Chapter 2:

Valuation of Stocks and Bonds

1
What is Value?

In general, the value of an asset is the

price that a willing and able buyer pays
to a willing and able seller

Note that if either the buyer or seller is

not both willing and able, then an offer
does not establish the value of the asset

2
Several Kinds of Value

There are several types of value, of which we

are concerned with three:

Book Value - The assets historical cost less

its accumulated depreciation
Market Value - The price of an asset as
determined in a competitive marketplace
Intrinsic Value - The present value of the
expected future cash flows discounted at the
decision makers required rate of return

3
 Determinants of Intrinsic Value
There are two primary determinants of the intrinsic
value of an asset to an individual:

The size and timing of the expected future cash flows

The individuals required rate of return (this is
determined by a number of other factors such as
risk/return preferences, returns on competing
investments, expected inflation, etc.)

Note that the intrinsic value of an asset can be,

and often is, different for each individual (thats
what makes markets work)
4
 Chapter 2:
Valuation of Stocks and Bonds

2.3 Valuation of Preferred

Stocks

5
 Preferred Stock Features
Preferred stock differs from common stock because it has
preference over common stock on payment of dividends and in the
distribution of corporation assets in the event of liquidation.
Preferred stock is a form of equity from a legal, tax, and regulatory
standpoint.
Holders of preferred stock generally have no voting privileges.
However, holders of preferred stock are often granted voting and
other rights if preferred dividends have not been paid for some
time.
Preferred stock have a stated liquidating value.
The cash dividend is described in dollars per share.
A preferred dividend is not like bond interest
Dividends on preferred stock are either cumulative or non-
cumulative.
Dividends not declared on cumulative preferred stock are carried
forward and must be paid before common shareholders can receive
anything
6
 Features of preferred stock
A hybrid security
May be perpetuity or redeemable
Paid before common dividends.
Cumulative or Non-cumulative dividends
Dividends not a liability
Protective provisions (voting)
Call provisions & sinking funds
Convertible or Non-convertible
Usually non-voting and non-participative.
Priority-lower than debt, higher than stock.

7
Preferred Stock Valuation

Preferred stocks can usually be

valued like a perpetuity:

Vp = D
kp

8
Example:

Xerox preferred that pays $4.125

dividend per year. Suppose our
required rate of return on Xerox
preferred is 9.5%

4.125
Vp = = $43.42
.095

9
 Expected Rate of Return on
Preferred
Just adjust the valuation model:

D
kp =
Vp

D
kp =
Po
10
Example

If we know the preferred stock

price is $40, and the preferred
dividend is $4.125, the expected
return is:

D 4.125
kp = = = .1031
Po 40

11
 Valuation of redeemable
preferred stock
The value of a preferred stock equals the present value
of all future dividends
n
D M
Vp
t 1 (1 k p ) (1 k p ) n
t

Vp Current value of preference stock

D periodical dividend
n life of the preference stock
k p required rate of return on preference stock
M maturity value
Since the stream of dividends is an ordinary annuity,
Vp D PVIFA k p ,n M PVIFk p ,n
12
 Chapter 2:
Valuation of Stocks and Bonds

2.4 Valuation of Common

Stocks

13
 Features of common stock
Residual income and asset claimants
Unlimited upside
First to suffer
Priority
1. Debt
2. Preferred Stock
3. Common Stock
A firm cannot go bankrupt for not declaring dividends
Dividends and Taxes
Dividend payments are not considered a business
expense, therefore, they are not tax deductible
Dividends received by individuals are taxed as
ordinary income
14
 Features of Common Stock
The term common stock usually implies the
shareholder has no special preference either in
dividends or in bankruptcy.
Shareholders, however, control the corporation
through their right to elect the directors. The
directors in turn hire management to carry out their
directives.
Directors are elected at an annual shareholders
meeting by a vote of the holding of a majority of
shares present and entitled to vote.

