CHAPTER 8

S T O C K V A L U AT I O N

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LLC.
 LEARNING OBJECTIVES
• Explain how stock prices depend on future dividends
and dividend growth.
• Show how to value stocks using multiples.
• Lay out the different ways corporate directors are
elected to office.
• Define how the stock markets work.

© McGraw Hill 8-2

 CHAPTER OUTLINE
• Common Stock Valuation.
• Some Features of Common and Preferred Stocks.
• The Stock Markets.

© McGraw Hill 8-3

 COMMON STOCK VALUATION
• Share of common stock is more difficult to value in practice
than a bond for at least three reasons:

1. With common stock, not even the promised cash flows are
known in advance.
2. Life of the investment is essentially forever because common
stock has no maturity.
3. No way to easily observe the rate of return that the market
requires.

© McGraw Hill 8-4

 CASH FLOWS 1

Imagine you are considering buying a share of stock today. You plan to
sell the stock in one year. You somehow know that the stock will be
worth $70 at that time. You predict the stock will also pay a $10 per
share dividend at the end of the year. If you require a 25% return on
your investment, what is the most you would pay for the stock? In
other words, what is the present value of the $10 dividend along with
the $70 ending value at 25%?
• Present value = ($10 + 70)/1.25 = $64.

Let P0 be the current price of the stock, and assign P1 to be the price in
one period. If D1 is the cash dividend paid at the end of the period and
R is the required return in the market on this investment , then:
P0   D1  P1  1  R 
© McGraw Hill 8-5
 CASH FLOWS 2

• Suppose we somehow knew the price in two periods, P2. Given a predicted
dividend in two periods, D2, the stock price in one period would be:
P1   D2  P2  1  R 

• Substitute this expression for P1 into our expression for P0.

D  P2
D1  2
D P 1 R
P0  1 1 
1 R 1 R
D1 D2 P2
  
1  R  1  R  1  R 
1 2 2

• The price of the stock today is equal to the present value of all of the future
dividends.
D1 D2 D3 D4 D5
P0       ...
1  R  1  R  1  R  1  R  1  R 
1 2 3 4 5

© McGraw Hill 8-6

 GROWTH STOCKS 1

You might be wondering about shares of stock in companies such as

Alphabet that currently pay no dividends. Small, growing companies
frequently plow back everything and pay no dividends. Are such shares
worth nothing? It depends. When we say that the value of the stock is equal
to the present value of the future dividends, we don’t rule out the possibility
that some number of those dividends are zero. They just can’t all be zero.
Imagine a company that has a provision in its corporate charter that
prohibits the paying of dividends now or ever. The corporation never
borrows any money, never pays out any money to stockholders in any form
whatsoever, and never sells any assets. Such a corporation couldn’t really
exist because the IRS wouldn’t like it, and the stockholders could always vote
to amend the charter if they wanted to. If it did exist, however, what would
the stock be worth?

© McGraw Hill 8-7

 GROWTH STOCKS 2

The stock would be worth absolutely nothing. Such a

company would be a financial “black hole.” Money goes in, but
nothing valuable ever comes out. Because nobody would ever
get any return on this investment, the investment would have
no value. This example is a little absurd, but it illustrates that
when we speak of companies that don’t pay dividends, what we
really mean is that they are not currently paying dividends.

© McGraw Hill 8-8

 ZERO GROWTH
• A share of common stock in a company with a constant dividend is much like a
share of preferred stock.
• Dividend on a share of preferred stock has zero growth and is constant through
time; for a zero-growth share of common stock, this implies that:
D1  D2  D3  D  Constant
• Value of the stock is:
D D D D D
P0       ...
1  R  1  R  1  R  1  R  1  R 
1 2 3 4 5

• Stock may be viewed as ordinary perpetuity with cash flow equal to D every period,
with the per-share value given by:

P0  D R

• Where R is the required return.

