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CHAPTER 8 Stocks and Their Valuation


In equilibrium, stock prices are stable and there is no general tendency for ... All information, even inside information, is embedded in stock prices. ... – PowerPoint PPT presentation

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Title: CHAPTER 8 Stocks and Their Valuation

CHAPTER 8Stocks and Their Valuation
  • Features of common stock
  • Determining common stock values
  • Efficient markets
  • Preferred stock

Facts about common stock
  • Represents ownership
  • Ownership implies control
  • Stockholders elect directors
  • Directors elect management
  • Managements goal Maximize the stock price

Different approaches for valuing common stock
  • Dividend growth model
  • Corporate value model
  • Using the multiples of comparable firms

What determines a stock's value?
  • P0 div1 div2 div3 div4 .
    divn Pn
  • (1r) (1r)2 (1r)3 (1r)4
    (1r)n (1r)n
  • Need to estimate the future dividends and capital
    gains (selling price)
  • Also need the discount rate to price these cash

Dividend growth model
  • Value of a stock is the present value of the
    future dividends expected to be generated by the

  • Where we can make some simplifying assumptions
    about the growth pattern of future dividends
  • No growth
  • Constant dividends div1div2.......D
  • Ex utility stocks, preferred stocks
  • P0 D
  • ks

Constant Growth Stock
  • One whose dividends are expected to
  • grow forever at a constant rate, g.
  • Growing perpetuity
  • P0 DIV1
  • (ks-g)
  • ks DIV1 g
  • P0
  • Market capitalization rate Dividend yield
    (DIV1/P0) expected rate of growth in dividends,

Constant growth stock
  • A stock whose dividends are expected to grow
    forever at a constant rate, g.
  • D1 D0 (1g)1
  • D2 D0 (1g)2
  • Dt D0 (1g)t
  • If g is constant, the dividend growth formula
    converges to

What happens if g gt ks?
  • If g gt 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 gt g
  • g is expected to be constant forever

If kRF 7, kM 12, and ß 1.2, what is the
required rate of return on the firms stock?
  • Use the CAPM to calculate the required rate of
    return (ks)
  • ks kRF (kM kRF)ß
  • 7 (12 - 7)1.2
  • 13

What would the expected price today be, if g 0?
  • The dividend stream would be a perpetuity.

If D0 2 and g is a constant 6, what is the
stocks market value?
  • Using the constant growth model

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,
  • Could also find expected P1 as

What is the expected dividend yield, capital
gains yield, and total return during the first
  • 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

Rearrange model to rate of return form

Then, ks 2.12/30.29 0.06 0.07 0.06
  • World Wide Inc. is expected to pay a per-share
    dividend of 3 next year. It also expects that
    this dividend will grow at a rate of 8 in
    perpetuity. What price would you expect to see
    for World Wide stock if the appropriate discount
    rate is 12?

  • Brown Inc. has just paid a 3 dividend per
    share of common stock. The stock is currently
    being sold at 40. Investors expect that Browns
    dividend will grow at a constant rate
    indefinitely. What growth rate is expected by
    investors if they require 8 return on the stock?

  • Consider the stock of Davidson Company that
    will pay an annual dividend of 2 in the coming
    year. This dividend is expected to grow at a
    constant rate of 5 permanently. The market
    requires a 12 return on the company.
  • What is the current price of the stock?
  • What will the stock price be 10 years from now?

Supernormal growthWhat 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

Valuing common stock with nonconstant growth


  • Whizkids Inc. is experiencing a period of rapid
    growth. Earnings and dividends are expected to
    grow at 18 during the next two years, 15 in the
    third year and a constant rate of 6 thereafter.
    Their last dividend which has already been paid
    was 1.15. If the required rate of return on the
    stock is 12, what should the price of the stock
    be today?

What is market equilibrium?
  • In equilibrium, stock prices are stable and there
    is no general tendency for people to buy versus
    to sell.
  • In equilibrium, expected returns must equal
    required returns.

Market equilibrium
  • Expected returns are obtained by estimating
    dividends and expected capital gains.
  • Required returns are obtained by estimating risk
    and applying the CAPM.

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
    (ß) could change
  • Growth rate (g) could change
  • Due to economic (market) conditions
  • Due to firm conditions

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

Weak-form efficiency
  • Cant profit by looking at past trends. A recent
    decline is no reason to think stocks will go up
    (or down) in the future.
  • Evidence supports weak-form EMH, but technical
    analysis is still used.

Semistrong-form efficiency
  • All publicly available information is reflected
    in stock prices, so it doesnt pay to over
    analyze annual reports looking for undervalued
  • Largely true, but superior analysts can still
    profit by finding and using new information

Strong-form efficiency
  • All information, even inside information, is
    embedded in stock prices.
  • Not true--insiders can gain by trading on the
    basis of insider information, but thats illegal.

Is the stock market efficient?
  • Empirical studies have been conducted to test the
    three forms of efficiency. Most of which suggest
    the stock market was
  • Highly efficient in the weak form.
  • Reasonably efficient in the semistrong form.
  • Not efficient in the strong form. Insiders could
    and did make abnormal (and sometimes illegal)
  • Behavioral finance incorporates elements of
    cognitive psychology to better understand how
    individuals and markets respond to different

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

If preferred stock with an annual dividend of 5
sells for 50, what is the preferred stocks
expected return?
  • Vp D / kp
  • 50 5 / kp
  • kp 5 / 50
  • 0.10 10