Chapter 7

Stocks and
Stock Valuation
Learning Objectives

1. Explain the basic characteristics of common

stock.
2. Define the primary market and the secondary
market.
3. Calculate the value of a stock given a history of
dividend payments.
4. Explain the shortcomings of the dividend pricing
models.
5. Calculate the price of preferred stock.

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-2

1 share = 1 vote 1 share = 10 votes Stocks Vs Bond
Standard Super voting • maturity
• no maturity
• Owner • Debt holder
• Coupon bond
Pay debt -> preferred -> common • Dividends ( periodic fixed
variable income )
Preferred stock
• Payment after debt
• Fixed div
• No voting

ar
=
3 =

n(1 M +
7.1 Characteristics of Common
Stock

• Major financing vehicle for corporations

• Provides holders with an opportunity to
share in the future cash flows of the issuer.
• Holders have ownership in the company.
• Unlike bonds, no maturity date and
variable periodic income.

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-3

7.1 (A) Ownership

• Share in the residual profits of the company.

• Claim to all its assets and cash flow once
the creditors, employees, suppliers, and
taxes are paid off.
• Voting rights
– participate in the management of the company
– elect the board of directors which selects the
management team that runs the company’s day-
to-day operations.

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-4

7.1 (B) Claim on Assets and
Cash Flow (Residual Claim)

• In case of liquidation…
Shareholders have a claim on the residual assets
and cash flow of the company.
Known as “residual” rights.

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-5

7.1 (C) Vote (Voice in
Management)

• Standard voting rights: Typically, one vote

per share provided to shareholders to vote
in board elections and other key changes to
the charter and bylaws.
• Can be altered by issuing several classes of
stock.
– Non-voting stock, which is usually for a
temporary period of time,
– Super voting rights, which provide the holders
with multiple votes per share, increasing their
influence and control over the company.

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-6

7.1 (D) No Maturity Date

• Considered to be permanent financing

• Infinite life, i.e. no maturity date
• No promised date when investment is
returned.

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-7

7.2 Stock Markets

Stocks are traded in two types of markets;

1. the primary or “first sale” market, and the
2. secondary or “after-sale” market,

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-8

7.3 Stock Valuation

• Value of a share of stock ➔the present

value of its expected future cash flow…
– Cash dividends paid (if any).
– Future selling price of the stock.
– The discount rate i.e. risk-appropriate rate of
return to be earned on the investment.
• No guaranteed cash flow information.
• No maturity date.
• Valuation is more of an “art” than a science.

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-9

7.3 Stock Valuation (continued)

Table 7.1 Differences between Bonds and

Stocks

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-10

7.3 Stock Valuation (continued)

Example 1: Stock price with known

dividends and sale price.

Agnes wants to purchase common stock of New

Frontier Inc. and hold it for 3 years. The
directors of the company just announced that
they expect to pay an annual cash dividend of
$4.00 per share for the next 5 years. Agnes
believes that she will be able to sell the stock
for $40 at the end of three years. In order to
earn 12% on this investment, how much should
Agnes pay for this stock?

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-11

7.3 Stock Valuation (continued)
Example 1 Answer
 1 
 1 − n 
Price = Future Price 
1
+ Dividend Stream   (1 + r ) 
(1+ r )n  r 
 
 

 1 
 1 − 
1  (1+ 0.12 )4 
Price = $40.00 
4
+ $4.00   
(1+ 0.12 ) 
0.12

 
 

Price = $40.00 x 0.635518 + $4.00 x 3.03734

Price = $25.42 + $12.149 = $37.57

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-12

7.3 Stock Valuation (continued)

4 variations of a dividend pricing model have

been used to value common stock

1. The constant dividend model with an infinite

horizon
2. The constant dividend model with a finite
horizon
3. The constant growth dividend model with a
finite horizon
4. The constant growth dividend model with an
infinite horizon

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-13

Dividend Valuation Model

• Where,
• = Price of stock today;
• D = Dividend for each year;
• = the required rate of return for common stock (discount
rate).
• This formula, with modifications is generally applied to
three different situations:
– No growth in dividends.
– Constant growth in dividends.
– Variable growth in dividends.

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-14

No Growth in Dividends

• The common stock pays a constant dividend as in the case of a

preferred stock.
• This is not a very popular option.

• Where,
• = Price of the common stock; = Current annual common stock
dividend (constant); = Required rate of return for common stock.

• Assuming = $1,86 and = 12%, the price of the stock would be:

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-15

Constant Growth in Dividends

• The general valuation process is shown:

• Where,
• = Price of common stock today;
• = Dividend in year 1, ;
• = Dividend in year 2, , and so on;
• g = Constant growth rate in dividends;
• = Required rate of return for common stock (discount rate).

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-16

Constant Growth Dividend Valuation
Model
• Where:

• = Price of the stock today;

• = Dividend at the end of the first year;
• = Required rate of return (discount rate);
• g = Constant growth rate in dividends.

• Based on the current example; = $2.00; = .12; g = .07.

is computed as:

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-17

7.3 (A) The Constant Dividend
Model with an Infinite Horizon
Assumes that the firm is paying the same dividend
amount in perpetuity.
i.e. Div1 = Div2 = Div3 = Div4 = Div5 = Div∞
For perpetuities,
PV = PMT/r
where r the required rate and PMT is the cash flow.

Thus, for a stock that is expected to pay the same

dividend forever,
Price = Dividend/Required rate of return

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-18

7.3 (A) The Constant Dividend Model
with an Infinite Horizon (continued)

Example 2. Quarterly dividends forever

Let’s say that the Peak Growth Company is paying a

quarterly dividend of $0.50 and has decided to pay the
same amount forever. If Joe wants to earn an annual
rate of return of 12% on this investment, how much
should he offer to buy the stock at?

Answer
Quarterly dividend = $0.50
Quarterly rate of return = Annual rate/4= 12%/4 = 3%
PV = Quarterly dividend/Quarterly rate of return
Price = 0.50/.03 = $16.67

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-19

7.3 (C) The Constant Growth Dividend
Model with an Infinite Horizon (cont’d)

QuickFix Enterprises’ Annual Dividends

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
$0.50 $0.55 $0.61 $0.67 $0.73 $0.81 $0.89 $0.98 $1.08 $1.25

Required rate of return = 14%

Compound growth rate “g” = (FV/PV) 1/n -1
Where FV = $1.25; PV = 0.50; n = 9
g = (1.25/0.50)1/9 – 1 ➔10.72%
Div1 = Div0(1+g)➔$1.25*(1.1072)➔$1.384
P0 = Div1/(r-g) ➔ $1.384/(.14-.1072)➔$42.19

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-20

7.4 Dividend Model
Shortcomings
• Need future cash flow estimates and a required rate of return,
therefore difficult to apply universally.
– Erratic dividend patterns,
– Long periods of no dividends,
– Declining dividend trends
• Need a pricing model that is more inclusive than the dividend
model, one that can estimate expected returns for stocks
without the need for a stable dividend history.

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-21

7.5 Preferred Stock

Pays constant dividend as long as the stock is outstanding.

Typically has infinite maturity, but some are convertible into

common stock at some pre-determined ratio.

Have “preferred status” over common stockholders in the case

of dividend payments and liquidation payouts.

Dividends can be cumulative or non-cumulative

To calculate the price of preferred stock, we use the PV of a

perpetuity equation, i.e. Price 0 = PMT/r

PMT = Annual dividend (dividend rate * par value); and

r = investor’s required rate of return.

Copyright ©2016 Pearson Education, Inc. All rights reserved. 7-22