Stock and Bond Valuation

Part 1 Introduction to Financial Management Part 4 Capital Structure and Dividend Policy
(Chapters 1, 2, 3, 4) (Chapters 15, 16)
Part 2 Valuation of Financial Assets Part 5 Liquidity Management and Special Topics
(Chapters 5, 6, 7, 8, 9, 10) in Finance (Chapters 17, 18, 19, 20)
Part 3 Capital Budgeting (Chapters 11, 12, 13, 14)

10C H A P T E R
Stock Valuation
Chapter Outline
10.1 Common Stock Objective 1. Identify the basic characteristics and
features of common stock and use the discounted
(pgs. 334–343)
cash flow model to value common shares.
10.2 The Comparables Approach Objective 2. Use the price/earnings (P/E) ratio to
value common stock.
to Valuing Common Stock
(pgs. 343–347)
10.3 Preferred Stock Objective 3. Identify the basic characteristics and

features of preferred stock and value preferred
(pgs. 347–352) shares.
332
M10_TITM2189_13_GE_C10.indd 332 18/05/17 12:44 PM

Principles P 1, P 2, P 3, P 4, and P 5 Applied
The determinants of stock valuation reflect the first three comes into play. The fundamental implication of P Principle 4:
principles of finance: P Principle 1: Money Has a Time Market Prices Reflect Information is that market prices
Value, P Principle 2: There Is a Risk-Reward Tradeoff, and are usually pretty good reflections of the value of the under-
P Principle 3: Cash Flows Are the Source of Value. We ap- lying shares of stock. In addition, P Principle 5: Individuals
ply these principles to the valuation of a firm’s common Respond to Incentives takes on importance because managers
and preferred stock in this chapter following the same basic respond to incentives in their contracts, and if these incentives
procedure we used to value a firm’s bonds in Chapter 9. And are not properly aligned with those of the firm’s shareholders,
because stock is typically sold in public markets where many managers may not make decisions consistent with increasing
investors are actively looking for under- and overpriced shareholder value.
stock to purchase or sell, the fourth basic principle of finance
If success is having your firm’s name become

a verb, then the founders of Google, Inc.
(GOOG), Sergey Brin and Larry Page, have
reached the very pinnacle of success. If you
want to learn more about something, what
do you do? Go to an encyclopedia? No, you
google it. If you’re writing a paper for a class,
you google the topic; if you’re buying a prod-
uct, you google it to find which brand is best;
and, if you’re considering a new doctor, you
may even google him or her.
In August of 2015, Google reorga-
nized, creating a holding company named
Alphabet with a number of subsidiary
companies, the largest of which is Google.
By almost any criterion, Google, as Alphabet, Inc., was originally called, is a phenomenal success story. But
Google’s early years were actually much like the early years of any start-up company.
In early 2004, Google’s board of directors deliberated over how to translate their firm’s success into money.
The answer came with their decision to sell some of Google’s stock to the public. They decided to auction off
about 20 million shares of Google’s common stock for between $108 and $135 per share. The offering was a
great success; the stock price doubled within the next year and then doubled again the following year.
However, the value of Google’s stock has fluctuated substantially since then. For example, in late 2007 it reached a
high of over $700 per share and then fell to less than half of that amount within a year, but by 2013, it had recovered and
set a new all-time high, closing above $800. Then by early 2016, in the year following its conversion to Alphabet, it overtook
Apple as the most valuable U.S. company. Any investor considering the purchase of shares of Alphabet, Apple, or any other
company would want to understand the fundamental determinants of its value. As we will discuss in this chapter, that value
is determined by the time value of money, the risk-reward tradeoff, and the value of expected cash flows.
We begin with an examination of the characteristics of common stock followed by a look at its valuation.
Here we not only consider the discounted cash flow method to value a firm’s stock but also look at some com-
mon market-based ratios, such as the price/earnings ratio, used to value common stock. We then move on to an
examination of the characteristics and valuation of preferred stock. Finally, we conclude with a discussion of the
various stock markets, where the shares of stock are traded after they are issued.
333
M10_TITM2189_13_GE_C10.indd 333 18/05/17 12:44 PM

334 PART 2 | Valuation of Financial Assets
Regardless of Your Major…
“
Getting Your Are you interested in starting your own busi-
ness? If you are, then you are probably aware
Fair Share” that you share this dream with millions of col-
lege students who are majoring in almost every
conceivable area of study. If you start a company that becomes a success, at some point you will
want to know the value of your ownership interest, and to determine that, you will need to know
how equity securities are valued in the financial markets. For example, when Larry and Sergey
were just getting started, they needed money to expand. Fortunately, one of their professors
linked them up with one of the founders of Sun Microsystems, Andy Bechtolsheim. After a short
demonstration in Larry’s dorm room, Andy was impressed with the potential and handed them a
check for $100,000—after which Larry and Sergey immediately filed incorporation papers so they
could cash the check made out to Google. But how did Larry and Sergey decide how much of
Google an investment of $100,000 would buy? Should $100,000 buy 10 percent of the business?
Is this is a fair price? To answer these questions, you need to know the value of Google, and to
determine that, you need to know something about finance and equity valuation.
Your Turn: See Study Question 10–1.
10.1 Common Stock

As you learned in Chapter 2, common stock represents ownership of the corporation, so the
common stockholders are the owners of the firm. They elect the firm’s board of directors,
who, in turn, appoint the firm’s top management team. The firm’s management team then
carries out the day-to-day management of the firm.
Characteristics of Common Stock

Common stock does not have a maturity date but exists as long as the firm does. Nor does
common stock have an upper or lower limit on its dividend payments. In the event of bank-
ruptcy, the common stockholders—as owners of the corporation—have the most junior claim,
which means that they are not entitled to the assets of the firm until the firm’s debt holders and
preferred shareholders have been fully paid.
As we learned in Chapter 2, new securities trade in the primary market, whereas previ-
ously issued securities trade in the secondary market. In other words, if you bought 100 shares
of Google (GOOG) stock during its initial public offering (IPO)—that is, the first time a
company issues stock to the public—you bought them in the primary market but will have to
sell them on the secondary market. When you sell them, the proceeds will go to you, the seller
of the stock, not to Google. In fact, the only time Google ever receives money from the sale
of one of its securities is when it is sold in the primary market.
Claim on Income
As the owners of the corporation, the common shareholders have the right to the firm’s
income that remains after bondholders and preferred stockholders have been paid. The com-
mon shareholders will either receive cash payments in the form of dividends or, if the firm’s
management reinvests its earnings back into the firm, reap any increase in value that results
from the reinvested earnings. As we will see in Chapter 16, many times firms return money to
their shareholders through stock repurchases or stock buybacks, where the firm uses its cash
to repurchase some of its stock, and as a result, every remaining shareholder owns a larger
portion of the company.
The right to residual income has both advantages and disadvantages for the common
stockholder. The main advantage is that the potential return is unlimited. Once the claims of
M10_TITM2189_13_GE_C10.indd 334 18/05/17 12:44 PM

CHAPTER 10 | Stock Valuation 335
There is no question that individuals are influenced by what

other individuals are doing. Back in the 1950s, Solomon Asch
conducted a number of studies. In one of them he asked ques-
tions that were clearly false, but because he presented them as
if everyone else had said they were true, the subjects answered
“true.” He referred to this as conformity or peer pressure, but
it is also part of the herd mentality that we see in investors.
There is also evidence that suggests that when individuals hear
that “other investors” are selling or buying stocks, they have a
tendency to do the same. They may ignore their own information
and financial goals and just follow the herd. You want to make
Finance for Life

sure that how you invest reflects the value of stocks and your
financial goals, not what others are doing.
Herd Mentality
Your Turn: See Study Question 10–5.
the more senior securities (bonds and preferred stock) have been satisfied, all the earnings
that remain belong to common stockholders. The disadvantage, of course, is that there may be
little or nothing left after paying the bondholders their principal and interest and paying the
preferred shareholders their dividends.
Claim on Assets
Just as common stock has a residual claim on income, it also has a residual claim on assets in
the case of liquidation. However, the claims of common shareholders get paid only after the
claims of debt holders and preferred stockholders have been satisfied. Unfortunately, when
bankruptcy does occur, the claims of the common shareholders generally go unsatisfied. This
residual claim on assets adds to the risk of common stock. Thus, although common stock has
historically provided a higher return than other securities, averaging about 10 percent com-
pounded annually from 1926 through 2015, the returns are also much riskier.
Voting Rights
The common shareholders elect the board of directors and are in general the only security
holders given a vote. Early in the twentieth century, it was not uncommon for a firm to issue
two classes of common stock that were identical except that only one carried voting rights.
For example, the Great Atlantic and Pacific Tea Company (GAP) had two such classes of
common stock. This practice was virtually eliminated by three developments: (1) the Public
Utility Holding Company Act of 1935, which gave the Securities and Exchange Commission
the power to require that newly issued common stock carry voting rights; (2) the New York
Stock Exchange’s refusal to list common stock without voting privileges; and (3) investor
demand for the inclusion of voting rights. However, with the merger boom of the 1980s, dual
classes of common stock with different voting rights again emerged, this time as a defensive
tactic used to prevent takeovers. Today, for example, Alphabet, Inc. (GOOG and GOOGL),
has three classes of common stock, an arrangement that gives majority control to the firm’s
top three executives.1 Likewise with Facebook (FB), just before the company went public in
2012, it created two classes of shares, and those owned by founder Mark Zuckerberg had far
more voting power than the ones sold to outside shareholders. In fact, at the time of Face-
book’s initial public offering, Zuckerberg owned only 18 percent of the company but had
control of 57 percent of the voting power.
1
Google’s Class A stock has one vote per share, while its Class B stock, owned only by Chief Executive Eric Schmidt
and founders Larry Page and Sergey Brin, has 10 votes per share and its Class C stock has no voting rights.
M10_TITM2189_13_GE_C10.indd 335 18/05/17 12:44 PM

