• P0 = .50(1+.02) / (.15 - .02) = $3.92
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A Word About Dividends in the Constant Growth Model
• It is critical to understand that in the constant growth model calculations are baCompute stock prices using the dividend growth model • Understand how growth opportunities affect stock values • Appreciate the PE ratio • Know how stock markets work
D 2 iD v 1 (1 i g v ) D 0 (1 i g v )2
D 3 iD v 2 (1 i ...g v ) D 0 (1 i g v )3 Since future cash flows grow at a constant rate forever,
the value of a constant growth stock is the present value
Chapter 6
Stock Valuation
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CMocpGyraigwh-tH©ill2/I0r1w1inby The McGraw-Hill Companies, Inc. All rights reserved.
Key Concepts and Skills
• Comprehend that stock prices depend on future dividends and dividend growth
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Chapter Outline
6.1 The Present Value of Common Stocks 6.2 Estimates of Parameters in the Dividend
Discount Model 6.3 Growth Opportunities 6.4 Price-Earnings Ratio 6.5 Some Features of Common and Preferred
• If a situation only provides information on the last dividend it must be increased by the growth rate to arrive at the next dividend
• The market rate of return is 8.5%.
• What is the maximum amount you should be willing pay for a common share of Big Deal Corporation?
• Formula for Zero Growth Model: P = Div / R
• Assume that dividends will remain at the same level
forever
D1iv D2i v D3i v
• Since future cash flows are constant, the value of a zero growth stock is the present value of a perpetuity:
P0 (1DRiv1)1 (1DRiv2)2 (1DRiv3)3 Div
P0 R
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Zero Growth Example
• Suppose Big Deal Company will pay an annual dividend of $2.00 per common share that will never increase or decrease.
Stock 6.6 The Stock Markets
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6.1 The PV of Common Stocks
• The value of any asset is the present value of its expected future cash flows.
• Stock ownership produces cash flows from:
• Dividends • Capital Gains
• Valuation of Different Types of Stocks
• Zero Growth • Constant Growth • Differential Growth
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Case 1: Zero Growth
of a growing perpetuity:
P0
Div 1 Rg
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Constant Growth Example
• Suppose Big D, Inc., just paid a dividend of $.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 level, how much should the stock be selling for?
• Solution: P = $2.00 / .085 P = $23.53
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Case 2: Constant Growth
Assume that dividends will grow at a constant rate, g, forever, i.e.,
D1i vD0i(1 vg)