15
Common Stock Features

Shareholders usually have the following rights

also:

1. The right to share proportionally in dividends

paid.
2. The right to share proportionally in assets
remaining after liabilities and preferred
shareholders have been paid in a liquidation.
3. The right to vote on stockholder matters of
great importance, such as a merger or new
share issuance.

16
Common Stock Features

Dividends

Dividend payments are at the discretion of the

BoD.
Dividends are not a liability of the corporation
until declared by the BoD.
Dividends are not tax deductible for the
issuing corporation.

17
Common Stock Features

Classes of Stock

Some firms have more than one class of

common stock; often, the classes are created
with unequal voting rights.
Non-voting shares must receive dividends no
lower than dividends on voting shares.
A primary reason for creating dual classes of
stock has to do with control of the firm.

18
Common Stock Valuation

Just like with bonds, the first step in

valuing common stocks is to determine
the cash flows
For a stock, there are two:
Dividend payments
The future selling price
Again, finding the present values of
these cash flows and adding them
together will give us the value
19
Cash flows for stockholders

If you buy a share of stock, you can receive

cash in two ways

The company pays dividends

You sell your shares, either to another investor
in the market or back to the company

As with bonds, the price of the stock is the

present value of these expected cash flows

20
Common Stock Valuation

Unlike bonds, valuing common stock is more

difficult.
Why?

1. The timing and amount of future cash flows is

not known.
2. The life of the investment is essentially
forever.
3. There is no way to observe the rate of return
that the market requires.

21
Some Notes About Common
Stock
In valuing the common stock, we have to make
two assumptions:
We know the dividends that will be paid in the future
We know how much you will be able to sell the stock
for in the future
Both of these assumptions are unrealistic,
especially knowledge of the future selling price
Furthermore, suppose that you intend on
holding on to the stock for twenty years, the
calculations would be very tedious!

22
Common Stock: Some
Assumptions
We cannot value common stock without making
some simplifying assumptions
If we make the following assumptions, we can
derive a simple model for common stock valuation:
Assume:
Your holding period is infinite (i.e., you will never sell the
stock)
The dividends will grow at a constant rate forever (this is
only one example of assumption that simplifies the
problem)
Note that the second assumption allows us to
predict every future dividend, as long as we know
the most recent dividend

23
Common Stock Valuation:
Dividend Discount Model

24
 Single-Period Valuation Model

Suppose you are thinking of purchasing the stock of Moore

Oil, Inc. and you expect it to pay a $2 dividend in one year
and you believe that you can sell the stock for $14 at that
time. If you require a return of 20% on investments of this
risk, what is the maximum you would be willing to pay?

Remember, the cash flows to the stockholder is simply the

dividends received + the future sales price

D1 P1
Vc
(1 k c ) (1 k c )
25
 Single Holding Period

You expect XYZ stock to pay a $5.50 dividend at the end of

the year. The stock price is expected to be $120 at that time.
If you require a 15% rate of return, what would you pay for
the stock now?

? 5.50 + 120

0 1
Ans: $
109.13 26
What happens if ?

The price of common stock is expected to

grow at the rate of g % annually ?
The current price P0 becomes Po(1+g) a year
hence.

D1 Po (1 g ) D1
Po
(1 k c ) (1 k c ) (k c g )

27
Example

The expected dividend per share on the equity

share of Roadking Limited is Rs 2.00. The
dividend per share of Roadking Limited has grown
over the past five years at the rate of 5 % per
year. This growth rate will continue in future.
Further, the market price of the equity share of
Roadking Limited, too, is expected to grow at the
same rate. What is a fair istimate of the intrinsic
value of the equity share of Roadking Limited if
the required rate is 15% ?
D1 2
Po Rs 20.00
(k c g ) (0.15 0.05)
28
Expected Rate of Return

What rate of return can the investor expect, given

the current market price and forecasted values of
dividend and share price ?