Common shareholders not only have the right to elect the board of directors but also
must approve any change in the corporate charter. A typical charter change might involve the
authorization to issue new stock or perhaps engage in a merger.
Voting for directors and charter changes occurs at the corporation’s annual meeting.
Some shareholders vote in person, but the majority generally vote by proxy. A proxy gives
a designated party the temporary power of attorney to vote for the signee at the corporation’s
annual meeting. The firm’s management generally solicits proxy votes, and if the sharehold-
ers are satisfied with their performance, managers have little problem securing them. How-
ever, in times of financial distress or when management takeovers are being attempted, battles
between rival groups for proxy votes often occur.
Although each share of stock generally carries the same number of votes, the voting
procedure is not always the same from company to company. The two procedures commonly
used are majority and cumulative voting. With majority voting, each share of stock allows
the shareholder one vote, and each position on the board of directors is voted on separately.
Because each member of the board of directors is elected by a simple majority, a majority of
shares has the power to elect the entire board of directors.
With cumulative voting, each share of stock allows the shareholder a number of votes
equal to the number of directors being elected. The shareholder can then cast all of his or
her votes for a single candidate or split them among the various candidates. The advantage
of a cumulative voting procedure is that it gives minority shareholders the power to elect a
director.
Agency Costs and Common Stock

In theory, the common stockholders elect the corporation’s board of directors, and the board
of directors picks the management team. As a result, shareholders effectively control the firm
through their representatives on the board of directors. In reality, the system frequently works
the other way around. Shareholders are offered a slate of nominees selected by management
from which to choose a board of directors. The end result is that management effectively selects
the directors, who then may have more allegiance to the managers than to the shareholders.
This, in turn, sets up the potential for the agency problems we discussed earlier in Chapter 1.
Recall from our discussion of P Principle 5: Individuals Respond to Incentives that
even though managers are employees and, as such, owe their loyalty to the firm’s stockholders
(its owners), if their incentives are not properly aligned with those of the firm’s shareholders,
they may put their personal interests ahead of those of the firm’s owners. This is referred to as
the agency problem and is particularly critical in very large corporations that are run by pro-
fessional managers who own only a small percentage of the firm’s shares. When this is the
case, managers are likely to avoid unpleasant tasks, such as reducing the number of employ-
ees; they may take less profitable projects that they personally like while avoiding very risky
projects that may jeopardize their jobs.
The costs associated with the manager-stockholder (owner) agency problem are difficult
to quantify, but, occasionally, we see indirect evidence of its importance. For instance, if
investors feel that the management of a firm has been damaging shareholder value, we will
observe a positive stock price response to the removal of that management team. For example,
on the day following the death of Roy E. Farmer, who had been chairman and president of the
coffee roaster Farmers Brothers (FARM), the firm’s stock price rose about 27 percent. Many
investors felt that Farmer was not an effective CEO and that his decision to hold a huge cash
reserve rather than either using the cash to expand the business or distributing it to the firm’s
stockholders had been harming the shareholders. So with his demise, investors perceived the
chance to change the direction of the firm in ways that would increase its value.
Valuing Common Stock Using the

Discounted Dividend Model
As with bonds, a common stock’s value is equal to the present value of all future cash flows
that the stockholder expects to receive from owning the share of stock. However, in contrast
to bonds, common stock does not offer its owners a promised interest payment, maturity pay-
ment, or dividend. For common stock, the dividend is based on (1) the profitability of the firm
M10_TITM2189_13_GE_C10.indd 336 18/05/17 12:44 PM

and (2) management’s decision as to whether it will pay dividends or retain the firm’s earn-
ings in order to grow the firm.
Thus, dividends will vary with a firm’s profitability and its stage of growth. In a com-
pany’s early years, few, if any, dividends are typically paid because all of the firm’s cash flow
is reinvested to finance the firm’s growth. As the company matures, additional investment
opportunities become less attractive, and the firm will typically begin paying more and more
dividends to the common stockholders.
Because there is no promised dividend, common stock is valued by discounting the divi-
dend stream that the firm is expected to pay to its shareholders. These expected dividends are
discounted back to the present using the investor’s required or expected rate of return, which
is the rate of return that investors expect to receive from an investment of equal risk. We will
refer to this expected rate of return as the investor’s required rate of return.
Three-Step Procedure for Valuing Common Stock

To value common stock, we will use the same three-step procedure we used to value bonds
in Chapter 9.
Step 1. Estimate the amount and timing of the receipt of the future cash flows the common
stock is expected to provide.
Step 2. Evaluate the riskiness of the common stock’s future dividends, and determine the
rate of return an investor would expect to receive from a comparable-risk invest-
ment. The expected return of a comparable investment is the stock’s required rate of
return.
Step 3. Calculate the present value of the expected dividends by discounting them back to
the present at the stock’s required rate of return.
Let’s take a look at these three steps. Each of them relies on one of our basic principles:
Step 1 relies on P Principle 3: Cash Flows Are the Source of Value, step 2 relies on P
Principle 2: There Is a Risk-Return Tradeoff, and step 3 relies on P Principle 1: Money
Has a Time Value. In step 1, we estimate the amount and timing of future cash flows. If you
bought a share of common stock and never sold it, the only cash flow you would ever receive
would be the dividends that the firm paid. Step 2 involves an estimate of the required rate of
return, which was covered in Chapter 8, whereas step 3 involves calculating the present value
of the future cash flows, discounted at the required rate of return. What this all means is that
the value of a common stock is equal to the present value of all future dividends.
Along with the first three principles, the fourth principle comes into play in determin-
ing the value of a share of common stock because stock is typically sold in public markets
where many investors are actively looking for under- and overpriced stock to purchase or
sell. The fundamental implication of P Principle 4: Market Prices Reflect Information
is that market prices are usually pretty good reflections of the value of the underlying
shares of stock.
Basic Concept of the Stock Valuation Model

To illustrate the basic concept of stock valuation, consider a situation in which we are valu-
ing a share of common stock that we plan to hold for only one year. The stock pays a $1.75
dividend at the end of the year and is expected to have a price of $50.00 in one year when we
plan to sell it. If investors require a 15 percent rate of return from investing in the stock, the
value of the stock today is simply the present value of the dividend plus the selling price of
the stock, discounted back one year using a 15 percent rate of return:
Value of Common $1.75 + 50.00
= = $45.00
Stock Today (1 + .15)1
In this instance, the share of stock is worth $45.00 today. Now let’s assume that we decide to
hold the stock for two years, so we receive two annual dividends of $1.75 and then sell the
share of stock for $55.75. What value should we assign to the stock today if we plan on hold-
ing it for two years? We find the answer as follows:
Value of Common $1.75 $1.75 + 55.75
= 1
+ = $45.00
Stock Today (1 + .15) (1 + .15)2
M10_TITM2189_13_GE_C10.indd 337 18/05/17 12:44 PM

In both examples, the value of the share of stock today is equal to the present value of
future dividends plus the selling price of the stock at the end of the holding period. This sell-
ing price is simply the present value of the dividends for all subsequent periods. For example,
based on what we know about this stock, what should the price of the firm’s stock be at the
end of Year 1? The answer is found by discounting the dividend for Year 2 and the price at the
end of Year 2 back one period to the end of Year 1:
Value of Common $1.75 + 55.75
= = $50.00
Stock at Year 1 (1 + .15)1
The important learning point is that the value of a share of common stock can be thought
of as the present value of future dividends where there are an infinite number of years ( ∞ )
over which dividends are received.
Value of Dividend for Year 1 Dividend for Year 2
= 1
+ 2
Common Stock in Year 0 Stockholder’s Stockholder’s
a1 + b a1 + b
Required Rate of Return Required Rate of Return
Dividend for Year 3 Dividend for Year ∞

+ 3
+ g + ∞
Stockholder’s Stockholder’s
a1 + b a1 + b
Valuing a share of common stock using this general discounted cash flow model is made diffi-
cult by virtue of the fact that the analyst has to forecast each of the future dividends. However,
the forecasting problem is greatly simplified if the future dividends are expected to grow at a
fixed or constant rate each year.
The Constant Dividend Growth Rate Model

If the firm’s cash dividends grow by a constant rate each year, then the discounted value of
these growing dividends forms the basis for a common stock valuation model that can be
defined as follows:
Dividend Dividend 1 Dividend Dividend 2

a1 + b a1 + b
Value of Common Paid in Year 0 Growth Rate Paid in Year 0 Growth Rate
= 1
+ 2
Stock in Year 0 Stockholder’s Stockholder’s
a1 + b a1 + b
∞
Dividend Dividend 3 Dividend Dividend
a1 + b a1 + b
Paid in Year 0 Growth Rate Paid in Year 0 Growth Rate
+ 3
+ g + ∞ (10–1)
Stockholder’s Stockholder’s
a1 + b a1 + b
Fortunately, Equation (10–1) can be simplified greatly using the present value of a growing
perpetuity, Equation (6–6), if dividends grow each year at a constant rate, g.
This constant dividend growth rate model of common stock valuation is defined in
Equation (10–2) as follows:
Dividend
Dividend in Year 0 a 1 + b
Value of Common Growth Rate Dividend in Year 1
= = (10–2)
Stock in Year 0 Stockholder’s Required Dividend Stockholder’s Required Dividend
- -
Rate of Return Growth Rate Rate of Return Growth Rate
Figure 10.1 provides a quick reference guide to Equation (10–2).

