Stock Valuation

Chapter 9.1,9.2
Outline
Investing in stocks
Capital gains, dividend yield, return
The Constant Dividend Growth Model
The Dividend and Growth Tradeoff
The DGM with Changing Growth rates
Further problems

Investing in Stocks
A One-Year Investor
There are two potential sources of cash flows form
owning a stock:
The firm might pay out cash to shareholders in
the form of dividends
The investor can generate cash flows by selling
shares at some future date
The investor pays the
current price P
0
and at the
end of the year expects to
receive dividend Div
1
and to
sell the stock at P
1

Equity Cost of Capital
Both potential sources of cash flows form owning a stock
are risky
Dividends change overtime
Stock prices fluctuate considerably

Equity investors demand compensation for this higher
risk and require a risk-premium as reflected in the:

Equity cost of capital r
E

P
0

Div
1
+ P
1
1+r
E
Capital Gains and Dividend Yield
The expected one-period total return on
investment in a stock is the sum of the expected
capital gain yield and dividend yield


r
E

Div
1
P
0
+
P
1
P
0
P
0
Dividend Yield
Capital Gain
Rate
Total return
on the
stock
Stock Prices and Returns
Dividend Yield for stocks
in the Dow Jones
Industrial Average
(2013)
5.33%
3.5% 1.79%
3.03%
2.18%
2.31%
Dividend Yield for stocks
in the Dow Jones
Industrial Average
(2013)
Dividend Yield for stocks
in the Nasdaq 100 (2013)
A Two Year Investment
Suppose that the investor wishes to hold the
stock for two years
Setting the stock price equal to the present
value of future cash flows implies
P
0

Div
1
1+r
E
+
Div
2
+P
2
1+r
E
( )
2
Dividend Discount Model
Suppose that the investor wishes to hold the
stock for n years
Dividend Discount Model
P
0

Div
1
1+r
E
+
Div
2
1+r
E
( )
2
+... +
Div
N
1+r
E
( )
N
+
P
N
1+r
E
( )
N
In Efficient Markets
P
0

Div
1
1+r
E
+
Div
2
1+r
E
( )
2
+... +
Div
N
1+r
E
( )
N
+...
Div
n
1+r
E
( )
n
n1

The Constant Dividend Growth Model

Estimating Future Expected Dividend
The simplest approach is to assume that Dividends grow
over time with a constant growth rate, g, forever
Constant Dividend Growth Model
P
0

Div
1
r
E
g
Stock Valuation: Constant Dividend
Growth
Market Information
Constant Dividend Growth:
Application GE
Historical Dividends
Dividends per-share (Dec 2000 Sept 2013)
Historical Stock Price
Stock price appreciation (from $48.8 to $24.22): -50%
Average annual dividend growth (2000-2013): 6.854%
Implied rate of return on equity for growth 6.854%
P
2013

Div
2014
r
E
g
r
E

Div
2014
P
2013
+g
r
E

$0.76
$24.23
+6.854% 9.99%
The Dividend and Growth Tradeoff
(within the Constant Dividend Growth model)
Dividends and Growth
The stock price increases with the level of
dividends and the growth rate
P
0

Div
1
r
E
g
What determines the level of growth?

Can management increase the share price by
changing its dividend policy?
A Simple Model of Growth
Dividends are paid out of earnings according to
the dividend payout rate
Div
n
EPS
n
Dividend Payout Rate
EPS
n

Earnings
n
Shares Outstanding
n
Cash flows that are not paid out as dividends are retained

Retention Rate = 1- Dividend payout rate
Dividends and Investment
The firm can pay a higher current dividend by
increasing its payout rate

How would a higher payout rate affect future
dividends?
Earnings year n Earnings year n+1
Div n New
Investment n
Div n+1 New
Investment n+1
Calculating Earnings Growth Rate
Change in Earnings
New Investment Return on Investment
New Investment = Earnings Retention rate
g Earnings growth rate
Change in Earnings
Earnings
Retention Rate Return on Investment
Cutting Dividends for Profitable Growth
Cutting Dividends for Profitable Growth
Cutting Dividends for Profitable Growth
Second Example
Comparing the two alternatives
Stocks in Nasdaq 100 that
have zero dividends
The DGM with changing Growth Rates
Changing Growth Rates
Often firms growth rates change overtime:

Young firms tend to retain a high fraction of earnings in
order to take advantage of investment opportunities and
as a result have high earnings growth rates

As firms mature, their growth slows to rates more typical
of established companies. At that point, their earnings
exceed their investment needs and they begin to pay
dividends
DDM with Constant Long-Term Growth
When growth rates only stabilize at a constant level
g after period N+1 ends we value according to:

P
0

Div
1
1+r
E
+
Div
2
1+r
E
( )
2
+... +
Div
N
1+r
E
( )
N
+
P
N
1+r
E
( )
N
P
N

Div
N+1
r
E
g
Where the future price P
N
is

Varying Growth Rate
Varying Growth Rate
Varying Growth Rate
Further Problems
Acap Corporation
Question 3 (2
nd
Edition)
Suppose Acap Corporation will pay a dividend of $2.80 per share at the
end of this year and $3 per share next year. You expect Acaps stock
price to be $52 in two years. If Acaps equity cost of capital is 10%:

a. What price would you be willing to pay for a share of Acap stock
today, if you planned to hold the stock for two years?
b. Suppose instead you plan to hold the stock for one year. What
price would you expect to be able to sell a share of Acap stock for
in one year?
c. Given your answer in part (b), what price would you be willing to
pay for a share of Acap stock today, if you planned to hold the
stock for one year? How does this compare to your answer in part
(a)?
Acap Corporation
Buy and hold for two years
P
0

Div
1
1+r
E
+
Div
2
+P
2
1+r
E
( )
2

$2.8
1.1
+
$55
1.1
2
48
Price one year from now
P
1

Div
2
+P
2
1+r
E
( )

$55
1.1
50
Price one year from now
P
0

Div
1
+P
1
1+r
E
( )
48
Colgate-Palmolive
Question 12 (2
nd
Edition):
Colgate-Palmolive Company has just paid an annual
dividend of $0.96. Analysts are predicting an 11% per
year growth rate in earnings over the next five years.
After then, Colgates earnings are expected to grow at the
current industry average of 5.2% per year.

If Colgates equity cost of capital is 8.5% per year and its
dividend payout ratio remains constant, what price does
the dividend-discount model predict Colgate Stock should
sell for?

Colgate-Palmolive
Expected price time 5
P
5

Div
6
r
E
g
LongTerm

$1.7
8.5% 5.2%
$51.52
Current Price
P
0

Div
t
(1+r
E
)
t
+
P
5
(1+r
E
)
5

t1
5

$1.07
( 2.5%)
1
1.11
1.085

+
$51.52
1.085
5
$39.43