Kc = (D1 / Po)+ g

29
 Multi-period Valuation Model

The value of a stock today (its current price) is

in theory equal to the present value of all
future dividends plus that of the selling price.

D1 D2 D3 D4 Dn Pn
P0 ...........
1 k c (1 k c ) (1 k c ) (1 k c )
2 3 4
(1 k c ) n
(1 k c ) n
n
Dt Pn

t 1 (1 k c ) (1 k c ) n
t

30
Multi-period Valuation Model

But common shares have no maturity period

they may be expected to bring a dividend
stream of infinite duration
D1 D2 D3 D4 D
P0 .......... .
1 k c (1 k c ) 2 (1 k c ) 3 (1 k c ) 4 (1 k c )

Dt

t 1 (1 k c ) t

31
Multi-period Valuation Model

That was the generalized multi-period

valuation formula which is general
enough to permit any dividend pattern
constant, rising, declining or randomly
fluctuating.

For practical applications, it is helpful to

make simplifying assumptions about the
pattern of dividend growth.

32
 Commonly used assumptions
types:
1. The dividend per share remains constant forever,
implying that the growth rate is nil (THE ZERO
GROWTH MODEL)
2. The dividend per share grows at a constant rate per
year forever (THE CONSTANT GROWTH MODEL)
3. The dividend per share grows at a constant rate for a
finite period, followed by a constant normal rate of
growth forever thereafter (THE TWO STAGE MODEL)
4. The dividend per share, currently growing at an
above-normal rate, experiences a gradually declining
rate of growth for a while. Thereafter it grows at a
constant normal rate (THE H MODEL)
33
Zero Growth Model
Assuming that the dividend per share
remains constant year after year, at a
value of D, the valuation model becomes
as that of the perpetual preference stock;

D D D D D
P0 ...........
1 k c (1 k c ) (1 k c ) (1 k c )
2 3 4
(1 k c )
D D

t 1 (1 k c )
t
kc

34
Example

Suppose stock is expected to pay a

$0.50 dividend every quarter and the
required return is 10% with quarterly
compounding. What is the price?

D 0.5
P0 $ 20.00
k c 0.025
35
 Constant Growth model

Assumes that the dividend per share

grows at a constant rate (g)
D1 D1 (1 g ) D1 (1 g ) 2 D1 (1 g ) 3 D1 (1 g ) n
P0 ........... n 1
.......
1 k c (1 k c ) 2
(1 k c ) 3
(1 k c ) 4
(1 k c )

With a little algebra, this reduces to:

D 0 (1 g) D1
P0
kc - g kc - g

36
Example 1

Suppose Big K, Inc. just paid a dividend

of $5. It is expected to increase its
dividend by 2% per year. If the market
requires a return of 15% on assets of
this risk, how much should the stock be
selling for?
5(1 0.02) 5.10
P0 $ 39.23
0.15 - 0.02 0.13

37
Example 2

Suppose Comolli, Inc. is expected to pay

a $2 dividend in one year. If the
dividend is expected to grow at 5% per
year and the required return is 20%,
what is the price?

Ans: $ 13.33

38
Example 3

Griggs Inc. last dividend (D0) was $2. The

dividend growth rate (g) is a constant 5%. If
the required return (kc) = 10%, what is P0?

2(1.05)
P0 $42
(.10 .05)

39
 Example 4

Overton Corp. just paid a $2 dividend.

If the dividends will grow at a constant
rate of 5% in the future, what is the
stock price in 4 years (at t = 4)
assuming a required rate of return =
10%?
2.1 2.1(1 0.05) 2.1(1 0.05) 2 2.1(1 0.05) 3
P0
1 0.10 (1 0.10) 2
(1 0.10) 3
(1 0.10) 4

40
 What drives growth ?
Most stock valuation models are based on the
assumption that dividends grow over time.
What drives this growth ?
The two major drivers of growth are :
a) Plough-back or Retention Ratio
b) Return on Equity (ROE)
Growth = Retention Ratio x Return on Equity
Illustration:
Omega limited has an equity (net worth) base of
100 at the beginning of year 1. It earns a ROE of
20 %. It pays out 40 % of its equity earnings and
ploughs back 60 % of its equity earnings
41
 Financials of Omega Limited

