Introduction to Corporate Finance

PARt 2: VALUAtIoN, RISk ANd REtURN

Now let’s turn our attention to the more challenging problem of using discounted cash flow techniques

to value ordinary shares.

5-2b oRdINARY SHARE VALUAtIoN EQUAtIoN

Valuing ordinary shares is a much more difficult task than valuing preferred shares because the

cash flows that ordinary shareholders receive are not set in advance by a contract. In this section,

we introduce a simple technique that connects the price of a share to the dividends that the

shareholder receives. In practice, the methods used by professional investors to value ordinary

shares are more complex than the approach we first present here. Nevertheless, the simplified

valuation model provides a framework that will help you understand the factors that determine

ordinary share values. Later, we will introduce some of the alternative approaches that investors

use to value shares.

When you buy a share, you may expect to receive a periodic dividend payment from the company,

and you probably hope to sell the share for more than its purchase price. But when you sell the share,

you are simply passing the rights to receive dividends to the buyer. The buyer purchases the share from

you in the belief that the dividends and capital gains justify the purchase price. This logic extends to

the next investor who buys the share from the person who bought it from you, and so on, forever. This

implies that the value of ordinary shares equals the present value of all future dividends that investors

expect the share to distribute.^3

The easiest way to understand this argument is as follows. Suppose an investor buys a share in a

company today for price P 0 , receives a dividend equal to D 1 at the end of one year, and immediately sells

the share for price P 1. The return on this investment is easy to calculate:

r

DPP

P

=

11 +− 0

0

The numerator of this expression equals the dollar profit or loss. Dividing that by the purchase

price converts the return into percentage form. Rearrange this equation to solve for the current share

price:

Eq. 5.2

()

0

11

P 1

DP

1r

=

+

+

This equation indicates that the value of a share today equals the present value of cash that the

investor receives in one year. But what determines P 1 , the selling price at the end of the year? Use

Equation 5.2 again, changing the time subscripts to reflect that the price next year will equal the

present value of the dividend and selling price received two years from now:

P

DP

(^1) r
22
= 1 1

• ()+
  3 Companies can distribute cash directly to shareholders in forms other than dividends. For instance, many companies regularly buy back
  their own shares. Also, when an acquiring company buys a target, it may distribute cash to the target’s shareholders. In this discussion, we
  assume, for simplicity, that cash payments always come in the form of dividends, but the logic of the argument does not change if we allow
  for other forms of cash payments.