The value of common

stocks
4-1 How Common Stocks are Traded
• Primary Market
• New securities

• Secondary Market
• Previously-issued securities

• Common Stock
• Ownership shares in publicly-held corporation
4-1 How Common Stocks are Traded

• Trading in BSE and NSE

• Exchange-Traded Funds (ETFs)

• Stock portfolios bought/sold in single trade
4-2 How Common Stocks are Valued
• Book Value
• Net worth of firm according to balance sheet
• Dividend
• Periodic cash distribution from firm to the shareholders
• P/E Ratio
• Price per share divided by earnings per share
• Market Value Balance Sheet
• Financial statement that uses market value of assets and
liabilities
4-2 How Common Stocks are Valued

• Discounted Cash Flow (DCF) Formula

• Value of a stock = present value of future cash flows

PV(stock) = PV(expected future dividends)

4-2 How Common Stocks are Valued
• Expected Return
• Percentage yield forecast from specific investment over time period
• Sometimes called market capitalization rate
4-2 How Common Stocks are Valued
• Example
• Fledgling Electronics sells for Rs.100 per share today; they are expected to sell
for Rs.110 in one year. What is expected return if dividend in one year is
forecasted to be Rs.5.00?

5 + 110 − 100
Expected return = = .15
100
4-2 How Common Stocks are Valued
• Price of share of stock is present value of future cash flows
• For a stock, future cash flows are dividends and ultimate sales price

Div1 + P1
Price = P0 =
1+ r
4-2 How Common Stocks are Valued
• Example
• Fledgling Electronics price

5 + 110
Price = P0 = = 100
1.15
4-2 How Common Stocks are Valued
• Market Capitalization Rate
• Estimated using perpetuity formula
• Also called cost of equity capital

Div1
Capitalization rate = P0 =
r−g
Div1
=r= +g
P0
4-2 How Common Stocks are Valued
• Dividend Discount Model
• Computation of today’s stock price: share value equals present value of all
expected future dividends
• H: Time horizon for investment

Div1 Div2 Div H + PH

P0 = + + ... +
(1 + r )1 (1 + r ) 2 (1 + r ) H
4-2 How Common Stocks are Valued
• Modified Formula

Div1 Div2 Div H + PH

P0 = + + ... +
(1 + r )1
(1 + r ) 2
(1 + r ) H

 (1 + r )
Divt PH
P0 = +
t =1
t
(1 + r ) H
4-2 How Common Stocks are Valued
• Example
• Fledgling Electronics forecasted to pay Rs. 5.00 dividend at end of year 1 and
Rs. 5.50 dividend at end of year 2. End-of-second-year stock will be sold for
Rs.121. Discount rate is 15%. What is the price of stock?

5.00 5.50 + 121

PV = +
(1 + .15)1
(1 + .15) 2

PV =` 100.00
4-2 How Common Stocks are Valued
• Example
• XYZ Company will pay dividends of Rs.3, Rs.3.24, and Rs.3.50 over next three
years. After three years, stock sells for Rs.94.48. What is the price of stock
given 12% expected return?

3.00 3.24 3.50 + 94.48

PV = + +
(1 + .12) (1 + .12)
1 2
(1 + .12) 3

PV =` 75.00
4-2 How Common Stocks are Valued
4-3 Estimating Cost of Equity Capital
• Dividend Yield
• Expected return on stock investment plus expected dividend growth
• Similar to capitalization rate

Div1
Price = P0 =
r−g
Div1
Dividend yield = r = +g
P0
4-3 Estimating Cost of Equity Capital
• Example
• Northwest Natural Gas shares sold for $47.30 at start of 2012. Dividend
payments for 2013 were $1.86 a share with no growth. What is dividend
yield?

Dividend Yield = r
1.86
r=
47.30
r = .039
4-3 Estimating Cost of Equity Capital
• Example
• Northwest Natural Gas shares sold for $47.30 at start of 2012. Dividend
payments for 2013 were $1.86 a share with 6.1% growth. What is dividend
yield?

Dividend yield = r
1.86
r= + .046
47.30
r = .085
4-3 Estimating Cost of Equity Capital
• Return Measurements
Div1
Dividend yield =
P0

Return on Equity = ROE

EPS
ROE =
Book equity per share
4-3 Estimating Cost of Equity Capital
• Dividend Growth Rate
• Derived by applying return on equity to percentage of
earnings reinvested in operations
• g = return on equity × plowback ratio
4-3 Estimating Cost of Equity Capital
• Valuing Non-Constant Growth

Div1 Div2 Div H PH

PV = + + ... + +
(1 + r )1
(1 + r ) 2
(1 + r ) H
(1 + r ) H

Div H +1
PH =
r−g
4-3 Estimating Cost of Equity Capital
• Example
• Phoenix pays dividends in three consecutive years of 0, .31, and .65. Year-4
dividend is estimated at .67 with perpetuity growth at 4%. With 10% discount
rate, what is stock price?

