Corporate Finance Thirteenth Edition

Stephen A. Ross / Randolph W. Westerfield / Jeffrey F. Jaffe / Bradford D. Jordan

Chapter 9

Stock Valuation

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 Key Concepts and Skills
• Understand how stock prices depend on future
dividends and dividend growth.
• Be able to compute stock prices using the dividend
growth model.
• Understand valuation comparables.
• Understand the basics of the stock market.

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 Chapter Outline
9.1 The Present Value of Common Stocks
9.2 Estimates of Parameters in the Dividend Discount
Model
9.3 Comparables
9.4 Valuing Stocks Using Free Cash Flows
9.5 The Stock Markets

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 9.1 The Present Value of Common Stocks

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.
• Differential Growth.

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 Case 1: Zero Growth
Assume that dividends will remain at the same level forever

D1 = D2 = D3 = !

• Since future cash flows are constant, the value of a zero

growth stock is the present value of a perpetuity:

D1 D2 D3
P0 = + + +!
1 + R (1 + R ) (1 + R )
2 3

D
P0 =
R

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 Case 2: Constant Growth
Assume that dividends will grow at a constant rate, g,
forever, i.e.,

D1 = D0 (1 + g )
D2 = D1 (1 + g ) = D0 (1 + g )
2

D3 = D2 (1 + g ) = D0 (1 + g )
3

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:
D1
P0 =
R-g
Note that when g = R or R < g, the dividend growth model fails
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 Constant Growth Example
Suppose Big D, Inc., just paid a dividend of $.50. It is
expected to increase its dividend by 2 percent per year. If the
market requires a return of 15 percent on assets of this risk
level, how much should the stock be selling for?

.50 (1.02 )
P0 = = $3.92
(.15 - .02 )

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 Case 3: Differential Growth
A common case: Assume that dividends will grow at g1 per
year for N years, and then will grow at g2 thereafter
To value a differential growth stock, we need to:
• Estimate future dividends in the foreseeable future.
• Estimate the future stock price when the stock becomes a
constant growth stock (in year N).
• Compute the total present value of the estimated future
dividends and future stock price at the appropriate
discount rate.

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 Case 3: Differential Growth
Assume that dividends will grow at rate g1 for N years
and grow at rate g2 thereafter.

D1 = D0 (1 + g1 )
= D1 (1 + g1 ) = D0 (1 + g1 )
2
D2
!
= DN +1 (1 + g1 ) = D0 (1 + g1 )
N
DN
DN +1 = DN (1 + g 2 ) = D0 (1 + g1 ) (1 + g 2 )
N

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 Case 3: Differential Growth
Dividends will grow at rate g1 for N years and grow at
rate g2 thereafter
Growing Annuity

+, (1 + ., )'
() = 1−
% − ., (1 + %)'

Growing Perpetuity/(1 + %)'

+'0,
% − .1
(/ =
(1 + %)'

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 Case 3: Differential Growth
We can value this as the sum of: a T-year annuity
growing at rate g1

$% (1 + (% )-
!" = 1−
& − (% (1 + &)-

plus the discounted value of a perpetuity growing at rate

g2 that starts in Year T+1

$-/%
& − (0
!. =
(1 + &)-

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 Case 3: Differential Growth
Consolidating gives:

#$%&'() !/$0/,+',-
! = #$%&'() *((+',- +
(1 + 3)5

6597
67 (1 + )7)5 3 − ):
!= 1− +
3 − )7 (1 + 3)5 (1 + 3)5

If R < g1, R = g1, R < g2 or R = g2 , then the formula for differential growth fails

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 A Differential Growth Example
A common stock just paid a dividend of $2. The dividend
is expected to grow at 8 percent for 3 years, then it will
grow at 4 percent in perpetuity.
What is the stock worth? Assume the discount rate is 12
percent.

$2 $2(1+8%) $2(1+8%)2 $2(1+8%)3 $2(1+8%)3(1+4%) $2(1+8%)3(1+4%)2

Po P1 P2 P3 P4 P5

……

0 1 2 3 4 5

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 With the Formula
#,-$
#$ (1 + '$), % − '.
!= 1− +
% − '$ (1 + %), (1 + %),

æ 2 (1.08 )3 (1.04 ) ö
ç ÷
$2 ´ 1.08 é 1.083 ù çè .12 - .04 ÷
ø
P= 1 - +
.12 - .08 êë 1.123 úû 1.123
$32.75
P = $54 ´ [1 - .8966] +
1.123
P = $5.58 + 23.31
P = $28.89

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 With Cash Flows

The constant growth

phase beginning in
Year 4 can be
valued as a growing
perpetuity at Year 3.
$2.16 $2.33 $2.52 + 32.75
P0 = + + = $28.89
1.12 1.122 1.123

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 9.2 Estimates of Parameters in the
Dividend Discount Model
The value of a firm depends upon its growth rate, g, and
its discount rate, R.
• Where does g come from?
Earnings Earnings Retained earnings Return on
next = this + this year × retained
year year earnings

Earnings next year æ Retained earnings this year ö

= 1+ ç ÷ ´ Return on retained earnings
Earnings this year è Earnings this year ø

1 + g = 1 + Retention ratio × Return on retained earnings

g = Retention ratio × Return on retained earnings
g = Retention ratio × ROE
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 Where Does R Come From?
The discount rate can be broken into two parts.
• The dividend yield.
• The growth rate (in dividends)

In practice, there is a great deal of estimation error

involved in estimating R.

