TOPIC 3:

STOCK VALUATION
1. To provide overview of Malaysian stock
market
2. To identify the basic features of preferred
stock
3. To calculate the value of preferred stock
4. To identify the basic features of common
stock
5. To calculate the value of common stock
6. To calculate a stock’s expected rate of return

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 At various stages of a company’s lifecycle, there is need to obtain
capital.
 In order to obtain capital, a company may either borrow money
from outside sources (debt financing), sell shares of stock of the
company (equity financing) or use its retained earnings.
 However, large volume of capital raise occurs mostly in the
capital market (i.e. debt financing and equity financing).
 A Capital market is the platform where the long-term financial
securities are traded between the individuals and the institutions.
 In other words, financial institutions sell long-term securities in
capital markets to raise funds.
 This market is composed of both primary and secondary markets.

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 Basically, there are four primary methods that companies can use
to raise funds in the capital market as discussed below:
1) Borrowing: Companies raise short term capital by getting loans
from banks or other financial institutions.

2) Issuance of Bonds: Bonds are long term debt securities used by

companies to borrow money from a wide variety of investors.
 When a company raises fund by issuing bond, the company

generally promises to make regular interests payments at a

specified dates and to repay the original amount borrowed at the
end of maturity period of the bond.
 In other words, the bondholders receive interest from the bond

issuing company at a fixed rate and specified dates.

 Moreover, the bondholders have the opportunity to sell their bonds

to someone else before the maturity period of the bond.

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3) Issuance of preferred stock: A company can issue preferred
stocks to raise capital.
Preferred stock is a hybrid security that possesses some of the

features of bond and common stock.

Preferred stockholders receive a stated cash dividend from the

issuing company.

4) Issuance of common stock: A company can also raise capital by

issuing common stock.
Common stock is a type of security/instrument that represents

equity ownership in a company.

In other words, the investors who purchase the shares of common

stock of a company become the owners of the company.

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 Bursa Malaysia (formerly known as KLSE) is the
Malaysian stock exchange that provides venue where
trading of stocks and shares can take place.
 It is a self-regulatory organization and responsible for
surveillance of marketplace.
 It governs and controls its members and member
companies in security dealings.
 Bursa Malaysia is divided into two (02) markets where
companies can be listed for security dealings:
1. Main market: It is usually reserved for larger, more
established companies.
2. ACE (Access, Certainty, Efficiency) market: It is
seen as the ideal market for start-ups and new
companies.
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Preferred stock is a long-term financial instrument that
can be used to raise fund in the capital market.

Preferred stocks are also known as preferred shares or

preference shares.

It possesses the characteristics/features of both bond

and commons stock.

 Preferred stock provides a fixed dividend, either stated

as a dollar amount or as a percentage of the preferred
stock’s par value (like a bond).

Preferred stock has no fixed maturity date (like a

common stock).
 Preferred stock generally does not carry voting rights

Dividends of preferred stock

• Preferred dividend must be paid before paying
dividends to common stockholders.

• Payment of preferred dividends is not a liability of

the firm.

• Preferred dividends can be deferred indefinitely.

• In most of the cases, preferred dividends are

cumulative – any missed preferred dividends have to
be paid before common stock dividends can be
paid.
 Max Electronics Ltd. wants to offer some preferred
stocks that pay an annual dividend of $2.00 per share.
The company has determined that stocks with similar
characteristics provide a 9 percent rate of return.
Calculate the price of this preferred stock.

 Solution:

Vps = D/k
= $2.00/0.09 = $22.22
The preferred stockholder’s expected rate of
return can be computed as follows:
kps = D/Vps

Where, kps = expected rate of return of preferred stock

D = Annual dividend
Vps = Market Price of preferred stock

Note: When the expected rate of return (kps) is greater

than the required rate of return (k), i.e.

kps > k

You should buy the stock

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Example:
Suppose you are planning to buy the preferred stock of ABC
Company. The price of the stock is $40, and the preferred
dividend is $4.125.
a) What is your expected rate of return?
b) If your required rate of return is 11%, should you buy the
preferred stock?

Solution:
a) kps = D/Vps

= $4.125 / $40 = 0.1031 = 10.31%

b) We shouldn’t buy the stock because the expected rate

of return (10.31%) is lower than the required rate of return
(11%).

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1) Calculate the expected return of preferred stocks that
a) Pay dividend $1.25 per share & currently sold for
$35.15
b) Currently sold for $48.50 per share and pay
dividend of $4.25 per share.

