common stock.
3. When you buy a preferred stock, you will have an
idea of when to expect a dividend because they
are paid at regular intervals.

5
 Preferred stock

 Dividend is fixed in amount and known in

advance on preferred stocks (like debt)
 The stream of dividends continues
forever(like on shares) unless it is called
 Proffered shareholders cannot force the firm
into liquidation if their dividend is not paid
(like in case of common stock)
 Preferred stock is also know is hybrid security
because it resembles both equity and fixed
income securities
 Preferred stock

 Proffered stocks have the feature of

cumulative dividends
 Preferred stock may carry variable rate of
dividend that is tied to current market
interest rate
 Dividend may also be auction-rate
proffered
 Proffered stock may also have feature of
convertibility into common stock (may be
mandatory or optional)
 Common stock

 Common stock represents the ownerships

interest of the corporation
 Ownership is concentrated or closely held
when the firm’s shares are held by few
individuals
 Ownership is scattered when shares are
held by lots of people
 Characteristic of common stock

 Common shares give the right to

shareholders to vote
 It gives the right to receive dividends,
however, dividend rate is not fixed
 Common shares also give the right to right
issues
 Common shares are riskier than preferred
stock and bonds
 Classification of Common Stock

 The separation of company equity into more

than one class of common shares, usually
called "Class A" and "Class B."
 Class A shares refers to a classification
of common stock that is accompanied by
more voting rights than Class B shares,
usually given to a company's management
team.

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 Tracking Stock

 The dividends of tracking stock are tied to a

particular division, rather than the company as a
whole.
 Investors can separately value the divisions.
 Its easier to compensate division managers with the
tracking stock.
 But tracking stock usually has no voting rights, and
the financial disclosure for the division is not as
regulated as for the company.

11
 Liquidation & Market Value

 Liquidation Value: Net proceeds that would be

realized by selling the firm’s assets and paying off
its creditors.
 Market Value: Net worth of a firm according to
ongoing conditions (amount that investors are
willing to pay)

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 Difference b/w book, liquidation
and market value

 Extra Earning Power: A company may have

ability to earn more as compared to its competitors.
 Intangible Assets: Assets that accountants don’t
put on the balance sheet such as patents,
copyrights.
 Value of future investments: If investors believe
that a company have the opportunity to make
exceedingly profitable investments in the future.

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 Return / Expected Return

Expected Return = Net Income

Investment

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 Return on common stock

1. Cash dividends
2. Capital gain

Expected Return = Cash dividends + Capital gain

Price of share

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 Return on common stock

 Suppose that the current price of a share is P0,

and the expected price a year from now is P1,
and that the expected dividend per share is DIV1.

16
 Question (Expected Return)

 Suppose Engro Foods stock is selling for $75 a

share. Investors expect a $3 cash dividend over
the next year. They also expect the stock to sell
for $81 a year hence. Then the expected return to
stockholders is?

17
Question (Expected Return)

18
 Question (Price Today)

 For Engro Foods DIV1 = $3 and P1 = $81. If

stocks of similar risk offer an expected return of r
= 12 percent, then today’s price ?

19
Question (Price Today)

20
 Different Approaches for Valuing
Common Stock

 Dividend Discount Model

 Constant growth stocks
 Nonconstant growth stocks

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 Dividend Discount Model

 Discounted cashflow model of today’s stock

price which states that share value equals
the present value of all expected future
dividends.

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 Stock value = PV of dividends
discounted at required return

^ D1 D2 D3 D∞
P0 = + + +…+
(1 + rs)1 (1 + rs)2 (1 + rs)3 (1 + rs)∞

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 Stock value = PV of dividends
discounted at required return

^ D1 D2 D3 D∞
P0 = + + +…+
(1 + rs)1 (1 + rs)2 (1 + rs)3 (1 + rs)∞

Conceptually correct, but how do you find

the present value of an infinite stream?

