Lecture 5

VALUING STOCKS
- CHAPTER 8
M: Finance 3rd Edition
Cornett, Adair, and Nofsinger
Copyright 2016 by McGraw-Hill Education. All rights reserved.

Common Stock
Represents ownership in corporation.
Allows investors to participate in the

profits of the corporations economic

activities.
Value of common stock is based on :
Companys profitability and growth prospects.
Current market interest rates.
Overall stock market and economic conditions.

Common Stock
Common stockholders vote to elect the

board of directors to monitor the corporation.

They also vote on major proposals made by
the management.
They are considered as Residual Claimants
because they have the right to claim any
cash flows or value after all other claimants
have received what they are owed.

Stock Markets
Provide liquidity through stock

exchanges.
Provide means for buyers and sellers
to transact stock trades with each
other.

Stock Markets
Some examples of stock exchanges :
New York Stock Exchange (NYSE)
American Stock Exchange (AMEX)
NASDAQ
FTSE
Nikkei
HKEx

Stock Markets
Brokers
Act as agents for those buying and selling stocks.

Dealers
Use their own stock inventory and capital to compete with

other dealers to buy and sell the stocks.

Stock Market Indexes (some examples)

Dow Jones Industrial Average (DJIA) tracks 30 large

industry-leading stocks in U.S.

Standard & Poors 500 (S&P 500) tracks the largest 500
U.S. firms.
NASDAQ Composite Index primarily tracks technology firms.

Stock Markets
Trading Stocks
Open stock trading accounts from brokerage firms.
Some brokerage firms will provide clients with research

and advice in addition to executing trades. (Full services

brokerage firms)
Some brokerage firms may only provide order execution
service, but at a much lower commission. (Discount
brokerage firms)
Quoted bid is highest price at which market makers
will buy.
Quoted ask is lowest price at which market makers
will sell.

Stock Markets
Trading Stocks :
Market Order to buy stock
Filled at the current ask price.

Limit Order to buy stock

Only executed if ask price is below price target/price

limit.
Examples :
With a buy limit order, a trade is executed if the ask
quote is at or below the price target.
For a sell limit order, a trade is executed if the bid
quote moves through the specified price.

Stock Markets
Advantages & Disadvantages of Market and

Limit Orders
Market Order
It is executed immediately at the best available price.
(Advantage)
The investor does not know in advance the fill price of
the order. (Disadvantage)
Limit Order
The investor makes the trade at the desired price.

(Advantage)
The trade may not be executed. (Disadvantage)

Basic Stock Valuation

Based on Time Value of Money (TVM)

concept, in particular the Present

Value (PV) concept.
Unlike present value for bonds, it is
more difficult to find the cash flows of
stock as they are unknown.
Dividends
Future selling price

Basic Stock Valuation

For bonds, cash flows are known to

the investor
Coupons
Par Value

For stocks, cash flows are unknown to

the investor
Dividends
Future selling price of the stock

Basic Stock Valuation

Equivalent to finding the sum of the

present values of all future dividends and

future selling price of stock.
Example : One-year-holding-period.
3 cash flows involved :
Initial cash flow (purchase price PV); Dividend in 1

year (D1), and future selling price (P1).

Basic Stock Valuation

Todays Value
= Present Value of next years dividend
and price, discounted at the market
rate i.

Basic Stock Valuation

Example : Two-year-holding-period
4 cash flows :
PV (purchase price PV); Dividend in 1st year (D1);

Dividend in the 2nd year (D2), and Future selling price

in 2 years (P2).

Basic Stock Valuation

In general, for a holding period of n

years, the value of a stock is measured

by the sum of the present values of the
dividends over n years plus the future
selling price of the stock.
To find the relevant stock value, we can
use the TVM concept and use the
following general equation.

Dividend Discount Model

However, unlike bond, there is no

maturity date for a stock.

Therefore, the value of a stock should
be the sum of the present values of an
infinite stream of dividends and no
future final sales price.
Therefore, the previous equation
should be changed as follows.
P0 = D1 /(1+i) + D2 /(1+i)2 + D3 /(1+i)3 +

Dividend Discount Model

However, it is difficult to apply this model

because we have to estimate an infinite

number of future dividends D1, D2, D3 etc
So in practice, analysts made simplifying
assumptions to make the model workable.
One common assumption is that the firm
has a constant dividend growth rate g.
Using this assumption, it becomes a
Constant Growth Model.