Although we do not expect a firm’s dividends to grow forever at a constant rate, this model
has value and is used in the real world. A commonly used variant of this model is known as a
three-stage growth model. With a three-stage growth model, rather than assuming a constant
rate forever, a constant rate is assumed for a number of years—perhaps 5 years—after which
the growth rate changes and continues on for a specified number of years—perhaps 10 more
M10_TITM2189_13_GE_C10.indd 338 18/05/17 12:44 PM

Figure 10.1
A Quick Reference Guide for the Constant Dividend Growth Rate Valuation Model
If the rate of growth in common stock dividends is expected to be constant into the indefinite future
and this rate of growth is less than the common stockholder’s required rate of return, the discounted
cash flow valuation model for common stock reduces to the following simple formula:
D0 (1 + g) D1
Vcs = = (10–2)
rcs - g rcs - g
Definitions and Assumptions:

• Vcs = the value of a share of common stock, which is equal to the present value of all
future expected dividends.
• D0 = the most recent annual cash dividend received by the common stockholder that
was paid in the year the valuation is being done (Year 0).
• g = the expected annual rate of growth in the cash dividend payment, which is
assumed to be constant forever.
• D1 = D0 (1 + g) = the expected dividend for the end of Year 1.
• rcs = the common stockholder’s required rate of return for the shares of common stock.
Note that this is not a market’s required yield or promised rate of return but the rate of
return the investor expects to earn from investing in the firm’s stock. This expected rate
of return reflects the riskiness of the stock’s future dividends.
>> END FIGURE 10.1
years—after which it changes again and stays at that final rate forever. The implications of
this more complicated model are the same as those of the simple constant growth model; that
is, the level of dividends, the annual dividend rate of growth, and the common stockholder’s
required rate of return determine the value of the firm’s common stock.
What Causes Stock Prices to Go Up and Down?
We can use the constant dividend growth rate model of stock valuation in Equation (10–2) to
develop a better understanding of what causes stock prices to move up and down.
D0 (1 + g) Dividend in Year 1
Vcs = = (10–2)
rcs - g Stockholder’s Required Growth
-
Rate of Return Rate
There are three variables on the right-hand side of the above stock valuation model that drive
share value, Vcs. These are the most recent dividend (D0), the investor’s required rate of
return (rcs), and the expected rate of growth in future dividends (g). Note that the most recent
dividend has already been paid so it can’t change, and, thus, this variable is not a source of
variation or changes in the stock price. This leaves two variables, rcs and g, that can vary and
lead to changes in stock prices. As a result, to understand what causes stock prices to go up
and down, we need to consider changes in the stockholder’s required rate of return, rcs, and
the growth rate in future dividend payments, g.
Determinants of the Investor’s Required Rate of Return

The investor’s required rate of return is determined by two key factors—the level of inter-
est rates in the economy and the risk of the firm’s stock. In Chapter 8, we used the Capital
Asset Pricing Model (CAPM) to describe the determinants of investor-required rates of
return. Recall that the expected or required rate of return of an investment using the CAPM
was expressed as follows:
Expected Rate Risk@Free Rate Common Stock Expected Rate of Return Risk@Free Rate
= + a - b (8–6)
of Return of Interest Beta Coefficient on the Market Portfolio of Interest
M10_TITM2189_13_GE_C10.indd 339 18/05/17 12:44 PM

Checkpoint 10.1
Valuing Common Stock

Consider the valuation of a share of common stock that paid a $2 dividend at the end of last year and is expected to pay
a cash dividend every year from now to infinity. Each year the dividends are expected to grow at a rate of 10 percent.
Based on an assessment of the riskiness of the common stock, the investor’s required rate of return is 15 percent. What
is the value of this common stock?
STEP 1: Picture the problem

With a growing perpetuity, a timeline doesn’t have an ending point but goes on forever, with the cash flows grow-
ing at a constant rate period after period—in this case, year after year:
i = 15%
Time Period 0 1 2 3 4 5... Years
Cash Flow $2.00 $2.00(1.10) $2.00(1.10)2 $2.00(1.10)3 $2.00(1.10)4 $2.00(1.10)5
Value of common stock = Present

value of expected dividends
The growing dividends

go on forever.
STEP 2: Decide on a solution strategy

Because the value a share of stock can be viewed as the present value of a growing perpetuity, the equation for
the value of a share of stock, which is presented in Equation (10–2), looks exactly like Equation (6–6), the equa-
tion for the value of a growing perpetuity. Because this equation involves only division, there is no need to look
at an Excel solution or any unique keystrokes with a financial calculator.
STEP 3: Solve
In this problem, we must first determine D1, the dividend next period. We know the stock paid a $2 dividend at
the end of last year and that dividends are expected to grow at a rate of 10 percent forever. Because the $2
dividend was paid last period, $2 is D0, and we are looking for D1. Thus,
D1 = D0 (1 + g) = $2 (1.10) = $2.20
Substituting D1 = $2.20, g = .10, and rcs = .15 into Equation (10–2), we get the following result:
$2.20
Vcs = = $44
.15 - .10
Thus, the value of the common stock is $44.
STEP 4: Analyze
As you can see, once we assume that dividends will grow at a constant rate forever, the equation for the value of
a share of stock boils down to just three variables, and one of them, D1, is simply the dividend that already took
place times (1 + g). That means that changes in the dividend growth rate, g, and the required rate of return, rcs,
will push the stock price up and down. Certainly, this is not a perfect formula—after all, we’ve assumed that divi-
dends will grow at a constant rate forever, and that simply isn’t realistic. But it does allow us to boil an unmanage-
able formula down to something pretty simple and as a result see what factors move stock prices up and down.
STEP 5: Check yourself

What is the value of a share of common stock that paid a $6 dividend at the end of last year and is expected to
pay a cash dividend every year from now to infinity, with that dividend growing at a rate of 5 percent per year, if
the investor’s required rate of return is 12 percent on that stock?
ANSWER: $90.
Your Turn: For more practice, do related Study Problem 10–3 at the end of this chapter. >> END Checkpoint 10.1
M10_TITM2189_13_GE_C10.indd 340 18/05/17 12:44 PM

Figure 10.2
A Quick Reference Guide for the Capital Asset Pricing Model
The Capital Asset Pricing Model (CAPM) is deceptively simple. It states that the expected rate of
return on any risky investment can be thought of as the sum of the risk-free rate of interest and a
risk premium. The risk premium, in turn, is determined by the market risk premium for the market
portfolio and the beta coefficient for the investment.
rcs = rf + bcs 3E(rm) - rf 4 (8–6)
Important Definitions and Concepts:
• rcs = the investor’s required rate of return on a firm’s common stock.

• rf = the risk-free rate of interest.
• bcs = the beta of the stock.
• E(rm) - rf = the market risk premium or the difference between the expected rate of
return on the market portfolio, E(rm), and the risk-free rate of interest, rf .
>> END FIGURE 10.2
Figure 10.2 contains a quick reference guide to the CAPM, including definitions for each of
the key terms.
If the risk-free rate rises, perhaps reacting to an increase in anticipated inflation, other
things remaining the same, the investor’s required rate of return will rise, and the stock price
will fall. Similarly, if the systematic risk of a stock increases, then the investor’s required rate
of return will rise accordingly, and, all else remaining the same, the share price will fall.
Determinants of the Growth Rate of Future Dividends

A change in the growth rate of expected future dividends can lead to a change in the stock
price. For example, if Merck (MRK), the large pharmaceutical firm, were to get approval to
market a revolutionary cancer-fighting drug, this would certainly raise investor expectations
regarding the future growth rate in its earnings and dividends, which would, in turn, lead to a
higher price for Merck’s stock.
The key determinants of the future growth of a firm’s earnings relate to the rates of
return the firm expects to earn when it reinvests its earnings (the return on equity, or ROE)
and the proportion of firm’s earnings that it reinvests (retains or does not pay out in cash
dividends), which is known as the retention ratio, b. To better understand this, consider
the case where the ROE the firm expects to earn on reinvested earnings and the proportion
of firm earnings that is retained and reinvested, b, are both assumed to be constant in the
future. The growth rate in the firm’s dividends, g, can then be thought of as simply the prod-
uct of the firm’s ROE and the ratio of the earnings it retains (the retention ratio, b). Because
we will find this formula useful later, it is worthwhile defining the growth rate formally as
follows:
Rate of Growth Retention Rate of Return

= *
in Dividends (g) Ratio (b) on Equity (ROE)
where the retention ratio, b, is equal to one minus the dividend payout ratio (D1/E1):
Rate of Growth Dividend Rate of Return

= ¢1 - ≤ * (10–3)
in Dividends (g) Payout Ratio on Equity (ROE)
Figure 10.3 contains a quick reference guide to Equation (10–3).
M10_TITM2189_13_GE_C10.indd 341 18/05/17 12:44 PM

Figure 10.3
A Quick Reference Guide for the Growth Rate in Earnings and Dividends
The rate of growth a firm can expect in its future dividends is a function of how much of the firm’s
earnings are reinvested in the firm (i.e., the dividend retention ratio, b), and the rate of return the firm
is expected to earn on the reinvested earnings (ROE).
g = (1 - D1 > E1) * ROE (10–3)
• g = the expected annual rate of growth in dividends.

• D1/E1 = the dividend payout ratio, reflecting the ratio of cash dividends to be paid next
period divided by the firm’s earnings.
• b = (1 - D1/E1), which is the proportion of firm earnings or net income that is
retained and reinvested in the firm.
• ROE = the return on equity earned when the firm reinvests a portion of its earnings
back into the firm.
• Equation (10–3) requires that the retention ratio, b, and ROE remain constant for all
future periods.
>> END FIGURE 8.3
We now have the tools of financial analysis to value common stock, assuming that the divi-
dends grow at a constant rate in perpetuity, which are shown as follows.
Tools of Financial Analysis—Common Stock Valuation

Name of Tool Formula What It Tells You
Common stock D1 D2 Dn • The value of a share of stock is
valuation Vcs = + + g + the present value of the expected
(1 + rcs)1 (1 + rcs)2 (1 + rcs)n
dividends discounted using the
D∞
+ g + investor’s required or expected
(1 + rcs) ∞ rate of return.
Common stock Dividend in Year 1 • What the value of a share of stock
valuation, assum- Vcs = would be if dividends grow at a
Required Rate of Return - Dividend Growth Rate
ing constant divi- constant rate in perpetuity and all
dend growth D1 else held constant.
Vcs =
rcs - g • If the required rate of return, rcs,
goes up, the value of the stock
goes down.
• If the growth rate, g, goes up, the
value of the stock climbs.
Investor’s required rcs = rf + b 3E (rm) - rf 4 • A stock’s required rate of return is
rate of return a function of the risk-free rate and a
using the CAPM return to compensate for the risk of
the firm’s stock.
Dividend growth Rate of Growth Retention Rate of Return • An estimation of a company’s
rate = * growth rate to be used in valuing
in Dividends (g) Ratio (b) on Equity (ROE)
the stock.
g = (1 - D1 > E1) * ROE • The growth rate of future dividends
is dependent on (1) the proportion
of the firm’s earnings that are
reinvested and (2) the rate of return
the firm earns on earnings that it
reinvests.
M10_TITM2189_13_GE_C10.indd 342 18/05/17 12:44 PM