2) RBC’s preferred stock currently sells for $55.50 per

share and pays dividends of $2.50 per share.
a) If you buy the RBC’s preferred stock, What is
your expected rate of return?
b) If your required rate of return is 4%, should you
buy the stock?
3. Resnor Inc., has an issue of preferred stock outstanding
that pays a $5.50 dividend every year in perpetuity. The
stock currently sells for $108 per share.

a) what is the expected return of the preferred stock?

b) Suppose the stock is expected to pay a $0.50 dividend

every quarter and the required rate of return is 10% with
quarterly compounding. Calculate the price of this
preferred stock.
 Common stock is a long-term financial instrument that
provides ownership rights on a company.

 In other words, common stockholders are the owners of

the issuing company.

 Common stock provides dividend (either in cash or

stock) to its holders.

 Common stock does not have a fixed maturity date but

exists as long as the firm does.
• Dividends are not a liability of the firm until a
dividend has been declared by the Board of
Directors (BoD) of the firm.
• Consequently, a firm cannot go bankrupt for not

declaring dividends.
• Dividend payments are not considered a business

expense; therefore, they are not tax deductible.

• The taxation of dividends received by individuals

varies across countries.

• Dividends received by corporations have a
minimum 70% exclusion from taxable income.
• Voting Rights
• Proxy voting
• Classes of stock
• Other Rights
• Share proportionally in declared
dividends
• Share proportionally in remaining
assets during liquidation
• Preemptive right – first shot at new
stock issue to maintain proportional
ownership if desired

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Earnings of common stock:
1. Dividend Income: dividends paid by the
company on a regular basis.
2. Capital gain (or loss) income: income earned by
selling the shares to another people in the market
or selling back to the company.

• Therefore, the price of the common stock is the

present value of these expected cash flows in the
future.
• In fact, the price of the common stock is the
present value of all expected future dividends.

8-18
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Common Stock Valuation Models
The following models are frequently used in

pricing the common stock:

Single-holding period

Multiple-holdingperiod
1. Zero-growth/Constant dividend model
2. Constant growth model
3. Non-constant growth/ Supernormal growth
Model
Suppose you are planning to buy the common stock issued
by XYZ company ltd. You expect XYZ’s stock to pay a $5.50 dividend at the
end of the year. The stock price is expected to be $120 at that time. If you
require a 15% rate of return, what would you pay for the stock now?

Solution:
Suppose you are thinking of purchasing the stock
of Moore Oil, Inc. and you expect it to pay a $2
dividend after one year and you believe that you
can sell the stock for $14 at that time. If you
require a return of 20% on investments of this
kind of security, what is the maximum you
would be willing to pay?
 Multiple-holding period

Zero-growth/Constant dividend model

 The firm will pay a constant/fixed amount of dividend
per year forever.
 This is like preferred stock.
 The price of common stock is computed using the
perpetuity formula.

The value of common stock can be computed by

applying the following equation:
Vcs = D/k
Where,
Vcs = market value/ price of the common stock
D = annual dividend
k = required rate of return
Zero-growth/Constant dividend model

Example:
Max Electronics Ltd. has issued some common stocks
that pay an annual dividend of $0.50 per share. The
company has determined that stocks with similar
characteristics provide a 10 percent rate of return.
Calculate the price of this common stock.

Solution:

Vcs = D/k = $0.50/ 0.10 = $5.00

Constant growth model
 The firm will increase the dividend by a constant/fixed
percent in every period.
 The price of common stock is computed using the
growing perpetuity model

The value of common stock can be computed by applying

the following equation:
Vcs = DO (1+g)/(k-g) = D1/(k-g)
Where,
Vcs = market value/ price of the common stock
DO = dividend at the end of period 0
D1 = dividend at the end of period 1
k = required rate of return
g = the constant growth rate in annual dividend
Constant growth model

Example:
XYZ Inc., just paid a dividend of $0.50 per share of common
stock. 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 be the price of the common stock?

Solution:
Vcs = DO (1+g)/(k-g) = D1/(k-g)

= 0.50 (1+ 0.02)/(0.15- 0.02)

= 0.51/ 0.13 = $3.92

Valuation of Common Stock (cont.)
Constant growth model
Exercise
1. XYZ stock recently paid a $5.00 dividend. The dividend is
expected to grow at 10% per year. What would you be
willing to pay if your required return on XYZ stock is 15%?
Solution:
Vcs = DO (1+g)/(k-g)

= 5 (1+ 0.10)/(0.15- 0.10)

= 5.5/ 0.05 = $110

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2. Header Bhd. paid a RM3.50 dividend last year. At a constant
growth rate of 5 percent, what is the value of the common
stock if the investors require a 20 percent rate of return?

3. Suppose Big D Inc., just paid a dividend of $0.50 per share. 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 stock be selling for?
4. Gordon Growth Company is expected to pay a
dividend of $4 next year, and dividends are
expected to grow at 6% per year. The required
return is 16%. What is the current price of the
company’s stock?

