Lahore School of Economics

Financial Management I
Stocks and their Valuation

Common Stock
A security that represents ownership in a corporation
Ownership implies control
Stockholders elect directors
Directors elect management
Managements goal: Maximize the stock price

Stock price vs Intrinsic Value

Stock price = current market price
Intrinsic value = true value of the stock and must be estimated; it cannot be observed directly
It is the value of an asset if all information about it is known to all market participants.

Managerial actions, economic and political climate determine the true as well as perceived investor returns and
risk
True risk is the risk associated with a particular asset or investment if all information is known about it.
True returns and risk => intrinsic value
Intrinsic value is then an estimate of a stocks true value based on true risk and accurate evaluation of return. It
is the based on perfect information of cash flows and correct assessment of risk.
Perceived risk is the opposite of it. Perceived risk is associated with investors expectations about risk and
different people have different perceptions of risk based on their knowledge, information, etc.
Perceived returns and risk => stock market price
Stock price = intrinsic value => market equilibrium

To the extent that investor perceptions are incorrect, a stocks price in the short run may deviate from its intrinsic
value.
The goal of investors is to discover which stocks are deviating from their intrinsic values.
When intrinsic value is less than market value, the stock is overvalued
When intrinsic value is greater than market value, the stock is undervalued
Investors will want to buy undervalued stocks and sell overvalued stocks so that when market goes back into
equilibrium, they can make a profit.
Managers needed to know how their actions will influence intrinsic value, since their goal is to maximize the
stock price.

Different Approaches for Estimating the Intrinsic Value of a Common Stock

Discounted dividend model
Corporate valuation model
P/E multiple approach
EVA approach

Discounted Dividend Model (DDM)

The value of a share of common stock depends on the cash flows it is expected to provide, and those flows consist
of two elements:
- the dividends the investor receives each year while he or she holds the stock
- the price received when the stock is sold. The final price includes the original price paid plus an expected
capital gain.
The analysis is performed by the marginal investor, whose actions actually determine the equilibrium stock price.
 Marginal investor is the investor (or group of investors with similar views) who is at the margin and would be
willing to buy if the stock price was slightly lower or to sell if the price was slightly higher.
It is this investors expectations about dividends, growth, and risk that are key in the valuation process.

Under the DDM, the value of a stock is the present value of the future dividends expected to be generated by the
stock.

Value of a stock = 0 = PV of expected future dividends

1
=
(1+ )1
+ (1+2 )2 + + (1+ )

=
=1
(1+ )

= expected price and expected intrinsic value of the stock at the end of each t year.

= the dividend a stockholder expects to receive at the end of each Year t.

D0 is the last dividend the company paid. Since it has already been paid, a buyer of the stock will not receive D0.
The first dividend a new buyer will receive is D1, which is paid at the end of Year 1.
D0 is known with uncertainty but D1, D2, and all other dividends are expected values; and different investors
will have different expectations about it.

= required, or minimum acceptable, rate of return on the stock considering its riskiness and the returns available
on other investments. This is determined by the CAPM equation.

Other important factors are:

0 = The price at which a stock sells in the market.

= the expected growth rate in dividends per share as predicted by an investor. If dividends are expected to grow at
a constant rate, g should also equal the expected growth rate in earnings and the stocks price.

= The rate of return on a common stock that a stockholder expects to receive in the future.
The expected return can be above or below the required return

A rational investor will buy the stock if expected return exceeds the required rate of return, sell the stock
if expected return is less than the required rate of return, and simply hold the stock if these returns are
equal.

1
= Dividend Yield: The expected dividend divided by the current price of a share of stock.
0

1 0
= Capital Gains Yield: The capital gain during a given year divided by the beginning price.
0

1 1 0

=
0
+ 0
= Expected Total Return: The sum of the expected dividend yield and the expected capital gains
yield.

When stock is held for a finite period and then sold (unless the company is likely to be liquidated or sold and thus
disappears), the value of the stock is again determined by the above equation.
The expected cash flows consist of expected dividends plus the expected sale price of the stock.
 However, the sale price to the current investor depends on the dividends some future investor expects, and that
investors expected sale price is also dependent on some future dividends, and so forth.
Therefore, for all present and future investors in total, expected cash flows must be based on expected future
dividends.
The cash flows a firm provides to its stockholders will consist only of a stream of dividends. Therefore, the value
of a share of stock must be established as the present value of the stocks expected dividend stream.

