7-1
Key 1-1 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 how corporate directors are
elected
Understand how stock markets work
Understand how stock prices are quoted
Chapter 7
Equity Markets and
Stock Valuation
0
McGraw-Hill/Irwin
1
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
1-2 7-2
Chapter Outline
1-3 7-3
Cash Flows to Stockholders
Common Stock Valuation
Some Features of Common and Preferred
Stocks
The Stock Markets
If you buy a share of stock, you can
receive cash in two ways
The company pays dividends
You sell your shares either to another investor
in the market or back to the company
As with bonds, the price of the stock is the
present value of these expected cash
flows
2
3
1-4 7-4
1-5 7-5
One-Period Example
Two-Period Example
Suppose you are thinking of purchasing
the stock of Moore Oil, Inc. You expect it
to pay a $2 dividend in one year, and you
believe that you can sell the stock for $14
at that time. If you require a return of 20%
on investments of this risk, what is the
maximum you would be willing to pay?
Now, what if you decide to hold the
stock for two years? In addition to the
$2 dividend in one year, you expect a
dividend of $2.10 and a stock price of
$14.70 both at the end of year 2.
Now how much would you be willing
to pay?
4
5
1-1
1-6 7-6
Three-Period Example
1-7 7-7
Developing The Model
Finally, what if you decide to hold the
stock for three periods? In addition to
the dividends at the end of years 1 and
2, you expect to receive a dividend of
$2.205 and a stock price of $15.435
both at the end of year 3. Now how
much would you be willing to pay?
You could continue to push back when
you would sell the stock
You would find that the price of the stock
is really just the present value of all
expected future dividends
So, how can we estimate all future
dividend payments?
6
7
1-8 7-8
1-9 7-9
Zero Growth
Estimating Dividends: Special Cases
Constant dividend
If dividends are expected at regular intervals
forever, then this is like preferred stock and is
valued as a perpetuity
The firm will pay a constant dividend forever
This is like preferred stock
The price is computed using the perpetuity
formula
Pt
Constant dividend growth
D t 1
R
Suppose stock is expected to pay a $0.50
dividend every quarter and the required return is
10% with quarterly compounding. What is the
price?
The firm will increase the dividend by a
constant percent every period
Supernormal growth
Dividend growth is not consistent initially, but
settles down to constant growth eventually
8
9
1-10 10
7-
Dividend Growth Model
1-11-11
7
Dividend Growth Model
Dividends are expected to grow at a constant
percent, g, per period.
D1 = D0(1+g)
D2 = D1(1+g) = D0(1+g)2
D3 = D2(1+g) = D0(1+g)3
Dividends are expected to grow at a constant
percent, g, per period.
Pt
Pt
Dt = Dt-1(1+g) = D0(1+g)t
10
D t 1
D t 2
D t 3
...
(1 R) 1 (1 R) 2 (1 R) 3
D t (1 g ) D t (1 g ) 2 D t (1 g ) 3
...
(1 R) 1
(1 R) 2
(1 R) 3
11
1-2
1-12 12
7-
1-13 13
7-
DGM Example 1
Dividend Growth Model
Suppose Big D, Inc. just paid a dividend
of $.50. It is expected to increase its
dividend by 2% per year. If the market
requires a return of 15% on assets of this
risk, how much should the stock be
selling for
With a little algebra, this reduces to:
P0
D 0 (1 g)
D
1
R-g
R-g
12
13
1-14 14
7-
1-15 15
7-
Stock Price Sensitivity to
Dividend Growth, g
DGM Example 2
Suppose TB Pirates, Inc. is expected to
pay a $2 dividend in one year. If the
dividend is expected to grow at 5% per
year and the required return is 20%,
what is the price?
