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Valuing Stocks

M: Finance 4th Edition

Cornett, Adair, and Nofsinger
© McGraw-Hill Education. All rights reserved. Authorized only for instructor use in a classroom. No reproduction or further distribution permitted without
the prior written consent of McGraw-Hill Education.

Common Stock
• Represents ownership in corporation
• Residual Claimants

• Value of common stock based on

• Company’s profitability and growth potential
• Current market interest rates
• Overall stock market conditions

© McGraw-Hill Education. 8-2

Stock Markets
• Provide liquidity through stock exchanges
• Provide means for buyers and sellers to
transact
• Most transactions occur through secondary
market

© McGraw-Hill Education. 8-3

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Stock Exchanges
• New York Stock Exchange (NYSE)
• American Stock Exchange (AMEX)
• NASDAQ
• FTSE
• Nikkei

© McGraw-Hill Education. 8-4

Stock Market Index

• Stock market indexes
• Dow Jones Industrial Average tracks 30 large
industry-leading stocks
• Standard & Poor’s 500 tracks largest 500 U.S.
firms
• NASDAQ Composite Index primarily tracks
technology firms

© McGraw-Hill Education. 8-5

Stock Market Trades

• Trading Stocks
• Quoted bid is highest price at which market
makers will buy
• Quoted ask is lowest price at which market
makers will sell

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Market and Limit Orders

• Trading Stocks
• Market order is filled at current ask price
• Limit order only executed if ask price is below
price target

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Stock Quotes

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Basic Stock Valuation

• Present value calculations used
• Unlike present value for bonds, stock cash
flows are unknown
• Dividends
• Future selling price

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Basic Stock Valuation Formula

• Find present value of future dividends and
future selling price
• One-year holding period timeline example

© McGraw-Hill Education. 8-10

Basic Stock Valuation – Today’s Value

• Today’s value = present value of next
year’s dividend and price

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Basic Stock Valuation – 2‐year Holding

• Two-year holding period timeline example

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Basic Stock Valuation – Holding

• For a holding period of n years, the value of
a stock is measured by the present value of
dividends over n years plus the sale price

© McGraw-Hill Education. 8-13

Basic Stock Valuation – Holding

• Value of Dividends and Future Price A firm is expected to pay a
dividend of $1.35 next year and $1.50 the following year. Financial
Analysts believe the stock will be at their price target of $75 in two
years. Compute the value of this stock with a required return of 11.5
percent.
D1 D2  P2
P0  
1  i (1  i ) 2

$1.35 $1.50  $75.00

P0  
1  0.115 (1  0.115) 2

$62.74  $1.21  $61.53

© McGraw-Hill Education. 8-14

Dividend Discount Model

• Stock’s value is the present value of an
infinite stream of dividends and no future
final sales price

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Constant Growth Model

• Assumes growth rate smaller than discount
rate
• Next year’s dividend ÷ (Discount rate -
Growth rate)

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Constant Growth Model

• Example: ACME stock recently paid a $4.00
dividend. The dividend is expected to grow at
9% per year indefinitely. What would we be
willing to pay if our required return on ACME
stock is 14%?

D1 4.36
P0 = = = $87.20
i-g .14 - .09

© McGraw-Hill Education. 8-17

Preferred Stock
• Has priority over common stock in
bankruptcy
• Pays a constant dividend
• Largely owned by other companies due to
dividends received deduction
• Valued using constant-growth model

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Common vs Preferred 2/12/16

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Preferred Stock
• Coca-Cola’s dividend is $1.36 per share at
a time when the market price of its stock is
$63.50. What would the value of Coke’s
stock be if the dividends were not expected
to grow (i.e. g=0)? The company’s cost of
capital is 11.5%.
P0 = 1.36/.115 = $11.83
• The difference between $63.50 and $11.83
represents the market value of the firm’s
expected growth

© McGraw-Hill Education. 8-20

Expected Return
• Investors demand higher returns from
higher-risk investments
• Dividend yield and expected stock price
appreciation comprise Expected Return

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Expected Return Formula

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Stop

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Variable‐Growth‐Rate Valuation
• Combines present-value cash flow with
constant-growth-rate model

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Two‐Stage Growth Valuation

• Variable-growth-rate stock
• Stock value = Present value of each dividend during
first growth stage + Present value of second growth
stage

© McGraw-Hill Education. 8-25

• Example: Suppose a firm currently has a

dividend of D0 = $5. We expect the firm to
grow at a rate of 10% for three years, after
which it will grow at 4% forever. The
required return is 9%.
• First we can calculate the dividends:
• D1 = 5(1+.10) = 5.50
• D2 = 5.50(1.10) = 6.05
• D3 = 6.05(1.10) = 6.655
• D4 = 6.655(1.04) = 6.92

© McGraw-Hill Education. 8-26

• Now we can calculate the present value of all

of the dividends in periods 4 to ∞, where the growth is

constant forever
P3 = D4/(i-g)
= 6.92/(.09-.04)
= 138.42
Now we have all the cash flows, and we can find P0
P0 = 5.50/1.091 + 6.05/1.092 + (6.655 + 138.42)/1.093
= $122.17

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© McGraw-Hill Education. 8-28

Price Earnings Ratio

• Compare cost of earnings
• Forward P/E measures next 12 months

© McGraw-Hill Education. 8-29

• The P/E ratio is simply the current price of the

stock divided by the last four quarters of
earnings per share:

Current stock price

P/E 
Per share earnings for last 12 months

• The P/E ratio is used as an indication of

expected growth of a company
• Larger growth rates lead to larger P/E ratios
• High P/E stocks are called growth stocks, whereas
low P/E stocks are called value stocks
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• Estimating Future Stock Prices

• Multiplying the P/E ratio by expected earnings
results in an expected stock price

Pn  ( P ) x E 0 x (1  g ) n
E

© McGraw-Hill Education. 8-31

• Example: The P/E ratio for Caterpillar is 12.98.

The company earned $5.05 per share and
paid a $1.10 dividend last year. Analysts
estimate that the company will grow at an
average annual rate of 12.8% over the next 5
years. Calculate the expected price of
Caterpillar’s stock price in 5 years.

P5 = (P/E) x E0 x (1 + g)5
= 12.98 x $5.05 x (1.128)5
= $119.70
© McGraw-Hill Education. 8-32

P/E Model and Cash Flow Valuation

Suppose that a firm’s recent earnings per share and
dividend per share are $2.50 and $1.30, respectively.
Both are expected to grow at 8 percent. However, the
firm’s current P/E ratio of 22 seems high for this
growth rate. The P/E ratio is expected to fall to 18
within five years. Compute a value for this stock by
first estimating the dividends over the next five years
and the stock price in five years. Then discount these
cash flows using a 10 percent required rate.

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