CHAPTER 9
Stocks and Their Valuation
Outline
Features of Common Stock
Different approaches for valuing common
stocks
 Preferred stock


9-1
Features of Common Stock


Represents ownership
Right to elect directors
◦ Directors appoint managers

Voting rights: One vote per stock
◦ Can transfer voting rights to another person by a
proxy.
◦ Proxy is a document giving one person the authority
to act for another

Preemptive Right: The provision that gives
common stockholders the right to purchase on
a pro rata basis new issues of common stocks.
9-2
Types of Common Stocks



Most companies have only one form of
common stock.
There are some companies who classify their
stocks into Class A and Class B to differentiate
between the difference in special rights of
each type of stocks. These are called
Classified Stocks.
Founders’ Shares are stocks owned by firm’s
founders that has sole voting rights but
restricted dividends for specified number of
years.
9-3
Stock Price VS Intrinsic Value
Stock Price - Current Market Price
Intrinsic Value - “True” value based
on it’s ability to generate cash now
and in the future.
 “Stock Price = Intrinsic Vale” when
market is at equilibrium.


◦ Consistent equilibrium leads to efficient
market
◦ Inefficient markets have “overvalued” and
“undervalued” stocks.
9-4
Different approaches for valuing
common stock
 Discounted Dividend model
◦ Zero Growth Dividend model
◦ Constant Growth Dividend model
◦ Variable or Non-Constant Growth Dividend
model
 Corporate valuation
◦ FCF valuation model
model
9-5
Discounted Dividend Model

Two types of cash flows are expected from Common
Stocks:
◦ The portion of the profit that investors receive
periodically while he or she holds the stock. This
constitutes the Dividend gain/yield.
◦ The price received when the stock is sold. This
constitutes the Capital gain/yield.
 CAPM gives us the rate of the expected capital gain.
9-6
Dividend growth model

Value of a stock is the present value of the
future dividends expected to be generated by
the stock.
◦ Assuming the stock will be held till eternity, so
there is no Capital gain.
D3
D1
D2
D
P0 


 ... 
1
2
3

(1  rs ) (1  rs )
(1  rs )
(1  rs )
^
9-7
Zero Growth Stock
A common stock whose future
dividends are not expected to grow at
all. G=0.
 So, D1= D2=…..= Dt
 Dividends behave like perpetuity

D
P0 
rs
^
9-8
Constant growth stock

A stock whose dividends are expected to grow
forever at a constant rate or same 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 Gordon Model:
D 0 (1  g)
D1
P0 

rs - g
rs - g
^
9-9
Constant Growth Model



Rs = required rate of return
At market equilibrium required return is
equal expected return.
Thus when market is at equilibrium stock
price grows at the same rate the dividend
grows
9-10
Dividend VS Growth
Dividends are paid out of profit
 Growth in dividend depends on growth in
profit.
 But if dividend grows retained earnings
reduces.
 Without reinvestment of earnings growth in
profit is not possible.

◦ Thus higher the percentage of retained earnings the
higher the profit growth.
◦ In the long run Dividends become constant, i.e. g=0.
9-11
Required Conditions for Constant
Growth Model

Rate of return should be greater than
growth rate. rs > g.
◦ Otherwise the stock price will have a
negative value, which is meaningless.

Growth rate has to be constant
throughout. g0 = g1 = g∞
9-12
Variable or Non-Constant Growth
Stock

Supernormal (Nonconstant) Growth: The
part of the firm’s life cycle in which it grows
much faster than the economy as a whole.

Terminal (Horizon) Date: The date when
the growth rate becomes constant.

Horizon (Terminal) Value: The value at the
horizon date of all dividends expected
thereafter.
9-13
Non-Constant Growth Stocks

The stock’s intrinsic value today is the
present value of the dividends during
the nonconstant growth period plus
present value of horizon value.
9-14
Corporate Valuation Model


A valuation model used as an alternative
to the discounted dividend model to
determine a firm’s value, especially one
with no history of dividends, or the value
of a division of a larger firm.
This model first calculates the firm’s
expected free cash flows, then finds their
present values to determine the firm’s
value.
9-15
Preferred Stock

Preferred stocks are a hybrid of
common stock and bonds.
◦ Like interest of bonds, the dividends of
preferred stocks are also fixed periodic
payments.
◦ Thus they behave like perpetuity.
9-16
If a preferred stock with an annual dividend of $5
sells for $50, what is the preferred stock’s
expected return?
Vp = D / kp
$50 = $5 / kp
kp = $5 / $50
= 0.10 = 10%
9-17