Chapter 4 The Value of Common Stocks

CHAPTER
4 4-1
THE VALUE OF
COMMON STOCKS
Brealey, Myers, and Allen

Principles of Corporate Finance
13th Edition
Slides by Matthew Will
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Topics Covered
4-2
• How Common Stocks Are Traded

• How Common Stocks Are Valued
• Estimating The Cost Of Equity Capital
• The Link between Stock Price and Earnings
per Share
• Valuing a Business by Discounted Cash Flow
How Common Stocks Are Traded
4-3
• Primary Market
o Market for the sale of new shares by corporations
• Secondary Market
o Market in which previously issued shares are
traded among investors
• Common Stock
o Ownership shares in a publicly held corporation
How Common Stocks Are Traded
Continued
4-4
• Electronic Communication Networks ( ECNs)

o A number of computer network stock exchanges
that connect traders with each other
• Exchange-Traded Funds (ETFs)
o Portfolios of stocks that can be bought or sold in a
single trade
Trading Results for Boeing
4-5
How Common Stocks Are Valued
4-6
• Book Value
o Net worth of the firm according to the balance sheet
• Dividend
o Periodic cash distribution from the firm to the
shareholders
• P/E Ratio
o Price per share divided by earnings per share
• Market Value Balance Sheet
o Financial statement that uses market value of
assets and liabilities
Stock Prices and Dividends
4-7
The value of any stock is the present value of

its future cash flows. This reflects the DCF
formula. Dividends represent the future cash
flows of the firm.
PV(share of stock) = PV(expected future dividends per share)
Stock Prices and Dividends Continued
4-8
Expected Return: The percentage yield that an

investor forecasts from a specific investment
over a set period of time. Sometimes called the
market capitalization rate.
DIV1 + P1 - P0
Expected return = r =
P0
Stock Prices and Dividends Continued 2
4-9
Example
If Fledgling Electronics is selling for $100 per share
today and is expected to sell for $110 one year from
now, what is the expected return if the dividend one year
from now is forecasted to be $5.00?
5  110  100
Expected return   .15
100
4-10
• The price of any share of stock can be thought

of as the present value of the future cash flows.
• For a stock, the future cash flows are dividends
and the ultimate sales price of the stock.
DIV1 + P1
Price = P0 =
1+ r
4-11
Example continued
Fledgling Electronics’s price can be thought of
as follows.
5  110
Price  P0   100
1.15
4-12
• Market capitalization rate can be estimated

using the perpetuity formula, given minor
algebraic manipulation.
• It is also called the cost of equity capital.
DIV1
Price = P0 =
r-g
Div1
Capitalization rate = r = +g
P0
4-13
• Dividend Discount Model

o Computation of today’s stock, price which states
that share value equals the present value of all
expected future dividends
DIV1 DIV2 DIVH + PH

P0 = + +...+ H
(1+ r) (1+ r)
1 2
(1+ r)
H—Time horizon for your investment
4-14
Modified formula
DIV1 DIV2 DIVH + PH

P0 = + +...+
(1+ r) 1
(1+ r) 2
(1+ r) H
H
PH
P0 = å
DIVt
t
+
t=1 (1+ r) (1+ r) H
4-15
Example
Fledgling Electronics is forecasted to pay a $5.00
dividend at the end of year one and a $5.50 dividend at
the end of year two. At the end of the second year the
stock will be sold for $121. If the discount rate is 15%,
what is the price of the stock?
5.00 5.50  121

PV  
(1  .15)1
(1  .15) 2
PV  $100.00
4-16
Another Example
Current forecasts are for XYZ Company to pay
dividends of $3, $3.24, and $3.50 over the next
three years, respectively. At the end of three
years you anticipate selling your stock at a
market price of $94.48. What is the price of the
stock given a 12% expected return?
Stock Prices and Dividends Concluded
4-17
Another Example
Current forecasts are for XYZ Company to pay dividends
of $3, $3.24, and $3.50 over the next three years,
respectively. At the end of three years you anticipate
selling your stock at a market price of $94.48. What is
the price of the stock given a 12% expected return?
3.00 3.24 3.50  94.48

PV   
(1  .12)1
(1  .12) 2
(1  .12) 3
PV  $75.00
Figure 4.1 Present Value and Horizon
Periods
4-18
Estimating the Cost of Equity Capital
4-19
• Expected Return
o The expected return on a stock investment plus the
expected growth in the dividends. Similar to the
capitalization rate.
DIV1
Price = P0 =
r-g
DIV1
Expected return = r = +g
P0
Estimating the Cost of Equity Capital Continued
4-20
Example
Northwest Natural Gas stock was selling for $49.43 per
share at the start of 2015. Dividend payments for the
next year were expected to be $2.00 a share. What is
the dividend yield, assuming no growth?
Dividend yield  r
2.00
r
49.43
r  .041
Continued 2
4-21
Example continued
Northwest Natural Gas stock was selling for $49.43 per
share at the start of 2015. Dividend payments for the
next year were expected to be $2.00 a share. What is
the dividend yield, assuming a growth rate of 7.7%?
Expected return  r
2.00
r  .077
49.43
r  .118
Concluded
4-22
Return Measurements
DIV1
Restated P0 =
DIV1 r-g
Dividend yield =
P0 DIV1
r= +g
P0
Return on equity  ROE

