Corporate Finance Thirteenth Edition

Stephen A. Ross / Randolph W. Westerfield / Jeffrey F. Jaffe / Bradford D. Jordan

Chapter 9

Stock Valuation

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 Key Concepts and Skills
• Understand how stock prices depend on future
dividends and dividend growth.
• Be able to compute stock prices using the dividend
growth model.
• Understand valuation comparables.
• Understand the basics of the stock market.

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 Chapter Outline
• Common Stocks
• Stock valuation
• Comparables
• Valuing Stocks Using Free Cash Flows
• The Stock Markets

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 Common stocks
• Common stock represents equity or an ownership
position in a corporation.
• Payments to common stock are in the form of
dividends:
• cash dividend
• stock dividend
• share repurchase
• Contrary to payments to bondholders, payments to
stockholders are uncertain in both magnitude and
timing.

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 Common stocks
• Main differences between debt and common stock:

• Residual claim : stockholders have claim to firm's

cash flows/assets after all obligations to creditors
are met.

• Limited liability: stockholders may lose their

investments, but no more

• Voting rights: stockholders are entitled to vote for

the board of directors and on other major decisions

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 One-year period
• The value of any asset is the present value of its
expected future cash flows (dividends and capital
gains).
$% + !%
!" =
1+(
• D1 is the expected dividend at year t
• R is the discount rate/required return
• P0 is the present value of the common stock investment.
Example: Imagine that buy a share of stock today. You expect the stock will be
$50 next year. You predict that the stock will also pay a $5 per share dividend
at the end of the year. If you require a 20 percent return on your investment,
what is the most you would pay for the stock?

+ + +*
)* = = /+. 01
, + *. .
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 Dividend Discount Model (DCF)

• The value of any asset is the present value of its

expected future cash flows (dividends and capital
gains).

• Dt is the expected dividend at year t

• R is the discount rate/required return
• P0 is the present value of the common stock investment.

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 Different Types of Stocks

• Zero Growth
• Constant Growth
• Differential Growth

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 Case 1: Zero Growth
Assume that dividends will remain at the same level forever

D1 = D2 = D3 = !

• Since future cash flows are constant, the value of a zero

growth stock is the present value of a perpetuity:

D1 D2 D3
P0 = + + +!
1 + R (1 + R ) (1 + R )
2 3

D
P0 =
R

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 Case 2: Constant Growth
Assume that dividends will grow at a constant rate, g,
forever, i.e.,
D1 = D0 (1 + g )
D2 = D1 (1 + g ) = D0 (1 + g )
2

D3 = D2 (1 + g ) = D0 (1 + g )
3

Since future cash flows grow at a constant rate forever, the

value of a constant growth stock is the present value of a
growing perpetuity:
D1
P0 =
R-g
Note that when g = R or R < g, the dividend growth model fails

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 Constant Growth Example
Dividends are expected to grow at 2% per year and the recent
dividend was $0.5 per share. If the market requires a return of
15 percent on assets of this risk level, how much should the
stock be selling for?

.50 (1.02 )
P0 = = $3.92
(.15 - .02 )

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 Case 3: Differential Growth
A common case: Assume that dividends will grow at g1 per
year for N years, and then will grow at g2 thereafter
To value a differential growth stock, we need to:
• Estimate future dividends in the foreseeable future.
• Estimate the future stock price when the stock becomes a
constant growth stock (in year N).
• Compute the total present value of the estimated future
dividends and future stock price at the appropriate
discount rate.
Appropriate discount rate Div1×(1+g1)N –1×(1+g2)
for this stock = R
Div1 Div1×(1+g1) Div1×(1+g1)2 … Div1×(1+g1)N –1 Div1×(1+g1)N –1×(1+g2)2 …
Po P1 P2 P3 PN PN+1 PN+2
…… ……
0 1 2 3 N N+1 N+2
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 Case 3: Differential Growth
Assume that dividends will grow at rate g1 for N years
and grow at rate g2 thereafter.