Before you move on to 10.2
Concept Check | 10.1

1. What are the attributes of common stock that distinguish it from bonds and preferred stock?
2. What does agency cost mean with respect to the owners of a firm’s common stock?
3. Describe the three-step process for valuing common stock using the discounted dividend model.
10.2 The Comparables Approach to Valuing

Common Stock
The discounted dividend valuation model provides a good framework for estimating the value
of common stock and for understanding what drives stock prices up and down. However, this
approach requires a number of inputs, such as the rate of growth and the discount rate, that
are difficult to estimate, especially for companies like Alphabet (GOOG), eBay (EBAY), and
Amazon.com (AMZN) that do not yet pay cash dividends. For this reason, analysts often use
market comparables or “comps” to estimate firm values. This method estimates the value of
the firm’s stock as a multiple of some measure of firm performance, such as the firm’s earn-
ings per share, book value per share, sales per share, or cash flow per share, where the multiple
is determined by the multiples observed from comparable companies. By far the most com-
mon performance metric is earnings per share, which means that the values are determined
from the price/earnings ratio, or the earnings multiplier, of comparable firms.
Defining the P/E Ratio Valuation Model

Investors regularly use the price/earnings ratio (sometimes referred to as the P/E ratio or
P/E multiple) as a measure of a stock’s relative value. The price/earnings ratio, or earnings
multiplier, is simply the price per share divided by the company’s earnings per share. In effect,
it is a relative value model because it tells the investor how many dollars investors are willing
to pay for each dollar of the company’s earnings. The earnings per share in the denominator
will be either the earnings per share for the most recent four quarters or the expected earnings
per share over the next four quarters.
We write it as
Value of
Appropriate Estimated Earnings P
Common Stock, = a b*a b = * E1 (10–4)
Price/Earnings Ratio per Share for Year 1 E1
Vcs
Figure 10.4 contains a quick reference guide to Equation (10–4).
P/E ratios allow us to express the price of stocks in relative terms—that is, the price per
dollar of earnings—which makes it easier to compare one stock to another. The investor can
decide what an appropriate P/E ratio is for the stock being valued by looking at the P/E ratio
of other stocks and then, based on the anticipated earnings, determine what the price of the
stock should be. As a result, it takes the emphasis off determining the price per share and puts
it on determining a fair P/E ratio.
What Determines the P/E Ratio for a Stock?

How do you determine an appropriate P/E ratio for a specific stock? One obvious answer
would be to look at the P/E ratios of similar stocks.
As a first step, we should look at the P/E ratio for the entire market. The P/E ratio of U.S.
stock market indexes such as the S&P 500 is typically between 15 and 25, depending on the
strength of the economy, the level of interest rates, the size of the federal deficit, and the infla-
tion rate. This overall market P/E ratio can then be adjusted depending on the specific pros-
pects for the individual stock. For example, if the growth potential is above average, we would
adjust the P/E ratio upward—but by how much is the real question. Looking at the P/E ratios
of firms of similar size in the same industry probably provides the most useful information.
M10_TITM2189_13_GE_C10.indd 343 18/05/17 12:45 PM

Figure 10.4
A Quick Reference Guide for the Price/Earnings Stock Valuation Model
The price/earnings stock valuation model is sometimes referred to as a relative valuation model that is
based on comparable-firm valuations. This reflects the fact that the price/earnings ratio used to value
the stock measures value relative to firm earnings and is chosen by looking at comparable firms.
P
Vcs = * E1 (10–4)
E1
• Vcs = the value of the common stock of the firm.

• P/E1 = the price/earnings ratio for the firm based on the current price per share divided
by earnings for the end of Year 1.2
• E1 = the estimated earnings per share of common stock for the end of Year 1.
>> END FIGURE 10.4
P/E ratios can vary widely from stock to stock. For example, at the same time IBM (IBM)
had a P/E ratio of 9, Ford (F) had a ratio of 7, Coca-Cola (COKE) had a ratio of 26, and
Netflix (NFLX) had a ratio of 300—all in all a pretty wide range of P/E ratios! The question
you might ask now is why anyone would pay $300 for every $1 of earnings that Netflix made
but only $7 for every dollar of earnings that Ford made. As we now illustrate, different P/E
ratios arise from differences in the risk and earnings growth expectations of the firms being
compared.
To open our discussion of the determinants of a firm’s P/E ratio, let’s first review the
constant dividend growth model of stock value presented earlier in Equation (10–2):
D0 (1 + g) Dividend in Year 1
Vcs = = (10–2)
rcs - g Stockholder’s Required Growth
-
Rate of Return Rate
Recall that D1 is the dividend expected at the end of the year, rcs is the investor’s required rate
of return, and g is the expected rate of growth in dividends. If we assume that the current mar-
ket price of the firm’s shares (P) is equal to the value of the firm’s shares, Vcs (i.e., the present
value of expected future dividends), we can rewrite Equation (10–2) as follows:
D1
P =
rcs - g
We now have a formula for the price of the firm’s common stock. Let’s divide both sides of
this equation by our estimated earnings per share for next year, E1, to find the P/E ratio, as
follows:
P D1 > E1
= (10–5)
E1 rcs - g
To better understand the determinants of the P/E ratio, we expand Equation (10–5) by sub-
stituting for g. Recall from Equation (10–3) that g = (1 - D1/E1) * ROE, which we now
substitute into Equation (10–5):
P D1 > E1 D1 > E1
= = (10–5a)
E1 rcs - g rcs - 3(1 - D1 > E1) * ROE4
2
echnically, this is the definition of the forward P/E ratio because it uses predicted earnings one year hence. The P/E
T
ratio can also be calculated using the most recent 12-month period’s earnings, or trailing 12 months (TTM), P/ETTM.
For our purposes we will follow the convention of using the end-of-period earnings—that is, the trailing 12 months.
In that way we do not have to rely on forecasts.
M10_TITM2189_13_GE_C10.indd 344 18/05/17 12:45 PM

Checkpoint 10.2
Valuing Common Stock Using the P/E Ratio

The Heels Shoe Company sells a line of athletic shoes for children and young adults, including cleats and other specialty
footwear used for various types of sports. The company is privately owned and is considering the sale of a portion of its
shares to the public. The company’s owners are currently in discussions with an investment banker who has offered to
manage the sale of shares to the public. The critical point of their discussion is the price that Heels might expect to receive
upon the sale of its shares. The investment banker has explained that this price can be estimated by looking at the P/E
multiples of other publicly traded firms that are in the same general business as the Heels Shoe Company and multiply-
ing their average P/E ratio by Heels’ expected earnings per share (EPS) for the coming year. Last year the Heels Shoe
Company had earnings of $1.65 per share for the 12-month period ended in March, 2016. Heels’ CFO estimates that
company earnings for 2017 will be $1.83 a share.
As a preliminary step, the banker has suggested that Heels’ management team consider the P/E multiples of three
companies: Wolverine World Wide (WWW), Nike (NKE), and Steve Madden (SHOO). The current P/E ratios for these firms
are as follows:
P/E Ratio
Wolverine 18.52
Nike 19.75
Steve Madden 16.32
Average 18.20
What is your estimate of the price of Heels’ shares based on the above comparable P/E ratios?
P/E Valuation (2016)

$35 $33.31
30
25
20 18.20
15
10
5
$1.83
0
Earnings per share × P/E multiple 5 Stock price

The P/E valuation method is deceptively easy because the analytics are simple. The estimated price per share is
simply the product of the firm’s estimated earnings per share for the coming year and what the analyst estimates
to be an appropriate P/E ratio. That is, we substitute these values into Equation (10–4):
Vcs = P > E1 * E1 (10–4)
STEP 3: Solve
Substituting into Equation (10–4), we estimate Heels’ share price to be $33.31:
Vcs = P > E1 * E1 = 18.20 * $1.83 = $33.31
(10.2 CONTINUED >> ON NEXT PAGE)
M10_TITM2189_13_GE_C10.indd 345 18/05/17 12:45 PM

STEP 4: Analyze
Based on the P/E ratios of these three comparable firms, we estimate the offering price of Heels’ shares to be
$33.31. However, this estimate is contingent on whether the companies chosen are appropriate comparables
for the Heels Shoe Company. Also, because the sale of a privately held company’s shares to the public can
take several months, this estimate is contingent on no significant changes in the market. For example, if infla-
tion worsens and the country slips into a recession, the P/E multiples of all public companies may fall. For this
reason, the final offering price for a firm’s shares that are being sold to the public is typically set the night before
the offering and reflects the most recent P/E ratios of comparable firms.

After some careful analysis and reflection on the valuation of the Heels’ shares, the company CFO has sug-
gested that the earnings projections are too conservative and that earnings for the coming year could easily jump
to $2.00. What does this do to your estimate of the value of Heels’ shares?
ANSWER: $36.40.
Now we are ready to investigate the determinants of the P/E ratio. Specifically, looking
at Equations (10–5) and (10–5a), we see that there are two fundamental determinants of a
firm’s P/E ratio:
1. Growth Rate in Dividends. The rate of growth in a firm’s dividends is itself determined
by how much of the firm’s earnings are retained and reinvested (i.e., 1 - D1/E1) and by
the rate of return the firm earns when it reinvests those funds (ROE) because the growth
rate equals the product of these two variables.
2. Investor-Required Rate of Return. The firm’s stockholders require that the firm earn
this rate of return, rcs on their investment in the firm’s stock.
Looking at the P/E equation found in Equation (10–5), we can make some quick observa-
tions about the mechanical or mathematical relationships between these variables and the
P/E ratio:
1. The higher the rate of growth in dividends, other things being the same, the higher
the P/E ratio. To see why, look at where g appears in the P/E equation, Equation (10–5a).
It is subtracted in the denominator, so the larger g is, the smaller the denominator is and,
consequently, the higher the P/E ratio is (assuming all else is held constant).
2. The higher the investor’s required rate of return, other things being the same, the
lower the P/E ratio. The required rate of return, rcs, is in the denominator of the P/E
equation, Equation (10–5a), and it has a positive sign. As a result, the higher the required
rate of return, rcs, is, holding all else constant, the lower the P/E ratio will be.
But what causes the growth rate in dividends (and earnings) and the investor’s required
rate of return to go up and down? These are the real determinants of the P/E ratio:
• Firm factors impacting the investor’s required rate of return, rcs. The higher the in-
vestor’s required rate of return, the lower the P/E ratio. If the firm becomes more risky,
rcs will rise, and as a result, the P/E ratio will fall. Likewise, if the firm becomes less risky,
rcs will fall, and as a result, the P/E ratio will rise.
• Economic or macro factors impacting the investor’s required rate of return, rcs. All
P/E ratios are affected by market interest rates and the general level of risk or uncertainty in
the stock market. Higher interest rates and greater uncertainty will increase the investor’s
required rate of return, whereas lower interest rates and less uncertainty will decrease the
investor’s required rate of return. As a result, when interest rates and uncertainty decline,
rcs will decline for all stocks, and as a result, the P/E ratios on all stocks will rise.
• Firm factors impacting the growth rate. The growth rate in firm dividends is itself
determined by two variables—dividend policy and the profitability of the firm’s invest-
ment opportunities.
M10_TITM2189_13_GE_C10.indd 346 18/05/17 12:45 PM

