MODULE 2 :

STOCKS AND
THEIR
VALUATION
STOCK VALUATION

A. DEFINITION OF COMMON STOCK

B. LEGAL RIGHTS & PRIVILEGES OF COMMON STOCKHOLDERS
C. TYPES OF COMMON STOCK
D. STOCK PRICE & INSTRINSIC VALUE
E. STOCK VALUATION MODELS
- Discounted Dividend Model
- Corporate Value Model
- Multiplier Model
COMMON STOCK : DEFINITION

 Represents ownership of equity in a company

 Holders of common stock own the rights to
claim a share in the company’s profits
 Ownership implies control
 Common stock owners can profit from the
capital appreciation of the securities
 Stockholders elect directors
 Directors elect management
 Management’s goal: Maximize the stock price
LEGAL RIGHTS & PRIVILEGES OF COMMON STOCKHOLDERS
LEGAL RIGHTS OF COMMON STOCKHOLDERS

1. Control of the firm (ownership) 2. Preemptive Right

Proxy: A document giving one person the authority A provision in the corporate charter or bylaws that
to act for another, typically the power to vote shares gives common stockholders the right to purchase on
of common stock. a pro rata basis new issues of common stock (or
convertible securities).
Proxy Fight: An attempt by a person or group to
gain control of a firm by getting its stockholders to
grant that person or group the authority to vote its
shares to replace the current management

Takeover: An action whereby a person or group

succeeds in ousting a firm’s management and taking
control of the company.

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TYPES OF COMMON STOCKS

CLASSIFIED STOCKS FOUNDERS’ SHARE

 Classified stock has special  Classified stock

provisions
 A class of stock owned by the firm’s
 Could classify existing stock as founders who have sole voting rights
founders’ shares, with voting rights for a particular time period
but dividend restrictions.
 New shares might be called “Class
A” shares, with voting restrictions
but full dividend rights
STOCK PRICE & INTRINSIC VALUE

 Outside investors, corporate insiders, and analysts use a variety of approaches to

estimate a stock’s intrinsic value (P0).
 In equilibrium we assume that a stock’s price equals its intrinsic value.
• Outsiders estimate intrinsic value to help determine which stocks are attractive to
buy and/or sell.
• Stocks with a price below (above) its intrinsic value are undervalued (overvalued).
DETERMINANTS OF INTRINSIC VALUE & STOCK PRICES
STOCK VALUATION MODELS

There are different approaches for estimating the Intrinsic Value of a Common Stock :
❑ Discounted dividend model
▪ Constant Growth or Gordon Growth Model DCF Valuation
▪ No-Growth Dividend Discount Model Approach
❑ Corporate valuation model
❑ Multiplier Model
▪ Price to Earnings
Relative Valuation
▪ Price to Cash Flows Approach
▪ Price to Sales
STOCK VALUATION MODELS

➢Terms: Market Price

 Terms: Intrinsic Value

STOCK VALUATION MODEL : DISCOUNTED DIVIDEND

 Value of a stock is the present value of the future dividends expected to be

generated by the stock.

P = share price
D = next year’s annual dividend per share
r = cost of equity
DISCOUNTED DIVIDEND MODEL : EXAMPLE

D1 D2 D3 D
P̂0 = + + + ... +
(1 + rs )1 (1 + rs ) 2 (1 + rs )3 (1 + rs ) 
FUTURE DIVIDENDS AND THEIR PRESENT VALUES
CONSTANT GROWTH OR GORDON GROWTH MODEL : EXAMPLE
FIND THE EXPECTED DIVIDEND STREAM FOR THE
NEXT 3 YEARS AND THEIR PVS (RS=13%)

D0= $2 and g is a constant 6%

0 1 2 3

2.12 2.247 2.382

1.88

1.76

1.65
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CONSTANT GROWTH OR GORDON GROWTH MODEL

• A stock whose dividends are expected to grow forever at a constant rate, g.

D1 = D0(1 + g)1 Requirements:

D2 = D0(1 + g)2 1. Required rate of return Rs is

greater than g.

Dt = D0(1 + g)t 2. Company’s growth rate is

expected to remain constant
in the future.
If g is constant, the discounted dividend formula converges to:
 CONSTANT GROWTH OR GORDON GROWTH MODEL
Requirements:
Definition:
1. Required rate of return Rs is greater than
A stock whose dividends are expected to grow forever at a constant rate, g.
g.
2. Company’s growth rate is expected to
remain constant in the future.

Discounted dividend formula if “g” is constant

Price for Y1-Y3:

2.12
P1= 32.10 = = 30.29
P2= 34.03 0.13 - 0.06
P3= 36.07

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FINDFIND
EXPECTED DIVIDEND
EXPECTED YIELD, CAPITAL
DIVIDEND YIELD, GAINS YIELD,
CAPITAL AND TOTAL
GAINS
RETURN DURING
YIELD, FIRST YEAR
AND TOTAL RETURN DURING FIRST YEAR

◉Dividend yield 𝐷1
𝑃𝑜
DY for Y2 & Y3:

2.12 Y2= 7%
= = 𝟕. 𝟎% Y3= 7%
30.29

◉Capital gains yield (𝑃1−𝑃0)

𝑃0 CGY for Y2 & Y3:
(32.10 − 30.29) Capital gains yield (CGY) is the price
= = 𝟔. 𝟎% Y2= 6%
appreciation on an investment or a
30.29 security expressed as a percentage
Y3= 6%

◉Total return (Rs) Dividend yield + Capital gains yield

= 7.0% + 6.0%=13.0%
For Constant Growth Rate

CGY= g
DY= Ks-CGY
Total Return = Ks
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WHAT WOUWHAT WOULD THE EXPECTED PRICE TODAY
BE, IF G=0?