D1 = D0 (1 + g1 )
= D1 (1 + g1 ) = D0 (1 + g1 )
2
D2
!
= DN +1 (1 + g1 ) = D0 (1 + g1 )
N
DN
DN +1 = DN (1 + g 2 ) = D0 (1 + g1 ) (1 + g 2 )
N

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 Case 3: Differential Growth
Dividends will grow at rate g1 for N years and grow at
rate g2 thereafter
Growing Annuity

+, (1 + ., )'
() = 1−
% − ., (1 + %)'

Growing Perpetuity/(1 + %)'

+'0,
% − .1
(/ =
(1 + %)'

Access the text alternative for slide images

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 Case 3: Differential Growth
We can value this as the sum of: a T-year annuity
growing at rate g1

$% (1 + (% )-
!" = 1−
& − (% (1 + &)-

plus the discounted value of a perpetuity growing at rate

g2 that starts in Year T+1

$-/%
& − (0
!. =
(1 + &)-

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 Case 3: Differential Growth
Consolidating gives:

#$%&'() !/$0/,+',-
! = #$%&'() *((+',- +
(1 + 3)5

6597
67 (1 + )7 )5 3 − ):
!= 1− +
3 − )7 (1 + 3)5 (1 + 3)5

If R < g1, R = g1, R < g2 or R = g2 , then the formula for differential

growth fails

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 A Differential Growth Example
A common stock paid a dividend of $2. The dividend is
expected to grow at 8 percent for 3 years, then it will
grow at 4 percent in perpetuity.
What is the stock worth? Assume the discount rate is 12
percent.

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 With the Formula
#,-$
#$ (1 + '$ ), % − '.
!= 1− +
% − '$ (1 + %), (1 + %),

æ 2 (1.08 )3 (1.04 ) ö
ç ÷
$2 ´ 1.08 é 1.083 ù çè .12 - .04 ÷
ø
P= 1 - +
.12 - .08 êë 1.123 úû 1.123
$32.75
P = $54 ´ [1 - .8966] +
1.123
P = $5.58 + 23.31
P = $28.89

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 With Cash Flows

The constant growth

phase beginning in
Year 4 can be
valued as a growing
perpetuity at Year 3.
$2.16 $2.33 $2.52 + 32.75
P0 = + 2
+ 3
= $28.89
1.12 1.12 1.12

Access the text alternative for slide images

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 Parameters of DDM:
• Growth rate, g

• Historical (past) growth as a measure of expected

growth

• Firm re-investment policy

• Firm’s project quality.

• Discount rate, R

20

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 How to estimate g?
The value of a firm depends upon its growth rate, g.
• Where does g come from?
Earnings Earnings Retained earnings Return on
next = this + this year × retained
year year earnings
Earnings next year æ Retained earnings this year ö
= 1+ ç ÷ ´ Return on retained earnings
Earnings this year è Earnings this year ø

1 + g = 1 + Retention ratio × Return on retained earnings

g = Retention ratio × Return on retained earnings
g = Retention ratio × ROE

21

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 Where Does R Come From?
The discount rate can be broken into two parts.
• The dividend yield.
• The growth rate (in dividends)

In practice, there is a great deal of estimation error

involved in estimating R.

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 Using the DGM to Find R
Start with the DGM:

D0 (1 + g ) D1
P0 = =
R-g R-g
Rearrange and solve for R:

D0 (1 + g ) D1
R= +g = +g
P0 P0

dividend yield Growth rate

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 Using the DGM to Find R

Suppose we observe a stock selling for $20 per share. The

next dividend is expected to be $1 per share. You think that
dividend will grow by 10% per year more or less indefinitely.
What is the expected return this stock offers you?

R = $1/$20 + 0.1 = 15%

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 Example
Firm A’s earnings is $2 million this year. It plans to retain 40%
of its earnings. The historical ROE is 0.16, a figure that is
expected to continue into the future. Firm A has 1,000,000
shares of stock outstanding. The stock is selling of $10.

a. How much will earnings grow over the coming year?

b. What is the required return, R, on the stock?

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 Problem 1
Determine the fair market price of a stock that recently paid a
dividend of $1.50, with a projected long-term annual growth
rate of 3%, and where investors expect a 16% return from
the stock.

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 Problem 2
You estimate a 30% chance that IBM's dividend next year will
be $4.50, and a 70% chance it will rise to $5.00. You also
expect the company to grow at a long-term rate of 8%, with a
required return of 12% on IBM stock. What is the fair price you
should pay for one share of IBM?

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 Problem 3
The expected dividend of Arnold Co for next year has the
following probability distribution: 20% $2.00, 30% $2.25, 40%
$2.50, and 10% $2.75. The growth rate of Arnold is almost
zero. If your required rate of return is 12%, find the price of an
Arnold share in your estimation.

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 Problem 4
Gro Ltd., also all equity financed, expects earnings per share
of €3 at the end of the current year as well. But its (fixed)
retention ratio of earnings for new investments is 60%.
Required return on equity is 10% per year. The expected
return on equity is 15% per year.
a. What is the expected growth rate of earnings?
b. When applying the DDM, what is the current share value of
Gro?

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 Comparables
• Since now, we evaluate stock value mostly according
to its cashflow from dividend and capital gains, but
how about stock pay no dividends?
• Common multiples include:
• Price-Earnings Ratios.
• Enterprise Value Ratios.

