This document discusses financial management concepts focusing on stock valuation models and types of common stock. It explains the differences between classified stocks, such as Class A and Class B, and how they help founders maintain control. Additionally, it covers methods for estimating intrinsic value, like the discounted dividend model, and various aspects of stock returns, including dividend yield and capital gains yield.

1. Financial
Management
Lecture 9-Week 9
by
Dr. Sehrish Gul

2. Week 9: Securities and Markets
 Learning Objectives:
 Stocks valuation Models

3. Types of Common Stock
 Although most firms have only one type of common stock,
in some instances, classified stock is used to meet special
needs. Generally, when special classifications are used, one
type is designated Class A, another Class B, and so forth.
 The key difference is that the Class B stock has 10 votes per
share while the Class A stock has 1 vote per share. Google’s
Class B shares are predominantly held by the company’s
two founders and its current CEO.
 The use of classified stock enables the company’s founders
to maintain control over the company without having to
own a majority of the common stock. For this reason, Class
B stock of this type is sometimes called founders’ shares.

4. Stock Price versus Intrinsic
Value
 The stock price is simply the current
market price, and it is easily observed
for publicly traded companies.
 By contrast, intrinsic value, which
represents the “true” value of the
company’s stock, cannot be directly
observed and must instead be
estimated.

5.  If the stock market is reasonably
efficient, gaps between the stock price
and intrinsic value should not be very
large, and they should not persist for
very long.
 However, in some cases, an individual
company’s stock may trade for an
extended period of time at a price much
higher or lower than its intrinsic value.

7.  When investing in common stocks,
one’s goal for investors is to purchase
stocks that are undervalued (i.e., the
price is below the stock’s intrinsic value)
and avoid stocks that are overvalued.
 Managers should consider whether
their stock is significantly undervalued
or overvalued before making certain
decisions.

8. Models for Stock’s valaution
 Two basic models are used to estimate
intrinsic values: the discounted
dividend model and the corporate
valuation model.
 The dividend model focuses on
dividends, while the corporate model
goes beyond dividends and focuses on
sales, costs, and free cash flows.

9. The Discounted Dividend
Model
 The value of a share of common stock
depends on the cash flows it is
expected to provide, and those cash
flows consist of two elements:
 (1) the dividends the investor receives
each year while he or she holds the
stock and
 (2) the price received when the stock is
sold.

10. The Discounted Dividend Model…
 The following terms are used in our analysis:
 Dt = the dividend a stockholder expects to receive at the end
of each Year t.
 D0 is the last dividend the company paid. Because it has
already been paid, a buyer of the stock will not receive D0 .
 The first dividend a new buyer will receive is D1 , which is
paid at the end of Year 1.
 D2 is the dividend expected at the end of Year 2; D3 , at the
end of Year 3; and so forth. D0 is known with certainty, but
D1 , D2 , and all other future dividends are expected values,
and different investors can have different expectations.

11. Share Price (Actual & Expected)
 Market Price, P0 The price at which a stock sells in
the market.
 P0 is known with certainty, but predicted future
prices are subject to uncertainty.
 P^t both the expected price and the expected
intrinsic value of the stock at the end of each Year t
(pronounced “P hat t”) as seen by the investor
doing the analysis.
 P^ t is based on the investor’s estimates of the
dividend stream and the riskiness of that stream.

12. Expected growth rate (g)
 g = expected growth rate g in dividends
as predicted by an investor.
 If dividends are expected to grow at a
constant rate, g should also equal the
expected growth rate in earnings and
the stock’s price.

13. Required, or minimum acceptable
rate of return (rs )
 rs = required, or minimum acceptable,
rate of return on the stock considering
its riskiness and the returns available
on other investments.
 The determinants of rs include factors
the real rate of return, expected
inflation, and risk.

14. Expected rate of return (r^s)
 r^s = expected rate of return (pronounced “r
hat s”) that an investor believes the stock will
provide in the future.
 The expected return can be above or below
the required return, but a rational investor will
buy the stock if r^s exceeds rs , sell the stock if
r^s is less than rs , and simply hold the stock if
these returns are equal.
 Stock is at equilibrium when rs and r^s are
equal.

15. Actual, or realized Return
 rs = actual, or realized, after-the-fact
rate of return, pronounced “r bar s.”
You can expect to obtain a return of rs 5
10% if you buy a stock today, but if the
market declines, you may earn an
actual realized return that is much
lower, perhaps even negative.