• Dividend policy. Firms that retain and reinvest their earnings put themselves in a posi-
tion where future earnings might grow, whereas firms that pay out all their earnings in
dividends cannot grow.
• Firm investment opportunities. Firm earnings and future dividends can grow only if
the firm’s investment opportunities are good enough to offer growth opportunities. This
occurs when ROE exceeds the investor’s required rate of return, rcs; in that case, the
higher the return on new investments (ROE), the higher the growth rate.
An Aside on Managing for Shareholder Value

If the ROE on a firm’s new investment is exactly equal to the firm’s required rate of return, the
new investment doesn’t add any value, and if that ROE is less than the required rate of return,
the firm may face problems. This is really a commonsense notion. If a company’s investors
require a 20 percent return on their stock and the company makes new investments that have
the same risk as its stock but that earn only 15 percent, the company’s equity investors will not
be pleased, and the stock price will decline. The lesson here is that shareholder value is created
only when the reinvested earnings generate a rate of return higher than the required risk-
adjusted rate of return. This may not sound like rocket science, but you would probably be
surprised to learn just how many managers lose sight of this fundamental fact of business life.
A Word of Caution About P/E Ratios

The P/E ratio is not always calculated using a consistent definition of earnings. Although you
would expect that the measure of earnings would be based on net income calculated using
Generally Accepted Accounting Principles (GAAP), this is not always the case. P/E ratios
are often reported using operating earnings, economic earnings, core earnings, or ongoing
earnings. These earnings numbers tend to be higher than reported net income because they
add back nonrecurring expenses that are labeled “one-time, exceptional, or noncash.” The
rationale for using these alternative earnings numbers is that they provide a clearer picture of
the firm’s long-term earnings potential. The problem is that there isn’t any standard approach
for determining what expenses should be omitted to provide a clearer picture of the firm’s
performance and the performance we might be able to expect to continue in the future.
Before you move on to 10.3

1. If a corporation decides to retain its earnings and reinvest them in the firm, does the market value of the firm’s shares
always increase? Why or why not?
2. What is the price/earnings model of equity valuation?
3. How does a firm’s dividend policy affect the firm’s P/E ratio?
10.3 Preferred Stock

In Chapter 2, we referred to preferred stock as a hybrid security that shares some of the fea-
tures of bonds and common stock. For example, like bonds that pay a contractually set interest
payment, preferred stock has a contractually stated cash dividend that is paid to the preferred
stockholder. Like common stock, and unlike bonds, there is no maturity for a preferred stock
issue. Let’s consider some of the key features of preferred stock that make it unique.
Features of Preferred Stock

In general, the size of the preferred stock dividend is fixed, and it is stated either as a dollar
amount or as a percentage of the preferred stock’s par value. For example, DuPont (DD.PB) has
issued $4.50 preferred stock, meaning that the preferred stock pays $4.50 per year in dividends.
On the other hand, Bank of America (BAC.PH) has 7.25 percent preferred stock outstanding
M10_TITM2189_13_GE_C10.indd 347 18/05/17 12:45 PM

Table 10.1 xamples of Different Pacific Gas & Electric Preferred Stock Issues
E
Outstanding, February 2016
Name Symbol Par Price Dividend Dividend
Value Yield
Pacific Gas & Electric 5% PF PCG.PD $25.00 $25.46 $1.25 4.91%
Pacific Gas & Electric 6% PF PCG.PA $30.00 $30.10 $1.50 4.98%
with a par value of $1,000.00 per share. The annual dividend on the Bank of America preferred
stock is $72.25 (7.25 * $1,000). Keep in mind that preferred stock dividends are fixed; that is,
regardless of how well the firm does, they still pay only their stated dividend. In effect, preferred
stockholders do not share in any improvement in the earnings of the firm.
Multiple Classes
If a company desires, it can issue more than one class of preferred stock, and each class can have
different characteristics. In fact, it is quite common for firms that issue preferred stock to issue
more than one class. For example, Public Storage (PSA) has 12 different classes of preferred stock
outstanding. These classes can be further differentiated in that some are convertible into common
stock and others are not, and some have more seniority—that is, they get paid earlier in the event
of the issuing firm’s bankruptcy. You’ll notice in Table 10.1 that there are listings for two different
classes of preferred stock issued by Pacific Gas & Electric (PCG); each has a different dividend
and is selling for a different price, but both provide approximately the same dividend yield.
Claim on Assets and Income

In the event of bankruptcy, the claims of preferred stockholders have priority over those of
common stockholders, which means that the preferred stockholders must be paid in full before
common stockholders are paid. However, the claims of preferred stockholders have lower
priority than those of the firm’s debt holders. In addition, the firm must pay its preferred stock
dividends before it pays common stock dividends, and most preferred stocks carry a cumula-
tive feature. Cumulative preferred stock requires all past unpaid preferred stock dividends
to be paid before any common stock dividends are declared. Thus, in terms of risk, preferred
stock is safer than common stock but riskier than the firm’s debt.
Preferred Stock as a Hybrid Security

As we noted earlier, preferred stock has characteristics of both common stock and bonds.
First, like common stock, preferred stock has no fixed maturity date. Also like common stock,
the nonpayment of dividends does not bring on bankruptcy, and dividends are not deductible
for tax purposes. On the other hand, like interest payments on debt, preferred stock dividends
are fixed in amount. In addition, although in theory preferred stock does not have a set matu-
rity associated with it, many issues of preferred stock require that money be set aside regularly
to retire the preferred stock issue, in effect resulting in a maturity date.
Valuing Preferred Stock

The owner of preferred stock generally receives a fixed dividend from the investment in each
period. Because preferred stocks are perpetuities (nonmaturing) and because the cash divi-
dend is the same every period, the dividend stream is a level perpetuity that can be valued by
applying what we learned in Chapter 6 about calculating the present value of a level perpetu-
ity, as done in Equation (6–5). In effect, the value of a share of preferred stock is dependent
on P Principle 1: Money Has a Time Value, P Principle 2: There Is a Risk-Return Trad-
eoff, and P Principle 3: Cash Flows Are the Source of Value.
Thus, the value of a share of preferred stock can be written as follows:
Value of Annual Preferred Stock Dividend

= (10–6)
Preferred Stock Market's Required Yield on Preferred Stock
Figure 10.5 contains a quick reference resource for this valuation model, along with defini-
tions of the symbols typically used. In addition, the figure contains other details concerning
the valuation of preferred stock that you will find useful.
M10_TITM2189_13_GE_C10.indd 348 18/05/17 12:45 PM

Figure 10.5
Quick Reference Guide for the Preferred Stock Valuation Model
The value of a share of preferred stock, like that of any security, is defined by the present value
of the cash flows it is expected to produce for the owner of the stock. Because the preferred
shares typically pay a fixed dividend, this cash flow stream is a level perpetuity, which, as we saw
in Equation (6–5), makes discounting the future dividends simple. We divide the dividend by the
required rate of return on the preferred stock:
Value of Annual Preferred Stock Dividend Dps
= = (10–6)
Preferred Stock (Vps) Market's Required Yield on Preferred Stock rps
• Vps = the value of a share of preferred stock.

• Dps = the annual preferred stock dividend. This dividend is the contractually promised
dividend. Remember that preferred dividends are paid only if the firm has the cash to pay
them, and they must be paid before common stockholders get any dividends. The critical
point here is that the preferred stock dividend may be skipped in some years if the company
is unable to pay it, so that the annual dividend is a promised dividend (not an expected
dividend). The amount of the dividend is the product of the promised dividend rate and the
par or face value of the preferred stock and is prescribed in the security contract.
• rps = the market’s required yield or promised rate of return on the preferred stock’s
contractually promised dividend. This market’s required yield is analogous to the mar-
ket’s required yield to maturity on a bond discussed in Chapter 9. Note that because this
market yield is based on the promised dividend, we can also think of it as a promised
rate of return to the preferred stock investor that will be realized only if preferred stock
dividends are always paid in a timely manner.
Dps
• = the present value of a level perpetuity, which equals the promised dividend on
rps
preferred stock discounted using the market’s required yield or promised rate of return
to the preferred stockholders (recall that we defined this useful present value equation
in Chapter 6).
>> END FIGURE 10.5
Dealing with Reality: Promised Versus Expected Returns

