Chapter 8

Stock Valuation

FIN 3504, Spring 2019

Samuel Rosen

1
Challenges of stock valuations
• The promised cash flows are unknown for stockholders

• The life of the investment is supposed to be infinite

• The rate of return required on the stock is unobservable

2
Important Concept
• Recall that bondholders receive returns in 2 ways: interest
payments and principal repayments

• The market price of a bond is always the present value of the

future interest and principal payments (calculated using the
current market interest rate on a bond of similar risk), so…

• Bond holders do not have to hold bonds to maturity – they

can always sell a bond in the open market to ‘capture’ the
discounted value of the FV payments.
3
Equity Claims are Similar
• Equity holders are in a similar situation as bondholders, except that
there is no ‘principal’ repayment

• Equity holders receive dividends (sometimes) and (ultimately)

liquidation value as returns on capital

• But they don’t have to wait until liquidation!

• The market price of a share is the present value of all future cash flows
• Equity holders can always sell their shares and ‘capture’ the discounted value
of future dividends and liquidation

4
Bond & Stock Comparison
Just as we saw with Bonds, Stocks provide us a way of applying
our TVM concepts for the purpose of determining value, just
with slightly different terminology
Category Bond Stock
Time Frame (N) Years (Periods) to Maturity Holding/Investment horizon

Discount Rate (I) YTM Cost of Equity

Present Value (PV) Bond Price “today” Stock Price “today”

Future Value (FV) Face Value of Bond Derived Expected FV

Payments (PMT) Coupon Payments Dividends

(although oftentimes NOT an annuity)

5
Illustration
• Suppose the current price of a share is P0, the expected dividend at
the end of one year is DIV1, and the expected stock price at the end of
one year is P1.
• If the expected return on the “next best alternative” is R, what should
be the price of the stock today (P0)?

DIV1 + P1
P0 =
(1 + R )
6
 DIV1 + P1
Extending the thinking….. Remember
P0 =
that
(1 + R )
• But what is P1?
DIV2 + P2 DIV1 DIV2 + P2
= P1 so =
P0 +
1+ R 1 + R (1 + R ) 2
• But what then is P2?
DIV3 + P3 DIV1 DIV2 DIV3 + P3
P2 = so P0 = + +
1+ R 1 + R (1 + R ) 2
(1 + R )
3

• Ad infinitum, what is P0? ∞

DIVt
P0 = ∑
(1 + R )
t
t =1
7
Warren Buffett

“Mr. Buffett, how do you go

about valuing the stock of the
companies you buy?”

Warren Buffett:
“It’s basically a dividend
discount model”.

8
Warren Buffett
• “All we care about is the intrinsic value of a business. The intrinsic
value of a business is the discounted value of the cash that can be
taken out of the business over its life.”

AND AGAIN: the value of anything is the present value of the after-
tax cash flow generated by the asset, discounted at a proper risk-
adjusted rate of return

9
Realistically…
• Dividends are not the only way that equity investors harvest cash from a
firm
• Share repurchases are far more common
• Many firms are acquired in takeovers, and the takeover price is like a
liquidating dividend

• We’ll continue our exploration of stock valuation via what are known as
dividend discount models

• Remember that this is a conceptual framework for learning about how the
market attaches a value to a stock

10
“Models”
• No Growth
• Constant Growth
• Non-Constant Growth

• In stock valuation there will be a perpetuity (or terminal) value at

some point
• And conveniently, we have a TVM formula for that
• We just need to know when and how to include/apply it

11
Our First ‘Rough’ Model:
No Growth
• Consider a firm that is in a steady state of zero growth. Such a firm
pays out all its earnings as dividends and does not reinvest in itself
(hence zero growth)
• For such a hypothetical firm, we can use our perpetuity formula:

DIV1
P 0=
R

12
Example
• A company forecasts to pay a $5 dividend next year (and every year
thereafter), which represents 100% of its earnings
• The expected return on similar-risk stocks is 12%
• What is an estimate of the market price for this no-growth firm?

13
Example
• A company forecasts to pay a $5 dividend next year (and every year
thereafter), which represents 100% of its earnings
• The expected return on similar-risk stocks is 12%
• What is an estimate of the market price for this no-growth firm?

DIV1 EPS1 $5.00

P0 = ≈ = = $41.67
R R .12

14
A Second Rough Model:
Constant Growth
• If the firm is in a steady-state of perpetual growth, we can use our
‘growing perpetuity’ formula:

DIV1
P 0=
R−g
• Also known as Dividend Growth Model (DGM) or Gordon
Growth formula
Remember: DIV1 is same as (DIV0 * (1+g))

15
DGM – Example 1

• Suppose Big D, Inc., just paid a dividend of $0.50 per share.

• 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?

16
DGM – Example 1

• Suppose Big D, Inc., just paid a dividend of $0.50 per share.

• 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?

• P0 = .50(1+.02) / (.15 - .02) = $3.92

17
DGM – Example 2

• Suppose TB Pirates, 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?

18
DGM – Example 2

• Suppose TB Pirates, 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?
 P0 = 2 / (.2 - .05) = $13.33

 Why isn’t the $2 in the numerator multiplied by (1.05) in this example?

19
Stock Price Sensitivity to Dividend Growth, g

20
What is “g”? What is “R”?
DIV1
P 0=
R−g
so
DIV1
R−g =
P0
DIV1
=R +g
P0
21
Example: Finding the Required Return

• Suppose a firm’s stock is selling for $10.50. It just paid a $1 dividend,

and dividends are expected to grow at 5% per year. What is the
required return?

