ADMS 3530 Winter 2012 – Professor Lois King
Lecture 5 – Valuing Stocks – Jan 31
5.1 Stocks & the Stock Market
− Stocks = equities.
o Common shares
o Preferred shares
− Common equity
o Represents a ‘share’ of ownership in a corporation.
o Entitled to a firm’s residual cash flow.
o Elects a board of directors.
o Entitled to any common dividends.
− Primary market
o Sales of ‘new’ shares by the firm.
− Secondary market
o Where shares are resold or ‘traded’, often on a stock exchange such as the Toronto
− Preferred equity
o Characteristics of both common stock and debt.
o The shares often have no maturity date.
o Dividend tends to be fixed.
o Entitled to dividends declared by the board of directors (but at the board’s
o Preferred shareholders cannot put the firm into receivership due to a missed
5.2 Stock Valuation – an Overview
− Valuing stocks
o Usually means determining the ‘market value’ of the shares.
o The terms market value, book value and liquidation value are different.
− Book value
o The accounting value of assets less the accounting value of liabilities.
− Liquidation value o The amount of cash per share that a firm could raise if it sold off its assets quickly
and paid off all its debts.
− Market value
o Analyze the expected amount of future cash flows and the variability or risk
associated with those cash flows.
− Equity valuation models
o Expected return model
o Dividend yield model
o Dividend discount model (DDM)
No growth DDM
Constant growth DDM
5.3 The Dividend Discount Model (DDM)
− The dividend discount model (or DDM)
o Share value = PV of all expected future dividends.
Since dividends are the cash flows which most truly belong to common
− Problem with general DDM
o It is unrealistic to know the amounts of all future dividends of a stock.
− Practical use of DDM: 2 special cases:
o No growth DDM – no growth in dividends.
o Constant growth DDM – growth rate in the dividends is constant.
Instead of no growth in dividends, the dividends (and earnings) will grow
at a constant rate ‘g’.
5.4 MultiStage Growth Version of DDM
− The basic version of the constant growth DDM: assumes constant growth in dividends
from now until infinity.
− With multiple growth versions, growth may be variable for the first few years and then
becomes constant at some future point in time until infinity. – There are multiple stages
− Four steps to solving multistage DDM problems:
o Step 1 – identify all the variables.
o Step 2 – calculate the dividends up to the year where growth rate becomes
o Step 3 – calculate the price of the stock for the year prior to which the growth
o Step 4 – enter the variables into your multistage DDM formula. 5.5 Notes on Market Efficiency
− Effective capital markets:
o What it means:
Financial markets and hence security prices rapidly reflect all the