24
Investors with Different Investment
Horizons

 A One year investor would value the

stock

25
Investors with Different Investment
Horizons (Cont.)

 A Two year investor would value the

stock

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Investors with Different Investment
Horizons (Cont.)

 A Three year investor would value the

stock

27
Investors with Different Investment
Horizons (Cont.)

 An H year investor would value the stock

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 Investors with Different Investment
Horizons (Example)

 The firm is growing steadily and investors expect both the

stock price and the dividend to increase at 8 percent per
year. Now consider three investors, A, B, and C. A plans to
hold stock for 1 year, B for 2, and C for 3 years. DIV1= 3
and P1 = 81, and r = 0.12,

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 Investors with Different Investment
Horizons (Example)

 The firm is growing steadily and investors expect both the

stock price and the dividend to increase at 8 percent per
year. Now consider three investors, A, B, and C. A plans to
hold stock for 1 year, B for 2, and C for 3 years. DIV1= 3
and P1 = 81, and r = 0.12,

A
B
C
30
 Present Value for A

 A One year investor would value the

stock

31
 Present Value for A

 A One year investor would value the

stock

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 Present Value for B

 A Two year investor would value the

stock

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 Present Value for B

 A Two year investor would value the

stock

34
 Present Value for C

 A Three year investor would value the stock

35
 Present Value for C

 A Three year investor would value the stock

36
 Basic Principle

 The value of a common stock equals the present

value of dividends received from the investment
horizon (period) plus the present value of the
forecasted stock price at the horizon.
 Moreover, when you move the horizon date, the
stock’s present value should not change. The
principle holds for horizons of 1, 3, 10, 20, and 50
years or more.

37
 Case

 Consider a company that pays out all its earnings

to its common shareholders.
 Such a company could not grow because it could
not reinvest.
 Stockholders might enjoy a perpetual stream of
equal cash payments (dividend), but they could
forecast no increase in future dividends.
 Therefore, DIV1 = DIV2 = . . . = DIVt = . . . .

38
 Case (Cont.)

 The discount rate is the rate of return demanded

by investors in other stocks of the same risk:

39
 Case (Cont.)

 Since our company pays out all its earnings as

dividends, dividends and earnings are the same,
and we could just as well calculate stock value by

40
 Question

 ABC Industries has produced a barrel per week

for the past 20 years but cannot grow because of
certain legal hazards. It earns $25 per share per
year and pays it all out to stockholders. The
stockholders have alternative, equivalent-risk
ventures yielding 20 percent per year on average.
How much is one share of ABC worth? Assume
the company can keep going indefinitely.

41
 Question (Cont.)

P0 = EPS1 / r = $25/0.20
= $125

42
Suppose dividends are expected to grow at a
constant rate, g, forever.

D1 = D0(1 + g)1
D2 = D0(1 + g)2
Dt = D0(1 + g)t

What is the present value of a constant

growth Dt when discounted at the stock’s
required return, rs? See next slide.

43
 Present Value of a Constant Growth Dividend

 Suppose a company pays $3 dividend in 1

Year and grows at constant rate of g=8%

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 Present Value of a Constant Growth Dividend

 Plug these forecasts of future dividends into

the dividend discount model:

45
 Present Value of a Constant Growth Dividend

 Growing Perpetuity:

46
 Question (Dividend Yield)

 Favored stock will pay a dividend this year

of $2.40 per share. Its dividend yield is 8
percent. At what price is the stock selling?

47
 Question (Dividend Yield)

 Favored stock will pay a dividend this year

of $2.40 per share. Its dividend yield is 8
percent. At what price is the stock selling?

 Stock Price = Dividend Paid / r

 = 2.40 / 0.08 = $30

48
 Question (Preferred Stock)

Preferred Products has issued preferred

stock with a $7 annual dividend that will
be paid in perpetuity.
a) If the discount rate is 12 percent, at what price
should the preferred sell?
b) At what price should the stock sell 1 year from
now?

49
 Question (Dividend Yield)

 Favored stock will pay a dividend this year

of $2.40 per share. Its dividend yield is 8
percent. At what price is the stock selling?