• What is the dividend yield?

• What is the capital gains yield?

22
Example: Finding the Required Return

• Suppose a firm’s stock is selling for $10.50. It just paid a $1 dividend,

and dividends are expected to grow at 5% per year. What is the
required return?
 R = [1(1.05)/10.50] + .05 = 15%

• What is the dividend yield?

• What is the capital gains yield?

23
Example: Finding the Required Return

• Suppose a firm’s stock is selling for $10.50. It just paid a $1 dividend,

and dividends are expected to grow at 5% per year. What is the
required return?
 R = [1(1.05)/10.50] + .05 = 15%

• What is the dividend yield?

 1(1.05) / 10.50 = 10%

• What is the capital gains yield?

24
Example: Finding the Required Return

• Suppose a firm’s stock is selling for $10.50. It just paid a $1 dividend,

and dividends are expected to grow at 5% per year. What is the
required return?
 R = [1(1.05)/10.50] + .05 = 15%

• What is the dividend yield?

 1(1.05) / 10.50 = 10%

• What is the capital gains yield?

 g = 5%

25
Where Does “g” Come From?
• How do we estimate g?
• We could use analysts forecasts (forecasted price growth, or
forecasted earnings growth)
• Long term (perpetuity) we’ll use inflation or GDP
• We could also make some ‘accounting’ estimates:
The Sustainable Growth Model
g ≈ ‘plowback ratio’ x ROE

26
Example
• Consider again our firm with expected EPS of $5 next year.
• The return on book equity for this firm has historically been 20%, and
the required rate of return is 12%.
• If the firm only pays out 60% of earnings, what is an estimate of the
stock price?

27
Example
• Consider again our firm with expected EPS of $5 next year.
• The return on book equity for this firm has historically been 20%, and
the required rate of return is 12%.
• If the firm only pays out 60% of earnings, what is an estimate of the
stock price?

g ≈ (1 − .60 )(.20 ) = .08

28
Example: Growing Firm
• Consider again our firm with expected EPS of $5 next year.
• The return on book equity for this firm has historically been 20%, and
the required rate of return is 12%.
• If the firm only pays out 60% of earnings, what is an estimate of the
stock price?

$5(.60)
g ≈ (1 − .60)(.20 ) = .08, so P0 ≈ = $75.00
.12 − .08

29
Example: No Growth
• On a previous slide, we considered a no growth version of the
growing firm we just looked at. We’ll consider this is a “cash cow” --
It has no opportunities to reinvest in itself, so it cannot grow. It
simply pays out all of its earnings as dividends.

• We got:
DIV1 EPS1 $5.00
P0 = ≈ = = $41.67
R R .12

30
The Punch Line
• The No-Growth Firm • The Growing Firm (which
(the “cash cow”) has $5 reinvests) has $5 current
current earnings, and earnings, and investors
investors require a 12% require a 12% return:
return: P0 = $75.00
P0 = $41.67

The only difference between

the two firms is the growth
opportunity.
31
Retention Rate and Firm Value
• An increase in the retention rate will:
• Reduce the dividend paid to shareholders
• Increase the firm’s growth rate

• These have offsetting influences on stock price

• Which one dominates?

• If ROE > R, then increased retention increases firm value since
reinvested capital earns more than the cost of capital.

32
A Third Rough Model: Nonconstant Growth
• Suppose a firm (like Tesla or First Solar) currently pays no dividends.
Instead, they use all profits for growth
• You expect the growth opportunities to dry up after a while, so you
forecast a $10 dividend in 10 years
• You then expect that dividend to grow at 10% for three years, and
then at 4% in perpetuity
• If the return on the “next best alternative” is 15% (hint: this is your
discount rate), what is your estimate of the stock price today?

33
Nonconstant Growth Example Setup

• 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.

34
Nonconstant Growth Example 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

 P2 = D3 / (R – 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

35
DDM in Practice: Kodak Example

36
 Kodak
• In 2003 Kodak was struggling
• Stock had quadrupled in about 20 years (Y1980 – Y2000), from $20 to $80
• Provided investors about 20%/year CAGR, dividends + capital (stock)
appreciation
• But stock had fallen to ~$30 by Sept 2003
• Kodak was paying $1.80/share dividend, or about 6% yield (had raised
from $1.77 in prior year)
• US treasuries: 5yr – 3%; 10yr – 4%; 20yr – 5%

37
Kodak
Announced dividend cut
from $0.45/share per qtr, to
$0.125/share per quarter;
Basically ~(72%) change

38
Kodak

39
Kodak
• Relating the dividend decline to stock price decline:
• Dividend from $1.80/year to $0.50/year
• Stock from $28 to 21

• Looking at it from a perpetuity standpoint:

• Cost of Equity, ~20% (given historical performance)
• PV of share decline = $1.30 / .20 = $6.50

• Stock actually fell about $7

• Market’s initial (knee jerk) reaction was to assume the lost perpetuity benefit,
then to revaluate going forward

40
Practice Problems
(see Excel File)

41
Practice Problem #1

42
Practice Problem #2

43
End of Chapter 8

44
Next
• Reading: Chapter 9 (Investment Criteria)

• Connect: Ch. 8 Assignment

45