Common stock valuation – I
Meaning and types of share or stock:
Meaning of common stock.
Characteristics of common stock.
Differences between common and preference share
Methods of common stock valuation.
Meaning and types of share (or stock)
Shares are long term financial instrument which is sold by a company to
raise long term or permanent capital.
Normally, Stock refers to the inventories of shares.
Types of stock or share
1. Common stock or common share or ordinary share or equity share
or share or stock.
2. Preference share or preferred stock
Features of common stock
Common share issues to raise ownership capital by firms.
Buyer of common shares becomes owner or shareholders of the firm.
Some features:
1. Par value: Also called face value
2. Dividend: Not fixed
3. Maturity: No maturity period
4. Claim on assets: Residual claim
5. Voting right: To elect BOD
6. Preemptive rights: First right to buy new offering
Major differences between common stock and preferred stock
Base of difference Common stock Preferred stock
Ownership Yes No
Dividend Not fixed Fixed
Maturity No May be
Claim Residual Prior to common stock
Voting right Yes No
Preemptive right Yes No
Methods of common stock valuation
1. Dividend discount model
2. Price-earnings model
3. Corporate valuation model
Dividend Discount Model
According to dividend discount model common stock can be classified into
following categories:
1. Constant or normal growth stock
2. Zero growth stock
3. Declining growth stock
4. Non constant or multiple growth stock
5. Valuation based on finite holding period
Constant or normal growth stock
Only one growth rate at present for infinite future is given.
This model is developed by Myron J. Gordon, so, it is also called Gordon's model.
D1 Do(1+g)
Formula: Intrinsic value (Vo) = = = Rs………
Ks−g Ks−g
Where,
D1 = Expected dividend per share. (Dividend express with future related words such as next
year, following year, at the end of year, will pay)
D0 = Current dividend per share. (Dividend express with present and just past related words
such as just, recently, currently, today, last year, previous year, paid, pays etc.)
g = Growth rate or capital gain for constant growth stock or normal growth rate (gn)
Ks = Required rate of return, or cost of equity, or equity capitalization rate or expected return
on similar risk stocks or discount rate. Etc.
Assumptions of constant growth stock valuation:
Dividend, earnings, and price of the stock will grow at the same and single
rate (g) indefinitely. Thus,
Dn = D0 (1 + g)n
EPSn = EPS0 (1 + g)n
Pn = P0 (1 + g)n
Growth rate (g) must be less than required rate of return (Ks) for reasonable
result
i.e. g < Ks.
Assumptions of constant growth stock valuation:
Total yield (Ks) = dividend yield + Capital gain yield
𝐷1
= +g
𝑃0
Capital gain yield is equal to growth rate.
Expected dividend yield (𝐷1/𝑃0)and capital gain yield (growth rate) are
constant forever.
Value of stock (V0) does not depend upon holding period i.e. the value
of stock will be the same at different holding periods.
Example of Constant growth stock
M & N company just paid dividend of Rs 15 per share. The dividend
is expected to grow at a constant rate of 8% a year. The required rate
of return on the stock is 15 percent. What is the value per share of the
company’s stock today? After 5 years?
Solve:
Current dividend per share (D0) = Rs 15
Expected growth rate (g) = 8% = 0.08
Required rate of return (KS) = 15% = 0.15
Example: solve
D1 Do(1+g) 15 (1+0.08)
Value of stock today (v0) = = = = Rs 231.42
Ks−g Ks−g 0.15 −0.08
6
D6 Do 1+g
Value of stock after 5 years (V5 or P5) = =
Ks−g Ks−g
15 1+0.08 6
= = Rs 340.04
0.15 −0.08
Alternatively,
Value of stock after 5 years (V5 or P5) = V0 (1+g)5
= 231.42 (1+ 0.08)5 = Rs 340.03
Zero growth stock
Zero growth stock is the share of the firm whose earnings and dividend both are always
fixed i.e. Growth rate is zero.
Do
Intrinsic value (V0) = = Rs…….
Ks
Example:
Bentex Corporation just paid a dividend of rs 5 a share. The dividend is expected to be
same indefinitely. Investors required a 10 percent rate of return. What is the intrinsic
value of common stock today?
Solve:
Current dividend per year (D0) = Rs 5,
Required rate of return (Ks) = 10%
Do 5
Intrinsic value (V0) = = = Rs 50
Ks 0.10
Hence, value of stock today is Rs 50 which is fair price.
Declining growth stock
Earnings and dividend growth rate is Solve:
negative. Company's growth rate (g) = -5 % = -0.05
Do (1+g)
Intrinsic value (V0) = = Rs……. Current dividend per share (D0) = Rs 5
Ks−𝑔
Required rate of return (Ks) = 15 %
Example:
𝐷𝑜 (1+𝑔)
McCue mining company's ore reserves are Intrinsic value (V0) =
𝐾𝑠 −𝑔
being depleted, so its sales are falling. Also its
5(1 − 0.05)
pit is getting deeper each year, so, its cost is =
0.15−(−0.05)
rising. As a result, the company's earning and
4.75
dividends are declining at the constant rate of 5 =
0.20
percent per year. D0= Rs 5 and K = 15%, What
=Rs 23.75
is the value of McCue mining's stock?
NON CONSTANT OR MULTIPLE GROWTH STOCK
More than one phases of growth rate in earnings and dividend are given. Growth
rate in final phase is either zero or constant.
