Chapter 7

Stock Valuation

Differentiate between debt and equity.

Discuss the features of both common and
preferred stock.
Understand how stock prices depend on future
dividends and dividend growth
Understand the concept of market efficiency and
basic stock valuation using zero-growth,
constant-growth, and variable-growth models.
Determine stockholders expected rate of return

7-2

Debt includes all borrowing incurred by a firm,

including bonds, and is repaid according to a
fixed schedule of payments.
Equity consists of funds provided by the firms
owners (investors or stockholders) that are repaid
subject to the firms performance.
Debt financing is obtained from creditors and
equity financing is obtained from investors who
then become part owners of the firm.
Creditors (lenders or debtholders) have a legal
right to be repaid, whereas stockholders only
have an expectation of being repaid.

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7-4

Unlike creditors, holders of equity (stockholders)

are owners of the firm.

Stockholders generally have voting rights that

permit them to select the firms directors and
vote on special issues.

In contrast, debtholders do not receive voting

privileges but instead rely on the firms
contractual obligations to them to be their voice.

7-5

Equityholders claims on income and assets are

secondary to the claims of creditors.
Their claims on income cannot be paid until the
claims of all creditors, including both interest
and scheduled principal payments, have been
satisfied.

Because equity holders are the last to receive

distributions, they expect greater returns to
compensate them for the additional risk they
bear.

7-6

Unlike debt, equity capital is a permanent

form of financing.

Equity has no maturity date and never has

to be repaid by the firm.

7-7

Interest payments to debtholders are treated as

tax-deductible expenses by the issuing firm.

Dividend payments to a firms stockholders are

not tax-deductible.

The tax deductibility of interest lowers the

corporations cost of debt financing, further
causing it to be lower than the cost of equity
financing.

7-8

Voting Rights
Proxy voting
A proxy statement is a statement transferring
the votes of a stockholder to another party.

Other Rights
Share proportionally in declared dividends
Share proportionally in remaining assets during
liquidation
Preemptive right first shot at new stock issue
to maintain proportional ownership if desired

7-9

Dividends are not a liability of the firm until a

dividend has been declared by the Board

Consequently, 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

710

Preferred stock gives its holders certain privileges that

make them senior to common stockholders.

Preferred stockholders are promised a fixed periodic

dividend, which is stated either as a percentage or as
a dollar amount.

Dividends

Stated dividend that must be paid before dividends can

be paid to common stockholders
Dividends are not a liability of the firm and preferred
dividends can be deferred indefinitely
Most preferred dividends are cumulative any missed
preferred dividends have to be paid before common
dividends can be paid

Preferred stock generally does not carry voting rights

7-11

Common stockholders, who are sometimes referred to

as residual owners or residual claimants, are the true
owners of the firm.

As residual owners, common stockholders receive

what is leftthe residualafter all other claims on the
firms income and assets have been satisfied.

They are assured of only one thing: that they cannot

lose any more than they have invested in the firm.

Because of this uncertain position, common

stockholders expect to be compensated with
adequate dividends and ultimately, capital gains.

7-12

The payment of dividends to the firms shareholders is

at the discretion of the companys board of directors.

Dividends may be paid in cash, stock, or merchandise.

Common stockholders are not promised a dividend,

but they come to expect certain payments on the
basis of the historical dividend pattern of the firm.

Before dividends are paid to common stockholders

any past due dividends owed to preferred
stockholders must be paid.

7-13

When a firm wishes to sell its stock in the primary

market, it has three alternatives.
A public offering, in which it offers its shares
for sale to the general public.
A rights offering, in which new shares are sold
to existing shareholders.
A private placement, in which the firm sells
new securities directly to an investor or a group
of investors.

7-14

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

Therefore, the price of the stock is the

present value of these expected cash flows

7-15

Economically rational buyers and sellers use their

assessment of an assets risk and return to
determine its value.

In competitive markets with many active

participants, the interactions of many buyers and
sellers result in an equilibrium pricethe market
valuefor each security.

Because the flow of new information is almost

constant, stock prices fluctuate, continuously
moving toward a new equilibrium that reflects the
most recent information available. This general
concept is known as market efficiency.
7-16

The value of any asset is the present

value of its expected future cash flows.

Stock ownership produces cash flows from:

Dividends
Capital Gains

Valuation of Different Types of Stocks

Zero Growth
Constant Growth
Variable Growth

7-17

Suppose you are thinking of purchasing the

stock of XYZ and you expect it to pay a RM2
dividend in one year and you believe that
you can sell the stock for RM14 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?
Compute the PV of the expected cash flows
Price = (14 + 2) / (1.2) = RM13.33

7-18

Now what if you decide to hold the stock for

two years? In addition to the dividend in one
year, you expect a dividend of RM2.10 in
two years and a stock price of RM15.00 at
the end of year 2. Now how much would
you be willing to pay?
PV = [2 /(1.2)]+ [(2.10+15)/(1.2)2] =
RM13.54

7-19

Finally, what if you decide to hold the

stock for three years? In addition to the
dividends at the end of years 1 and 2, you
expect to receive a dividend of RM2.21 at
the end of year 3 and the stock price is
expected to be RM15.44. Now how much
would you be willing to pay?