Year 1 Year 2 Year 3

Beginning Equity
ROE
Equity Earnings
Dividend Payout
Ratio
Dividends
Retention Ratio
Retained earnings

What is the growth Rate of Dividend ? 42

 Financials of Omega Limited
Year 1 Year 2 Year 3
Beginning Equity 100 112 125.44
ROE 20% 20% 20%
Equity Earnings 20 22.4 25.1
Dividend Payout 0.40 0.40 0.40
Ratio
Dividends 8 8.96 10.04
Retention Ratio 0.60 0.60 0.60
Retained earnings 12 13.44 15.06

Growth Rate = RE x ROE = 0.60 x 20 %= 12 %

43
What is this growth actually ?

Sustainable growth rate =ROE

Retention ratio

Return on equity (ROE) = Net income / Equity

Retention ratio = 1 Payout ratio

44
 Estimation of Growth
The growth rate in
dividends (g) can be
estimated in a number of
ways.

Using the companys

historical average growth
rate.
Using an industry median
or average growth rate.
Using the sustainable
growth rate.
45
 Two Stage Growth Model

The simplest extension of the constant growth

model assumes that the extraordinary growth will
continue for a finite number of years and thereafter
the normal growth rate will prevail indefinitely.

D1 D1 (1 g1 ) D1 (1 g1 ) 2 D1 (1 g1 ) n 1 Pn
P0 ......
1 k c (1 k c ) 2
(1 k c ) 3
(1 k c ) n
(1 k c ) n

where, P0 current price of the equity share

D1 dividend expected a year hence
g1 extraordinary growth rate applicable for n years
Pn price of the equity share at the end of the year n

46
Two Stage Growth Model
(contd.)

The first term on the right hand side of

above equation is the PV of a growing
annuity, and its value is equal to:

47
Reminder: Present Value of a Growing
annuity
If ,
A(1 g) cash flow at the end of 1st year
A(1 g) 2 cash flow at the end of 2nd year
A(1 g) n cash flow at the end of nth year

(1 r) n (1 g ) n
PV of growing annuity A(1 g)
( r g ) (1 r) n

This is true for g r and g r but not for g r in the
case of which, PV shall be only nA.
48
Two Stage Growth Model
(contd.)
The first term on the right hand side of above
equation is the PV of a growing annuity, and
its value is equal to:

1 g1
n

1
D1
1 kc
k c g1

49
Two Stage Growth Model
(contd.)
Hence,

1 g1
n

1
P0 D1
1 kc

Pn
k c g1 (1 k ) n
c

50
 Two Stage Growth Model
(contd.)
Since the two-stage growth model assumes that
the growth rate after n years remains constant at
g2, Pn will be equal to:

D n 1
Pn
kc g2

where, D n 1 dividend for year (n 1) D1 (1 g1 ) n 1 (1 g 2 )

g 2 growth rate in the second period

51
Two Stage Growth Model
(contd.)
Substituting the above expressions, we have:

1 g1
n

1
1 k D (1 g ) n 1
(1 g 2 ) 1
P0 D1 c
1 1


k c g1
k c g1 (1 k c ) n

52
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%
for a period of 6 years. Thereafter, the growth
rate will fall and stabilize at 10%. Equity
investors require a return of 15 %. What is the
intrinsic value of the equity share of Vertigo ?

g1 = 20 %, g2 = 10 %, n = 6 years, kc = 15%, D0
= Rs 2.00
Ans: Rs
79.597
53
Non-constant growth

Suppose a firm is expected to increase

dividends by 20% in one year and by 15% in
two years. After that dividends will increase
at a rate of 5% per year indefinitely. If the
last dividend was $1 and the required return
is 20%, what is the price of the stock?

