# Valuation Of Common Stock

**Topics:**Discounted cash flow, Time value of money, Stock market

**Pages:**16 (788 words)

**Published:**July 16, 2015

Ashok Banerjee

Common (Equity) Stocks

• Because common stock never matures, today’s

value is the present value of an infinite stream of

cash flows (i.e., dividend).

• But dividends are not fixed.

• Not knowing the amount of the dividends—or

even if there will be future dividends— makes it

difficult to determine the value of common stock.

• So what are we to do?

Valuation Models

• Dividend Valuation Model (DVM):

– Constant dividend: Let D be the constant

DPS:

The required rate of return (re) is the return shareholders

demand to compensate them for the time value of money tied

up in their investment and the uncertainty of the future cash flows from these investments.

Valuation Models

• Dividend growth at a constant rate (g):

(also known as Gordon Model)

OR

OR

Exercise 1

• You buy a stock for Rs.230 and you

expect the next year’s dividend to be

Rs.12.42. Furthermore, you expect the

dividend to grow at a constant rate of 8%

p.a.

– What is the expected return of the stock?

– What is the dividend yield?

– What is the expected price of the stock in five

years?

Dividend and Earnings Growth

• Growth in dividends occurs primarily as a result

of growth in EPS.

• Growth in earnings, in turn, results from a

number of factors, including (1) inflation, (2)

retention ratio; and (3) ROE.

• Shareholders care about all dividends, both

current and those in the future.

• If most of a stock’s value is due to long-term

cash flows, why do managers and analysts pay

so much attention to quarterly earnings?

Valuation Models

• Varying Dividend Growth Rate:

– For many companies, it is unreasonable to

assume that it grows at a constant rate.

– P0 = Present value of dividends based on

short-run non-constant rate + Present value of

dividends using constant growth rate.

Example 2

• A company’s stock just paid a Rs.11.50

dividend, which is expected to grow at

30% for next three years. After that, the

dividend is expected to grow at 8%

constantly forever. The stock’s required

return is 13.4%.

– What is the price of the stock today?

Link between stock price and EPS

• Stock price can be thought of as the

capitalized value of average earning under

a no-growth policy, plus PVGO, the net

present value of growth opportunities:

– P0=EPS1/r +PVGO

Valuing Common Stocks

Example

Our company forecasts to pay a $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?

Valuing Common Stocks

Example

Our company forecasts to pay a $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

8.33

P0

$55.56

.15

With Growth

g .25 .40 .10

5.00

P0

$100.00

.15 .10

Valuing Common Stocks

Example - continued

If the company did not plowback 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

Valuing Common Stocks

Present Value of Growth Opportunities

(PVGO) - Net present value of a firm’s

future investments.

Sustainable Growth Rate - Steady rate at

which a firm can grow: plowback ratio X

return on equity.

Do stock prices reflect long-term or

short-term cash flows?

• Managers often complain that the stock market

is shortsighted, and that it cares only about next

quarter’s performance. Is this true?

• The current stock price is Rs.230. Current...

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