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 Using the DGM to Find R
Start with the DGM:

D0 (1 + g ) D1
P0 = =
R-g R-g
Rearrange and solve for R:

D0 (1 + g ) D1
R= +g = +g
P0 P0

dividend yield Growth rate

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 Using the DGM to Find R

Suppose we observe a stock selling for $20 per share. The

next dividend is expected to be $1 per share. You think that
dividend will grow by 10% per year more or less indefinitely.
What is the expected return this stock offers you?

R = $1/$20 + 0.1 = 0.15 or 15%

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 Example
Firm A’s earnings is $2 million this year. It plans to retain 40%
of its earnings. The historical ROE is 0.16, a figure that is
expected to continue into the future. Firm A has 1,000,000
shares of stock outstanding. The stock is selling of $10.

a. How much will earnings grow over the coming year?

b. What is the required return, R, on the stock?

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 9.3 Comparables
Comparables are used to value companies based
primarily on multiples.
Common multiples include:
• Price-Earnings Ratios.
• Enterprise Value Ratios.

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 Price-Earnings Ratio
The price-earnings ratio is calculated as the current stock
price divided by annual E P S.
• The Wall Street Journal uses last four quarters’ earnings.
Price per share
PE ratio =
EPS

Example:
The average PE ratio in the specialty retail industry is 12.
A particular company in this industry has earnings of $10
million. If this company is judged to be similar to the rest of
the industry, we may estimate the company’s value to be
$120 million.

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 Enterprise Value Ratios
The PE ratio focuses on equity, but what if we want the value
of the firm?
Use enterprise value:
• EV = Market value of equity + Market value of debt − Cash.

Like PE, we compare the value to a measure of earnings.

From a firm level, this is EBITDA, or earnings before interest,
taxes, depreciation, and amortization.
• EBITDA represents a measure of total firm cash flow.

Enterprise value ratio = EV/EBITDA

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 9.4 Valuing Stocks Using Free Cash Flows

In Chapters 5 and 6 you learned that the value of a

project (i.e., its NPV) was the discounted value of the
cash flows it generates.
The firm value is the consolidated present value of the
cash flow from all of its projects.

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 Valuing Stocks Using FCF - Example
§ Revenue is forecast to be $500 million in one year, is expected to grow at
10% for 2 years after that, 8% for the next 2 years, and 6 percent per year
after that.
§ Expenses including depreciation are 60% of revenues.
§ Net investment, including net working capital and capital spending less
depreciation, is 10% of revenues.

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 Valuing Stocks Using FCF - Example
§ Because all costs are proportionate to revenues, FCF grows at the
same rate as revenue.
§ The firm has 12 million shares outstanding.
§ Discount rate = 16%

FCF in Year 6 = $152.43 * 1.06 = $161.57m

PV as of Year 5 of all future cash flows = $161.57 / (0.16-0.06) = $1615.7m

PV as of today of this terminal value = $1615.7 / 1.16^5 = $769.26m

PV of FCF during the first 5 years = $415.63m

Today’s value of firm = $415.63m + $769.26m = $1184.89m

Price per share = $1184.89 / 12 = $98.74

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 9.5 The Stock Markets
Dealers vs. Brokers.
• A broker brings buyers and sellers together, but
does not maintain an inventory
•
A dealer maintains an inventory and stands ready
to buy and sell at any time
Operations.
Floor activity.
New York Stock Exchange (NYSE)
License holders (formerly “members”)
• Entitled to buy or sell on the exchange floor.

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 Market and Limit Orders
Market orders:
You specify ticker and quantity.
Immediate execution at best available price.
• Market buy will be executed at lowest ask.
• Market sell will be executed at highest bid.
Limit orders:
You specify ticker, quantity, and price.
The order will be executed only if trade can be made at the limit
price or better.
• Limit buy can only be executed at limit price or lower.
• Limit sell can only be executed at limit price or higher.

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 Stop Orders
The stop price is the trigger or activation point.
• If the stop price is reached or passed, the order
becomes a market order to be executed at the best
available price.
• Risk: Price suddenly plummets or rises and the
execution price is much different than expected.

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 Nasdaq
Not a physical exchange but a computer-based quotation system.
Multiple market makers.
Electronic communications networks.
Three levels of information:
• Level 1—timely, accurate quotes, freely available.
• Level 2—view quotes from all Nasdaq market makers, small fee.
• Level 3—view and update quotes, market makers only.

Large portion of technology stocks.

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 Stock Market Reporting

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 Quick Quiz
What determines the price of a share of stock?
What determines g and R in the DGM?
Discuss the importance of valuation ratios.
What are some of the major characteristics of NYSE
and Nasdaq?

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 Suggested exercises
Concept Questions
2, 6

Questions and Problems

7, 9, 10, 13, 16, 17, 23, 25, 26, 33

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Note for mid-term exam
• 19 June (Wednesday), 8h30
• Duration: 90 mins
• Format: 50 MCQs, cover Weeks 1 – 4
• Closed book exam, equation sheet is provided on the
test page.
• Remember to bring your own calculator.
• Cell phones, iphones, ipads, & notebooks are not
allowed.

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