 Stock Price = Dividend Paid / r

 = 2.40 / 0.08 = $30

50
 Question (Rate of Return)

ABC will pay a year-end dividend of $2.50

per share. Investors expect the dividend
to grow at a rate of 4 percent indefinitely.
1. If the stock currently sells for $25 per
share, what is the expected rate of return
on the stock?
2. If the expected rate of return on the
stock is 16.5 percent, what is the stock
price?
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 Question (Rate of Return-1)

Stock Price = DIV1 /(r – g)

25 = 2.5 / (r – 0.04)
(r – 0.04)*25 = 2.5
(r – 0.04) = 2.5/25
(r – 0.04) = 0.10
r = 0.10 + 0.04 = 0.14 = 14%

52
 Question (Rate of Return-2)

Stock Price = DIV1 /(r – g)

Stock Price = 2.5 / (0.165 – 0.04)
Stock Price = 2.5/0.125
Stock Price = $20

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 Nonconstant Growth Stock

 Nonconstant growth of 30% for Year

0 to Year 1, 25% for Year 1 to Year
2, 15% for Year 2 to Year 3, and then
long-run constant g = 6%. DIV0 = $2,
r = 13%
 Can no longer use constant growth
model.
 However, growth becomes constant
after 3 years.
54
 Steps to Estimate Current Stock Value

(Continued) 55
 Steps to Estimate Current Stock Price (Continued)

 Find PV of each dividend in the forecast

period.
 Find PV of horizon value.
 Sum PV of dividends and PV of horizon
value.
 Result is estimated current stock value.

56
Example of Estimating Current Stock
Value (D0 = $2.00, rs = 13%)

g0,1 = 30% g1,2 = 25% g2,3 = 15% gL = 6%

Year 0 1 2 3 4
D0(1+g0,1) D1(1+g1,2) D2(1+g2,3)
↓ ↓ ↓
Dividends $2.600 $3.250 $3.7375

↓
$2.301 ← $2.600/(1+rs)1
PVs of divs. ← $3.250/(1+rs)2
$2.545

$2.590 ← $3.7375/(1+rs)3 ↓

$39.224 $56.596/(1+rs)3 ←
$46.661

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 Payout and Plowback Ratio

 Payout Ratio: Dividend Paid / Net income

 The amount of dividends paid to stockholders
relative to the amount of total net income of a
company.
 Plowback Ratio: Retained Earnings / Net income
 The amount of earnings retained relative to the
amount of total net income of a company.

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 Questions (1)

 ABC Industries pays a dividend of $2 per

quarter on its preferred stock. The dividend
yield on its stock is reported at 4.8 percent.
What price is the stock selling at?

59
 Questions (1)

 Stock Price = DIV1 / r

 Stock Price = 2/ (0.048/4)
 Stock Price = 2/0.012
 Stock Price = $166.67

60
 Questions (2)

 Integrated Potato Chips paid a $1 per share dividend

yesterday. You expect the dividend to grow steadily at a
rate of 4 percent per year.
a) What is the expected dividend in each of the next 3 years?
b) If the discount rate for the stock is 12 percent, at what
price will the stock sell?
c) What is the expected stock price 3 years from now?
d) If you buy the stock and plan to hold it for 3 years, what
payments will you receive? What is the present value of
those payments? Compare your answer to (b).

61
 Questions (2-a)

Expected dividend in each of the next 3 years?

