Chapter

6
McGraw-Hill/Irwin

Common Stock
Valuation

Copyright 2009 by The McGraw-Hill Companies, Inc. All

rights reserved.

Learning Objectives
Separate yourself from the commoners by having a good
Understanding of these security valuation methods:
1. The basic dividend discount model.
2. The two-stage dividend growth model.
3. The residual income model.
4. Price ratio analysis.

6-2

Common Stock Valuation

Our goal in this chapter is to examine the methods
commonly used by financial analysts to assess the
economic value of common stocks.
These methods are grouped into three categories:
Dividend discount models
Residual Income models
Price ratio models

6-3

Security Analysis: Be Careful Out There

Fundamental analysis is a term for studying a
companys accounting statements and other financial and
economic information to estimate the economic value of
a companys stock.
The basic idea is to identify undervalued stocks to buy
and overvalued stocks to sell.
In practice however, such stocks may in fact be correctly
priced for reasons not immediately apparent to the
analyst.

6-4

The Dividend Discount Model

The Dividend Discount Model (DDM) is a method to estimate the

value of a share of stock by discounting all expected future dividend
payments. The basic DDM equation is:

D3
D1
D2
DT
P0

2
3
1 k 1 k 1 k
1 k T

In the DDM equation:

P0 = the present value of all future dividends
Dt = the dividend to be paid t years from now
k = the appropriate risk-adjusted discount rate

6-5

Example: The Dividend Discount Model

Suppose that a stock will pay three annual dividends of
$200 per year, and the appropriate risk-adjusted discount
rate, k, is 8%.
In this case, what is the value of the stock today?
P0

D3
D1
D2

1 k 1 k 2 1 k 3

P0

$200
$200
$200

$515.42
2
3
1 0.08 1 0.08 1 0.08

6-6

The Dividend Discount Model:

the Constant Growth Rate Model

Assume that the dividends will grow at a constant growth rate g. The
dividend next period (t + 1) is:
D t 1 D t 1 g
So, D 2 D1 (1 g) D 0 (1 g) (1 g)

For constant dividend growth for T years, the DDM formula

becomes:
D1 (1 g)
1 g
P0

1
k g
1

if k g

P0 T D 0

if k g

6-7

Example: The Constant Growth Rate Model

Suppose the current dividend is $10, the dividend growth rate is

10%, there will be 20 yearly dividends, and the appropriate discount
rate is 8%.

What is the value of the stock, based on the constant growth rate
model?

D 0 (1 g)
1 g
P0

1
k g
1 k
T

$10 1.10
1.10
P0
1

.08 .10
1.08

20

$243.86

6-8

The Dividend Discount Model:

the Constant Perpetual Growth Model.
Assuming that the dividends will grow forever at a
constant growth rate g.
For constant perpetual dividend growth, the DDM formula
becomes:

P0

D 0 1 g
D
1
kg
kg

(Important : g k)

6-9

Example: Constant Perpetual Growth Model

Think about the electric utility industry.

In 2007, the dividend paid by the utility company, DTE Energy Co.
(DTE), was $2.12.
Using D0 =$2.12, k = 6.7%, and g = 2%, calculate an estimated value
for DTE.

P0

$2.12 1.02
$46.01
.067 .02

Note: the actual mid-2007 stock price of DTE was $47.81.

What are the possible explanations for the difference?

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The Dividend Discount Model:

Estimating the Growth Rate
The growth rate in dividends (g) can be estimated in a
number of ways:
Using the companys historical average growth rate.
Using an industry median or average growth rate.
Using the sustainable growth rate.

6-11

The Historical Average Growth Rate

Suppose the Broadway Joe Company paid the following dividends:

2002: $1.50
2003: $1.70
2004: $1.75

2005: $1.80
2006: $2.00
2007: $2.20

The spreadsheet below shows how to estimate historical average

growth rates, using arithmetic and geometric averages.

