Chapter 8

Stock Valuation
 Outcomes

• Understand how stock prices depend on

future dividends and dividend growth
• Able to compute stock prices using the
dividend growth model
• Understand how stock markets work
• Understand how stock prices are quoted

8-1
 Chapter Outline

• Common Stock Valuation

• Some Features of Common and
Preferred Stocks
• The Stock Markets

Types of common stock

[Link]

8-2
 Stock valuation

• How would you value a stock?

• Have you tried?

8-3
 Cash Flows for Stockholders

• If you buy a share of stock, you can

receive cash in two ways
– The company pays dividends
– You sell your shares in the market,

• As with bonds, the price of the stock is

the present value of these expected
cash flows
8-4
 One-Period Example
Suppose you are thinking of purchasing the stock of X, Inc.
You expect it to pay a $2 dividend in one year, and you
believe that you can sell the stock for $14 at that time. If
you require a return of 20% on investments of this risk,
what is the maximum you would be willing to pay?

Compute the PV of the expected cash flows

– Price = (14 + 2) / (1.2) = $13.33

8-5
One-Period Example: Using a Timeline
expect a $2 dividend in 1
year and sell the stock for
$14
0 20% 1 2 3

D1=$2
+
P1=14
P0 $16
PVIF20%,1 Expect to sell stock at this
price
 Two-Period Example
Now, what if you decide to hold the stock for two years? In
addition to the dividend in one year, you expect a dividend
of $2.10 in two years and a stock price of $14.70 at the
end of year 2. Now how much would you be willing to pay?

Compute the PV of the expected cash flows

– Price = 2 / (1.2) + (2.10 + 14.70) / (1.2)2 = 13.33
– Using financial calculator: 0 CF0; 2 CF1; 16.80 CF2; 20 I/Y; CPT
NPV = 13.33

8-7
 Two-Period Example: Using a Timeline
dividend of $2 at yr 1
dividend of $2.10 at yr 2
stock price of $14.70 at yr 2

0 20% 1 2 3

1.667 D1 = $2 D2=$2.10
P2=$14.70
+
11.667 $16.80
$13.33

P0
 Three-Period Example
Finally, what if you decide to hold the stock for three
years? In addition to the dividends at the end of years 1
and 2, you expect to receive a dividend of $2.205 at the
end of year 3 and the stock price is expected to be
$15.435. Now how much would you be willing to pay?

Compute the PV of the expected cash flows

– Price = 2 / (1.2) + 2.10 / (1.2)2 + (2.205 + 15.435) / (1.2)3 =
13.33
– Using financial calculator: 0 CF0; 2 CF1; 2.10 CF2; 17.635
CF3; 20 I/Y; CPT NPV = 13.33

8-9
 Three-Period Example: Using a Timeline
dividend of $2 at yr 1
dividend of $2.10 at yr 2
dividend of $2.205 at yr 3
stock price of $15.435 at yr 3
0 20% 1 2 3

1.667 D1 = $2
D3= $2.205
1.458 D2= $2.10 P =$15.435
3
+ 10.208 $17.64
$13.33
P0
 Developing The Model
• You could continue to push back the year in which
you will sell the stock
• You would find that the price of the stock is really just
the present value of all expected future dividends

D t +1 D t+2 D t+3 D
Pt = t +1
+ t+2
+ t+3
+ ... +
(1 + rs ) (1 + rs ) (1 + rs ) (1 + rs ) 
• So, how can we estimate all future dividend
payments?

8-11
 Estimating Dividends: Special Cases
• Constant dividend, any realistic example?
– The firm will pay a constant dividend forever
– This is like preferred stock
– The price is computed using the perpetuity formula
• Constant dividend growth any realistic example?
– The firm will increase the dividend by a constant percent every
period
– The price is computed using the growing perpetuity model
• Supernormal growth any realistic example?
– Dividend growth is not consistent initially, but settles down to
constant growth eventually
– The price is computed using a multistage model

Guess the dividend history of Coca-cola:

[Link] 8-12
 Zero Growth

• If dividends are expected at regular intervals forever,

then this is a perpetuity and the present value of
expected future dividends can be found using the
perpetuity formula
– P0 = D / R

• Suppose stock is expected to pay a $0.50 dividend

every quarter and the required return is 10% with
quarterly compounding. What is the price?
– P0 = .50 / (0.1 / 4) = $20

8-13
 Constant Dividend Growth Model
• Dividends are expected to grow at a constant percent
per period.
– P0 = D1 /(1+R) + D2 /(1+R)2 + D3 /(1+R)3 + …
– P0 = D0(1+g)/(1+R) + D0(1+g)2/(1+R)2 + D0(1+g)3/(1+R)3 + …

• With a little algebra and some series work, this reduces

to:

D 0 (1 + g) D1
P0 = =
R -g R -g

The derivation of the formula can be found in the text or say using AI
8-14
 Constant Dividend Growth Model –
Example 1
Suppose Big XX, Inc., just paid a dividend of $0.50 per
share. It is expected to increase its dividend by 2% per
year. If the market requires a return of 15% on assets of
this risk, how much should the stock be selling for?