© McGraw Hill 8-9
 CONSTANT GROWTH 1

• Suppose we know that the dividend for some company always grows at a steady
rate. Call this growth rate g. If we let D0 be the dividend just paid, then the next
dividend, D1, is:
D1  D0  1  g 

• The dividend in two periods is:

D2  D1  1  g 
  D0  1  g   1  g 

 D0  1  g 
2

• We could repeat this process to come up with the dividend at any point in the
future.
• The dividend t periods into the future, Dt, is given by:

Dt  D0  1  g 
t

© McGraw Hill 8-10

 CONSTANT GROWTH 2

• The dividend growth model determines the current price of

a stock as its dividend next period divided by the discount
rate less the dividend growth rate, and can be written as
follows, so long as the growth rate, g, is less than the
discount rate, r:
D0  1  g  D1
P0  
Rg Rg
• We can use the dividend growth model to get the stock price
at any point in time; in general, the price of the stock as of
Time t is:
Dt  1  g  Dt  1
Pt  
© McGraw Hill
Rg Rg 8-11
 CONSTANT GROWTH
(CONCLUDED)
• Suppose D0 is $2.30, R is 13%, and g is 5%. The price per share in this case is:
P0 = D0 × (1 + g)/(R − g)
= $2.30 × 1.05/(. 13 − . 05 )
= $2.415 / .08
= $30.19
• Suppose we are interested in the price of the stock in five years, P5. We first need
the dividend at Time 5, D5. Because the dividend just paid is $2.30 and the growth
rate is 5% per year, D5 is:
D5 = $2.30 × 1.055 = $2.30 × 1.2763 = $2.935
• The price of the stock in five years is:

D5  1  g  $2.935  1.05 $3.0822

P5     $38.53
Rg .13  .05 .08

© McGraw Hill 8-12

 NONCONSTANT GROWTH 1

Main reason to consider this case is to allow for “supernormal” growth rates over
some finite length of time.
• Require dividends start growing at a constant rate sometime in future.

Consider the case of a company that is currently not paying dividends. You predict
that, in five years, the company will pay a dividend for the first time. The dividend will
be $.50 per share. You expect that this dividend will then grow at a rate of 10% per
year indefinitely. The required return on companies such as this one is 20%. What is
the price of the stock today?
1. Find out what it will be worth once dividends are paid; price in four years will be:
• P4 = D4 × (1 + g)/(R − g) = D5/(R − g) = $.50 /( .20 − .10) = $5.
2. If the stock will be worth $5 in four years, then we can get the current value by
discounting this price back four years at 20%:
• P0 = $5/1.204 = $5/2.0736 = $2.41.

© McGraw Hill 8-13

 NONCONSTANT GROWTH 2

• Suppose you have come up with the following dividend forecasts for the next
three years. After the third year, the dividend will grow at a constant rate of 5%
per year. The required return is 10%. What is the value of the stock today?
Year Expected Dividend
1 $1.00
2 $2.00
3 $2.50

• In dealing with nonconstant growth, a time line can be helpful.

© McGraw Hill
Access the text alternative for slide images.
8-14
 NONCONSTANT GROWTH
(CONCLUDED)
• Value of the stock is the present value of all the future dividends:

1. Compute the PV of the stock price three years down the road.
P3  D3  1  g   R  g 
 $2.50  1.05 .10  0.5 
 $52.50
3. Add in the PV of dividends that will be paid between now and then.
D1 D2 D3 P3
P0    
1  R  1  R  1  R  1  R 
1 2 3 3

$1 2 2.50 52.50
   
1.10 1.10 1.10 1.103
2 3

 $.91  1.65  1.88  39.44

© McGraw Hill
 $43.88
8-15
 TWO-STAGE GROWTH
In this case, the dividend will grow at a rate of g1 for t years and then grow at a rate
of g2 thereafter, forever.
The value of the stock can be written as:
• First term in expression is the PV of a growing annuity.
• In first stage, g1 can be greater than R.
• Second part is PV of stock price once second stage begins at Time t.
D1   1  g1 t  Pt
P0   1     
R  g1   1  R   1  R t

We can calculate Pt as follows:

• In this second stage, g2 must be less than R.
D  1  g1   1  g 2 
t
Dt 1
Pt   0
R  g2 R  g2

© McGraw Hill 8-16

 TWO-STAGE GROWTH: AN EXAMPLE 1

The Highfield Company’s dividend is expected to grow at 20 percent for the next five
years. After that, the growth is expected to be 4 percent forever. If the required
return is 10 percent, what’s the value of the stock? The dividend just paid was $2.
There is a fair amount of computation here, but it is mostly just “plug and chug” with
a calculator. We can start by calculating the stock price five years from now, P 5:
D  1  g1   1  g 2 
5
D6
P5   0
R  g2 R  g2
$2  1  .20   1  .04 
5
$5.18
 
