FINC 331 – Business Finance
CHAPTER 7 – Equity Markets and Stock Valuation
How the time value equations can be used for the valuation of securities
Preferred stock (Zero Growth)
A share of preferred stock is a perpetuity. They pay a stated dividend every year,
forever. They fall in priority between bonds and common stock for bankruptcy
purposes. No dividends can be paid to common stockholders until all preferred
dividends have been paid.
Example:
Assume a preferred stock with yearly dividend of $10. Assume a real rate of 3% and
an inflation expectation of 3% and the risk premium is 2.5%, what is the market price for
a share of this stock?
Common Stock: A Growing Perpetuity
Common Stock dividends are equally spaced through time and continue indefinitely,
thus it acts like a perpetuity. On the other hand, the dividend may be changed, unlike a
perpetuity. In general, dividends grow over time, thus it can be referred to as a
growing perpetuity.
One of the most significant constructs in finance is the idea that the value of a share of
common stock is the expected future dividends discounted back to the present at the
appropriate required rate of return. An efficient market will price all stocks in this way.
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