Slide Financial Management - Chapter 8 potx

8-1
CHAPTER 8
Stocks and Their Valuation
 Features of common stock
 Determining common stock values
 Efficient markets
 Preferred stock
8-2
Facts about common stock
 Represents ownership
 Ownership implies control
 Stockholders elect directors
 Directors elect management
 Management’s goal: Maximize the
stock price
8-3
Social/Ethical Question
 Should management be equally concerned
about employees, customers, suppliers,
and “the public,” or just the stockholders?
 In an enterprise economy, management
should work for stockholders subject to
constraints (environmental, fair hiring,
etc.) and competition.
8-4
Types of stock market
transactions
 Secondary market
 Primary market
 Initial public offering market
(“going public”)

8-5
Different approaches for
valuing common stock
 Dividend growth model
 Corporate value model
 Using the multiples of comparable
firms
8-6
Dividend growth model
 Value of a stock is the present value of the
future dividends expected to be generated by
the stock.
∞
∞
+
++
+
+
+
+
+
=
)k(1
D

)k(1
D

)k(1
D

)k(1
D
P
s
3
s
3
2
s
2
1
s
1
0
^
8-7
Constant growth stock
 A stock whose dividends are expected to
grow forever at a constant rate, g.
D
1

= D
0

(1+g)
1
D
2

= D
0

(1+g)
2
D
t

= D
0

(1+g)
t
 If g is constant, the dividend growth formula
converges to:
g -k
D

g -k
g)(1D
P
s
1
s
0
0
^
=
+

=
8-8
Future dividends and their
present values
t
0t
) g 1 ( DD +=
t
t
t
) k 1 (
D
PVD
+
=
t0
PVDP
∑
=
$
0.25
Years (t)
0
8-9
What happens if g > k
s

?
 If g > k
s

, the constant growth formula
leads to a negative stock price, which
does not make sense.
 The constant growth model can only be
used if:
 k
s
> g
 g is expected to be constant forever
8-10
If k
RF

= 7%, k
M

= 12%, and β

= 1.2,
what is the required rate of return on
the firm’s stock?
 Use the SML to calculate the required
rate of return (k
s
):
k
s

= k
RF

+ (k
M

–k
RF

)β
= 7% + (12% -

7%)1.2
= 13%
8-11
If D
0

= $2 and g is a constant 6%,
find the expected dividend stream for
the next 3 years, and their PVs.
1.8761
1.7599
D
0
= 2.00
1.6509
k
s
= 13%
g = 6%
0 1

2.247
2
2.382
3
2.12
8-12
What is the stock’s market value?
 Using the constant growth model:
$30.29

0.07
$2.12

0.06 - 0.13
$2.12

g - k
D
P
s
0
=
=
==
1
8-13
What is the expected market price
of the stock, one year from now?
 D
1

will have been paid out already. So,
P
1
is the present value (as of year 1) of
D
2
, D
3
, D
4
, etc.
 Could also find expected P
1
as:
$32.10
0.06 - 0.13
$2.247

g - k
D
P
s
2
^
1
=
==
$32.10 (1.06) P P
0
^

1
==
8-14
What is the expected dividend yield,
capital gains yield, and total return
during the first year?
 Dividend yield
= D
1

/ P
0

= $2.12 / $30.29 = 7.0%
 Capital gains yield
= (P
1

–P
0

) / P
0
= ($32.10 -

$30.29) / $30.29 = 6.0%
 Total return (k
s
)
= Dividend Yield + Capital Gains Yield

= 7.0% + 6.0% = 13.0%
8-15
What would the expected price
today be, if g = 0?
 The dividend stream would be a
perpetuity.
2.00 2.002.00
0 1 2 3
k
s
= 13%

$15.38
0.13
$2.00

k
PMT
P
^
0
===
8-16
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.
8-17
Valuing common stock with
nonconstant growth
k
s
= 13%
g = 30% g = 30% g = 30% g = 6%

P
=
0.06
$66.54
3
4.658
0.13
−
=
2.301
2.647
3.045
46.114
54.107 = P
0
^
0 1 2 3 4
D
0
= 2.00 2.600 3.380 4.394

4.658
8-18
Find expected dividend and capital gains
yields during the first and fourth years.
 Dividend yield (first year)
= $2.60 / $54.11 = 4.81%
 Capital gains yield (first year)
= 13.00% -

4.81% = 8.19%
 During nonconstant growth, dividend yield
and capital gains yield are not constant,
and capital gains yield ≠ g.
 After t = 3, the stock has constant growth
and dividend yield = 7%, while capital
gains yield = 6%.
8-19
Nonconstant growth:

What if g = 0% for 3 years before long-

run growth of 6%?
k
s
= 13%
g = 0% g = 0% g = 0% g = 6%
0.06

$30.29P
3

2.12
0.13
=
−
=
1.77
1.57
1.39
20.99
25.72 = P
0
^
0 1 2 3 4
D
0
= 2.00 2.00 2.00 2.00

2.12
8-20
Find expected dividend and capital gains
yields during the first and fourth years.
 Dividend yield (first year)
= $2.00 / $25.72 = 7.78%
 Capital gains yield (first year)
= 13.00% -

7.78% = 5.22%
 After t = 3, the stock has constant
growth and dividend yield = 7%,
while capital gains yield = 6%.

8-21
If the stock was expected to have
negative growth (g = -6%), would anyone
buy the stock, and what is its value?
 The firm still has earnings and pays
dividends, even though they may be
declining, they still have value.
$9.89
0.19
$1.88

(-0.06) - 0.13
(0.94) $2.00

g - k
)g1(D

g - k
D
P
s
0
s
1
^
0
===
+
==
8-22

Find expected annual dividend and
capital gains yields.
 Capital gains yield
= g = -6.00%
 Dividend yield
= 13.00% -

(-6.00%) = 19.00%
 Since the stock is experiencing constant
growth, dividend yield and capital gains
yield are constant. Dividend yield is
sufficiently large (19%) to offset a negative
capital gains.
8-23
Corporate value model
 Also called the free cash flow method.
Suggests the value of the entire firm
equals the present value of the firm’s
free cash flows.
 Remember, free cash flow is the firm’s
after-tax operating income less the net
capital investment
 FCF = NOPAT – Net capital investment
8-24
Applying the corporate value model
 Find the market value (MV) of the firm.
 Find PV of firm’s future FCFs
 Subtract MV of firm’s debt and preferred stock to
get MV of common stock.
 MV of = MV of – MV of debt and

common stock firm preferred
 Divide MV of common stock by the number of
shares outstanding to get intrinsic stock price
(value).
 P
0
= MV of common stock / # of shares
8-25
Issues regarding the
corporate value model
 Often preferred to the dividend growth
model, especially when considering number
of firms that don’t pay dividends or when
dividends are hard to forecast.
 Similar to dividend growth model, assumes at
some point free cash flow will grow at a
constant rate.
 Terminal value (TV
n
) represents value of firm
at the point that growth becomes constant.