# Valuation Of Common Stock

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Valuation of Common Stock
Ashok Banerjee

Common (Equity) Stocks
• Because common stock never matures, today’s value is the present value of an infinite stream of cash flows (i.e., dividend).
• But dividends are not fixed.
• Not knowing the amount of the dividends—or even if there will be future dividends— makes it difficult to determine the value of common stock.
• So what are we to do?

Valuation Models
• Dividend Valuation Model (DVM):
– Constant dividend: Let D be the constant
DPS:

The required rate of return (re) is the return shareholders demand to compensate them for the time value of money tied up in their investment and the uncertainty of the future cash flows from these investments.

Valuation Models
• Dividend growth at a
This will provide investors with a 15% expected return.
Instead, we decide to plow back 40% of the earnings at the firm’s current return on equity of 25%. What is the value of the stock before and after the plowback decision?

Valuing Common Stocks
Example
Our company forecasts to pay a \$8.33 dividend next year, which represents 100% of its earnings. This will provide investors with a
15% expected return. Instead, we decide to plow back 40% of the earnings at the firm’s current return on equity of 25%. What is the value of the stock before and after the plowback decision?

No Growth

8.33
P0 
\$55.56
.15

With Growth

g .25 .40 .10
5.00
P0 
\$100.00
.15  .10

Valuing Common Stocks
Example - continued
If the company did not plowback some earnings, the stock price would remain at \$55.56. With the plowback, the price rose to \$100.00.
The difference between these two numbers is called the
Present Value of Growth Opportunities (PVGO).

PVGO 100.00  55.56 \$44.44

Valuing Common Stocks
Present Value of Growth Opportunities
(PVGO) - Net present value of a firm’s future investments.
Sustainable Growth Rate - Steady rate at which a firm can grow: plowback ratio