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 Price-Earnings Ratio
• The price-earnings ratio is calculated as the current stock
price divided by annual EPS.
• Last four quarters’ earnings are commonly used.
Price per share
PE ratio =
EPS
• Benchmark PE based on:
• PE of Market
• PE of Peers
• Historical PE

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 Enterprise Value Ratios
The PE ratio focuses on equity, but what if we want the value of
the firm?
Use enterprise value:
• EV = Market value of equity + Market value of debt − Cash

• Like PE, we compare the value to a measure of earnings.

From a firm level, this is EBITDA, or earnings before interest,
taxes, depreciation, and amortization.
• EBITDA represents a measure of total firm cash flow.

Enterprise value ratio = EV/EBITDA

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 Valuing Stocks Using Free Cash Flows

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 Valuing Stocks Using Free Cash Flows

In Chapters 5 and 6 you learned that the value of a

project (i.e., its NPV) was the discounted value of the
cash flows it generates.
The firm value is the consolidated present value of the
cash flow from all of its projects.

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 Valuing Stocks Using FCF - Example
§ Revenue is forecast to be $500 million in one year, is expected to
grow at 10% for 2 years after that, 8% for the next 2 years, and 6
percent per year after that.
§ Expenses including depreciation are 60% of revenues.
§ Net investment, including net working capital and capital spending
less depreciation, is 10% of revenues.

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 Valuing Stocks Using FCF - Example
§ Because all costs are proportionate to revenues, FCF grows at the
same rate as revenue.
§ The firm has 12 million shares outstanding.
§ Discount rate = 16%

FCF in Year 6 = $152.43 * 1.06 = $161.57m

PV as of Year 5 of all future cash flows = $161.57 / (0.16-0.06) = $1615.7m

PV as of today of this terminal value = $1615.7 / 1.16^5 = $769.26m

PV of FCF during the first 5 years = $415.63m

Today’s value of firm = $415.63m + $769.26m = $1184.89m

Price per share = $1184.89 / 12 = $98.74

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 The Securities Markets

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 The Securities Markets

• The securities market is a part of the capital market,

which mechanism of meeting between supply and
demand of securities, thereby forming prices and
payment methods.

• Products of securities markets: bond, stock,

deriavative securities.

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 Classification of Securities Markets

• Based on Circulating Goods:

• Bond market | Stock market | Derivatives market

• Based on Nature of Issuance:

• Primary market | Secondary market

• Based on Method of Transaction

• Centralized market (listed on the stock exchange)

• Decentralized market (OTC)

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 Participants of Securities Market
• Issuers
• Firms, goverments, financial institutions
• Investors
• Institutional investors vs individual investors
• Organizations provide products/ services on the stock
market
• Securities company, brokerage firms,
• Organizations related to the stock market
• Stock exchanges, Credit rating agency, Financial Data
& Analytics Firms

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 Participants of Securities Market
Dealers vs. Brokers.
• A broker brings buyers and sellers together, but
does not maintain an inventory
• A dealer maintains an inventory and stands ready
to buy and sell at any time

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 Market and Limit Orders
Market orders:
You specify ticker and quantity.
Immediate execution at best available price.
• Market buy will be executed at lowest ask.
• Market sell will be executed at highest bid.

Limit orders:
You specify ticker, quantity, and price.
The order will be executed only if trade can be made at the limit
price or better.
• Limit buy can only be executed at limit price or lower.
• Limit sell can only be executed at limit price or higher.

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 Stop Orders
The stop price is the trigger or activation point.
• If the stop price is reached or passed, the order
becomes a market order to be executed at the best
available price.
• Risk: Price suddenly plummets or rises and the
execution price is much different than expected.

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 Nasdaq
Not a physical exchange but a computer-based quotation system.
Multiple market makers.
Electronic communications networks.
Three levels of information:
• Level 1—timely, accurate quotes, freely available.
• Level 2—view quotes from all Nasdaq market makers, small fee.
• Level 3—view and update quotes, market makers only.

Large portion of technology stocks.

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 Stock Market Reporting

Access the text alternative for slide images

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 Suggested exercises
Concept Questions
2, 6

Questions and Problems

7, 9, 10, 13, 16, 17, 23, 25, 26, 32

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Note for mid-term exam
• Schedule: MyISB
• Duration: 90 mins
• Format: paper form, 50 MCQs
• Contents: cover Weeks 1 – 4, 50% theory + 50%
calculations
• Closed book exam, equation sheet is provided on the
test page.
• Remember to bring your own calculator.
• Cell phones, iphones, ipads, & notebooks are not
allowed.

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