5. TB Pirates Inc., is expected to pay a $2 dividend

in one year. The dividend is expected to grow at
5% per year and the required return is 20%. What
is the current price of the company’s stock
Non-constant growth/ Supernormal growth Model
 Dividends grow at non-constant rate ever year
 Dividend growth is not consistent initially, but settles down to
constant growth eventually
 The price is computed using a multistage model

The value of common stock can be computed by applying the

following equation:

Vcs = D1/(1+ k)1+ D2/(1+ k)2 + D3/(1+ k)3+------+ Dn/(1+ k)n

+ Pn/(1+ k)n
Where,
Vcs = market value/ price of the common stock
D1, D2, D3 -----Dn = dividend at the end of period 1, 2, 3----
n
k = required rate of return
Pn = Price of the stock at the end of non-constant growth
period
Non-constant growth/ Supernormal growth Model
Steps in calculation of price of common stock:
a) Calculate the dividends at the non-constant growth period
(i.e. D1, D2, D3, ------ Dn)
D1 = D0 (1 + g)1
D2 = D0 (1 + g)2
D3 = D0 (1 + g)3
- -
Dn = D0 (1 + g)n

b) Calculate the price of the stock at the end of non-constant

growth period (i.e. Pn )
Pn = Dn+1 / (k – g)
c) Calculate the PV of (a) & (b) to find the value of the stock (i.e. Vcs)

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Supposed a company is experiencing a supernormal
growth rate in cash dividends of 25% for each of the
next 4 years. After that, the dividend growth rate is
expected to be 5% per year forever. The latest annual
dividend is $0.75. The required return is 22%. How
much does the company’s stock worth?

Solution:
Vcs = D1/(1+ k)1+ D2/(1+ k)2 + D3/(1+ k)3+------+ Dn/(1+ k)n
+ Pn/(1+ k)n
 a) Calculation of dividends at the non-constant
growth period (i.e. D1, D2, D3, ------ Dn)

D1 = D0 (1 + g)1 = 0.75 (1 + 0.25)1 = 0.75 (1.25)1 = 0.938

D2 = D0 (1 + g)2 = 0.75 (1 + 0.25)2 = 0.75 (1.25)2 = 1.172
D3 = D0 (1 + g)3 = 0.75 (1 + 0.25)3 = 0.75 (1.25)3 = 1.465
D4 = D0 (1 + g)4 = 0.75 (1 + 0.25)4 = 0.75 (1.25)4 = 1.831
b) Calculation of price of the stock at the end of non-
constant growth period (i.e. Pn )

Pn = Dn+1 / (k – g)
P4 = D5/(k – g) = D4 (1 + g)1 / (k – g)
=1.831(1+0.05)1/(0.22–0.05)=$11.312 33
c) Calculation of PV of (a) & (b) to find the value of
the stock (Vcs)

Vcs = D1/(1+ k)1 + D2 /(1+ k)2 + D3/(1+ k)3+ D4/(1+ k)4

+ P4/(1+ k)4

Vcs = 0.938/(1.22)1 + 1.172/(1.22)2 +1.465/(1.22)3

+1.831/(1.22)4 + 11.312/(1.22)4

= $8.93

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By applying the Constant Growth Model, we can compute
required return, dividend yield and capital gains yield
as follows:
Vcs = DO (1+g)/(k-g) = D1/(k-g)
By modifying the above equation, we can calculate the
required return:
k = [DO (1+g)/Vcs] +g = [D1/Vcs] +g

Dividend yield = DO (1+g)/Vcs = D1/Vcs

Capital gains yield = g

Suppose a firm’s stock is selling for $10.50. It just paid
a $1 dividend, and dividends are expected to grow at
5% per year. What is the required return, dividend yield
and capital gains yield of the stock?

Solution: The required return:

k = [DO (1+g)/Vcs] +g = [1(1.05)/10.50] + 0.05 = 15%

Dividend yield = DO (1+g)/Vcs = 1(1.05) / 10.50 = 10%

Capital gains yield = g = 5%

Expected Rate of Return of Common Stock
The common stockholder’s expected rate of return
can be computed as follows:

where
D1 = dividend in year 1
D1 Vcs = Market price of the
kcs = ( )+ g stock
Vcs g = growth rate in dividend
Note: When the expected rate of return (kcs) is greater than
the required rate of return (k), i.e.

kcs > k
You should buy the stock

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Sunrise Corporation’s stock paid a dividend of $4 at the
end of last year and is expected to increase each year at
a 5% growth rate. The stock is currently selling for $75.
Compute the expected rate of return of the stock.

Solution:

kcs = $ 4 x (1 + .05) + 0.05

$ 75
= 0.056 + 0.05 = 0.106 = 10.6%
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Thank You For Your Attention !!!