Fundamentals of

Chapter 6 Corporate Finance

Fourth Edition

Valuing Stocks

Slides by
Matthew Will

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 6- 2

Topics Covered
Stocks and the Stock Market
Book Values, Liquidation Values and
Market Values
Valuing Common Stocks
Simplifying the Dividend Discount Model
Growth Stocks and Income Stocks
No more free lunches on Wall Street
Behavioral Finance and [Link]

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Stocks & Stock Market

Primary Market - Place where the sale of new stock
first occurs.
Initial Public Offering (IPO) - First offering of stock
to the general public.
Seasoned Issue - Sale of new shares by a firm that
has already been through an IPO

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Stocks & Stock Market

Common Stock - Ownership shares in a

publicly held corporation.
Secondary Market - market in which already
issued securities are traded by investors.
Dividend - Periodic cash distribution from the
firm to the shareholders.
P/E Ratio - Price per share divided by
earnings per share.

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Stocks & Stock Market

Book Value - Net worth of the firm according

to the balance sheet.
Liquidation Value - Net proceeds that would
be realized by selling the firm’s assets and
paying off its creditors.
Market Value Balance Sheet - Financial
statement that uses market value of assets
and liabilities.

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Valuing Common Stocks

Expected Return - The percentage yield that an

investor forecasts from a specific investment over
a set period of time. Sometimes called the holding
period return (HPR).

Div1  P1  P0
Expected Return r 
P0

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Valuing Common Stocks

The formula can be broken into two parts.

Dividend Yield + Capital Appreciation

Div1 P1  P0
Expected Return r  
P0 P0

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Blue Skies Value

80
Value per share, dollars

70

60

50

40
PV (Terminal Value)
30 PV (Dividends)

20

10

0
1 2 3 10 20 30 50 100

Investment Horizon, Years

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Valuing Common Stocks

Dividend Discount Model - Computation of today’s
stock price which states that share value equals the
present value of all expected future dividends.

Div1 Div2 Div H  PH

P0  1
 2
... H
(1  r ) (1  r ) (1  r )

H - Time horizon for your investment.

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Valuing Common Stocks

Example
Current forecasts are for XYZ Company to pay
dividends of $3, $3.24, and $3.50 over the next
three years, respectively. At the end of three years
you anticipate selling your stock at a market price
of $94.48. What is the price of the stock given a
12% expected return?

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Valuing Common Stocks

Example
Current forecasts are for XYZ Company to pay dividends of $3, $3.24,
and $3.50 over the next three years, respectively. At the end of three
years you anticipate selling your stock at a market price of $94.48.
What is the price of the stock given a 12% expected return?

3.00 3.24 3.50  94.48

PV  1
 2
 3
(1.12) (1.12) (1.12)
PV $75.00

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Valuing Common Stocks

If we forecast no growth, and plan to hold out
stock indefinitely, we will then value the stock as
a PERPETUITY.

Div1 EPS1
Perpetuity  P0  or
r r
Assumes all earnings are
paid to shareholders.

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Valuing Common Stocks

Constant Growth DDM - A version of the

dividend growth model in which dividends
grow at a constant rate (Gordon Growth
Model).
Div1
P0 
r g
Given any combination of variables in the
equation, you can solve for the unknown variable.

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Valuing Common Stocks

Example
What is the value of a stock that expects to pay a
$3.00 dividend next year, and then increase the
dividend at a rate of 8% per year, indefinitely?
Assume a 12% expected return.

Div1 $3.00
P0   $75.00
r  g .12  .08

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Valuing Common Stocks

Example- continued
If the same stock is selling for $100 in the stock
market, what might the market be assuming about
the growth in dividends?

$3.00 Answer
$100  The market is
.12  g
assuming the dividend
g .09 will grow at 9% per
year, indefinitely.
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Valuing Common Stocks

 If a firm elects to pay a lower dividend, and
reinvest the funds, the stock price may increase
because future dividends may be higher.

Payout Ratio - Fraction of earnings paid out as

dividends
Plowback Ratio - Fraction of earnings retained by
the firm.

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Valuing Common Stocks

Growth can be derived from applying the

return on equity to the percentage of
earnings plowed back into operations.

g = return on equity X plowback ratio

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Valuing Common Stocks

Example
Our company forecasts to pay a $5.00
dividend next year, which represents
100% of its earnings. This will
provide investors with a 12% expected
return. Instead, we decide to plow
back 40% of the earnings at the firm’s
current return on equity of 20%. What
is the value of the stock before and
after the plowback decision?

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Valuing Common Stocks

Example
Our company forecasts to pay a $5.00 dividend next year, which
represents 100% of its earnings. This will provide investors with a
12% expected return. Instead, we decide to blow back 40% of the
earnings at the firm’s current return on equity of 20%. What is the
value of the stock before and after the plowback decision?

No Growth With Growth

5 g .20.40 .08
P0  $41.67
.12
3
P0  $75.00
.12  .08

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Valuing Common Stocks

Example - continued
If the company did not plowback some earnings,
the stock price would remain at $41.67. With the
plowback, the price rose to $75.00.

The difference between these two numbers (75.00-

41.67=33.33) is called the Present Value of
Growth Opportunities (PVGO).

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Valuing Common Stocks

Present Value of Growth Opportunities

(PVGO) - Net present value of a firm’s
future investments.

Sustainable Growth Rate - Steady rate at

which a firm can grow: plowback ratio X
return on equity.

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No Free Lunches
Technical Analysts
 Forecast stock prices based on the watching the
fluctuations in historical prices (thus “ wiggle
watchers”)
watchers

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No Free Lunches

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Random Walk Theory

The movement of stock prices from day to
day DO NOT reflect any pattern.
Statistically speaking, the movement of
stock prices is random (skewed positive over the
long term).

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Random Walk Theory

Coin Toss Game Heads
$106.09
Heads
$103.00
$100.43
Tails
$100.00
Heads
$100.43
$97.50
Tails
$95.06
Tails

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Random Walk Theory

S&P 500 Five Year Trend?
or
5 yrs of the Coin Toss Game?

180
Level

130

80
Month

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Random Walk Theory

S&P 500 Five Year Trend?
or
5 yrs of the Coin Toss Game?
230
Level

180

130

80
Month

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Random Walk Theory

Market
Index
1,300

1,200

1,100

Cycles
disappear
once Last This Next
identified Month Month Month
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Another Tool
Fundamental Analysts
 Research the value of stocks using NPV and other
measurements of cash flow

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Efficient Market Theory

Weak Form Efficiency
 Market prices reflect all historical information
Semi-Strong Form Efficiency
 Market prices reflect all publicly available
information
Strong Form Efficiency
 Market prices reflect all information, both
public and private

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Efficient Market Theory

Announcement Date
39
Cumulative Abnormal Return

34
29
24
19
14
(%)

9
4
-1
-6
-11
-16
Days Relative to annoncement date

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Behavioral Finance
Attitudes towards risk
Beliefs about probabilities
How to interpret PE ratios

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Web Resources
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