Chapter 8:
Stocks and Their
Valuation.
Stocks and Their Valuation.
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Chapter Outline:
 Features of Common Stock.
 Common Stock Valuation.
 Preferred Stock.
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Features of Common Stock:
 Facts about common stock.
 Legal Rights and Privileges of
Common Stockholders.
 Types of Common Stock.
 The Market for Common Stock.
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Facts about common stock:
 Represents ownership
 Ownership implies control
 Stockholders elect directors
 Directors elect management
 Management’s goal: Maximize the
stock price
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Legal Rights and Privileges of
Common Stockholders:
 Control
of the Firm.
 Voting Rights
 Preemptive rights
 Right of access to meeting minutes
and lists of existing shareholders
 Right to vote on issues that affect the
firm’s property as a whole
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Legal Rights and Privileges
of Common Stockholders:
 Proxy.
 Proxy Fight.
 Takeover.
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Types of Common Stock:
 Classified stock has special provisions.
 Could classify existing stock as founders’
shares, with voting rights but dividend
restrictions.
 New shares might be called “Class A”
shares, with voting restrictions but full
dividend rights.
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Types of Common Stock:
 Classified Stock.
 Founders Shares.
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The Market for Common
Stock:

Closely Held Corporation.
 Publicly Owned Corporation.
 Secondary market.
 Primary market.
 going public.
 Initial public offering market (IPO).
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Common Stock Valuation:
 Dividend Growth Model.
 Corporate Value Model.
 Using the Multiples of Comparable
Firms.
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Dividend Growth Model:
 Expected Dividends as the Basis for Stock
Values.
 Stock Values with Zero Growth.
 Normal, or Constant, Growth (Gordon Model).
 Expected Rate of Return on a Constant Growth
Stock.
Valuing Stocks with Nonconstant Growth. 12
Expected Dividends as
the Basis for Stock Values:
 If you hold a stock forever, all you receive
is the dividend payments.
 The value of the stock today is the present
value of the future dividend payments.
ˆ  PV of expected future dividends
Value of Stock  Vs  P
0
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Expected Dividends as
the Basis for Stock Values:
P̂0 
D̂1
1  k s 
1


t 1

D̂ 2
1  k s 
2

D̂ 
1  k s 

D̂ t
1  k s 
t
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Stock Values with Zero
Growth:
A Zero Growth Stock is a common stock
whose future dividends are not expected
to grow at all.
g  0, and D̂ 1  D̂ 2  D̂   D 0
P̂0 
D
1  k s 
1

D
1  k s 
2

D
1  k s 

D

ks
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Constant Growth Stock
(Gordon Model):
A stock whose dividends are expected to grow
forever at a constant rate, g.
D1 = D0 (1+g)1
D2 = D0 (1+g)2
Dt = D0 (1+g)t
If g is constant, the dividend growth formula
converges to: ^
D0 (1  g)
D1
P0 

ks - g
ks - g
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What is the stock’s market
value?
Using the constant growth model:
D1
$2.12
P0 

ks - g
0.13 - 0.06
$2.12

0.07
 $30.29
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What is the expected market price
of the stock, one year from now?
 D1 will have been paid out already. So, P1 is
the present value (as of year 1) of D2, D3, D4,
etc.
^
D2
$2.247

ks - g
0.13 - 0.06
 $32.10
P1 
 Could also find expected P1 as:
^
P1  P0 (1.06)  $32.10
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What is the expected dividend yield,
capital gains yield, and total return
during the first year?
Dividend yield
= D1 / P0 = $2.12 / $30.29 = 7.0%
Capital gains yield
= (P1 – P0) / P0
= ($32.10 - $30.29) / $30.29 = 6.0%
Total return (ks)
= Dividend Yield + Capital Gains Yield
= 7.0% + 6.0% = 13.0%
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What happens if g > ks?
 If g > ks, the constant growth formula leads
to a negative stock price, which does not
make sense.
 The constant growth model can only be
used if:
ks > g
g is expected to be constant forever
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Expected Rate of Return on a
Constant Growth Stock:
 Dividend yield
 Expected growth rate, or capital gains
yield
k̂ s
D̂1

 g
P0
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Valuing Stocks with
Nonconstant Growth:
 Nonconstant Growth: The part of the life
cycle of a firm in which its growth is either
much faster or much slower than that of
the economy as a whole.
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Valuing Stocks with
Nonconstant Growth:
1. Compute the value of the dividends that
experience nonconstant growth, and then find the
PV of these dividends,
2. Find the price of the stock at the end of the
nonconstant growth period, at which time it has
become a constant growth stock, and discount
this price back to the present, and
3. Add these two components to find the intrinsic
value of the stock P0.
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Corporate Value Model:
 Also called the free cash flow method.
Suggests the value of the entire firm equals
the present value of the firm’s free cash
flows.
 Remember, free cash flow is the firm’s
after-tax operating income less the net
capital investment
FCF = NOPAT – Net capital investment 24
Firm Multiples Method:
Analysts often use the following multiples to
value stocks.
P / E
P / CF
P / Sales
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Factors that affect stock
price:
Required return (ks) could change
Changing inflation could cause kRF to change
Market risk premium or exposure to market
risk (β) could change
Growth rate (g) could change
Due to economic (market) conditions
Due to firm conditions
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What is the Efficient Market
Hypothesis (EMH)?
 Securities are normally in equilibrium and are
“fairly priced.”
 Investors cannot “beat the market” except through
good luck or better information.
 Levels of market efficiency
Weak-form efficiency
Semistrong-form efficiency
Strong-form efficiency
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Preferred Stock:
 Hybrid security
 Like bonds, preferred stockholders
receive a fixed dividend that must be paid
before dividends are paid to common
stockholders.
 However, companies can omit preferred
dividend payments without fear of
pushing the firm into bankruptcy.
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Preferred Stock:
 If preferred stock with an annual
dividend of $5 sells for $50, what is the
preferred stock’s expected return?
Vp = D / k p
$50 = $5 / kp
kp = $5 / $50
= 0.10 = 10%
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The End of The Course.
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