for Preferred Stock
Recall from Chapter 9 that the market’s required yield to maturity used to value a bond is not
the same thing as the expected rate of return on the bond. The reason for this is that the bond
interest and principal payments used to value the bond are the contractual or promised payments
that are received only if the borrowing firm makes all the contractually promised interest and
principal payments on time (i.e., the firm does not default). The same idea is applied to the valu-
ation of preferred stock. Preferred stock dividends are promised dividends that are paid only if
the firm earns sufficient income to pay them. This causes no problem for valuing the preferred
stock because we simply discount the promised dividends back to the present using the market’s
required yield or promised rate of return for similar shares of preferred stock in the financial
marketplace. In other words, we value preferred shares by discounting the contractually prom-
ised dividend payments using a promised rate of return to the preferred shareholders.
Estimating the Market’s Required Yield. The market’s required yield on a share of
preferred stock is typically estimated using the market prices of similar shares of preferred
stock that can be observed in the financial market. For example, let’s assume that the electric
utility Pacific Gas & Electric (PCG) is considering the sale of an issue of preferred stock. The
preferred issue would pay a 5.00 percent annual dividend based on a par value of $50, for a
dividend of $2.50. To determine the price that this issue might sell for, we must look at the
market yields on other classes of preferred stock issued by PCG or on classes of preferred
stock issued by similar companies. Let’s for a moment assume that PCG does not have any
other classes of preferred stock outstanding. In that case, we must look for a company of
M10_TITM2189_13_GE_C10.indd 349 18/05/17 12:45 PM

similar risk with preferred stock outstanding. After a careful analysis of comparable firms, we
choose American Electric Power (AEP) because we deem its level of risk to be very similar to
that of PCG and it has preferred stock outstanding. The American Electric Power preferred has
a promised annual dividend of $1.25 per share, and each share is currently selling for $25.46.
We can use Equation (10–6) to solve for the market’s required yield, rps, as follows:
Dps
Vps =
rps
Dps $1.25
Vps = = = .0491, or 4.91%
Vps $25.46
We can now use the 4.91 percent market’s required yield for the American Electric Power
preferred stock to estimate the value of the preferred stock of Pacific Gas & Electric. First, we
calculate the annual dividend to reflect a 5.00 percent dividend yield and a par value of $50
per share. The resulting dividend is $2.50 ($50 3 .05) a share. Substituting this dividend and
the promised rate of return estimated using American Electric Power into Equation (10–6),
we estimate the value of Pacific Gas & Electric’s preferred stock to be $50.92, as follows:
Dps $2.50
Vps = = = $50.92
rps .0491
Note that we have valued the new issue of preferred stock using the contractual or promised
dividend for the issue and estimated the market’s required yield using the current market price
and dividend for a comparable-risk preferred issue. Recall that this is very similar to the way
that we valued a corporate bond in Chapter 9.
In summary, the value of a preferred stock is the present value of all future dividends.
Because most preferred stocks are perpetuities, which means that the firm is promising to pay the
dividends forever, we simply use our formula for the present value of a perpetuity to value them.
We now have the tools of financial analysis to value preferred stock, assuming that the
dividends grow at a constant rate in perpetuity, which are shown as follows.
Tools of Financial Analysis—Preferred Stock Valuation

Name of Tool Formula What It Tells You
Preferred
Annual Preferred Stock Dividend
• The value of preferred stock is equal to the pres-
stock Vps = ent value of all the future dividends in perpetuity.
valuation Market’s Required Yield or Promised Rate of Return
Dps • As the investor’s required yield or return goes up,
Vps = perhaps as a result of the firm becoming riskier
rps
or market interest rates climbing, the value of a
share of preferred stock falls.
A Quick Review: Valuing Bonds, Preferred Stock,

and Common Stock
In Chapter 9, we learned how to value bonds by discounting their contractually promised
interest and principal payments back to the present. In this chapter, we used the same dis-
counted cash flow procedure to value both preferred and common stock. However, there is a
subtle but important difference between how bonds and preferred stock are valued and how
common stock is valued using the discounted cash flow method.
Bonds and preferred stock are valued using contractually promised yields and promised
cash flows. However, because common stock does not have a promised cash flow and we
must estimate the expected dividends for each future period, we discount these expected divi-
dends using an expected rate of return for investing in the company’s shares. Table 10.2 sum-
marizes the application of discounted cash flow in valuing all three types of securities.
M10_TITM2189_13_GE_C10.indd 350 18/05/17 12:45 PM

M10_TITM2189_13_GE_C10.indd 351
Table 10.2 Summary of Discounted Cash Flow Valuation of Bonds, Preferred Stock, and Common Stock
Bonds and preferred stock specify a promised cash payment to the security holder. In the case of a bond, interest and principal must be paid in accordance with the terms of the bond
contract (indenture). Preferred shares have a stated dividend yield, which, when multiplied by the face or par value of the preferred stock, equals the promised preferred dividend. Both
bonds and preferred stock are valued by discounting these promised cash flows back to the present. However, because these are promised (and not expected) cash flows, we dis-
count them using the promised rate of return reflected in the current market prices of similar securities. Common stock, on the other hand, does not have a contractual promised divi-
dend payment, so we apply the discounted cash flow model in this instance by estimating expected future dividends and then discounting them back to the present using the expected
rate of return that an investor would require if investing in a stock with the risk attributes of the shares being valued.
Type of Security Cash Flow Discount Rate Valuation Model

Bond Promised interest and principal Market’s required yield to maturity. The value of a bond is equal to the present value of the future interest and
payments. These payments are Typically, the YTM on a similar bond is the repayment of the bond’s principal at maturity.
set forth in the contract between used to value a bond. This YTM is the
1
the bond-issuing company and the realized rate of return to the bondholder 1 -
owner of the bond. only if all promised payments are made Bond 1
= Interest
on time. Consequently, the yield to ma- Value YTMMarket (1 + YTM)n
£ (1 + YTMMarket)n §
turity calculated for a bond is a promised

+ Principal c d
yield and not the expected yield.

Preferred stock Promised dividends. Dividends Market or promised yield on pre- The value of a share of preferred stock is equal to the present value of the
are defined using a contractually ferred stock. We typically calculate this future preferred stock dividends.
set dividend yield that is multi- yield using market prices and promised
Value of
plied by the par or face value of dividends for similar shares of preferred Annual Preferred Stock Dividend
the preferred stock to get the pre- stock. This yield is a promised yield that Preferred =
Market’s Required Yield on Preferred Stock
ferred stock dividend. will be earned only if the preferred stock Stock (Vps)
dividends are fully paid every period as Dps
promised. =
rps
Common stock Expected future dividends. No Investor’s expected rate of return, Value of a share of common stock is equal to the present value of the
dividend is prescribed for com- which is the investor’s required rate future dividends.
mon stock. Instead, dividends of return. Because common stock divi-
Value of
must be estimated, so we value dends are risky, we use expected future D0(1 + g)
common stock using expected dividends and discount them using a Common =
rcs - g
rather than promised future cash risk-adjusted or expected rate of return Stock (Vcs)
flows. In the constant dividend for investing in shares of stock of firms
growth rate model, dividends are with similar risk to the firm issuing the
CHAPTER 10 | Stock Valuation
estimated using a constant rate of common stock being valued. We can

growth from year to year. estimate this expected rate of return us-
351
ing the CAPM.
18/05/17 12:45 PM
Checkpoint 10.3
Valuing Preferred Stock

Consider Con Edison’s (ED) preferred stock issue, which pays an annual dividend of $5.00 per share and does not have a
maturity date; the market’s required yield or promised rate of return (rps) for similar shares of preferred stock is 6.02 percent.
What is the value of the Con Edison preferred stock?

Because preferred stock dividends are constant for all future years, they form a level perpetuity. In effect, a
perpetuity can be visualized as a timeline that doesn’t have an ending point, with the same cash flow occurring
period after period—in this case, year after year:
rps = 6.02%
Time Period 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 . . . Years
Cash Flow $5.00 per year forever
Value of preferred stock = Present

value of promised dividends
The $5.00 dividends

go on forever.

Because preferred stock dividends are constant and have no maturity or end date, these dividends are a level
perpetuity. Consequently, calculating the present value of a share of preferred stock using Equation (10–6)
involves only simple division, and there is no need for an Excel solution or any unique keystrokes with a financial
calculator. We just divide the amount you receive at the end of each period forever by the market’s required yield.
STEP 3: Solve
Substituting $5.00 for Dps and 0.0602 for rps in Equation (10–6), we can determine the value of the Con Edison
preferred stock as follows:
Dps $5.00
Vps = = = $83.06
rps 0.0602
Thus, the present value of this preferred stock is $83.06.
STEP 4: Analyze
Because preferred stock is a level perpetuity, its present value on any future date will be the same as its pres-
ent value today. That is, the value of the preferred stock is $83.06 today, and if all else remains the same, the
preferred shares will be worth $83.06 five years from now, 10 years from now, and 100 years from now.

What is the present value of a share of preferred stock that pays a dividend of $12.00 per share if the market’s
required yield on similar issues of preferred stock is 8 percent?
ANSWER: $150.00.
Before you begin end-of-chapter material

1. What are three common features of preferred stock?
2. What is the market’s required yield on a preferred stock?
3. Explain the meaning of the following statement: The market yield is a promised rate of return rather than an expected
rate of return.
M10_TITM2189_13_GE_C10.indd 352 18/05/17 12:45 PM

