Equity markets and

share valuation
Chapter 7

Key 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
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-2

Chapter outline
Ordinary share valuation
Some features of ordinary and
preference shares
The share markets

Copyright 2011 McGraw-Hill Australia Pty Ltd

PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-3

Cash flows for

stockholders
If you own a share of stock, you can
receive cash in two ways:
1. The company pays dividends.
2. 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.
Dividends cash income
Selling capital gains
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-4

One-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.
You believe you can sell the stock for
$14 at that time.
You require a return of 20% on
investments of this risk.
What is the maximum you would be
willing to pay?
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-5

One-period example
(cont.)

D1 = $2 dividend expected in one year

CF1 = $2 + $14 = $16

R = 20%
P1 = $14
Compute the PV of the expected cash flows

( 2 14 )
P0
$13.33
1.20

Calculator:
16 [FV]; 20 [I/Y]; 1 [N]; [CPT] [PV] = -13.33

Copyright 2011 McGraw-Hill Australia Pty Ltd

PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-6

Two-period example

Now, what if you decide to hold the share for two

years?
In addition to the dividend in one year, you expect a
dividend of $2.10 and a share price of $14.70 at the
end of year 2. Now how much would you be willing
2
( 2.10 14.70 )
to pay?
P

$13.33
0

1.20

(1.20 )2

Calculator:
CF0 = 0; C01 = 2; F01 = 1; C02 = 16.80; F02 = 1;
[NPV]; I = 20; [CPT][NPV] = $13.33
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-7

Three-period example
What if you decide to hold the stock for three years?
In addition to the dividends at the end of years 1
and 2, you expect to receive a dividend of $2.205 at
the end of year 3 and a share price of $15.435.
Now how much would you be willing to pay?

P0

2
2.10
( 2.205 15.435 )

$13.33
2
3
1.20 (1.20)
(1.20)

Calculator:

CF0 = 0; C01 = 2; F01 = 1; C02 = 2.10; F02

= 1; C03 = 17.64; F03 = 1;
[NPV]; I = 20; [CPT] [NPV] = $13.33
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-8

Developing the model

You could continue to push back
when you would sell the share.
You would find that the price of the
share is really just the present
value of all expected future
dividends.

Copyright 2011 McGraw-Hill Australia Pty Ltd

PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-9

Stock value = PV of
dividends
P0 =

D1
(1+R)1

+D

D2

(1+R)2
(1+R)

D3

+
3
(1+R)
+

Dt
P0
t
t 1 (1 R )
How can we estimate all future dividend
payments?
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-10

Estimating dividends:
Special cases
Constant dividend
The firm will pay a constant dividend forever
This is like a preference share
The price is computed using the perpetuity
formula

Constant dividend growth

The firm will increase the dividend by a
constant percentage every period

Supernormal growth
Dividend growth is not consistent initially,
but settles down to constant growth
eventually
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-11

Zero growth
If dividends are expected at regular
intervals forever, this is like a
preference share and is valued as a
perpetuity
P0 = D/R

Suppose a share is expected to pay a

$0.50 dividend every half-year and the
required return is 10% with half-yearly
compounding. What is the price?
P0 = .50 / (0.1 / 2) = $10
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-12

Constant growth stock

Dividends are expected to grow at
a constant percentage per period.
D1 = D0(1+g)1
D2 = D0(1+g)2
Dt = Dt(1+g)t
D0 = Dividend JUST PAID
D1 Dt = Expected dividends
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-13

Dividend growth model

(DGM)
P0 = D1 /(1+R) + D2 /(1+R)2 + D3 /(1+R)3
+
P0 = D0(1+g)/(1+R) + D0(1+g)2/(1+R)2 +
D0(1+g)3/(1+R)3 + (with a constant
dividend
t
(1 g )
growth g)
P0 D0
t
(
1

R
)
t 1

D 0 (1 g)
D1
P0

R -g
R -g
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-14

DGMExample 1
Suppose Outback Ltd just paid a
dividend of $0.50. 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
share be selling for?
D0 (1 g)
P0
D0= $0.50
Rg
g = 2%
R = 15%
0.50(1 .02)
P0
$3.92
.15 .02

Copyright 2011 McGraw-Hill Australia Pty Ltd

PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-15

DGMExample 2
Suppose Deep Pirates Ltd 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?
D1 = $2.00
g = 5%
r = 20%

D1
P0
Rg

2.00
P0
$13.33
.20 .05
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-16

Share price sensitivity to

dividend growth (g)
D1 = $2; R =
20%

Copyright 2011 McGraw-Hill Australia Pty Ltd

PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-17

Share price sensitivity to

required return (R)
D1 = $2; g = 5%

Copyright 2011 McGraw-Hill Australia Pty Ltd

PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-18

Example 7.3Gordon
Growth Company I
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
P0
Rg
4.00
P0
$40
.16 .06
Remember that we already have the dividend
expected next year, so we dont multiply the dividend
by 1+g.
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-19

Example 7.3Gordon
Growth Company II
What is the price expected to be in
year 4?
P4 = D4(1 + g) / (R g) = D5 / (R g)
P4 = 4(1+.06)4 / (.16 - .06) = 50.50

What is the implied return given the

change in price during the 4-year
period?
50.50 = 40(1+return)4; return = 6%
-40[PV]; 50.50[FV]; 4[N]; [CPT][I/Y] = 6%

