Valuation Of Common Stock
Valuation of Common Stock
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.
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.