PV =[2/1.2]+[2.10/(1.2)2] +[(2.21+15.44)/
(1.2)3] = 13.34
7-20

The value of a share of common stock is equal to the

present value of all future cash flows (dividends) that it
is expected to provide.
where

P0 = value of common stock

Dt = per-share dividend expected at the end of year
t
Rs = required return on common stock
P0 = value of common stock
7-21

Constant dividend (zero-growth model)

The firm will pay a constant dividend forever
This is like preferred stock
The price is computed using the perpetuity formula
Constant dividend growth (constant-growth
model)
The firm will increase the dividend by a constant
percent every period
Differential growth (variable-growth model)
Dividend growth is not consistent initially, but
settles down to constant growth eventually

7-22

The zero dividend growth model assumes that the

stock will pay the same dividend each year, year
after year.

The equation shows that with zero growth, the value

of a share of stock would equal the present value of
a perpetuity of D1 dollars discounted at a rate rs.

7-23

Suppose a stock is expected to pay a

RM3.00 dividend every year indefinitely
and the required return is 10%. What is
the price?
P0 = 3/0.10 = RM30

7-24

The constant-growth model is an approach that assumes

that dividends will grow at a constant rate, but a rate that is
less than the required return.

The Gordon model is a common name for the constantgrowth model. Since future cash flows grow at a constant rate
forever, the value of a constant growth stock is the present
value of a growing perpetuity:

7-25

Suppose ABC Inc. has just paid a dividend of

RM0.50. ABC 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) = RM3.92

7-26

Suppose KAL, Inc. is expected to pay a RM2

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) = RM13.33

*** Why isnt the RM2 in the numerator

multiplied by (1.05) in this example?

7-27

D1 = RM2; R = 20%

828

D1 = RM2; g = 5%

829

AXY Company paid the following per share dividends:

7-30

We find that the historical annual growth rate of AXY

Company dividends equals 7%.

7-31

The zero- and constant-growth common stock

models do not allow for any shift in expected
growth rates.

The variable-growth model is a dividend

valuation approach that allows for a change in
the dividend growth rate.

To determine the value of a share of stock in the

case of variable growth, we use a four-step
procedure.

7-32

Step 1. Find the value of the cash dividends

at the end of each year, Dt, during the initial
growth period, years 1 though N.
Dt = D0 (1 + g1)t

7-33

Step 2. Find the present value of the

dividends expected during the initial growth
period.

7-34

Step 3. Find the value of the stock at the end

of the initial growth period, PN = (DN+1)/(rs
g2), which is the present value of all
dividends expected from year N + 1 to
infinity, assuming a constant dividend
growth rate, g2.

7-35

Step 4. Add the present value components

found in Steps 2 and 3 to find the value of
the stock, P0.

7-36

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 RM1
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.
7-37

Compute the dividends until growth levels

off
D1 = 1(1.2) = RM1.20
D2 = 1.20(1.15) = RM1.38
D3 = 1.38(1.05) = RM1.449

Find the expected future price

P2 = D3 / (R g) = 1.449 / (.2 - .05) =RM9.66

Find the present value of the expected

future cash flows
P0 = [1.20/(1.2)]+ [(1.38 + 9.66)/(1.2)2] =RM8.67

7-38

The most recent annual (2012) dividend payment of

Warren Industries, a rapidly growing boat
manufacturer, was $1.50 per share. The firms
financial manager expects that these dividends will
increase at a 10% annual rate, g1, over the next
three years. At the end of three years (the end of
2015), the firms mature product line is expected to
result in a slowing of the dividend growth rate to 5%
per year, g2, for the foreseeable future. The firms
required return, rs, is 15%.
Steps 1 and 2 are detailed in Table 7.3 (refer to the
textbook)

7-39

7-40

Step 3. The value of the stock at the end of the initial growth
period
(N = 2015) can be found by first calculating DN+1 = D2016.
D2016 = D2015 (1 + 0.05) = $2.00 (1.05) = $2.10
By using D2016 = $2.10, a 15% required return, and a 5% dividend
growth rate, we can calculate the value of the stock at the end of
2015 as follows:
P2015 = D2016 / (rs g2) = $2.10 / (.15 .05) = $21.00

7-41

Step 3 (cont.) Finally, the share value of $21 at the end of 2015
must be converted into a present (end of 2012) value.
P2015 / (1 + rs)3 = $21 / (1 + 0.15)3 = $13.81
Step 4. Adding the PV of the initial dividend stream (found in
Step 2) to the PV of the stock at the end of the initial growth
period (found in Step 3), we get:
P2012 = $4.12 + $13.81 = $17.93 per share

7-42

D 0 (1 g)
D1
P0

R -g
R -g
rearrange and solve for R
D 0 (1 g)
D1
R
g
g
P0
P0

7-43

Suppose a firms stock is selling for

RM10.50. They just paid a RM1 dividend
and dividends are expected to grow at 5%
per year. What is the expected 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%

7-44

Any measure of required return consists of two components: a

risk-free rate and a risk premium. We expressed this
relationship as in the previous chapter, which we repeat here
in terms of rs:

Any action taken by the financial manager that increases the

risk shareholders must bear will also increase the risk
premium required by shareholders, and hence the required
return.
Additionally, the required return can be affected by changes in
the risk free rateeven if the risk premium remains constant.

7-45

Bursa Malaysia (Malaysia Exchange)

secondary market transactions
Venue where the trading of stocks and shares
can take place in a controlled and conducive
environment.
Fully automated trading system.

7-46