.10  .04 .06
 $86.26

We then plug this result into our two-stage growth formula to get the price today:

© McGraw Hill 8-17

 TWO-STAGE GROWTH: AN EXAMPLE 2

D1   1  g1  
t
Pt
P0   1    
R  g1   1  R   1  R t

$2  1  .20    1  .20   $86.26

5

  1    
.10  .20    1  .10 
5
  1 .10
 $66.64
Notice that we were given D0 = $2 here, so we had to grow it by
20 percent for one period to get D1. Notice also that g1 is bigger
than R in this problem, but that fact does not cause an issue.

© McGraw Hill 8-18

 COMPONENTS OF THE REQUIRED
RETURN
Earlier, we calculated P0 as: P0 = D1/(R − g). If we rearrange this to solve for R, we get:

R  g  D1 P0
R  D1 P0  g
Total return, R, has two components:
1. Dividend yield is a stock’s expected cash dividend divided by its current price
(That is, D1/P0).
2. Dividend growth rate, g, can be interpreted as the capital gains yield, the rate at
which the value of an investment grows.
Suppose we observe a stock selling for $20 per share. The next dividend will be $1 per
share. You think that the dividend will grow by 10% per year more or less indefinitely.
What return does this stock offer if this is correct?
• R = Dividend yield + Capital gains yield.
• R = $1/$20 + .10 = .05 + .10 = .15, or 15%.
© McGraw Hill 8-19
 STOCK VALUATION USING MULTIPLES
Obvious problem with dividend-based approach to stock valuation is that many
companies don’t pay dividends.
If the company is profitable (That is, has positive earnings), use the P E ratio,
calculated as the ratio of a stock’s price per share to its earnings per share (E PS) over
the previous year .
• Idea is to have some sort of benchmark PE ratio, which we then multiply by
earnings to come up with a price:
Price at Time t  Pt  Benchmark PE ration  EPSt
• Benchmark PE ratio could come from a variety of sources (For Example, based on
similar companies, based on a company’s own historical values).
• PE ratio based on estimated future earnings is a forward PE ratio.
Some companies do not pay dividends nor are they profitable.
• In this case, use the price-sales ratio, calculated as the price per share on the stock
divided by sales per share, or the E V/EBITDA ratio.
© McGraw Hill 8-20
 PE, PS, AND EV/EBITDA RATIOS FOR
VARIOUS INDUSTRIES
PE PS EV/EBITDA
Aerospace/Defense 21.31 1.54 10.78
Beverage (Soft) 24.71 3.84 18.48
Cable TV 23.55 1.79 9.12
Drugs (Biotechnology) 43.88 5.87 10.00
Entertainment 87.08 3.02 14.23
Farming/Agriculture 15.88 0.58 11.03
Food wholesalers 16.73 0.37 12.29
Furniture/Home 13.89 0.68 7.18
furnishings
Green & renewable energy 28.64 3.73 18.64
Power 18.21 1.99 10.93
Restaurant/Dining 24.88 2.66 16.97

© McGraw Hill 8-21

 INCREMENTAL CASH FLOWS 2

Financing Costs:
• In analyzing a proposed investment, we will not include interest paid or
any other financing costs (For Example, dividends or principal repaid)
because we are interested in the cash flow generated by the assets of the
project.
• Goal in project evaluation is to compare cash flow from a project to the
cost of acquiring that project in order to estimate N PV .
Other Issues:
• We are interested only in measuring cash flow at the time when it actually
occurs, not when it accrues in an accounting sense
• We are always interested in aftertax cash flow because taxes are definitely
a cash outflow

© McGraw Hill 8-22

 SUMMARY OF STOCK VALUATION 1

I.The General Case:

In general, the price today of a share of stock, P0, is the present value of all of its
future dividends, D1, D2, D3, . . . where R is the required return.
D1 D2 D3
P0     .......
1  R  1  R  1  R 
1 2 3

II. Constant Growth Case:

If the dividend grows at a steady rate, g, then the price can be written as:

D1
P0 
Rg

This result is called the dividend growth model.