DIV0 = $1
DIV1 = DIV0 (1 + g) = 1 (1 + 0.04) = $1.04
DIV2 = DIV1 (1 + g) = 1.04(1 + 0.04)
= $1.0816
DIV3 = DIV2 (1 + g) = 1.0816 (1 + 0.04)
= $1.125
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 Questions (2-b)

If the discount rate for the stock is 12 percent,

at what price will the stock sell?
 Stock Price = DIV1 / (r – g)

 Stock Price = 1.04/ (0.12 – 0.04)

 Stock Price = $13

63
 Questions (2-c)

What is the expected stock price 3 years from

now?
 Stock Price (P3) = DIV4 / (r – g)

DIV4 = DIV3 (1 + g) = 1.125 (1 + 0.04)

= $1.17
 Stock Price (P3) = 1.17/ (0.12 – 0.04)

 Stock Price (P3) = $14.625

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 Questions (2-d)

 If you buy the stock and plan to hold it for 3 years, what
payments will you receive? What is the present value of
those payments? Compare your answer to (b).
Present Value = DIV1 + DIV2 + DIV3 + P3
(1+r) (1+r)^2 (1+r)^3
= 1.04 + 1.0816 + 1.125 +14.625
(1+0.12) (1+0.12)^2 (1+0.12)^3
= 0.9285 + 0.8622 + 11.2105
= $13

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Common stock valuation
-Relative measures
 P/E ratios
 An alternative to DDM is relative valuation
 Measures such as P/E value stocks in comparison
to some bench mark such as the market, industry
or stocks own history over time
 P/E ratios or Earning multiplier
 It is commonly used technique among
practitioners, stock traders, and analysts
 It always appears in report from a stock advisor
 P/E ratio means how much price investors are
willing to pay for one rupee of earning
 PSO had earnings of Rs.80 per share in 2007, it
market price was Rs.400, how do you interpret it
in P/E terminology
 PSO P/E ratio is = 400/80 = 5
 It means for one rupee earnings investors are
willing to pay Rs.5 for buying one share of PSO
 Suppose POL’s P/E ratio is = 8
 Determinants of P/E ratio
 To understand the determinants of P/E
ratio, consider a constant growth model
of DDM P
D1
kg

 Dividing both side of the equation on

expected next years earning,
D /E E 1
P / E1  1 1
kg
 Other things remaining constant,
P / E1 
D1 / E1
 1: higher expected dividend payout? k  g
 2?
 3?
 P/E ratio: Growth and risk
 Low P/E shares are cheap, investors have to pay
lesser price for the same one rupee of earnings, its
why these shares can give higher returns
 P/E ratio reflect investors optimism or pessimism
about a stock
 Companies with high P/E ratio are considered
growing companies or less risky companies this is
why investors are willing to pay higher prices for
same one rupee earnings
 What is the relationship of P/E with interests rate
 P/E
 Q= in periods of lower interest rates, P/E ratios
will be higher of lower?
 Valuation using P/E ratios

 First P/E should be calculated with current

earnings and price of stock
 Then find estimated earnings in the coming
year i.e E1
 Intinsic Value = P/E x E1
 The security should be purchased if IV is
equal to or greater than the current market
value
 Estimates of next years earnings can be
obtained from analysts, investment advisory
services, like KASB or can be calculated
through growth rate in earnings
 Suppose PSO current EPS is 80 per share
and future earning estimate is Rs. 100 per
share, current market price is 400, what is
its P/E
 P/E = 400/80 = 5x

So buy or not?
 The investment decision
 The investment decision is either made on
the basis of P/E in relations to:
 The company own current earning
 Or in relation to industry P/E
 In the previous example, what should be
the price of PSO based on its own P/E?
 In relation to company owns earnings

 The P/E was = 5x

 P/E = Price/Earning
 Price = (P/E)x future Earnings
 = 5x 100 = 500
 Current price is 400, so we should buy it
 In relation to industry Or market P/E

 Analysts usually calcualte P/E ratio for an

industry or whole market
 An individual stocks’ P/E is compared with
others in the industry
 If it is traded at discount in relations to
others, then the stock is recommended for
buying
 Example: Relative to industry

 Assume PSO current share price is = 400

 EPS = 80, and EPS1=100
 Industry P/E ratio is = 5.5
 What should be the price of PSO relative to
industry P/E ratio
 Intrinsic value = P/E ratio x EPS1
= 5.5x100 = 550
 PSO is under-priced in comparison to industry
valuation and should be purchased