Constant Growth (Gordon) Model

A constant growth stock is one whose dividends are expected to grow forever at a constant rate, g. Hence,

D1 = D0(1 + g)1

D2 = D0(1 + g)2

Dt = D0(1 + g)t

0 (1 + ) 0 (1 + )2 0 (1 + )
0 = + + +
(1 + )1 (1 + )2 (1 + )

If g is constant, the discounted dividend formula converges to:

0 (1 + )
0 =

1
=

is the required rate of return, which is a riskless rate plus a risk premium. (determined by CAPM equation)
Under equilibrium, the required rate of return must equal the expected rate of return

Expected rate of return = Expected dividend yield + Expected capital gains yield

1
= + g
0
What happens if g > ?:
If g > 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.

Zero-Growth stock: a common stock whose future dividends are not expected to grow at all.

0
=

Example
A company recently paid a dividend of $2 and is expected to grow at a constant rate of 6%. The beta of its stock is
1.2. Currently, the risk-free rate is 7% and return on the market is 12%.
a) Calculate the required rate of return, , of the stock.
b) Find the expected dividend stream for the next 3 years.
c) What is the stocks intrinsic value?
d) What is the stocks expected value, one year from now?
e) Find expected dividend yield, capital gains yield, and total return during first year.
f) What would the expected price today be, if g = 0?

Dividends vs. Growth

A higher value for D1 increases a stocks price.
A higher growth rate also increases the stocks price.
Dividends are paid out of earnings.
=> Growth in dividends requires growth in earnings.
=> Earnings growth occurs because firms retain earnings and reinvest them in the business.
=> The higher the percentage of earnings retained, the higher the growth rate.

Example:
Assets = $1,000,000, no debt, Equity = $1,000,000 of equity. The expected return on equity (ROE) equals 10.0%.
Expected earnings for the coming year are (0.10)$1,000,000 = $100,000.
Option 1: Dividends = $100,000
Option 2: Reinvest some or all of the $100,000 in the business.
If you pay out all the earnings, you will have $100,000 of dividend income this year, but dividends will not grow
because assets and therefore earnings will not grow.

However, suppose you decide to have the firm pay out 40% and retain 60%.
Dividend income in Year 1 = $40,000
Assets will rise by $60,000, and earnings and dividends will likewise increase:

Next year's earnings = Prior earnings + ROE*Retained earnings

= $100,000 + 0.1*$60,000
= $106,000

Next year's dividends = 0.4*$106,000 = $42,400

Dividend income will continue to grow by 6% per year thereafter.

Growth rate = (1 - Payout ratio)*ROE

= (1 - 0.4)*10.0%
= 60%
 This demonstrates that in the long run, growth in dividends depends primarily on the firms payout ratio
and its ROE.

A firm can provide a relatively high dividend yield or a higher growth rate but not both.
Choice depends on what shareholders want.
Empirical research has not revealed the optimal strategy for maximizing share price.

Non-Constant Growth Stocks

Many firms go through life cycles where they experience different growth rates during different parts of the cycle.
Supernormal (Nonconstant) Growth: The part of the firms life cycle in which it grows much faster than the
economy as a whole.
The value of this firms stock, like any other asset, is the present value of its expected future dividends.

To calculate the value, first we assume that the dividend will grow at a nonconstant rate (generally a relatively
high rate) for N periods, after which it will grow at a constant rate, g.
N is often called the terminal, or horizon, date.
Second, we can use the constant growth formula to determine what the stocks horizon, or terminal, value will be
N periods from today:

+1

Horizon Value = =

The stocks intrinsic value today, 0 , is the present value of the dividends during the nonconstant growth period
plus the present value of the horizon value:

We go through the following three steps:

1. Find the PV of each dividend during the period of nonconstant growth and sum them.
2. Find the expected stock price at the end of the nonconstant growth period, at which point it has become
a constant growth stock so it can be valued with the constant growth model, and discount this price
back to the present.
3. Add these two components to find the stocks intrinsic value, 0 .

Example: For a new Firm M, assume that the stockholders required rate of return is 13.4%. The company faces
three years of supernormal growth of 30%, after which it will face a constant growth rate of 8%. The last dividend
paid to the stockholders was $1.15. Calculate the intrinsic value of Firm Ms stock.