© McGraw Hill 8-23

 SUMMARY OF STOCK VALUATION 2

III. Nonconstant Growth:

If the dividend grows steadily after t periods, then the price can be written as:
D1 D2 Dt Pt
P0    ...  
1  R  1  R  1  R  1  R 
1 2 t t

Where:
Dt  1  g 
Pt 
R  g 
IV. Two-Stage Growth:
If the dividend grows at rate g1 for t periods and then grows at rate g2 thereafter, then
the price can be written as:
D1   1  g1 t  Pt Where:
P0   1    
R  g1   1  R   1  R t D0  1  g1   1  g 2 
t
Dt 1
Pt  
© McGraw Hill
R  g 2 R  g2 8-24
 SUMMARY OF STOCK VALUATION 3

V. Valuation Using Multiples:

For stocks that don’t pay dividends (or have erratic dividend growth rates), we can
value them using the PE ratio and/or the price-sales ratio:
Pt = Benchmark PE ratio × EPSt
Pt = Benchmark price-sales ratio × Sales per share t

VI. The Required Return:

The required return, R, can be written as the sum of two things:
R = D1/P0 + g
where D1/P0 is the dividend yield and g is the capital gains yield (which is the same
thing as the growth rate in dividends for the steady growth case).

© McGraw Hill 8-25

 COMMON STOCK FEATURES:
SHAREHOLDER RIGHTS
Common stock is equity without priority for dividends or in bankruptcy.
Shareholders elect directors who, in turn, hire managers to carry out their directives.
Directors are elected each year at an annual meeting by a vote of the holders of a
majority of shares who are present and entitled to vote.
• In cumulative voting, a shareholder may cast all votes for one member of the
board of directors; all directors are elected at once.
• In straight voting, a shareholder may cast all votes for each member of the board
of directors; directors are elected one at a time.

Many companies have staggered elections for directors (That is, classified boards), but
several have been pressured to declassify.
Staggering has two basic effects:

1. Makes it more difficult for a minority to elect a director.

2. Makes takeover attempts less likely to be successful.
© McGraw Hill 8-26
 COMMON STOCK FEATURES:
PROXY VOTING AND STOCK CLASSES
A proxy is a grant of authority by a shareholder allowing another individual to vote
his or her shares.
Shareholders can come to the annual meeting and vote in person, or they can
transfer their right to vote to another party.
• Most voting in large public corporations is done by proxy.
• If shareholders are not satisfied with management, an “outside” group of
shareholders can try to obtain votes via proxy, with the resulting battle called a
proxy fight.
Some firms have more than one class of common stock:
• For Example, Ford Motor Company has Class B common stock, which is not publicly
traded.
• Primary reason for creating dual or multiple classes of stock has to do with control
of the firm.
• If multiple classes exist, management can raise equity capital by issuing nonvoting
or limited-voting stock while maintaining control.
© McGraw Hill 8-27
 COMMON STOCK FEATURES:
OTHER RIGHTS
In addition to the right to vote for directors, shareholders usually have the following
rights:
• Right to share proportionally in dividends paid.
• Right to share proportionally in assets remaining after liabilities have been paid in
a liquidation.
• Right to vote on stockholder matters of great importance (For Example, a merger),
with voting usually done at the annual meeting or a special meeting.
Stockholders sometimes have a preemptive right, the right to share proportionally in
any new stock sold:
• Purpose is to give stockholders the opportunity to protect their proportionate
ownership in the corporation.
• Company that wishes to sell stock must first offer it to the existing stockholders
before offering it to the general public .