For example:
Two Phase Growth Stock
0 1 2
3 4 ∞
First phase (g1 = 20%)
2nd or normal Phase (g or gn = 8%)
Three Phase Growth Stock
0 1 2 3
4 5
First phase (g1 = 20%) 6 7 ∞
2nd phase (g2 = 15 %)
Final or normal Phase
(g or gn = 8%)
Steps for find out value of non constant growth stock
Step 1. Calculate expected divided for each year up to end of non constant
period (terminal year or horizon date) like as below:
Year Expected dividend
1 D1 = D0 ( 1+ g ) = ……….
2 D2 = D1 ( 1+ g ) = ……….
3 D3 = D2 ( 1+ g ) = ……….
. .
. .
n D n = ……….
Note: we use “n” to denote end of nonconstant period or terminal year or horizon
date.
Step 2. Find value of stock at the end of non-constant period or terminal price or
horizon value (P n ) using following formula:
Dn 1+ gn
Price of stock at end of nonconstant period (P n ) = = Rs….
Ks−gn
Step 3. Find the value of stock today (V0) using following equation:
D1 D2 D3 Dn Pn
Intrinsic value (V0 ) = 1 + 2 + 3 +⋯+ n + n
1+Ks 1+Ks 1+Ks 1+Ks 1+Ks
= PV of dividend + PV of P n
Additional requirements:
1. Value of stock at end of year 1 (V1 or P1)
D2 D3 𝐷𝑛 𝑃𝑛
= 1 + 2 + ⋯+ +
(1+𝐾𝑠)𝑛 −1
1+Ks 1+Ks (1+𝐾𝑠)𝑛 −1
2. Value of stock at end of year 2 (V2 or P2)
D3 𝐷𝑛 𝑃𝑛
= 1 + ⋯+ (1+𝐾𝑠)𝑛 −2
+
(1+𝐾𝑠)𝑛 −2
1+Ks
Dividend yield and Capital gain yield
Year Dividend yield Capital gain yield
1 D1 Ks – dividend yield = …..%
= ……..%
P0 or V0
2 D2 Ks – dividend yield = …..%
= ……..%
P1 or V1
3 D3 Ks – dividend yield = …..%
= ……..%
P2 or V2
Example of Non constant growth stock
Sunlight Computer Chips Inc., is experiencing a period of rapid growth.
Earnings and dividends are expected to grow at a rate of 15 percent during
the next 2 years, at 13 percent in the third year, and at a constant rate of 6
percent thereafter. Sunlight’s last dividend was Rs l.15, and the required
rate of return on the stock is 12 percent.
a) Calculate the value of the stock today (V0).
b) Calculate price at end of first year (P1)
c) Calculate price at end of second year (P2)
d) Calculate price at end of 10th year (P10)
e) Calculate dividend yield and capital gain yield in year 1, 2 and 3.
Example: solve:
Given, Growth rate in year 1 and 2 (g1) = 15%
Growth rate in year 3 (g2) = 13%
Growth rate after year 3 (g n) = 6%
Current or last dividend per share (D0) = Rs 1.15
Required rate of return (Ks) = 12%
a) Value of stock today (V0) = ?
Step 1. Calculation of expected dividend up to end of non-constant period i.e. up to year 3.
Year Expected dividend
1 D1 = D0 ( 1+ g1 ) = 1.15 (1 + 0.15) = Rs 1.33
2 D2 = D1 ( 1+ g1 ) = 1.33 (1+0.15) = 1.52
3 D3 = D2 ( 1+ g2) = 1.52 (1+0.13) = 1.72
𝐷3 1+𝑔𝑛
Step 2. Price of stock at end of 3rd year (V3 or P3) =
𝐾𝑠 −𝑔𝑛
1.72 1+0.06
= = Rs 30.39
0.12 −0.06
Now,
D1 D2 D3 P3
Step 3. Value of stock today (V0) = 1 + 2 + 3 + 3
1+KS 1+KS 1+KS 1+KS
1.33 1.52 1.72 30.39
= 1 + 2 + 3 + 3
1+0.12 1+0.12 1+0.12 1+0.12
=………………………………
= Rs 25.25
Hence, fair value of stock today is Rs 25.25.
D2 D3 P3
(b) Price of stock at year 1 (V1 or P1) = 1 + 2 + 2
1+KS 1+KS 1+KS
1.52 1.72 30.39
= 1 + 2 + 2
1+0.12 1+0.12 1+0.12
= Rs 26.96
D3 P3
(c) Price of stock at year 2 (V2 or P2) = 1 + 1
1+KS 1+KS
1.72 30.39
= 1 + 1
1+0.12 1+0.12
= Rs 28.67
8
𝐷11 𝐷3 1+𝑔𝑛
(d) Price of stock at end of year 10 (V10 or P10) = =
𝐾𝑠−𝑔𝑛 𝐾𝑠−𝑔𝑛
1.72 1+0.06 8
=
0.12 −0.06
= Rs 45.69
(e) Calculation of dividend yield and capital gain yield
Year Dividend yield Capital gain yield (Ks – dividend yield)
𝐷1 1.33
1 = = 0.0524 =5.24% 12 – 5.24 = 6.76%
𝑉0 25.25
2 𝐷2 6.36%
=…….= 5.64%
𝑉1
3 𝐷3 6%
= …. = 6%
𝑉2
Valuation based on finite holding period
Steps of finite holding period are similar to non constant growth stock
Step 1. Calculate expected divided for each year up to end of holding period.
Step 2. Calculate price of stock at end of holding period (Pn).
D1 D2 D3 Dn Pn
Step 3. Intrinsic value (V0) = 1 + 2 + 3 + ⋯+ n + n
1+Ks 1+Ks 1+Ks 1+Ks 1+Ks
= PV of dividend + PV of Pn
Corporate valuation model
Steps of
Thank You