McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Valuing Stocks
This chapters introduces valuations techniques
for equity (stocks).
The Dividend Discount Model provides an
excellent measure of a stock’s intrinsic value.
7-2
The Stock Market
The two principal stock exchanges in the US are the New York
Stock Exchange & NASDAQ
 Primary Market vs. Secondary Market
 Initial Public Offering
 Primary Offering
7-3
Primary vs. Secondary Markets:
Example
Shannon sells 100 shares of Google stock from her portfolio for $500
per share to help pay for her son Domenic’s college education.
How much does Google receive from the sale of its shares?
Does this transaction occur on the primary or secondary
market?
7-4
Bid Price/Ask Price
Bid Price: The prices at which investors are willing to buy
shares.
Ask Price: The prices at which current shareholders are
willing to sell their shares.
Example:
If an investor wishes to purchase 100 shares of Apple with a bid
price of $253.40 and an ask price of $253.48, how much could
the investor expect to pay for the shares?
Answer: $253.80
7-5
Terminology
Investors use a number of methods to determine the
quality of a company’s shares.
 Market Cap
 P/E Ratio
 Dividend Yield
7-6
Basic Terminology: Example
You are considering investing in a firm whose shares are currently
selling for $50 per share with 1,000,000 shares outstanding. Expected
dividends are $2/share and earnings are $6/share.
What is the firm’s Market Cap? P/E Ratio? Dividend Yield?
Market Capitalization  $50 1, 000, 000  $50, 000, 000
$50
P/E Ratio 
 8.33
$6
$2
Dividend Yield 
 .04  4%
$50
7-7
Measures of Value
Three ways to value a firm:
Book Value
– Net worth of the firm according to the balance sheet.
Liquidation Value
– Net proceeds that could be realized by selling the firm’s
assets and paying off its creditors.
Market Value
– The value of the firm as determined by investors who would
be willing to purchase the company.
7-8
Going-Concern Value
The difference between a company’s actual value and its
book or liquidation value is called its going-concern
value.
 Refers to three factors:
1.
2.
3.
Extra earning power
Intangible assets
Value of future investments
7-9
Price and Intrinsic Value
7-10
Price and Intrinsic Value
Example:
What is the intrinsic value of a share of stock if
expected dividends are $2/share and the expected price
in 1 year is $35/share? Assume a discount rate of 10%.
7-11
Expected Return
7-12
Expected Return: Example
What should be the price of a stock in one year if it sells for $40
today, has an expected dividend per share of $3, and an expected
return of 12%?
7-13
The Dividend Discount Model
Div1
Div 2
Div H  PH
P0 

 ... 
1
2
H
(1  r ) (1  r )
(1  r )
where :
H  Time Horizon
Divi  Dividend in the ith period.
r  Required Rate of Return
7-14
The Dividend Discount Model
Consider three cases:
1. No growth
2. Constant Growth
3. Nonconstant Growth
7-15
The Dividend Discount Model
 Case 1: No Growth
What should the price of a share of stock be if dividends are
projected at $5/share, the discount rate is 10%, and growth is 0%?
7-16
The Dividend Discount Model
 Case 2: Constant Growth
Example: What should the price of a share of stock be if the firm
will pay a $4 dividend in 1 year that is expected to grow at a
constant rate of 5%? Assume a discount rate of 10%.
7-17
The Dividend Discount Model
 Case 3: Nonconstant Growth
Div1
Div 2
Div H
PH
P0 

 ... 

1
2
H
H
(1  r ) (1  r )
(1  r )
(1  r )
PV of dividends from
year 1 to horizon
PV of stock price
at horizon
7-18
Nonconstant Growth Dividend
Discount Model
Example:
A firm is expected to pay $2/share in dividends next year. Those dividends
are expected to grow by 8% for the next three years and 6% thereafter. If
the discount rate is 10%, what is the current price of this security?
7-19
Required Rates of Return
Estimating Expected Required Rates of Return:
Example: What rate of return should an investor expect on a share
of stock with a $2 expected dividend and 8% growth rate that sells
today for $60?
7-20
Sustainable Growth Rate
If a firm earns a constant return on its equity and plows back a
constant proportion of earnings, then the growth rate g is:
g  Return on Equity  Plowback Rate = ROE  b
where : b 
earnings  dividends
earnings
Example: Suppose a firm that pays out 35% of earnings as dividends and
expects its return on equity to be 10%. What is the expected growth rate?
g  .10  (1  .35)  .065  6.5%
7-21
Valuing Growth Stocks
Present Value of Growth Opportunities (PVGO) –
Where:
EPS = Earnings per share
PVGO = Present Value of Growth Opportunities
7-22
Valuing Growth Stocks:
Example
Suppose a stock is selling today for $55/share and there are
10,000,000 shares outstanding. If earnings are projected to be
$20,000,000, how much value are investors assigning to growth per
share? Assume a discount rate of 10%.
7-23
Methods of Analysis
Investors have many strategies for trying to
beat the market consistently.
 Technical Analysis
 Fundamental Analysis
7-24
Technical Analysis
Technical analysts try to achieve superior returns by
spotting and exploiting patterns in stock prices.
 Problem with this approach:

Prices follow a “random walk”
7-25
Technical Analysis
Returns on NYCI on two successive weeks, 1970-2010
Are successive security prices related?.
7-26
Fundamental Analysis
Fundamental analysts are paid to uncover stocks
for which price does not equal intrinsic value.
What happens in a market with many talented
and competitive fundamental analysts?
7-27
Efficient Market Hypotheses
Is the US stock market a highly efficient market?
Degrees of efficiency:
• Weak-form Efficiency
• Semistrong-form Efficiency
• Strong-form Efficiency
7-28
Market Anomalies
There are a number of market anomalies that seem to puzzle
efficient market theorists, including:
The Earnings Announcement Puzzle
The New-Issue Puzzle
Bubbles
7-29
Behavioral Finance
Some believe that deviations in prices from intrinsic
value can be explained by behavioral psychology, in
two broad areas:
1. Attitudes toward risk--People generally dislike incurring
losses, yet they are more apt to take bigger risks if they are
experiencing a period of substantial gains.
2. Beliefs about probabilities--Individuals commonly look
back to what has happened in recent periods and assume this is
representative of future outcomes.
7-30