Remember that we have to find the PV of all

expected future dividends.

54
Non-constant growth solution
Compute the dividends until growth levels off
D1 = 1(1.2) = $1.20
D2 = 1.20(1.15) = $1.38
D3 = 1.38(1.05) = $1.449
Find the expected future price (by using the
final dividend calculation)
P2 = D3 / (k g) = 1.449 / (.2 - .05) = 9.66
Find the present value of the expected future
cash flows
P0 = 1.20 / (1.2) + (1.38 + 9.66) / (1.2)2 =
8.67

55
Non-constant growth

The Green Shoe Companys last

dividend paid (D0) was $1.00. Dividends
are projected to grow at a rate of 7%
per year for the next 2 years, 5% per
year for the 3rd year, and starting with
year 4 they will grow at a constant rate
of 4%, forever. If the required return on
the stock is 12%, what is the price of
the stock today?

56
Non-Constant Growth

At times, a new company may pay no dividends

early in its life but start paying dividends that grow
at a constant rate some time in the future.
At other times, a new company may pay small
dividends initially and, at some point in the future,
start paying dividends that grow at a constant
rate.
However, as always, the value of the stock is the
present value of all future dividends.
Many cash flow scenarios are possible in this
situation.

57
 Non-Constant Growth

Example:
ABC Company does not plan to pay a dividend
until year 5. ABCs expects the dividend in year
five to be $1 and dividends in future years to grow
at a constant rate of 5%. If the firms risk-adjusted
required rate of return is 13%, what is the value of
a share of stock in the company today?

P4 = 1/(.13 .05) = $12.50

P0 = 12.50(1.13)-4 = $7.67

58
Components of Required Return
Thus far, the discount rate or required rate of
return has been given to us.
Later chapters have more to say about this,
but for now, using the dividend growth model,
lets analysis the required rate of return:

Rearranging:
kc = r = D1/P0 + g

where, D1/P0 = the dividend yield

g = the capital gains yield
59
 Components of Required Return

Hence, Total Return on Common Stock has two

components:
Dividend Yield
Capital Gains Yield.

Return = Dividend Yield + Capital Gains Yield

D t Pt Pt 1
r
Pt 1 Pt 1
60
 Illustration:

We observe a stock selling for $ 20 per share. The next

dividend will be $ 1 per share. You think that the
dividend will grow by 10 % per year more or less
indefinitely. What return does this stock offer you if this
is correct ?

Return = Dividend Yield + Capital Gains Yield

r = D1/P0 + g
= 1 / 20 + 0.10
= 0.05 + 0.10
= 0.15
i.e. 15 %
61
 Verification
We can verify this answer by calculating the price in one year P 1 ,
using 15 % as the required return.

P1 = D1 (1+g) / (r g)
= $ 1 x 1.10 / (0.15 -0.10)
= $ 22

$ 22 is 10 % more than $ 20, so the stock price has grown by 10 %

If you buy the stock today in $ 20, itll pay $ 1 dividend at the end
of the year, and youll gain $ 2 by selling it.
Dividend yield is thus $ 1 / 20 = 0.05 i.e. 5%
Capital gains yield is thus $ 2 /20 = 0.10 i.e. 10 %
So your Total return would be 5 % + 10 % = 15 %

62
Impact of growth on Price, Returns and
P/E Ratio
The expected growth rates of the companies
differ widely.
Some are expected to remain virtually
stagnant or grow slowly; others are expected
to show normal growth; still others are
expected to achieve supernormal growth
rate.
Assuming a constant total required return,
differing expected growth rates mean
differing stock prices, dividend yields, capital
gains yields, and P/E ratios.
63
 Illustration (contd.)

Consider three cases of growth rates:

Low growth firm 5 %
Normal growth firm 10 %
Supernormal growth firm 15%

The expected earnings per share and dividend per

share of each of the three firms are Rs 3.00 and Rs
2.00 respectively. Investors required total return
from equity investments is 20%.