0 .31 .65  1 .67 

PV = + + +  
(1 + .1) (1 + .1) (1 + .1)  (1 + .1) (.10 − .04) 
1 2 3 3

= 9.13
4-4 Stock Price and Earnings Per Share

• If firm pays lower dividend and reinvests funds, stock price may
increase due to higher future dividends
• Payout Ratio
• Fraction of earnings paid out as dividends
• Plowback Ratio
• Fraction of earnings retained by firm
4-4 Stock Price and Earnings Per Share

• Example
• Company plans Rs.8.33 dividend next year (100% of
earnings). Investors will get 15% expected return.
Instead, company plows back 40% of earnings at firm’s
current return on equity of 25%. What is the stock value
before and after plowback decision?
4-4 Stock Price and Earnings Per Share

• Example (Continued)
• No Growth
8.33
P0 = =` 55.56
• With Growth .15

g = .25  .40 = .10

5.00
P0 = = ` 100.00
.15 − .10
4-4 Stock Price and Earnings Per Share

• Example (Continued)
• Stock price remains at Rs.55.56 with no earnings plowed back
• With plowback, price is Rs. 100.00
• Difference is called present value of growth opportunities (PVGO)

PVGO = 100.00 − 55.56 =` 44.44

4-4 Stock Price and Earnings Per Share

• Present Value of Growth Opportunities (PVGO)

• Net present value of firm’s future investments

• Sustainable Growth Rate

• Steady rate at which firm can grow: plowback ratio x return on equity
 TWO - STAGE GROWTH MODEL : EXAMPLE
THE CURRENT DIVIDEND ON AN EQUITY SHARE OF
VERTIGO LIMITED IS RS.2.00. VERTIGO IS EXPECTED
TO ENJOY AN ABOVE-NORMAL GROWTH RATE OF 20
PERCENT FOR A PERIOD OF 6 YEARS. THEREAFTER
THE GROWTH RATE WILL FALL AND STABILISE AT 10
PERCENT. EQUITY INVESTORS REQUIRE A RETURN
OF 15 PERCENT. WHAT IS THE INTRINSIC VALUE OF
THE EQUITY SHARE OF VERTIGO ?
THE INPUTS REQUIRED FOR APPLYING THE TWO-
STAGE MODEL ARE :
g1 = 20 PERCENT
g2 = 10 PERCENT
n = 6 YEARS
r = 15 %
D1 = D0 (1+g1) = RS.2(1.20) = 2.40
 TWO - STAGE GROWTH MODEL : EXAMPLE

Solution: Rs. 70.76

• The share of a certain stock paid a dividend of Rs.10.00 last year. The
dividend is expected to grow at a constant rate of 15 percent in the
future. The required rate of return on this stock is considered to be 18
percent. How much should this stock sell for now? Assuming that the
expected growth rate and required rate of return remain the same, at
what price should the stock sell 4 years hence?
Solution
• Do = Rs.10.00, g = 0.15, r = 0.18
• Po = D1 / (r – g) = Do (1 + g) / (r – g)
= Rs.10.00 (1.15) / (0.18 - 0.15)
=Rs.383.33
• Assuming that the growth rate of 15% applies to market price as well,
the market price at the end of the 4th year will be:
• P2 = Po x (1 + g)4 = Rs.383.33 (1.15)4
= Rs. 669.87
• The equity stock of Amulya Corporation is currently selling for
Rs.1200 per share. The dividend expected next is Rs.25.00. The
investors' required rate of return on this stock is 12 percent. Assume
that the constant growth model applies to Amulya Corporation. What
is the expected growth rate of Amulya Corporation?
• Soln: 9.92%
• The current dividend on an equity share of Omega
Limited is Rs.8.00 on an earnings per share of Rs.
30.00.

Assume that the dividend per share will grow at the rate
of 20 percent per year for the next 5 years. Thereafter,
the growth rate is expected to fall and stabilise at 12
percent. Investors require a return of 15 percent from
Omega’s equity shares. What is the intrinsic value of
Omega’s equity share?
Solution
• g1 = 20 %, g2 = 12 %, n = 5 yrs , r = 15%,
D1 = 8 (1.20) = Rs. 9.60
Using 2-stage growth formula;
• Price = Rs. 415.02
4-5 Valuing a Business
• Valuing a Business or Project
• Usually computed as discounted value of FCF to valuation horizon (H)
• Valuation horizon sometimes called terminal value and calculated like PVGO

FCF1 FCF2 FCFH PVH

PV = + + ... + +
(1 + r )1
(1 + r ) 2
(1 + r ) H
(1 + r ) H
4-5 Valuing a Business
• Valuing a Business or Project

FCF1 FCF2 FCFH PVH

PV = + + ... + +
(1 + r )1
(1 + r ) 2
(1 + r ) H
(1 + r ) H

PV (free cash flows) PV (horizon value)

4-5 Valuing a Business
• Example
• Given cash flows for Concatenator Manufacturing Division, calculate PV of
near-term cash flows, PV (horizon value), and total value of firm; r = 10% and
g = 6%
4-5 Valuing a Business
• Example (Continued)

1  1.09 
PV(horizon value) = 6   = 15.4
(1.1)  .10 − .06 