Fundamentals of Financial Management (Concise 6th Edition)

Chapter 9 Stocks and Their Valuation 293

KEY TERMS Define the following terms:

a. Proxy; proxy fight; takeover

b. Preemptive right

c. Classified stock; founders’ shares

d. Marginal investor; intrinsic value (Pˆ 0 ); market price (P 0 )

e. Required rate of return, rs; expected rate of return, rˆs ; actual (realized) rate

of return, r ̄s

f. Capital gains yield; dividend yield; expected total return; growth rate, g

g. Zero growth stock

h. Constant growth (Gordon) model; supernormal (nonconstant) growth

i. Corporate valuation model

j. Terminal (horizon) date; horizon (terminal) value

k. Preferred stock

STOCK GROWTH RATES AND VALUATION You are considering buying the stocks of two

companies that operate in the same industry. They have very similar characteristics except

for their dividend payout policies. Both companies are expected to earn $3 per share this

year; but Company D (for “dividend”) is expected to pay out all of its earnings as

dividends, while Company G (for “growth”) is expected to pay out only one-third of its

earnings, or $1 per share. D’s stock price is $25. G and D are equally risky. Which of the

following statements is most likely to be true?

a. Company G will have a faster growth rate than Company D. Therefore, G’s stock

price should be greater than $25.

b. Although G’s growth rate should exceed D’s, D’s current dividend exceeds that of G,

which should cause D’s price to exceed G’s.

c. A long-term investor in Stock D will get his or her money back faster because D pays

out more of its earnings as dividends. Thus, in a sense, D is like a short-term bond

and G is like a long-term bond. Therefore, if economic shifts cause rd and rs to increase

and if the expected dividend streams from D and G remain constant, both Stocks D

and G will decline, but D’s price should decline further.

d. D’s expected and required rate of return is rˆs " rs " 12%. G’s expected return will be

higher because of its higher expected growth rate.

e. If we observe that G’s price is also $25, the best estimate of G’s growth rate is 8%.

CONSTANT GROWTH STOCK VALUATION Fletcher Company’s current stock price is

$36.00, its last dividend was $2.40, and its required rate of return is 12%. If dividends are

expected to grow at a constant rate, g, in the future and if rs is expected to remain at 12%,

what is Fletcher’s expected stock price 5 years from now?

NONCONSTANT GROWTH STOCK VALUATION Snyder Computers Inc. is experiencing

rapid growth. Earnings and dividends are expected to grow at a rate of 15% during the

SELF!TEST QUESTIONS AND PROBLEMS

(Solutions Appear in Appendix A)

SELF!TEST QUESTIONS AND PROBLEMS

(Solutions Appear in Appendix A)

ST-1ST-1

ST-2ST-2

ST-3ST-3

ST-4ST-4

Two types of stock valuation models were discussed: the discounted dividend
model and the corporate valuation model. The discounted dividend model is useful
for mature, stable companies. It is easier to use, but the corporate valuation model is
more! exible and better for use with companies that do not pay dividends or whose
dividends would be especially hard to predict.
We also discussed preferred stock, which is a hybrid security that has some char-
acteristics of a common stock and some of a bond. Preferreds are valued using mod-
els similar to those for perpetual and “regular” bonds.