The price grows at the same rate as

the dividends.
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-20

Constant growth model

conditions
1. Dividend expected to grow at g forever.
2. Stock price expected to grow at g
forever.
3. Expected dividend yield is constant.
4. Expected capital gains yield is constant
and equal to g.
5. Expected total return, R, must be > g.
6. Expected total return (R):
= expected dividend yield (DY)
+ expected growth rate (g)
= dividend yield + g
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-21

Non-constant growth
problem statement
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 share?
Remember that we have to find the PV
of all expected future dividends.
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-22

Non-constant growth
problemSolution
Compute the dividends until growth
levels of
D1 = 1(1.2) = $1.20
D2 = 1.20(1.15) = $1.38
D3 = 1.38(1.05) = $1.449

Find the expected future price

P2 = D3 / (R g) = 1.449 / (.2 - .05) = $9.66

Find the present value of the expected

future cash flows
P0 = 1.20 / (1.2) + (1.38 + 9.66) / (1.2) 2 =
$8.67
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-23

Non-constant +
Constant growth
Basic PV of all future dividends formula

D1
P0
1 R

D2

1 R

D3

1 R

D
...
1 R

Dividend growth
model
Dt 1
Pt

R g

Copyright 2011 McGraw-Hill Australia Pty Ltd

PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-24

Non-constant +
Constant growth
(cont.)
D1
D2
P2
P0

1
2
2
1 R 1 R (1 R)
Because

Dt
t
(
1

R
)
t 3

P2

If g constant after t 2, then

D3
P2
Rg
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-25

Non-constant growth
followed by constant
growth
0 rs=20% 1
g = 20%

D0 = 1.00

g = 15%

1.20

g = 5%

1.38

1.449

1.0000
0.9583
6.7083
8.6667

= P0

^
P2 = $1.449 = $9.66
0.20
0.05

Copyright 2011 McGraw-Hill Australia Pty Ltd

PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-26

Quick quiz: Part 1

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%?

2.00
P0
$13.33
.15

What if the company starts increasing dividends by 3% per

year, beginning with the next dividend? The required return
remains at 15%.

2.00(1.03)
P0
$17.17
.15 .03
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-27

Using the DGM to find

R
Start with the DGM:
D0 (1 g)
D1
P0

R-g
R-g

Rearrange and solve for

R:
D0 (1 g)
D1
R
g
g
P0
P0
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-28

Finding the required

return Example
Suppose a firms shares are selling
for $10.50. They just paid a $1
dividend and dividends are expected
to grow at 5% per year. What is the
required return?
R = [1(1.05)/10.50] + .05 = 15%

What is the dividend yield?

1(1.05) / 10.50 = 10%

What is the capital gains yield?

g = 5%
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-29

Summary of share
valuation
Table 7.1

Copyright 2011 McGraw-Hill Australia Pty Ltd

PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
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7-30

Features of ordinary
shares
Voting rights
Stockholders elect directors
Cumulative voting vs straight
voting
Proxy voting

Classes of share
One share, one vote
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-31

Features of ordinary
shares (cont.)
Other rights
Share proportionally in declared
dividends
Share proportionally in remaining
assets during liquidation
Pre-emptive right
Right of first refusal to buy new stock
issue to maintain proportional
ownership if desired
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
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7-32

Dividend
characteristics
Dividends are not a liability of the firm
until declared by the Board of Directors
A firm cannot go bankrupt for not
declaring dividends

Dividends and taxes

Dividends are not tax deductible for a firm
Taxed as ordinary income for individuals
Dividends received by corporations have a
minimum 100% exclusion from taxable
income
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
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7-33

Features of preference
shares
Dividends
Stated dividend must be paid before
dividends can be paid to ordinary
shareholders
Dividends are not a liability of the firm and
preference dividends can be deferred
indefinitely
Most preference dividends are cumulative
any missed preference dividends have
to be paid before ordinary dividends can
be paid

Preference shares generally do not

carry voting rights
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
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7-34

The share markets

Primary vs secondary markets
Primary = new-issue market
Secondary = existing shares traded
among investors

Dealers vs brokers
Dealer: Maintains an inventory
Ready to buy or sell at any time
Think Used car dealer
Broker: Brings buyers and sellers
together
Think Real estate broker
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-35

Australian Stock
Exchange (ASX)
Australian Stock Exchange (ASX)1987
Result of amalgamation of state-based exchanges

1987Introduction of Stock Exchange

Automated Trading System (SEATS)
1998Demutualisation of ASX
2006Merger with Sydney Futures Exchange
and now called Australian Securities Exchange
New Zealand Stock Exchange
Created in 1974
1991Introduction of Computer Based Trading
System
Demutualised in 2002
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-36

ASX and NZX

operations
Operational goal = Attract order flow
Both ASX and NZX are auction markets
Agency tradingBrokers buying and
selling for clients
Principal tradingBrokers buying and
selling their own accounts

Orders
Limit orderspecified sell/buy price
Market orderat best market price

Trading in both ASX and NZX takes

place on computer network
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-37

Share market reporting

Figure 7.2

Copyright 2011 McGraw-Hill Australia Pty Ltd

PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-38

Work the Web

Click on the information icon to go
to <http://
markets.smh.com.au/apps/qt/index
.ac
>
Search for other equities like the
one in the last example
Understand the reported figures
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al.
Slides prepared by David E. Allen and Abhay K. Singh

7-39

Quick quiz: Part 2

You observe a share 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 ordinary shares?
What are some of the major
characteristics of preference shares?
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al
Slides prepared by David E. Allen and Abhay K. Singh.

7-40

Chapter 7

END

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