The dividend stream would be a perpetuity.

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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.

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SUPERNORMAL GROWTH: WHAT IF G=30% FOR 3 YEARS BEFORE
ACHIEVING LONG-RUN GROWTH OF 6%? (RS 13%)

D0= $2; Find P0

0 1 2 3 4
g=30% g=30% g=30% g=6%
2.6 3.380 4.394 4.658

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SUPERNORMAL GROWTH: WHAT IF G=30% FOR 3 YEARS
BEFORE ACHIEVING LONG-RUN GROWTH OF 6%? (RS
13%)

D0= $2
0 1 2 3 4
g=30% g=30% g=30% g=6%
2.6 3.380 4.394 4.658
2.301
PV of 4.394
2.647 4.658
P3= = $66.54
0.13 − 0.06
3.045 + 46.114
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FIND EXPECTED DIVIDEND YIELD, CAPITAL GAINS YIELD,
AND TOTAL RETURN DURING FIRST YEAR

◉Dividend yield 𝐷1
𝑃𝑜
2.60
= = 𝟒. 𝟖𝟏%
54.11

◉Capital gains yield (Expected Rate of return- Dividend Yield)

= 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%.

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NONCONSTANT GROWTH: WHAT IF G=0% FOR 3
YEARS BEFORE LONG-RUN GROWTH OF 6%? (RS 13%)

D0= $2; Find Po

0 1 2 3 4
g=0% g=0% g=0% g=6%
2.0 2.0 2.0 2.12

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NONCONSTANT GROWTH: WHAT IF G=0% FOR 3
YEARS BEFORE LONG-RUN GROWTH OF 6%? (RS 13%)

D0= $2; Find Po

0 1 2 3 4
g=0% g=0% g=0% g=6%
2.0 2.0 2.0 2.12
1.77
PV of 2.0
1.57 2.12
P3= = $30.29
0.13 − 0.06
1.39 + 20.99
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FIND EXPECTED DIVIDEND YIELD, CAPITAL GAINS YIELD, AND
TOTAL RETURN DURING FIRST YEAR AND FOURTH YEARS

◉Dividend yield 𝐷1
𝑃𝑜
2.0
= = 𝟕. 𝟕𝟖%
25.72

◉Capital gains yield (Expected Rate of return- Dividend Yield)

= 13.00 − 7.78 = 𝟓. 𝟐𝟐%

◉After t=3, the stock has constant growth and dividend yield = 7%, while capital gains yield =6%

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NO GROWTH DIVIDEND DISCOUNT MODEL

 This variant expects the dividend to stay the same, with no growth. It is the same as the
present value of perpetuity:
NO GROWTH DIVIDEND DISCOUNT MODEL : EXAMPLE
CORPORATE VALUATION 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.
 Depr. and   Capital 
FCF = EBIT(1 − T) + − +  NOWC
 amortizati on expenditures 
APPLYING THE CORPORATE VALUATION MODEL

 Find the market value (MV) of the firm, by finding the PV of the firm’s
future FCFs.

 Subtract MV of firm’s debt and preferred stock to get MV of common

stock.
 Divide MV of common stock by the number of shares outstanding to get
intrinsic stock price (value).
ISSUES REGARDING THE CORPORATE VALUATION MODEL

 Often preferred to the discounted dividend model, especially when considering

number of firms that don’t pay dividends or when dividends are hard to forecast.

 Similar to discounted dividend model, assumes at some point free cash flow will
grow at a constant rate.

 Horizon value (HVn) represents value of firm at the point that growth becomes
constant.
CORPORATE VALUE MODEL EXAMPLE:

FCF= 500M + 100M – 200M= $400M

$400𝑀
MV Firm= = $10𝐵
0.10−0.06

MV cs= $10𝐵 − $3𝐵

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USE THE CORPORATE VALUATION MODEL TO FIND THE
FIRM’S INTRINSIC VALUE ?

Given: Long-run g=6% (4th year) and WACC =10%. FCF Y1: -5, Y2: 10, Y3: 20.0 (in
million)
0 1 2 3 4
g=6%
-5 10 20.0 21.2

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 USE THE CORPORATE VALUATION MODEL TO FIND THE
FIRM’S INTRINSIC VALUE ?

Given: Long-run g=6% (4th year) and WACC =10%. FCF Y1: -5, Y2: 10, Y3: 20.0 (in
million)
0 1 2 3 4
g=6%
-5 10 20.0 21.2
-4.545
PV of 20
8.264 21.2
416.942
0.10 − 0.06
15.026 + 398.197 = $530
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WHAT IS THE FIRM’S INTRINSIC VALUE PER SHARE?

The firm has $40 million total in debt and preferred stock and has 10 million shares of common stock.

◉MV of equity = MV of the firm- MV of debt and preferred

= 416.94 − 40 = 𝟑𝟕𝟔. 𝟗𝟒 𝒎𝒊𝒍𝒍𝒊𝒐𝒏

◉Value per share =MV of equity / #shares

= 376.94/10 = $𝟑𝟕. 𝟔𝟗

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 PREFERRED STOCK

▪ Hybrid security,
▪ Like bonds, preferred stockholders receive a fixed
dividend that must be paid before dividends are paid to
common stockholders.
▪ However, companies can omit preferred dividend
payments without fear of pushing the firm into
bankruptcy.

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PREFERRED STOCK

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