Lecture 17 BH CH 9 Stock and Their Valuation Part 1

PRINCIPLES OF FINANCE
Chapter 9 (BH)
Stock and Their Valuation

Part 1
1
CHAPTER 9
Stocks and Their Valuation
 Key Concepts
 Features of common stock
 Determining common stock values
 Preferred stock
Facts about common stock
 Represents ownership
 Ownership implies control
 Stockholders elect directors
 Directors elect management
 Management’s goal: Maximize the stock price
Types of stock market transactions
 Initial
public offering market (“going public”)
(IPO /Company sells shares to the public for the 1st times.)
 Secondary market (stockholders sell shares to each other)

Stock Market Transactions
 Apple Computer decides to issue additional stock with the
assistance of its investment banker. An investor
purchases some of the newly issued shares. Is this a
primary market transaction or a secondary market
transaction?
transaction?
 Since new shares of stock are being issued, this is a primary market
transaction.
transaction?
transaction.
 What if instead an investor buys existing shares of Apple
stock in the open market – is this a primary or secondary
market transaction?
transaction?
transaction.
 What if instead an investor buys existing shares of Apple
stock in the open market – is this a primary or secondary
market transaction?
 Since no new shares are created, this is a secondary market transaction.
Intrinsic Value and Stock Price
 Outside investors, corporate insiders, and analysts use

a variety of approaches to estimate a stock’s intrinsic
value (P0).
 In equilibrium we assume that a stock’s price equals
its intrinsic value.
 Outsiders estimate intrinsic value to help determine which stocks are
attractive to buy and/or sell.
 Stocks with a price below (above) its intrinsic value are undervalued
(overvalued).
Determinants of Intrinsic Value and Stock Prices
Different approaches for valuing
common stock
 Dividend growth model

 Corporate value model
 Using the multiples of comparable firms
Dividend growth model
 Value
of a stock is the present value of the future dividends
expected to be generated by the stock.
^ D1 D2 D3 D
P0  1
 2
 3
 ... 
(1  rs ) (1  rs ) (1  rs ) (1  rs ) 
Constant growth stock
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
 Ifg is constant, the dividend growth formula

converges to:
^ D 0 (1  g) D1
P0  
rs - g rs - g
What happens if g > rs?
 Ifg > rs, the constant growth formula leads to a
negative stock price, which does not make sense.
 The constant growth model can only be used if:

 rs > g
 g is expected to be constant forever
If rRF = 7%, rM = 12%, and b = 1.2, what is the
required rate of return on the firm’s stock?
If rRF = 7%, rM = 12%, and b = 1.2, what is the
required rate of return on the firm’s stock?
 Usethe SML to calculate the required rate of
return (rs):
rs = rRF + (rM – rRF)b

= 7% + (12% - 7%)1.2
= 13%
If D0 = $2 and g is a constant 6%, find the expected
dividend stream for the next 3 years, and their
PVs. (Remember required rate of return of the
firm’s stock is 13%)
If D0 = $2 and g is a constant 6%, find the expected
dividend stream for the next 3 years, and their PVs.
(Remember required rate of return of the firm’s
stock is 13%)
0 1 2 3
g = 6%
D0 = 2.00 2.12 2.247 2.382

1.8761
rs = 13%
1.7599
1.6509
What is the stock’s intrinsic value?
 Using the constant growth model:
ˆP  D1  $2.12
0
rs - g 0.13 - 0.06
$2.12

0.07
 $30.29
What is the expected market price of
the stock, one year from now?
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
P1  
rs - g 0.13 - 0.06
 $32.10
 Could also find expected P1 as:

^
P1  P0 (1.06)  $32.10
What are the expected dividend yield, capital
gains yield, and total return during the first year?
What are 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 (rs)
= Dividend Yield + Capital Gains Yield
= 7.0% + 6.0% = 13.0%
What would the expected price today be,
if g = 0?
What would the expected price today be,
if g = 0?
 The dividend stream would be a

perpetuity.
0 1 2 3
rs = 13%
...
2.00 2.00 2.00
^ PMT $2.00
P0    $15.38
r 0.13
Supernormal growth:
What if g = 30% for 3 years before achieving
long-run growth of 6%?
Supernormal growth:
What if g = 30% for 3 years before achieving
long-run growth of 6%?
 Can no longer use just the constant

growth model to find stock value.
 However, the growth does become

constant after 3 years.
Valuing common stock with
nonconstant growth
0 r = 13% 1 2 3 4
s
...
g = 30% g = 30% g = 30% g = 6%
D0 = 2.00 2.600 3.380 4.394 4.658
2.301
2.647
3.045
4.658
46.114 $ =
P = $66.54
3
^ 0.13 - 0.06
54.107 = P0
If the stock was expected to have negative
growth (g = -6%), would anyone buy the stock,
and what is its value?
If the stock was expected to have negative
growth (g = -6%), would anyone buy the stock,
and what is its value?
 Thefirm still has earnings and pays dividends, even though
they may be declining, they still have value.
^ D1 D0 ( 1  g )
P0  
rs - g rs - g
$2.00 (0.94) $1.88
   $9.89
0.13 - (-0.06) 0.19

Lecture 17 BH CH 9 Stock and Their Valuation Part 1

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Lecture 17 BH CH 9 Stock and Their Valuation Part 1

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PRINCIPLES OF FINANCE

Stock and Their Valuation

 Secondary market (stockholders sell shares to each other)

 Outside investors, corporate insiders, and analysts use

 Dividend growth model

 Ifg is constant, the dividend growth formula

 The constant growth model can only be used if:

rs = rRF + (rM – rRF)b

D0 = 2.00 2.12 2.247 2.382

 Using the constant growth model:

 Could also find expected P1 as:

 The dividend stream would be a

 Can no longer use just the constant

 However, the growth does become

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