6-12

The Sustainable Growth Rate

Sustainabl e Growth Rate ROE Retention Ratio

ROE (1 - Payout Ratio)

Return on Equity (ROE) = Net Income / Equity

Payout Ratio = Proportion of earnings paid out as dividends

Retention Ratio = Proportion of earnings retained for investment

6-13

Example: Calculating and Using the

Sustainable Growth Rate

In 2007, American Electric Power (AEP) had an ROE of 10.17%,

projected earnings per share of $2.25, and a per-share dividend of
$1.56. What was AEPs:
Retention rate?
Sustainable growth rate?

Payout ratio = $1.56 / $2.25 = .693

So, retention ratio = 1 .693 = .307 or 30.7%

Therefore, AEPs sustainable growth rate = .1017 .307 = .03122, or

3.122%

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Example: Calculating and Using the

Sustainable Growth Rate, Cont.

What is the value of AEP stock, using the perpetual growth model,
and a discount rate of 6.7%?

P0

$1.56 1.03122
$44.96
.067 .03122

The actual mid-2007 stock price of AEP was $45.41.

In this case, using the sustainable growth rate to value the stock
gives a reasonably accurate estimate.

What can we say about g and k in this example?

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The Two-Stage Dividend Growth Model

The two-stage dividend growth model assumes that a
firm will initially grow at a rate g1 for T years, and
thereafter grow at a rate g2 < k during a perpetual second
stage of growth.
The Two-Stage Dividend Growth Model formula is:
D 0 (1 g1 )
1 g1
P0
1

k g1
1

1 g1

1 k

D 0 (1 g 2 )
k g2

6-16

Using the Two-Stage

Dividend Growth Model, I.
Although the formula looks complicated, think of it as two
parts:
Part 1 is the present value of the first T dividends (it is the same
formula we used for the constant growth model).
Part 2 is the present value of all subsequent dividends.

So, suppose MissMolly.com has a current dividend of

D0 = $5, which is expected to shrink at the rate, g1 = 10%
for 5 years, but grow at the rate, g2 = 4% forever.
With a discount rate of k = 10%, what is the present value
of the stock?
6-17

Using the Two-Stage

Dividend Growth Model, II.
D 0 (1 g1 )
1 g1
P0

1
k g1
1

1 g1

D 0 (1 g 2 )
k g2

5
$5.00(0.90 )
0.90 0.90
P0

1
0.10 ( 0.10)
1 0.10 1 0.10

$5.00(1 0.04)
0.10 0.04

$14.25 $31.78
$46.03.

The total value of $46.03 is the sum of a $14.25 present value of the
first five dividends, plus a $31.78 present value of all subsequent
dividends.

6-18

Example: Using the DDM to Value a Firm

Experiencing Supernormal Growth, I.

Chain Reaction, Inc., has been growing at a phenomenal rate of 30%

per year.

You believe that this rate will last for only three more years.

Then, you think the rate will drop to 10% per year.

Total dividends just paid were $5 million.

The required rate of return is 20%.

What is the total value of Chain Reaction, Inc.?

6-19

Example: Using the DDM to Value a Firm

Experiencing Supernormal Growth, II.

First, calculate the total dividends over the supernormal growth

period:
Year

Total Dividend: (in $millions)

$5.00 x 1.30 = $6.50

$6.50 x 1.30 = $8.45

$8.45 x 1.30 = $10.985

Using the long run growth rate, g, the value of all the shares at
Time 3 can be calculated as:
P3 = [D3 x (1 + g)] / (k g)
P3 = [$10.985 x 1.10] / (0.20 0.10) = $120.835
6-20

Example: Using the DDM to Value a Firm

Experiencing Supernormal Growth, III.