© McGraw Hill 8-28

 COMMON STOCK FEATURES:
DIVIDENDS
Distinctive feature of corporations is that they have shares of stock on which they are
authorized by law to pay dividends to their shareholders .
Dividends are payments by a corporation to shareholders, made in either cash or
stock.
Payment of dividends is at discretion of the board of directors.
Important characteristics of dividends include the following:
• Unless a dividend is declared by the board of directors of a corporation, it is not a
liability of the corporation. A corporation cannot default on an undeclared
dividend. Therefore, corporations cannot become bankrupt because of
nonpayment of dividends.
• Payment of dividends by the corporation is not a business expense. Dividends are
not deductible for corporate tax purposes.
• Dividends received by individual shareholders are taxable. In 2020, the tax rate
was 15 to 20 percent.
© McGraw Hill 8-29
 PREFERRED STOCK FEATURES:
STATED VALUE AND DIVIDENDS
Preferred stock has dividend priority over common stock, normally with a fixed
dividend rate, sometimes without voting rights.
Preferred shares have a stated liquidating value, usually $100 per share, with the
cash dividend described in terms of dollars per share.
• “$5 preferred” translates into a dividend yield of 5% of stated value.

Preferred dividend is not like interest on a bond.

• Board of directors may decide not to pay dividends on preferred share, (which may
have nothing to do with the current net income of the corporation), in which case:
• Common shareholders must also forgo dividends.
• Holders of preferred shares are often granted voting and other rights if preferred
dividends have not been paid for some time.

Dividends payable on preferred stock are either cumulative or noncumulative, though

most are cumulative.
Unpaid preferred dividends are not debts of the firm.
© McGraw Hill 8-30
 PREFERRED STOCK FEATURES:
IS PREFERRED STOCK REALLY DEBT?
Good case can be made that preferred stock is really debt in disguise, a kind of equity
bond, for the following reasons:
• Preferred shareholders receive a stated dividend only.
• If corporation is liquidated, preferred shareholders get a stated value .
• Preferred stocks often carry credit ratings much like those of bonds.
• Preferred stock is sometimes convertible into common stock.
• Preferred stocks are often callable .
• Many issues of preferred stock have obligatory sinking funds, effectively creating a
final maturity.

In the 1990s, firms began to sell securities that looked a lot like preferred stocks but
were treated as debt for tax purposes, making the interest payments tax deductible.
• Until 2003, interest payments and dividends were taxed at the same marginal tax
rate; when the tax rate on dividend payments was reduced, these instruments
were not included.

© McGraw Hill 8-31

 THE STOCK MARKETS:
DEALERS AND BROKERS
Recall the stock market consists of a primary and secondary market.
Most securities transactions involve dealers and brokers.
• Dealer is an agent who buys and sells securities from inventory.
• Stands ready to buy securities from investors wishing to sell them and sell securities to
investors wishing to buy them.
• The price the dealer is willing to pay is called the bid price.
• The price at which the dealer will sell is called the ask price (That is, asked, offered, or
offering price).
• Difference between the bid and ask prices is the spread, the basic source of dealer
profits.
• Broker is an agent who arranges security transactions among investors.
• Does not buy or sell securities for their own accounts, but rather facilitates trades by
others.

© McGraw Hill 8-32

 ORGANIZATION OF THE NYSE:
MEMBERS 1

As of 2006, a member is the owner of a trading license on the NYSE:

• NYSE has 1,366 exchange members.
• Prior to 2006, exchange members owned “seats” on the exchange, and collectively
the members were also the owners.
• Seat prices reached a record $4 million in 2005.

NYSE became a publicly owned corporation in 2006.

• Instead of purchasing seats, exchange members were required to purchase trading
licenses, which entitle you to buy and sell securities on the floor of the exchange.
In 2007, NYSE merged with Euronext to form NYSE Euronext, becoming the world’s
“first global exchange”.
In 2008, NYSE Euronext merged with the American Stock Exchange.
In 2013, Intercontinental Exchange (I CE) acquired the NYSE.
NYSE is a hybrid market, with trading taking place both electronically and face-to-face.
© McGraw Hill 8-33
 ORGANIZATION OF THE NYSE:
MEMBERS 2

With electronic trading, orders to buy and orders to sell are submitted to the
exchange.
• Orders are compared by a computer and whenever there is a match, the orders
are executed with no human intervention.
• Most trades on the NYSE occur this way.
For orders that are not handled electronically, the NYSE relies on its three types of
license holders:
1. Designated market makers (DMMs) are NYSE members who act as dealers in
particular stocks; formerly known as “specialists”.
2. Floor brokers are NYSE members who execute customer buy and sell orders.
3. Supplemental liquidity providers (SLPs) are investment firms that are active
participants in stocks assigned to them.
• Their job is to make a one-sided market (That is, offering to either buy or sell), and
they trade purely for their own accounts.
© McGraw Hill 8-34
 ORGANIZATION OF THE NYSE:
FLOOR ACTIVITY
How does trading take place?
• DDM’s post is a fixed place on the exchange floor where the DMM operates.
• DMMs normally operate in front of their posts to monitor and manage trading in the
stocks assigned to them.
• Floor brokers move between the many workstations lining the walls of the
exchange and the exchange floor.
• They are receiving customer orders, walking to DMMs’ posts where the orders can be
executed, and returning to confirm order executions and receive new customer orders.