Constant Growth Model

Assuming a constant dividend growth rate

g, next years dividend is simply this

years dividend that grew one year at this
growth rate. (e.g. D1 = D0 x (1 + g).
So, the previous Dividend Discount
Model can be rewritten as :
P0 = D0(1+g)/(1+i) + D0(1+g)2/(1+i)2 + D0(1+g)3/(1+i)3 +

Constant Growth Model

If we further assumes that growth rate g is smaller

than discount rate i, the equation can be written as :

If g i, the denominator would be zero or negative,

which is meaningless economically. So, the

assumption that g is smaller than i is important.
The Constant Growth Model is also known as
Gordon Growth Model.

Preferred Stock
Preferred stockholders have a higher

priority for receiving proceeds from

bankruptcy proceedings than common
stockholders.
Pays a constant dividend to the holders.
Preferred stockholders do not have voting
rights like common stockholders.
Can be valued using Constant-Growth
Model.

Expected Return
Investors demand higher returns from

higher-risk investments.
Dividend Yield and Expected Stock
Price Appreciation comprise the
Expected Return for the
stockholders.

Variable Growth-Rate Valuation

Some companies may grow at a high rate that

constant growth model cannot be used to forecast

their value.
But, the high growth rate cannot sustain.
The competition for high growth companies will
finally drive down the growth rates so that the longterm growth rate will become only average.
To value these firms, we have to use a variable
growth rate technique, which combines the present
value concept and the constant growth rate model.

Variable Growth-Rate Valuation

Combining the present-value cash flow with

constant-growth-rate model, we may

develop a variable growth rate valuation
model like this :

In this model, we have two different growth

rates g1 and g2.

Two-Stage Growth Valuation in details

Variable-Growth-Rate Stock
Stock value = Sum of the Present Values
of each dividend during first growth stage
+ Sum of the Present values of second
growth stage

Two-Stage Growth Valuation in

details

Divide into 2 stages at the first year of the new growth rate g2.

Calculate the dividends in the first stage with growth rate g1.

Two-Stage Growth Valuation in

details

Calculate the dividends in the second stage with growth rate g2.

Replace all of the dividends to infinity with the Terminal Value in year n.

Variable Growth-Rate Valuation vs.

Constant Growth-Rate Valuation
The practical application of the variable-growth

valuation technique requires the investor to decide

how long the current high growth rate will last before
declining to a more stable rate.
It works well for dividend-paying companies that
have an unusually fast rate of growth in the near
future but are expected to enter a more stable
growth rate in the future.
Constant Growth-Rate valuation, on the other hand,
is most useful for large, mature companies that grow
in a stable manner.

Problems from Both Valuation

Models

These two models work when the

companies concerned do pay

dividends.
They are not applicable when the
companies do not pay any dividends,
and this is quite common in high
growth, or relatively new companies.

Price/Earning Model
Another model that may be used to

assess a stocks value is to compare

one companys stock valuation to
other firms stock values and evaluate
whether the target companys stock is
properly priced.

Price/Earning Model
Price-Earnings (P/E) ratio :
The most common valuation yardstick in
the investment industry.
Allows investors to quickly compare the
cost of earnings.
It is simply the current price of the stock
divided by the earnings per share of the
company last year.

Price/Earning Model
Trailing P/E ratio (or Historical P/E

ratio)
Based on past earnings.

Forward P/E ratio (or Prospective P/E

ratio)
Based on earning forecasts.

P/E Ratios and Growth

Estimates

Example : Stock Valuation using financial calculator

Cash
INPUT
Flow 1

1
N

11.5
I/YR

2
N

11.5
I/YR

3
N

11.5
I/YR

OUTPUT
INPUT
Cash
Flow 2
OUTPUT
Cash
INPUT
Flow 3

OUTPUT

PV
-1.69
PV
-1.61
PV
-62.8

0
PMT

1.88
FV

0
PMT

2.00
FV

0
PMT

87.12
FV

What is the value of Coca-Cola stock if the price of the stock

at the end of 2013 will be $85 per share, the discount rate is
11.5%, and dividends are $2.00 in 2012 and $2.12 in 2013 ?
Stock Value : $1.69 + $1.61 + $62.8 = $66.15

End of Lecture 5