Therefore, to determine the present value of the firm today, we need

the present value of $120.835 and the present value of the dividends
paid in the first 3 years:
P0

D3
P3
D1
D2

1 k 1 k 2 1 k 3 1 k 3

$6.50
$8.45
$10.985
$120.835
P0

1 0.20 1 0.20 2 1 0.20 3 1 0.20 3

$5.42 $5.87 $6.36 $69.93
$87.58 million.
6-21

Discount Rates for

Dividend Discount Models

The discount rate for a stock can be estimated using the capital
asset pricing model (CAPM ).
We will discuss the CAPM in a later chapter.
However, we can estimate the discount rate for a stock using this
formula:
Discount rate = time value of money + risk premium
= U.S. T-bill Rate + (Stock Beta x Stock Market Risk Premium)
T-bill Rate: return on 90-day U.S. T-bills
Stock Beta: risk relative to an average stock
Stock Market Risk Premium: risk premium for an average stock

6-22

Observations on Dividend
Discount Models, I.
Constant Perpetual Growth Model:

Simple to compute
Not usable for firms that do not pay dividends
Not usable when g > k
Is sensitive to the choice of g and k
k and g may be difficult to estimate accurately.
Constant perpetual growth is often an unrealistic assumption.

6-23

Observations on Dividend
Discount Models, II.
Two-Stage Dividend Growth Model:

More realistic in that it accounts for two stages of growth

Usable when g > k in the first stage
Not usable for firms that do not pay dividends
Is sensitive to the choice of g and k
k and g may be difficult to estimate accurately.

6-24

Residual Income Model (RIM), I.

We have valued only companies that pay dividends.
But, there are many companies that do not pay dividends.
What about them?
It turns out that there is an elegant way to value these
companies, too.

The model is called the Residual Income Model (RIM).

Major Assumption (known as the Clean Surplus Relationship, or

CSR): The change in book value per share is equal to earnings per
share minus dividends.
6-25

Residual Income Model (RIM), II.

Inputs needed:

Earnings per share at time 0, EPS0

Book value per share at time 0, B0
Earnings growth rate, g
Discount rate, k

There are two equivalent formulas for the Residual Income Model:
P0 B 0

EPS 0 (1 g) B 0 k
kg

or
P0

BTW, it turns out that the

RIM is mathematically the
same as the constant
perpetual growth model.

EPS 1 B 0 g
kg

6-26

Using the Residual Income Model.

Superior Offshore International, Inc. (DEEP)

It is July 1, 2007shares are selling in the market for $10.94.
Using the RIM:

EPS0 = $1.20
DIV = 0
B0 = $5.886
g = 0.09
k = .13

What can we say

about the market
price of DEEP?

P0 B 0

EPS 0 (1 g) B 0 k
kg

P0 $5.886

$1.20 (1 .09) $5.886 .13

.13 .09

P0 $5.886

$1.308 $.7652
$19.46.
.04

6-27

DEEP Growth

Using the information from the previous slide, what growth rate
results in a DEEP price of $10.94?
P0 B 0

EPS 0 (1 g) B 0 k
k g

$10.94 $5.886

$1.20 (1 g) $5.886 .13

.13 g

$5.054 (.13 g) 1.20 1.20g .7652

$.6570 5.054g 1.20g .4348
.2222 6.254g
g .0355 or 3.55%.

6-28

Price Ratio Analysis, I.

Price-earnings ratio (P/E ratio)
Current stock price divided by annual earnings per share (EPS)

Earnings yield
Inverse of the P/E ratio: earnings divided by price (E/P)

High-P/E stocks are often referred to as growth stocks,

while low-P/E stocks are often referred to as value
stocks.

6-29

Price Ratio Analysis, II.

Price-cash flow ratio (P/CF ratio)
Current stock price divided by current cash flow per share
In this context, cash flow is usually taken to be net income plus
depreciation.

Most analysts agree that in examining a companys

financial performance, cash flow can be more informative
than net income.
Earnings and cash flows that are far from each other may
be a signal of poor quality earnings.

6-30

Price Ratio Analysis, III.

Price-sales ratio (P/S ratio)
Current stock price divided by annual sales per share
A high P/S ratio suggests high sales growth, while a low P/S ratio
suggests sluggish sales growth.

Price-book ratio (P/B ratio)

Market value of a companys common stock divided by its book
(accounting) value of equity
A ratio bigger than 1.0 indicates that the firm is creating value for
its stockholders.

6-31

Price/Earnings Analysis, Intel Corp.

Intel Corp (INTC) - Earnings (P/E) Analysis
5-year average P/E ratio
Current EPS
EPS growth rate

27.30
$.86
8.5%

Expected stock price = historical P/E ratio projected EPS

$25.47 = 27.30 ($.86 1.085)
Mid-2007 stock price = $24.27

6-32

Price/Cash Flow Analysis, Intel Corp.