250
D1 = $2; R = 20%
Stock Price
200
150
100
50
0
0
0.05
0.1
0.15
0.2
Growth Rate
14
15
1-16 16
7-
Stock Price Sensitivity to
Required Return, 17
7-
Example R
1-17 7.3 Gordon Growth
Company - I
250
Stock Price
Gordon Growth Company is expected to
pay a dividend of $4 next period and
dividends are expected to grow at 6% per
year. The required return is 16%.
What is the current price?
D1 = $2; g = 5%
200
150
100
50
0
0
0.05
0.1
0.15
0.2
0.25
0.3
Required Rate of Return
16
17
1-3
1-18 18
7-
Example 7.3 Gordon Growth
Company II
1-19 19
7-
Nonconstant Growth Problem
Statement
What is the price expected to be in year 4?
What is the implied return given the change in
price during the four-year period?
The price grows at the same rate as the
dividends
Suppose a firm is expected to increase
dividends by 20% in one year and by
15% in two years. After that, dividends
will increase at a rate of 5% per year
indefinitely. If the last dividend was $1
and the required return is 20%, what is
the price of the stock?
Remember that we have to find the PV
of all expected future dividends.
18
19
1-20 20
7-
Quick Quiz: Part 1
1-21 21
7-
Using the DGM to Find R
What is the value of a stock that is
expected to pay a constant dividend of $2
per year if the required return is 15%?
What if the company starts increasing
dividends by 3% per year beginning with
the next dividend? The required return
stays at 15%.
Start with the DGM:
D 0 (1 g)
D1
R-g
R-g
r earrangea nd solve for R
P0
R
D 0 (1 g)
D
g 1 g
P0
P0
20
21
1-22 22
7-
Finding the Required Return Example
1-23 23
7-
Table 7.1
Suppose a firms stock is selling for
$10.50. It just paid a $1 dividend and
dividends are expected to grow at 5% per
year. What is the required return?
What is the dividend yield?
What is the capital gains yield?
22
23
1-4
1-24 24
7-
Features of Common Stock
1-25 25
7-
Dividend Characteristics
Voting Rights
Proxy voting
Classes of stock
Other Rights
Dividends are not a liability of the firm until a
dividend has been declared by the Board
Consequently, a firm cannot go bankrupt for
not declaring dividends
Dividends and Taxes
Share proportionally in declared dividends
Share proportionally in remaining assets
during liquidation
Preemptive right first shot at new stock
issue to maintain proportional ownership if
desired
Dividend payments are not considered a
business expense; therefore, they are not taxdeductible
Dividends received by individuals have
historically been taxed as ordinary income
Dividends received by corporations have a
minimum 70% exclusion from taxable income
24
25
1-26 26
7-
1-27 27
7-
Features of Preferred Stock
Stock Market
Dividends
Dealers vs. Brokers
New York Stock Exchange (NYSE)
Stated dividend that must be paid before
dividends can be paid to common
stockholders
Dividends are not a liability of the firm and
preferred dividends can be deferred
indefinitely
Most preferred dividends are cumulative
any missed preferred dividends have to be
paid before common dividends can be paid
Members
Operations
Floor activity
NASDAQ
Not a physical exchange, but a computerbased quotation system
Large portion of technology stocks
Preferred stock does not generally
carry voting rights
26
27
1-28 28
7-
Stock Market
1-29 29
7-
Quick Quiz: Part 2
Electronic Order Matching Market
Istanbul Stock Exchange (ISE)
You observe a stock price of $18.75. You
expect a dividend growth rate of 5% and
the most recent dividend was $1.50. What
is the required return?
What are some of the major
characteristics of common stock?
What are some of the major
characteristics of preferred stock?
Members
Operations
Floor activity
28
29
1-5
1-30 30
7-
Comprehensive Problem
XYZ stock currently sells for $50 per
share. The next expected annual dividend
is $2, and the growth rate is 6%. What is
the expected rate of return on this stock?
If the required rate of return on this stock
were 12%, what would the stock price be,
and what would the dividend yield be?
30
1-6