353
Applying the Principles of Finance to Chapter 10
P Principle 1: Money Has a Time Value The value of common never sold it, the only cash flow you would ever receive would be the dividends
stock is equal to the present value of the future cash flows, discounted at the that the firm paid. It is these cash flows that are discounted back to present to
determine the value of a share of stock.
C H A P T E R
required rate of return. As a result, Principle 1 plays a pivotal role in determin-
ing the value of debt. P Principle 4: Market Prices Reflect Information Principle
P Principle 2: There Is a Risk-Return Tradeoff Different com- 4 implies that market prices are a pretty good reflection of the value of the
mon stocks have different levels of risk associated with them, with more risk underlying shares of stock.
resulting in a higher required rate of return. P Principle 5: Individuals Respond to Incentives This principle
P Principle 3: Cash Flows Are the Source of Value The calcu- takes on importance because managers respond to incentives in their contracts.
lation of the value of a share of stock begins with an estimation of the amount If these incentives are not properly aligned with those of the firm’s shareholders,
and timing of future cash flows. If you bought a share of common stock and managers may not make decisions consistent with increasing shareholder value.
Chapter Summaries
10
10.1 Identify the basic characteristics and features of common stock and use
the discounted cash flow model to value common shares. (pgs. 334–343)
SUMMARY: Common stock does not have a maturity date and has a life that is limited only by
the life of the issuing firm. Common dividends have no minimums or maximums. In the event of
bankruptcy, the common stockholders cannot exercise claims on assets until the firm’s creditors,
including the bondholders and preferred shareholders, have been satisfied.
The common stockholders are the owners of the firm and are in general the only security hold-
ers given a vote. Common shareholders have the right to elect the board of directors and to approve
any change in the corporate charter. Although each share of stock carries the same number of votes,
the voting procedure is not always the same from company to company.
A popular model used to calculate the present value of the future dividends of a firm’s com-
mon stock is the constant dividend growth rate model. This model can be stated as follows:
Value of Dividend for Year 1
= (10–2)
Common Stock Investor’s Required Dividend Growth
a b - a b
Rate of Return Rate
The valuation of common stock differs from the valuation of preferred stock (and bonds) because
common stock has no promised dividends. As a result, we use expected future dividends to esti-
mate the cash flows to the common stockholders. Because we are discounting expected future cash
flows, we discount them using the expected rate of return the investor anticipates from an invest-
ment with the risk of the common stock being valued.
KEY TERMS
Constant dividend growth rate model, Initial public offering (IPO), page 334 The
page 338 A common stock valuation model that first time a company issues stock to the public.
assumes that dividends will grow at a constant rate This occurs in the primary markets.
forever. Majority voting, page 336 Each share of stock
Cumulative voting, page 336 Voting in allows the shareholder one vote, and each position
which each share of stock allows the shareholder on the board of directors is voted on separately.
a number of votes equal to the number of directors Proxy, page 336 A means of voting in which
being elected. The shareholder can then cast all of a designated party is provided with the temporary
his or her votes for a single candidate or split them power of attorney to vote for the signee at the cor-
among the various candidates. poration’s annual meeting.
KEY EQUATIONS
1. What are the attributes of Dividend Dividend 1 Dividend Dividend 2
common stock that distinguish a1 + b a1 + b
Value of Common Paid in Year 0 Growth Rate Paid in Year 0 Growth Rate
it from bonds and preferred = +
Stock in Year 0 1 2
stock? Stockholder’s Stockholder’s
a1 + b a1 + b
2. What does agency cost mean Required Rate of Return Required Rate of Return
with respect to the owners of a
∞
firm’s common stock? Dividend Dividend 3 Dividend Dividend
a1 + b a1 + b
3. Describe the three-step Paid in Year 0 Growth Rate Paid in Year 0 Growth Rate
process for valuing common + 3
+ g + ∞
(10–1)
stock using the discounted Stockholder’s Stockholder’s
a1 + b a1 + b
dividend model. Required Rate of Return Required Rate of Return
M10_TITM2189_13_GE_C10.indd 353 18/05/17 12:45 PM

Dividend
Dividend in Year 0 a 1 + b
Growth Rate Dividend in Year 1
Vcs = = (10–2)
Stockholder’s Required Dividend Stockholder’s Required Dividend
- -
Rate of Return Growth Rate Rate of Return Growth Rate
Rate of Growth Dividend Rate of Return

= a1 - b * (10–3)
in Dividends 1 g 2 Payout Ratio on Equity 1 ROE 2
10.2 Use the price/earnings (P/E) ratio to value common stock. (pgs. 343–347)
SUMMARY: The price/earnings model for stock valuation is commonly referred to as a relative
valuation approach. The reason is that we define value relative to firm earnings and relative to how
similar firms’ earnings are valued. The P/E valuation model is defined as follows:
Value of Price>Earnings Firm
= a b * a b (10–4)
Common Stock Ratio Earnings per Share
The P/E valuation method is generally used in association with the comparables approach. Specifi-
cally, the P/E multiple is generally determined by examining the P/E ratios of comparable firms.
We learned that the price/earnings ratio is determined by the profitability of the firm’s investment
opportunities, the fraction of the firm’s earnings that it reinvests in the firm, and the riskiness of
the firm’s common stock.
KEY TERM
Price/earnings ratio, page 343 The price the market places on $1 of a firm’s earnings. For
1. If a corporation decides to example, if a firm has earnings per share of $2 and a stock price of $30, its price/earnings ratio is
retain its earnings and reinvest 15 ($30 , $2).
them in the firm, does the
market value of the firm’s KEY EQUATIONS
shares always increase? Why
or why not? Value of Appropriate Estimated Earnings P
= a b * a b = * E1 (10–4)
2. What is the price/earnings Common Stock, Vcs Price/Earnings Ratio per Share for Year1 E1
model of equity valuation?
3. How does a firm’s dividend P D1 > E1
policy affect the firm’s P/E ratio? = (10–5)
E1 rcs - g
10.3 Identify the basic characteristics and features of preferred stock and
value preferred shares. (pgs. 347–352)
SUMMARY: Preferred stock has several characteristics that make it unique. Specifically, unlike
bonds, preferred stock does not have a fixed maturity date. Moreover, preferred stock dividends are
typically fixed, unlike common stock, which may not pay any dividend. The following are some of
the more common characteristics of preferred stock:
• There are multiple classes of preferred stock.
• Preferred stock has a priority claim over common stock with respect to the proceeds from
the sale of assets and the distribution of income.
• Preferred stock dividends must be paid as promised before any common stock dividends
can be paid.
• Protective provisions are often included in the contract for the preferred shareholder in
order to reduce the investment’s risk.
M10_TITM2189_13_GE_C10.indd 354 18/05/17 12:45 PM

The value of a share of preferred stock is equal to the present value of the stream of con-
tractually promised future dividends discounted using the market’s required yield on shares
of preferred stock of similar risk. Because the preferred dividend is typically the same for all
future years and there is no maturity date, the present value of these dividends can be solved
as the present value of a level perpetuity. That is, the value of a preferred stock is simply the
ratio of the promised preferred dividend divided by the promised yield of a preferred stock with
similar risk.
Value of Annual Preferred Stock Dividend

= (10–6)
Preferred Stock Market’s Required Yield on Preferred Stock
Concept Check | 10.3 KEY TERMS

1. What are three common
Cumulative preferred stock, page 348 Market’s required yield, page 349 The rate
features of preferred stock? Preferred stock that requires all past unpaid of return on the preferred stock’s contractually
preferred stock dividends to be paid promised dividend. The market’s required yield
2. What is the market’s required
yield on a preferred stock?
before any common stock dividends are on a preferred stock is analogous to the market’s
declared. required yield to maturity on a bond.
3. Explain the meaning of the
following statement: The market KEY EQUATIONS
yield is a promised rate of return
rather than an expected rate of Value of Annual Preferred Stock Dividend Dps
return. = = (10–6)
Preferred Stock(Vps) Market’s Required Yield on Preferred Stock rps
Study Questions
10–1. Regardless of Your Major: Getting Your Fair Share on page 334 focuses on the
valuation of a new business venture. If you were faced with the need to value this
business, what would you want to know about the business?
10–2. Why is preferred stock referred to as a hybrid security?
10–3. Because preferred stock dividends must be paid before common stock dividends,
should preferred stock be considered a liability and appear on the right side of the
balance sheet alongside of the firm’s long-term debt?
10–4. Discuss two reasons why investors may perceive preferred stock to be less risky than
common stock.
10–5. In Finance for Life: Herd Mentality on page 335, we learned that it is common
for investors to follow the investment lead of others. If they are all investing in
dotcom firms or biotech firms, you might be swayed to jump on the bandwagon
and do the same. How might the media help reinforce herd behavior?
10–6. Compare the methods for valuing preferred stock and common stock.
10–7. The market’s required yield on preferred stock is actually a promised rate of return.
Explain this statement.
10–8. Common stockholders receive two types of return from their investment. What
are they?
10–9. The opening vignette on page 333 described Google first going public in
2004. Prior to going public, did Google’s stock have a market price? What
principles would go into determining the value of a company that hadn’t gone
public yet?
M10_TITM2189_13_GE_C10.indd 355 18/05/17 12:45 PM

Study Problems
MyLab Finance Common Stock
Go to www.myfinancelab.com 10–1. (Measuring growth) If Pepperdine, Inc.’s return on equity is 16 percent and the man-
to complete these exercises online agement plans to retain 60 percent of earnings for investment purposes, what will be
and get instant feedback.
the firm’s growth rate?
10–2. (Measuring growth) If the Stanford Corporation’s net income is $200 million, its
common equity is $833 million, and management plans to retain 70 percent
of the firm’s earnings to finance new investments, what will be the firm’s
growth rate?
10–3. (Valuing common stock) (Related to Checkpoint 10.1 on page 340) Header
Motor, Inc., paid a $3.50 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?
10–4. (Valuing common stock) J. Pinkman Motors, Inc., paid a $3.75 dividend last year.
If J. Pinkman’s return on equity is 24 percent and its retention rate is 25 percent,
what is the value of the common stock if the investors require a 20 percent rate of
return?
10–5. (Valuing common stock) The common stock of NCP paid $1.32 in dividends last
year. Dividends are expected to grow at an 8 percent annual rate for an indefinite
number of years.
a. If your required rate of return is 10.5 percent, what is the value of the stock to
you?
b. Should you make the investment?
10–6. (Measuring growth) Given that a firm’s return on equity is 18 percent and manage-
ment plans to retain 40 percent of earnings for investment purposes, what will be the
firm’s growth rate? If the firm decides to increase its retention rate, what will happen
to the value of its common stock?
10–7. (Valuing common stock) Wayne, Inc.’s outstanding common stock is currently sell-
ing in the market for $33. Dividends of $2.30 per share were paid last year, return on
equity is 20 percent, and its retention rate is 25 percent.
a. What is the value of the stock to you, given a 15 percent required rate of return?
b. Should you purchase this stock?
10–8. (Measuring growth) Walter White, Inc.’s return on equity is 13 percent, and man-
agement has plans to retain 20 percent of earnings for investment in the company.
a. What will be the company’s growth rate?
b. How would the growth rate change if management (i) increased retained earnings
to 35 percent or (ii) decreased retention to 13 percent?
10–9. (Measuring growth) Solarpower Systems expects to earn $20 per share this year and
intends to pay out $8 in dividends to shareholders and retain $12 to invest in new
projects with an expected return on equity of 20 percent. In the future, Solarpower
expects to maintain the same dividend payout ratio, expects to earn a 20 percent re-
turn on its equity invested in new projects, and will not be changing the number of
shares of common stock outstanding.
a. Calculate the future growth rate for Solarpower’s earnings.
b. If the investor’s required rate of return for Solarpower’s stock is 15 percent, what
is the price of Solarpower’s common stock?
M10_TITM2189_13_GE_C10.indd 356 24/06/17 12:59 PM