Intel Corp (INTC) - Cash Flow (P/CF) Analysis
5-year average P/CF ratio
Current CFPS
CFPS growth rate

14.04
$1.68
7.5%

Expected stock price = historical P/CF ratio projected CFPS

$25.36 = 14.04 ($1.68 1.075)
Mid-2007 stock price = $24.27

6-33

Price/Sales Analysis, Intel Corp.

Intel Corp (INTC) - Sales (P/S) Analysis
5-year average P/S ratio
Current SPS
SPS growth rate

4.51
$6.14
7%

Expected stock price = historical P/S ratio projected SPS

$29.63 = 4.51 ($6.14 1.07)
Mid-2007 stock price = $24.27

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An Analysis of the
McGraw-Hill Company
The next few slides contain a financial
analysis of the McGraw-Hill Company, using
data from the Value Line Investment Survey.

6-35

The McGraw-Hill Company Analysis, I.

6-36

The McGraw-Hill Company Analysis, II.

6-37

The McGraw-Hill Company Analysis, III.

Based on the CAPM, k = 3.1% + (.80 9%) = 10.3%
Retention ratio = 1 $.66/$2.65 = .751
Sustainable g = .751 23% = 17.27%
Because g > k, the constant growth rate model cannot be
used. (We would get a value of -$11.10 per share)

6-38

The McGraw-Hill Company Analysis

(Using the Residual Income Model, I)

Lets assume that today is January 1, 2008, g = 7.5%, and k = 12.6%.

Using the Value Line Investment Survey (VL), we can fill in column two
(VL) of the table below.

We use column one and our growth assumption for column three (CSR) of
the table below.
End of 2007

2008 (VL)

NA

$6.50

$6.50

EPS

$3.05

$3.45

$3.2788

DIV

$.82

$.82

$2.7913

Ending BV per share

$6.50

$9.25

$6.9875

Beginning BV per share

2008 (CSR)

3.05 1.075 6.50 1.075

" Plug" 3.2788 - (6.9875 - 6.50)

6-39

The McGraw-Hill Company Analysis

(Using the Residual Income Model, II)

Using the CSR assumption:

P0 B 0

EPS 0 (1 g) B 0 k
kg

P0 $6.50

Stock price at the time = $57.27.

What can we say?

Using Value Line numbers for

EPS1=$3.45, B1=$9.25
B0=$6.50; and using the actual
change in book value instead of an
estimate of the new book value,
(i.e., B1-B0 is = B0 x k)

$3.05 (1 .075) $6.50 .126

.126 .075

P0 $54.73.

P0 B 0

EPS 0 (1 g) B 0 k
kg

P0 $6.50

$3.45 ($9.25 - 6.50)

.126 .075

P0 $20.23
6-40

The McGraw-Hill Company Analysis, IV.

6-41

Useful Internet Sites

www.nyssa.org (the New York Society of Security Analysts)

www.aaii.com (the American Association of Individual
Investors)
www.eva.com (Economic Value Added)
www.valueline.com (the home of the Value Line Investment
Survey)
Websites for some companies analyzed in this chapter:
www.aep.com
www.americanexpress.com
www.pepsico.com
www.intel.com
www.corporate.disney.go.com
www.mcgraw-hill.com
6-42

Chapter Review, I.
Security Analysis: Be Careful Out There
The Dividend Discount Model

Constant Dividend Growth Rate Model

Constant Perpetual Growth
Applications of the Constant Perpetual Growth Model
The Sustainable Growth Rate

6-43

Chapter Review, II.

The Two-Stage Dividend Growth Model
Discount Rates for Dividend Discount Models
Observations on Dividend Discount Models

Residual Income Model (RIM)

Price Ratio Analysis

Price-Earnings Ratios
Price-Cash Flow Ratios
Price-Sales Ratios
Price-Book Ratios
Applications of Price Ratio Analysis

An Analysis of the McGraw-Hill Company

6-44