Week 1A

Advanced Portfolio Management
Review of Stock Valuation

S&P 500 Index Historical Returns
Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved
Common Stock
• Represents ownership
• Ownership implies control
• Stockholders elect directors
• Directors elect management
Cash Flows for Stockholders
• If you buy a share of stock, you can receive cash
in two ways:
 The company pays dividends
 You sell your shares
• As with bonds, the price of the stock is the

present value of these expected cash flows
How should we value stocks?
• So many different factors!
• Look into the future?
• What are we doing again?
Discounted Dividend Model
• Value of a stock is the present value of the
future dividends expected to be generated
by the stock.
D1 D2 D3 D∞
P̂0 = + + + ... +
(1 + rs )1 (1 + rs )2 (1 + rs )3 (1 + rs )∞
• For common stocks, the future cash flows

(dividends) are highly uncertain.
9-7
What if g = 0?---Zero Growth

If ABC corp. has a policy of paying a $2 per share
dividend every year, what is the stock price if discount
rate is 13%?
The dividend stream would be a perpetuity.
0 rs = 13% 1 2 3……
2.00 2.00 2.00
PMT $2.00
P̂0 = = = $15.38
r 0.13
Constant Growth Stock
• A stock whose dividends are expected to grow
forever at a constant rate, g.
D1 = D0(1 + g)1
D2 = D0(1 + g)2
Dt = D0(1 + g)t
• If g is constant, the discounted dividend formula

converges to:
D0 (1 + g) D1
P̂0 = =
rs − g rs − g
Dividend Streams
D0 = $2 and g is a constant 6%.
0 g = 6% 1 2 3……
2.12 2.247 2.382

rs = 13%
Stock’s Value
• Using the constant growth model:
D1 $2.12
P̂0 = =
rs − g 0.13 − 0.06
$2.12
=
0.07
= $30.29
What is P1?
• What is the stock’s expected value, one year from
now?
• D1 will have been paid out already. So, expected P1 is
the present value (as of Year 1) of D2, D3, D4, etc.
D2 $2.247
P̂1 = =
rs − g 0.13 − 0.06
= $32.10
Dividend Yield & Capital Gains
Yield
• Dividend yield
= D1/P0 = $2.12/$30.29 = 7.0%
• Capital gains yield

= (P1 – P0)/P0
= ($32.10 – $30.29)/$30.29 = 6.0%
• Total return (rs)

= Dividend yield + Capital gains yield
= 7.0% + 6.0% = 13.0%
Supernormal Growth Stocks
• Challenge Problem
• NEU Manufacturing is expected to pay a dividend of $1.25 per share at the end of the year
(D1 = $1.25). The stock sells for $32.50 per share, and its required rate of return is 10.5%.
The dividend is expected to grow at some constant rate, g, forever. What is the equilibrium
expected growth rate?
a. 6.01%
b. 6.17%
c. 6.33%
d. 6.49%
e. 6.65%
Expected dividend (D1) $1.25

• Solution: Stock price $32.50
Required return 10.5%
Dividend yield 3.85%
Growth rate = rs − D1/P0 = 6.65%
Supernormal Growth Stocks
• What if g = 30% for 3 years before achieving
long-run growth of 6%?
―Can no longer use just the constant growth model
to find stock value.
―However, the growth does become constant after
3 years.
9-15
Non-constant Growth Stocks

D0 = $2.00.
0 rs = 13% 1 2 3 4
g = 30% g = 30% g = 30% g = 6%

2.600 3.380 4.394 4.65
2.301 8
2.647
3.045
46.114
4.658
P̂3 = = $66.54
54.107 = P̂0 0.13 − 0.06
Supernormal
• Challenge Problem Growth Stocks
• Supergrowth Inc. is presently enjoying relatively high growth because of a surge in
the demand for its new product. Management expects earnings and dividends to grow
at a rate of 25% for the next 4 years, after which competition will probably reduce the
growth rate in earnings and dividends to zero, i.e., g = 0. The company's last dividend,
D0, was $1.25, its required rate of return for equity is 9.60%. What is the current
price of the common stock? RATIONALE:
a. $26.77 Last dividend (D0) $1.25

b. $27.89
Short-run growth rate 25%
c. $29.05
d. $30.21
Long-run growth rate 0%
e. $31.42
• Solution:
Year 0 1 2 3 4
25% 25% 25% 25% 0%
Dividend $1.25 $1.56 $1.95 $2.44 $3.05 $3.0
00 25 31 14 18 1
Horizon value = D5/(rs − g5) = 31.78
91
Total CFs $1.56 $1.95 $2.44 $34.8
25 31 14 409
PV of the CFs $1.42 $1.62 $1.85 $24.1
56 60 44 461Price
Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved =
Sum
Preferred Stock
• Hybrid security.
• Like bonds, preferred stockholders receive a fixed
dividend that must be paid before dividends are
paid to common stockholders.
• However, companies can omit preferred dividend
payments without fear of pushing the firm into
bankruptcy.
Preferred Stock Cont.
• ABC Company’s preferred stock is paying a fixed dividend of
$25 every year, starting one year from now, and the required
rate of return is 10%, what is the price of the preferred stock?
25
P̂0 = =250
0.1
Other Stock Valuation Models
• Discounted Cash Flow Model
Reason: many firms do not pay dividends
• Comparables Model
Reason: many firms do not pay dividends, nor
do they have positive cash flow.
• Gut feeling and experience
Discounted Cash Flow Model
• Also called the free cash flow method. Suggests the
value of the entire firm equals the present value of
the firm’s free cash flows.
• Remember, free cash flow is the firm’s after-tax
operating income less the net capital investment.
Depr. and   Capital

FCF = EBIT(1 − T) + − + ∆ NOWC
 amortization expenditures 
Applying the Discounted Cash Flow Model
• Find the market value (MV) of the firm, by finding the
PV of the firm’s future FCFs.
• Subtract MV of firm’s debt and preferred stock to get
MV of common stock.
• Divide MV of common stock by the number of shares
outstanding to get intrinsic stock price (value).
Use the Discounted Cash Flow Model to Find
the Firm’s Intrinsic Value
Given: Long-Run gFCF = 6% and WACC = 10%
0 r = 10% 1 2 3 4
g=
-5 10 20 6% 21.2
0
-4.545
8.264
15.026
21.20
398.197 530 = = HV3
0.10 − 0.06
416.942
What is the firm’s intrinsic value per
share?
The firm has $40 million total in debt and

preferred stock and has 10 million shares of
common stock.
MV of equity = MV of firm − MV of debt and preferred
= $416.94 − $40
= $376.94 million
Value per share = MV of equity/# of shares

= $376.94 /10
= $37.69

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Advanced Portfolio Management

Review of Stock Valuation

• As with bonds, the price of the stock is the

• Look into the future?

• What are we doing again?

• For common stocks, the future cash flows

What if g = 0?---Zero Growth

2.00 2.00 2.00

• If g is constant, the discounted dividend formula

D0 = $2 and g is a constant 6%.

2.12 2.247 2.382

• Capital gains yield

• Total return (rs)

Expected dividend (D1) $1.25

Non-constant Growth Stocks

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

a. $26.77 Last dividend (D0) $1.25

Depr. and   Capital

The firm has $40 million total in debt and

Value per share = MV of equity/# of shares

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