D 0 (1 + g) 0 .5 0 (1 .0 2 )
P0 = = = 3 .9 2
R -g 0 .1 5 - 0 .0 2

8-15
 Constant Dividend Growth Model –
Example 2
Suppose Student, Inc., is expected to pay a $2 dividend
in one year. If the dividend is expected to grow at 5%
per year and the required return is 20%, what is the
price?
D 0 (1 + g) D1 2
P0 = = = = 1 3 .3 3
R -g R - g 0 .2 - 0 .0 5
– Why isn’t the $2 in the numerator multiplied by
(1.05) in this example?

8-16
Stock Price Sensitivity to Dividend
Growth Rate, g

D1 = $2; R = 20%

8-17
Stock Price Sensitivity to
Required Return, R

D1 = $2; g = 5%

8-18
 Gordon Growth Company - I
Gordon Growth Company is expected to pay a
dividend of $4 next period, and dividends are
expected to grow at 6% per year. The required
return is 16%. What is the current price?

D 0 (1 + g) D1 4
P0 = = = = 40
R -g R - g 0 .1 6 - 0 .0 6

– Remember that we already have the dividend

expected next year, so we don’t multiply the
dividend by 1+g

8-19
 Gordon Growth Company - II
• What is the price expected to be in year 4?
D5 D 1 (1 + g) 4 4 (1 + 0 .0 6 ) 4
P4 = = = = 5 0 .5 0
R -g R -g 0 .1 6 - 0 .0 6

• What is the implied return given the change in price during

the four year period?

P 4 = P 0 (1 + r) 4
50.50 = 40(1 + r) 4  r = 0.06 = 6%

– Using financial calculator: -40 PV; 50.50 FV; 4 N; CPT I/Y

= 6%

• The price grows at the same rate as the dividends

8-20
Constant DGM: Price Grows at
Same Rate as Dividends

D 0 (1 + g) t +1
Pt =
r−g
D 0 (1 + g) t + 2
Pt +1 =
r−g
Pt +1 D 0 (1 + g) t + 2 D 0 (1 + g) t +1
= 
Pt r−g r−g
= 1+ g

 the price grows at the same rate as the dividends

8-20
 Nonconstant Growth

• Suppose a firm is expected to increase

dividends by 20% for one year and then
by 15% in the year following. After that,
dividends will increase at a rate of 5% per
year indefinitely. If the dividend at time 0,
D0, was $1 and the required return is 20%,
what is the price of the stock?

8-22
Nonconstant Growth Solution
• Compute the dividends until growth levels off
– D1 = 1(1.2) = $1.20
– D2 = 1.20(1.15) = $1.38
– D3 = 1.38(1.05) = $1.449

• Find the expected future price

– P2 = D3 / (R – g) = 1.449 / (.2 - .05) = 9.66

• Find the present value of the expected future cash

flows
D1 D 2 + P2 1 .2 1 .3 8 + 9 .6 6
P0 = + = + = 8 .6 7
1 + R (1 + R ) 2
1 + 0 .2 (1 + 0 .2 ) 2

8-23
 In class exercise– Part I
• A company has just paid a dividend of $2. What is
the value of its stock if it expects to maintain this
level of dividend every year. Assume that the
required return is 15%.
• P0= 2/0.15 as the cash flow is a perpertuity
• What if the company starts increasing dividends
by 3% per year, beginning with the next dividend?
The required return stays at 15%.
• P0=D1/(R-g)=2*(1.03)/(0.15-0.03)

8-24
 Using the Constant DGM to Find
Required Return, Dividend Yield,
Capital Gains Yield

• Start with the Constant DGM:

D 0 (1 + g) D1
P0 = =
R -g R -g

D 0 (1 + g) D1
R= +g= +g
P0 P0

8-25
Finding the Required Return, Dividend
Yield, Capital Gains Yield - Example

Suppose a firm’s stock is selling for $10.50. It just

paid a $1 dividend, D0, and dividends are expected
to grow at 5% per year.
•What is the required return?
D 0 (1 + g) 1 (1 + 0 . 0 5 )
R = +g = + 0 .0 5 = 1 5 %
P0 1 0 .5 0

•What is the dividend yield, D1/P0?

D 1 D 0 (1 + g) 1 (1 + 0 .0 5 )
d iv yie ld = = = = 10%
P0 P0 1 0 .5 0

•What is the capital gains yield?

g =5%
8-26
Table 8.1 - Stock Valuation Summary

8-27
 Extension of dividend growth model: Free cash flow model
(brief account)
Instead of using expected dividend as cash flow, we use free cash flow
directly, free cash flow can be calculated directly from financial statements

Free Cash Flow to the Firm (FCFF) =EBIT - Taxes + Depreciation &
Amortization - Capex – Change in Working Capital

Example Apple:
Assume Apple has a constant growth rate in free cash flow, which may not be the
case in reality. You can try a multi-stage method later.

