FINANCIAL MANAGEMENT

THEORY & PRACTICE

ADAPTED FOR THE SECOND CANADIAN

EDITION BY:
JIMMY WANG
LAURENTIAN
UNIVERSITY
CHAPTER 8

STOCKS, STOCK VALUATION,

Copyright © 2014 by Nelson Education Ltd. 8-2

 CHAPTER 8 OUTLINE

• Legal Rights and Privileges of Common Shareholders

• Types of Common Stock
• Stock Market Reporting
• Valuing Common Stock
• Valuing a Constant Growth Stock
• Expected Rate of Return on a Constant Growth
Stock
• Valuing Nonconstant Growth Stocks

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Copyright © 2014 by Nelson Education Ltd. 8-4
Common Stock: Owners, Directors,
and Managers
• Represents ownership
• Ownership implies control.
• Stockholders elect directors.
• Directors hire management.
• Managers are “agents” of shareholders; they
always solicit shareholders’ proxies and
usually succeed.

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Shareholders and Control
Managers

Appoint

Directors

Elect

Shareholders

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Legal Rights and Privileges of Common
Shareholders: Control of the Firm
• Managers of most publicly owned firms can be
removed by the shareholders if managers are
not effective.
• Proxy fight refers to the process that an
outside group may solicit the proxies in an
effort to overthrow management and take
control of the firm.

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 The Preemptive Right
• Shareholders’ right to purchase any additional
shares sold by the firm
• Protects the control of the present
shareholders and also prevents dilution of
their value
• Makes it more difficult to raise equity capital
from new large shareholders

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 Types of Common Stock
• Not all common shares are created equally.
• Most firms have only one type of common
stock.
• A system of dual-class shares is used to meet
the special needs of the company.

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 Dual-Class Shares
• Classified stock has special provisions.
• Could classify existing stock as founders’
shares, with voting rights but dividend
restrictions (multiple or super-voting shares)
• New shares might be called “Class A” shares,
with voting restrictions but full dividend rights
(restricted or subordinate shares).

Copyright © 2014 by Nelson Education Ltd. 8-10

 Valuing Common Stocks
• Most stocks’ expected total return = dividend
yield + capital gains yield.
• The intrinsic value of a stock is the present
value of its expected future cash flow stream.
– Dividend growth model
– Free cash flow approach
– Using the multiples of comparable firms

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 Stock Value = PV of Expected
Future Dividends
^ D1 D2 D3 D∞
P0 = + + +…+
(1+rs)1 (1+rs)2 (1+rs)3 (1+rs)∞

What is a constant growth stock?

One whose dividends are expected

to grow forever at a constant rate, g.

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Valuing a Constant Growth Stock
D1 = D0(1 + g)1
D2 = D0(1 + g)2
Dt = D0(1 + g)t

If g is constant and less than rs, then:

^ D0(1+g) D1
P0 = =
rs - g rs - g

Use decimals, not %, in the calculation.

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 What Happens if g > RS?

^ D0(1+g)1 D0(1+g)2 D0(1+rs)∞

P0 = + +…+
(1+rs) 1 (1+rs)2 (1+rs)∞

If g > rs, then (1+g)t ^

> 1, and P0 = ∞
(1+rs)t

So g must be less than rs to use the

constant growth model.

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 Projected Dividends

• D0 = $2 and constant g = 6% = 0.06

• D1 = D0(1+g) = 2(1.06) = $2.12

• D2 = D1(1+g) = 2.12(1.06) = $2.2472
• D3 = D2(1+g) = 2.2472(1.06) = $2.3820

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 Expected Dividends and PVS

0 g = 6% 1 2 3 4

2.12 2.2472 2.3820

13 %
1.8761
1.7599
1.6508

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 Intrinsic Stock Value

Constant growth model:

^ D0(1+g) D1
P0 = =
rs – g rs – g

$2.12 $2.12
= = $30.29
0.13 – 0.06 0.07

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Expected Value One Year from Now
• D1 will have been paid, so expected dividends
are D2, D3, D4, and so on.

^ D2 $2.2427
P1 = =
rs – g 0.07
= $32.10 = $30.29(1 + 0.06)

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Expected Dividend Yield and Capital
Gains Yield (Year 1)

D1 $2.12
Dividend yield = = = 7.0%
P0 $30.29

^
P1 – P0 $32.10 – $30.29
CG Yield = =
P0 $30.29
= 6.0%

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 Total Year-1 Return
• Total return = Dividend yield + Capital gains yield
• Total return = 7% + 6% = 13%
• Total return = 13% = rs
• For constant growth stock:
– Capital gains yield = 6% = g

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Expected Rate of Return on a
Constant Growth Stock

^ D1 ^ D1
P0 = to rs = +g
rs – g P0

^
Then, rs = $2.12/$30.29 + 0.06
= 0.07 + 0.06 = 13%

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 If g = 0, the Dividend Stream
is a Perpetuity
0 r =13% 1 2 3
s

2.00 2.00 2.00

^ PMT $2.00
P0 = = = $15.38
r 0.13

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Valuing Nonconstant Growth Stocks
• A typical firm goes through life cycles:
supernormal growth during its early years,
normal growth in the middle age, and slow
constant growth in the end.
• The constant growth model can no longer be
used for the whole but can be used for the
constant growth stage:
• Horizon value = PN = DN+1/(rs – g)

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Copyright © 2014 by Nelson Education Ltd. 8-24
Non-constant Growth Followed By
Constant Growth (D0 = $2):
0 1 2 3 4
rs=13%

g = 30% g = 30% g = 30% g = 6%

2.60 3.38 4.394 4.6576
2.3009
2.6470
3.0453
^ $4.6576
46.1135 P3 = = $66.5371
54.1067 = ^P0 0.13 – 0.06

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 Suppose g = 0 FOR t = 1 to 3, and
Then g is a Constant 6%
0 1 2 3 4
rs=13%
g = 0% g = 0% g = 0% g = 6%
2.00 2.00 2.00 2.12

1.7699
1.5663
1.3861 2.12
20.9895 
P3   30.2857
25.7118 0.07

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 If g = -6%, Would Anyone
Buy the Stock? If So, at What Price?
Firm still has earnings and still pays
^
dividends, so P0 > 0:
^ D0(1+g) D1
P0 = =
rs – g rs – g
$2.00(0.94) $1.88
= = = $9.89
0.13 – (-0.06) 0.19

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 Preferred Stock
• Hybrid security
• Similar to bonds in that preferred stockholders
receive a fixed dividend that must be paid
before dividends can be paid on common
stock
• However, unlike bonds, preferred stock
dividends can be omitted without fear of
pushing the firm into bankruptcy.

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 Preferred Stock Valuation
• Similar to the valuation of perpetual bonds
DPS
VPS 
rPS
• A preferred stock pays a quarterly dividend of
$1.25 ($5 per year) with a required return of
10%. Its value is
DPS 4($1.25) $5
VPS     $50
rPS 0.1 0.1

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