Given the above information, calculate the stock

price, dividend yield, capital gains yield, and P/E ratio
for the three cases
64
 Illustration (contd)

Price Dividend Capital P/E

P0 = D1 / (r Yield Gains Ratio
g) (D1/P0) Yield P0/EPS
(P1-P0)/P0
Low
Growth
Firm
Normal
Growth
Firm
Supernor
mal
Growth
Firm
65
 Illustration (contd)

Price Dividend Capital P/E

P0 = D1 / (r Yield Gains Ratio
g) (D1/P0) Yield P0/EPS
(P1-P0)/P0
Low 13.33 15 % 5% 4.44
Growth
Firm
Normal 20.00 10 % 10 % 6.67
Growth
Firm
Supernor 40.00 5% 15 % 13.33
mal
Growth
Firm
66
 Inference

As the expected growth in dividend, increases,

other things remaining constant, the expected
return depends more on capital gains yield and
less on the dividend yield.
As the expected growth rate in dividend
increases, other things remaining constant, the
P/E ratio increases.
High dividend yield and low P/E ratio imply
limited growth prospects.
Low dividend yield and high P/E ratio imply
considerable growth prospects.
67
Valuation of Common Stock

Price Ratio Approach

68
Price Ratio Analysis

Price-earnings ratio (P/E ratio)

Current stock price divided by annual
earnings per share (EPS).
Earnings yield
Inverse of the P/E ratio: earnings divided by
price (E/P).
High-P/E stocks are often referred to as
growth stocks, while low-P/E stocks are often
referred to as value stocks.

69
Price Ratio Analysis

Price-cash flow ratio (P/CF ratio)

Current stock price divided by current cash
flow per share.
In this context, cash flow is usually taken to
be net income plus depreciation.
Most analysts agree that in examining a
companys financial performance, cash flow
can be more informative than net income.
Earnings and cash flows that are far from each
other may be a signal of poor quality earnings.

70
Price Ratio Analysis

Price-sales ratio (P/S ratio)

Current stock price divided by annual sales per
share.
A high P/S ratio suggests high sales growth,
while a low P/S ratio suggests sluggish sales
growth.
Price-book ratio (P/B ratio)
Market value of a companys common stock
divided by its book (accounting) value of equity.
A ratio bigger than 1.0 indicates that the firm is
creating value for its stockholders.

71
Price Ratio Analysis
Intel Corp (INTC) - Earnings (P/E) Analysis
Current EPS $1.35
5-year average P/E ratio 30.4
EPS growth rate 16.5%

expected = historical projected EPS

stock price P/E ratio
= 30.4 ($1.351.165)
= $47.81
72
Price Ratio Analysis
Intel Corp (INTC) - Cash Flow (P/CF) Analysis
Current CFPS $1.97
5-year average P/CF ratio 21.6
CFPS growth rate 15.3%

expected = historical projected CFPS

stock price P/CF ratio
= 21.6 ($1.971.153)
= $49.06
73
Price Ratio Analysis
Intel Corp (INTC) - Sales (P/S) Analysis
Current SPS $4.56
5-year average P/S ratio 6.7
SPS growth rate 13.3%

expected = historical projected SPS

stock price P/S ratio
= 6.7 ($4.561.133)
= $34.62
74
P/E Ratio Approach

P0
P0 E1
E1
where, P0 Estimated Price
E1 Estimated EPS
P0
Justified P/E Ratio
E1
75
 Determinants of P/E Ratio

According to Constant Growth Dividend Discount Model

D1 E1 (1 b)
P0
r - g r ROE b
P0 (1 b)

E1 r ROE b

where, b ploughback or retention ratio

76
Determinants of P/E Ratio

Factors that determine the P/E ratio are:

1. The dividend payout ratio, (1-b)

2. The required rate or return, r
a) Interest Rate
b) Risk
3. The expected growth rate, g = ROE x b

77