EPS
ROE 
book equity per share
Dangers Lurk in Constant-Growth Formulas
4-23
• Dividend growth rate can also be derived from

applying the return on equity to the percentage
of earnings plowed back into operations.
g = return on equity × plowback ratio
Continued
4-24
• Valuing Nonconstant Growth
DIV1 DIV2 DIVH PH

PV = + +...+ H
+
(1+ r) 1
(1+ r) 2
(1+ r) (1+ r) H
DIVH+1
PH =
r-g
Concluded
4-25
Example
Phoenix produces dividends in three consecutive years
of 0, .31, and .65, respectively. The dividend in year 4 is
estimated to be .67 and should grow in perpetuity at 4%.
Given a discount rate of 10%, what is the price of the
stock?
0 .31 .65  1 .67 

PV     
(1  .1) (1  .1) (1  .1)  (1  .1) (.10  .04) 
1 2 3 3
 9.13
The Link between Stock Price and
Earnings Per Share
4-26
• If a firm elects to pay a lower dividend and

reinvest the funds, the stock price may
increase because future dividends may be
higher
• Payout Ratio
o Ratio of dividends to earnings per share
• Plowback Ratio
o Fraction of earnings retained by the firm
Earnings Per Share Continued
4-27
Example
Our company forecasts to pay an $8.33 dividend next year, which
represents 100% of its earnings. This will provide investors with a
15% expected return. Instead, we decide to plow back 40% of the
earnings at the firm’s current return on equity of 25%. What is the
value of the stock before and after the plowback decision?
No Growth With Growth
P0 
8.33
 $55.56
g  .25  .40  .10
.15 5.00
P0   $100.00
.15  .10
Earnings Per Share Continued 2
4-28
Example continued
If the company did not plow back some earnings, the stock
price would remain at $55.56. With the plowback, the price
rose to $100.00.
The difference between these two numbers is called the
present value of growth opportunities (PVGO).
PVGO  100.00  55.56  $44.44
Earnings Per Share Concluded
4-29
• Present Value of Growth Opportunities (PVGO)

o Net present value of a firm’s future investments.
Valuation Format
4-30
Valuing a Business or Project

The value of a business or project is usually computed
as the discounted value of free cash flows out to a
valuation horizon (H).
The valuation horizon is sometimes called the terminal
value and is calculated like PVGO.
FCF1 FCF2 FCFH PVH

PV    ...  
(1  r ) (1  r )
1 2
(1  r ) H
(1  r ) H
Valuation Format Continued
4-31
Valuing a Business or Project
FCF1 FCF2 FCFH PVH

PV    ...  
(1  r ) (1  r )
1 2
(1  r ) H
(1  r ) H
PV (free cash flows) PV (horizon value)
Table 4.8 Valuing the Concatenator
Business
4-32
Estimating Horizon Value
4-33
Example continued
Given the cash flows for Concatenator Manufacturing Division,
calculate the PV of near-term cash flows, PV (horizon value), and the
total value of the firm when r = 10% and g = 6%.
PV(business) = PV(free cash flow) + PV(horizon value)

= 0.9 +15.4
= $16.3 million
Estimating Horizon Value Continued
4-34
Example continued
Given the cash flows for Concatenator Manufacturing Division,
calculate the PV of near term cash flows, PV (horizon value), and
the total value of the firm when r = 10% and g = 6%.
æ 1.09 ö
Horizon value = ç ÷ = $27.3 million
è .10 -.06 ø
27.3
PV (horizon value) = = $15.4 million
(1.1)
6
0 0 0 0.42 0.46 .50

PV(FCF)      
1.1 1.1 1.1 1.1 1.1 1.16
2 3 4 5
 0.90

Chapter 4 The Value of Common Stocks

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Chapter 4 The Value of Common Stocks

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CHAPTER

Brealey, Myers, and Allen

• How Common Stocks Are Traded

• Electronic Communication Networks ( ECNs)

The value of any stock is the present value of

PV(share of stock) = PV(expected future dividends per share)

Expected Return: The percentage yield that an

• The price of any share of stock can be thought

• Market capitalization rate can be estimated

• Dividend Discount Model

DIV1 DIV2 DIVH + PH

DIV1 DIV2 DIVH + PH

5.00 5.50  121

3.00 3.24 3.50  94.48

Return on equity  ROE

• Dividend growth rate can also be derived from

g = return on equity × plowback ratio

• Valuing Nonconstant Growth

DIV1 DIV2 DIVH PH

0 .31 .65  1 .67 

• If a firm elects to pay a lower dividend and

No Growth With Growth

PVGO  100.00  55.56  $44.44

• Present Value of Growth Opportunities (PVGO)

Valuing a Business or Project

FCF1 FCF2 FCFH PVH

Valuing a Business or Project

FCF1 FCF2 FCFH PVH

PV (free cash flows) PV (horizon value)

PV(business) = PV(free cash flow) + PV(horizon value)

0 0 0 0.42 0.46 .50

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