16. Dividend yield
 The expected dividend divided by the
current price of a share of stock.
 D1 /P0 = dividend yield expected during
the coming year.
 If Company X’s stock is expected to pay a
dividend of D1 = $1 during the next 12
months and if X’s current price is P0 = $20,
the expected dividend yield will be $1/$20
= 0.05 = 5%.

17. Capital gains yield
 Capital Gains Yield The capital gain during a
given year divided by the beginning price.
 (P^1 - P0)/P0 = expected capital gains yield
on the stock during the coming year.
 If the stock sells for $20.00 today and if it is
expected to rise to $21.00 by the end of the
year, the expected capital gain will be (P^1 -
P0) = $21.00 - $20.00 = $1.00 and the
expected capital gains yield will be
$1.00/$20.00 = 0.05 = 5%.

18. Expected Total Return
 The sum of the expected dividend yield
and the expected capital gains yield.
 Expected total return = r^s = expected
dividend yield (D1 /P0 ) plus expected
capital gains yield f(P^1-P0)/P0.
 In our example, the expected total
return = 5% + 5% = 10%.

19. Dividend Discount Model

20. Constant Growth Stocks

21. Zero Growth Stock
 Zero Growth Stock
 A common stock whose future
dividends are not expected to grow at
all; that is, g= 0.

22. Problem (Solution on next
slide)
 Firm A is expected to pay a dividend of
$1.00 at the end of the year. The
required rate of return is rs = 11%.
Other things held constant, what would
the stock’s price be if the growth rate
was 5%? What if g was 0%?
 ($16.67, $9.09)

23. Solution

24. Preferred Stock
 Preferred Stock
 A preferred stock entitles its owners to
regular, fixed dividend payments. If the
payments last forever, the issue is a
perpetuity whose value, Vp, is found as
follows:

25. PREFERRED STOCK VALUATION
Full Solution on next slide
 Example Question
 Earley Corporation issued perpetual preferred stock with
an 8% annual dividend. The stock currently yields 7%,
and its par value is $100. a. What is the stock’s value?
 we can solve for the expected rate of return on preferred
stock as follows:
 Dividend= 0.08* 100= 8$
 Rearrange the formula to find Vp
 Vp= 8/0.07= 114.28 Ans

26. Solution

27. PREFERRED STOCK RETURNS
Solution on Next Slide
 Example Question
 Avondale Aeronautics has perpetual
preferred stock outstanding with a par
value of $100. The stock pays a
quarterly dividend of $1.00 and its
current price is $45. What is its nominal
annual rate of return?
 rp = Dp/ Vp

28. Solution

29. Homework
 CONSTANT GROWTH STOCK VALUATION
Fletcher Company’s current stock price
is $36.00, its last dividend was $2.40,
and its required rate of return is 12%. If
dividends are expected to grow at a
constant rate, g, in the future, and if rs
is expected to remain at 12%, what is
Fletcher’s expected stock price 5 years
from now?

30. Remaining Solution on Next Slide

32. Homework
 CONSTANT GROWTH VALUATION
 Holtzman Clothiers’s stock currently
sells for $38.00 a share. It just paid a
dividend of $2.00 a share (i.e., D0 =
$2.00). The dividend is expected to
grow at a constant rate of 5% a year.
What stock price is expected 1 year
from now? What is the required rate of
return?

33. Solution (Part 1)

34. Solution (Part 2)

35. Solution (Part 3)

36. Short Solution without
explanation

37. Homework
 CONSTANT GROWTH VALUATION
 Tresnan Brothers is expected to pay a
$1.80 per share dividend at the end of
the year (i.e., D1 = $1.80). The dividend
is expected to grow at a constant rate
of 4% a year. The required rate of return
on the stock, rs , is 10%. What is the
stock’s current value per share?

38. Solution

39. Valuing Non-constant Growth
Stocks
 For many companies, it is not appropriate to
assume that dividends will grow at a constant rate.
 Indeed, most firms go through life cycles where
they experience different growth rates during
different parts of the cycle.
 In their early years, most firms grow much faster
than the economy as a whole; then they match the
economy’s growth; and finally they grow at a
slower rate than the economy.
 Microsoft & Google

40. Valuing Non-constant Growth
Stocks

45. Thank You