Expected (FCFF1) = 70 billion

WACC (discount rate) = 8.5%
Steady growth rate = 2% (an underestimate?)
=>Firm value (not stock value) based on FCFF using DDM using FCFF =
70 billion/(0.085-0.02) =1,077B
You may compare it with say the firm value (approximately the enterprise
value) = $720 Billion around 2017, 2018 (about $2.52T Sep 2021)
How did Warren Buffett value PetroChina 857?
 Other Stock Valuation Methods:
Market Multiple Method
• Also known as the peer comparison method.
• The value of a company is derived by applying a certain
multiplier to the company’s profitability parameter.
• Analysts often use the following multiples to value stocks.
– P / E (Price-to-earnings) ratio, say IPO of jewelry firm 1929 or
Alibaba vs Amazon if you want
– [Link]
– P / Sales
• Example: Based on comparable firms, estimate the
appropriate P/E. Multiply this by expected earnings to
obtain an estimate of the stock price.

8-29
 Problems with Market Multiple Method
• Often hard to find comparable firms.
– 1314 (TSUI WAH HLDG) vs ?
• The average ratio from a sample of comparable firms can
have a wide range.
– Example: The average P/E ratio of comparable firms is
20 but the range is from 10 to 50.
– Auto companies , GM vs Tesla (this comparison is
similar today as Sep 2021)

[Link] [Link]

How about the PE of Nvidia and Palantir about 50 and 900 2025 September 8-30
 Features of Common Stock
• Voting Rights (Similar to the example in the textbook)
– Cumulative voting increases the likelihood of minority shareholders getting a seat
on the board.
– Cumulative voting: allocate all votes at once to one candidate or more candidates.
• 4 directors to be elected.
• You have 20 shares, I have 80 shares
• You get 4x20 = 80 votes, I get 4x80=320 votes
• Ignore tie, one cannot get elected if 81, 81, 81 and 77 votes for the 4
candidates
– Straight voting (each share gets one vote per seat):
• Directors elected one at a time
• I can always cast 80 vote
• Study the example in the text

8-31
 Features of Common Stock
• Voting Rights
• Proxy voting
– one person can authorize someone else to vote on her
behalf
• Classes of stock
– E.g. create class A and B share structures with different
voting rights in order to maintain control of the firm
• Other Rights
– Share proportionally in declared dividends
– Share proportionally in remaining assets during liquidation
– Preemptive right – first shot at new stock issue to maintain
proportional ownership if desired

8-32
 Dividend Characteristics
• Dividends are not a liability of the firm until a
dividend has been declared by the Board
• Consequently, a firm cannot go bankrupt for not
declaring dividends
• Dividends and Taxes
– Dividend payments are not considered a business
expense; therefore, they are not tax deductible
– The taxation of dividends received by individuals varies
across countries

8-33
 Features of Preferred Stock
• Dividends
– Preferred dividend must be paid before dividends
can be paid to common stockholders
– Dividends are not a liability of the firm.
– Preferred dividends can be deferred indefinitely
– Most preferred dividends are cumulative – any
missed preferred dividends have to be paid before
common dividends can be paid
• Preferred stock generally do not carry voting rights

Types of preferred stock

[Link]
8-34
 Preferred Stock – Example

If preferred stock with an annual dividend of $5

sells for $50, what is the preferred stock’s expected
return?

D
P0 =
r
D 5
r = = = 0.10 = 10%
P0 50
 Stock Market
Dealers vs. Brokers
Dealer:
maintains an inventory. Make their profit from the
difference between the bid and ask prices
Broker:
matches buyers and sellers for a fee (commission). They
do not hold an inventory of securities.
 Stock Exchange
[Link]

[Link]
NASDAQ
• Not a physical exchange – computer-based quotation
system
• Electronic Communications Networks
• Large portion of technology stocks

Hong Kong Exchanges

• Visit [Link]

8-37
 Reading Stock Quotes
• Sample Quote

• What information is provided in the stock

quote?

8-38
 Quick Quiz – Part II

• You observe a stock price of $18.75. You expect a

dividend growth rate of 5%, and the most recent
dividend was $1.50. What is the required return?

r = [1.5(1.05)/18.75] + 0.05 = 13.4%

• What are some of the major characteristics of

common stock?
• What are some of the major characteristics of
preferred stock?

8-39
 Problem
• XYZ stock currently sells for $50 per share. The
next expected annual dividend is $2, and the
growth rate is 6%. What is the expected rate of
return on this stock?
• If the required rate of return on this stock were
12%, what would the stock price be, and what
would the dividend yield be?

• Expected return = 2/50 + 0.06 = 0.10

• Price = 2/ (0.12 - 0.06) = $33.33
Dividend yield = 2 / 33.33 = 6%

8-40