Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

III. Valuation of Future

Cash Flows

8. Stock Valuation © The McGraw−Hill^273
   Companies, 2002

CHAPTER

8

Stock Valuation

When the stock market closedon July 3, 2001, the common stock of McGraw-

Hill, publisher of fine-quality college textbooks, was going for $67.40 per share.

On that same day, stock in General Motors (GM), the world’s largest automaker,

closed at $64.72, while eBay, the on-line auction company, closed at $69.16.

Since the stock prices of these three companies were so similar, you might

expect that the three companies would be offering similar dividends to their

stockholders, but you would be wrong. In fact, GM’s annual dividend was $2.00

per share, McGraw-Hill’s was $0.98 per share, and eBay was paying no dividends

at all!

As we will see in this chapter, the dividends currently being paid are one of

the primary factors we look at when attempting to value common stocks.

However, it is obvious from looking at eBay that current dividends are not the

end of the story, so this chapter explores dividends, stock values, and the

connection between the two.

n our previous chapter, we introduced you to bonds and bond valuation. In this chap-

ter, we turn to the other major source of financing for corporations, common and pre-

ferred stock. We first describe the cash flows associated with a share of stock and then

go on to develop a very famous result, the dividend growth model. From there, we

move on to examine various important features of common and preferred stock, focus-

ing on shareholder rights. We close out the chapter with a discussion of how shares of

stock are traded and how stock prices and other important information are reported in

the financial press.

8. Stock Valuation

A share of common stock is more difficult to value in practice than a bond, for at least

three reasons. First, with common stock, not even the promised cash flows are known in

advance. Second, the life of the investment is essentially forever, since common stock has

no maturity. Third, there is no way to easily observe the rate of return that the market

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