For a very actively traded stock, there may be many buyers and sellers around the
DMM’s post, and most of the trading will be done directly between brokers (i.e.,
trading in the “crowd”).
• DMM’s responsibility is to maintain order and to make sure that all buyers and
sellers receive a fair price.

© McGraw Hill 8-35

 NASDAQ OPERATIONS 1

Introduced in 1971, the Nasdaq market is a computer network of securities dealers

and others that disseminates timely security price quotes to computer screens
worldwide.
• Second largest stock market in the U.S.
• Nasdaq dealers act as market makers for securities listed on Nasdaq, posting bid
and ask prices at which they accept sell and buy orders.
• Nasdaq market makers trade on an inventory basis, using their inventory as a
buffer to absorb buy and sell order imbalances.
• Nasdaq features multiple market makers for actively traded stocks.

Two key differences between the NYSE and Nasdaq:

1. Nasdaq is a computer network and has no physical location where trading takes
place.
2. Nasdaq has a multiple market maker system rather than a D MM system.

© McGraw Hill 8-36

 NASDAQ OPERATIONS 2

Nasdaq is often referred to as an OTC market, but Nasdaq officials prefer the term O T
C not be used when referring to Nasdaq market.
• Over-the-counter (OTC) market is a securities market in which trading is almost
exclusively done through dealers who buy and sell for their own inventories.

Nasdaq network operates with three levels of information access:

• Level 1 is designed to provide a timely, accurate source of price quotations, with
prices freely available over the internet.
• Level 2 allows users to view price quotes from all Nasdaq market makers, and is not
available on the web (sometimes for a small fee).
• Allows access to inside quotes, the highest bid quotes and the lowest ask quotes for a
security.
• Level 3 is for the use of market makers only, as it allows Nasdaq dealers to enter or
change their price quote information.

© McGraw Hill 8-37

 NASDAQ OPERATIONS
(CONCLUDED)
• Nasdaq is made up of three separate markets:

1. Nasdaq Global Select Market is the market for Nasdaq’s larger and more
actively traded securities, listing about 1,400 companies (For Example,
Microsoft and Intel).
2. Nasdaq Global Market companies are somewhat smaller in size; Nasdaq
lists about 810 of these.
3. Nasdaq Capital Market contains the smallest companies listed on Nasdaq,
of which there are about 820 currently listed.
In the late 1990s, the Nasdaq system was opened to electronic
communication networks (ECNs), websites that allow investors to trade
directly with each other.
• ECNs act to increase liquidity and competition by essentially allowing
individual investors, not just market makers, to enter orders.
© McGraw Hill 8-38
 STOCK MARKET REPORTING:
COSTCO
• Price $299.85 is the real-time price of the
last trade.
• Reported change is from previous day’s
closing price.
• Opening price is first trade of day.
• Bid and ask prices of $299.24 and $299.57,
respectively.
• Market “depth,” is number of shares sought
at bid price and offered at ask price.
• Volume is number of shares traded today.
• Market Cap is number of shares outstanding
multiplied by current price per share.
• Yield is reported dividend divided by the
previous stock price: $2.60/$300.84 =
0.86%.
© McGraw Hill
Access the text alternative for slide images.
8-39
 SELECTED CONCEPT QUESTIONS
• Does the value of a share of stock depend on how long you
expect to keep it?
• What is the value of a share of stock when the dividend
grows at a constant rate?
• What is a proxy?
• What rights to stockholders have?
• What is the difference between a securities broker and a
securities dealer?
• How does Nasdaq differ from the NSYE?

© McGraw Hill 8-40

 END OF CHAPTER
CHAPTER 8

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