c. What would happen to the price of Solarpower’s common stock if it raised its
dividends to $12 this year and then continued with that same dividend payout
ratio permanently? Should Solarpower make this change? (Assume that the inves-
tor’s required rate of return remains at 15 percent.)
d. What would happen to the price of Solarpower’s common stock if it lowered its
dividends to $4 this year and then continued with that same dividend payout ratio
permanently? Does the constant dividend growth rate model work in this case?
Why or why not? (Assume that the investor’s required rate of return remains at 15
percent and all future new projects earn 20 percent.)
10–10. (Measuring growth) Tyrion L.’s Gadgets Inc. is trying to decide whether to cut
its expected dividends for next year from $8 per share to $5 per share in order to
have more money to invest in new projects. If it does not cut the dividend, the
firm’s expected rate of growth in dividends will be 5 percent per year, and the
price of its common stock will be $100 per share. However, if it cuts the dividend,
the dividend growth rate is expected to rise to 8 percent in the future. Assuming
that the investor’s required rate of return does not change, what would you expect
to happen to the price of Tyrion L.’s Gadgets’ common stock if the firm cuts the
dividend to $5? Should Tyrion L.’s Gadgets cut its dividend? Support your
answer as best as you can.
10–11. (Valuing common stock) Dubai Metro’s stock price was at $100 per share when it
announced that it would cut its dividends for next year from $10 per share to $6 per
share, with the additional funds to be used for expansion. Prior to the dividend cut,
Dubai Metro expected its dividends to grow at a 4 percent rate, but with the expan-
sion, dividends are now expected to grow at 7 percent. How do you think the an-
nouncement will affect Dubai Metro’s stock price?
Comparables Approach to Valuing

Common Stock
10–12. (Using relative valuation for common stock) (Related to Checkpoint 10.2 on page
345) Using the P/E ratio approach to valuation, calculate the value of a share of stock
under the following conditions:
• The investor’s required rate of return is 12 percent.
• The expected level of earnings at the end of this year (E1) is $4.00.
• The firm follows a policy of retaining 30 percent of its earnings.
• The return on equity (ROE) is 15 percent.
• Similar shares of stock sell at multiples of 13.3325 times earnings per share.
Now show that you get the same answer using the discounted dividend model.
10–13. (Valuing common stock) Assume the following:
• The investor’s required rate of return is 13.5 percent.
• The retention ratio is 50 percent.
• The return on equity (ROE) is 15 percent (that is, it can earn 15 percent on rein-
vested earnings).
• Similar shares of stock sell at multiples of 16.667 times earnings per share.
a. Determine the expected growth rate for dividends.
b. Determine the price/earnings ratio (P/E1) using Equation (10–5a).
c. What is the stock price using the P/E ratio valuation method?
d. What is the stock price using the dividend discount model?
M10_TITM2189_13_GE_C10.indd 357 18/05/17 12:45 PM

e. What would happen to the P/E ratio (P/E1) and stock price if the company in-
creased its retention rate to 60 percent (holding all else constant)? What would
happen to the P/E ratio (P/E1) and stock price if the company paid out all its earn-
ings in the form of dividends?
f. What have you learned about the relationship between the retention rate and the
P/E ratio?
10–14. (Valuing common Stock) Assume the following:
• The investor’s required rate of return is 15 percent.
• The retention ratio is 50 percent.
• The return on equity (ROE) is 20 percent (that is, it can earn 20 percent on rein-
vested earnings).
• Similar shares of stock sell at multiples of 10 times earnings per share.
a. Determine the expected growth rate for dividends.
b. Determine the price/earnings ratio (P/E1) using Equation (10–5a).
c. What is the stock price using the P/E ratio valuation method?
d. What is the stock price using the dividend discount model?
e. What would happen to the P/E ratio (P/E1) and stock price if the firm could earn
25 percent on reinvested earnings (ROE)?
f. What does this tell you about the relationship between the rate the firm can earn
on reinvested earnings and the P/E ratio?
Preferred Stock
10–15. (Valuing preferred stock) (Related to Checkpoint 10.3 on page 352) Calculate the
value of a preferred stock that pays a dividend of $6 per share when the market’s re-
quired yield on similar shares is 12 percent.
10–16. (Valuing preferred stock) Pioneer’s preferred stock is selling for $33 in the market
and pays a $3.60 annual dividend.
a. If the market’s required yield is 10 percent, what is the value of the stock to
investors?
b. Should investors acquire the stock?
10–17. (Valuing preferred stock) What is the value of a preferred stock where the dividend
rate is 14 percent on a $100 par value and the market’s required yield on similar
shares is 12 percent?
10–18. (Valuing preferred stock) You own 200 shares of Somner Resources preferred stock,
which currently sells for $40 per share and pays annual dividends of $3.40 per share.
If the market’s required yield on similar shares is 10 percent, should you sell your
shares or buy more?
10–19. (Valuing preferred stock) Kendra Corporation’s preferred shares are trading for $25
in the market and pay a $4.50 annual dividend. Assume that the market’s
required yield is 14 percent.
a. What is the stock’s value to you, the investor?
b. Should you purchase the stock?
M10_TITM2189_13_GE_C10.indd 358 18/05/17 12:45 PM

Mini-Case
You have finally saved $10,000 and are ready to make your first Your required rates of return for these investments are 6
investment. You have the following three alternatives for invest- percent for the bond, 7 percent for the preferred stock, and 15
ing that money: percent for the common stock. Using this information, answer
the following questions.
• Capital Cities ABC, Inc., bonds, which have a par value of
$1,000 and a coupon interest rate of 8.75 percent, are selling a. Calculate the value of each investment based on your re-
for $1,314 and mature in 12 years. quired rate of return.
• Southwest Bancorp preferred stock is paying a dividend of b. Which investment would you select? Why?
$2.50 and selling for $25.50. c. Assume Emerson Electric’s managers expect an earnings
• Emerson Electric common stock is selling for $36.75. The downturn and a resulting decrease in growth of 3 percent.
stock recently paid a $1.32 dividend, and the firm’s earn- How does this affect your answers to parts a and b?
ings per share have increased from $1.49 to $3.06 in the d. What required rates of return would make you indifferent to
past five years. The firm expects to grow at the same rate all three options?
for the foreseeable future.
M10_TITM2189_13_GE_C10.indd 359 18/05/17 12:45 PM

Stock and Bond Valuation

Uploaded by

Copyright:

Available Formats

Stock and Bond Valuation

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Stock and Bond Valuation

Uploaded by

Copyright:

Available Formats

Part 1 Introduction to Financial Management Part 4 Capital Structure and Dividend Policy

(Chapters 1, 2, 3, 4) (Chapters 15, 16)

Part 3 Capital Budgeting (Chapters 11, 12, 13, 14)

10.3 Preferred Stock Objective 3. Identify the basic characteristics and

M10_TITM2189_13_GE_C10.indd 332 18/05/17 12:44 PM

If success is having your firm’s name become

M10_TITM2189_13_GE_C10.indd 333 18/05/17 12:44 PM

Regardless of Your Major…

Your Turn: See Study Question 10–1.

10.1 Common Stock

Characteristics of Common Stock

M10_TITM2189_13_GE_C10.indd 334 18/05/17 12:44 PM

There is no question that individuals are influenced by what

Finance for Life

M10_TITM2189_13_GE_C10.indd 335 18/05/17 12:44 PM

Agency Costs and Common Stock

Valuing Common Stock Using the

M10_TITM2189_13_GE_C10.indd 336 18/05/17 12:44 PM

Three-Step Procedure for Valuing Common Stock

Basic Concept of the Stock Valuation Model

M10_TITM2189_13_GE_C10.indd 337 18/05/17 12:44 PM

Dividend for Year 3 Dividend for Year ∞

The Constant Dividend Growth Rate Model

Dividend Dividend 1 Dividend Dividend 2

Figure 10.1 provides a quick reference guide to Equation (10–2).

M10_TITM2189_13_GE_C10.indd 338 18/05/17 12:44 PM

Definitions and Assumptions:

>> END FIGURE 10.1

Determinants of the Investor’s Required Rate of Return

M10_TITM2189_13_GE_C10.indd 339 18/05/17 12:44 PM

Valuing Common Stock

STEP 1: Picture the problem

Time Period 0 1 2 3 4 5... Years

Cash Flow $2.00 $2.00(1.10) $2.00(1.10)2 $2.00(1.10)3 $2.00(1.10)4 $2.00(1.10)5

Value of common stock = Present

The growing dividends

STEP 2: Decide on a solution strategy

STEP 5: Check yourself

M10_TITM2189_13_GE_C10.indd 340 18/05/17 12:44 PM

rcs = rf + bcs 3E(rm) - rf 4 (8–6)

Important Definitions and Concepts:

• rcs = the investor’s required rate of return on a firm’s common stock.

>> END FIGURE 10.2

Determinants of the Growth Rate of Future Dividends

Rate of Growth Retention Rate of Return

Rate of Growth Dividend Rate of Return

Figure 10.3 contains a quick reference guide to Equation (10–3).

M10_TITM2189_13_GE_C10.indd 341 18/05/17 12:44 PM

g = (1 - D1 > E1) * ROE (10–3)

Important Definitions and Concepts:

• g = the expected annual rate of growth in dividends.

Tools of Financial Analysis—Common Stock Valuation

M10_TITM2189_13_GE_C10.indd 342 18/05/17 12:44 PM

Before you move on to 10.2

Concept Check | 10.1

10.2 The Comparables Approach to Valuing

Defining the P/E Ratio Valuation Model

What Determines the P/E Ratio for a Stock?

M10_TITM2189_13_GE_C10.indd 343 18/05/17 12:45 PM

rcs = rf + bcs 3E(rm) - rf 4 (8–6)

g = (1 - D1 > E1) * ROE (10–3)

Vcs = P > E1 * E1 (10–4)