Chapter 7: Company Stock Valuation

Tuan Minh Nguyen

Learning Objectives

• Understand the foundation of valuation for common stocks, discounted

cash flow techniques, and the concept of intrinsic value.
• Use the dividend discount model to estimate the intrinsic value of a stock.
• Estimate target prices for stocks using the P/E ratio and EPS.
• Recognize the role of relative valuation metrics in the valuation process.
Content

• Overview
• Discounted Cash Flow Model
• Dividend Discount Model
• Growth Rate Cases for the Dividend Discount Model
• Other Discounted Cash Flow Approach
• The Multiplier Approach
• Relative Valuation Metrics
1. Overview

• Major approaches to valuing common stocks using fundamental security

analysis include:
• Discounted cash flow (DCF) techniques
• Earnings multiplier approach
• Relative valuation metrics
1. Overview

• DCF techniques attempt to estimate the value of a stock (its intrinsic

value) using a present value analysis.
• The multiplier approach attempts to estimate intrinsic value by
multiplying an estimated firm characteristic by an estimated multiple.
• With the relative value approach, the emphasis is on selecting stocks for
possible purchase based on a comparison between comparable firms
rather than estimating each stock’s value
2. Discounted Cash Flow Model

• The DCF model estimates the value of a security by discounting its

expected future cash flows back to the present and adding them together
2. Discounted Cash Flow Model

• Two broad DCF approaches

• Value the equity of the firm using the required rate of return to shareholders (the cost of
equity capital):
• Dividend discount model (DDM)—A firm’s expected dividends represent the CF stream that is
discounted.
• Free cash flow to equity (FCFE) model—A firm’s expected FCFE represents the CF stream that is
discounted
• Free cash flow to the firm (FCFF) model—Value the entire firm using the weighted average
cost of capital as the discount rate and then subtract the value of debt and preferred stock. A
firm’s expected FCFFs represent the CF stream that is discounted.
3. Dividend Discount Model

• The process involved with the dividend discount model

3. Dividend Discount Model

• The DDM equation

3. Dividend Discount Model

• Implementing DDM
• Investors are dealing with infinity. They must value a stream of dividends that may
be paid forever, since common stock has no maturity date.
• The dividend stream is uncertain:
• There is no specified number of dividends if in fact any are paid at all. Dividends are
declared periodically by the firm’s board of directors.
• The dividends for most firms are expected to grow over time; therefore, investors usually
cannot simplify.
4. Growth Rate Cases For The DDM

• The zero-growth rate model

• One of three growth rate cases of the DDM, when the dollar dividend being paid is
not expected to change.

Where D0 is the constant dollar dividend expected for all future time periods and k is the
opportunity cost or required rate of return for this particular common stock.
4. Growth Rate Cases For The DDM

• The zero-growth rate model example

• Assume Magna Corporation annual‐pay preferred stock has a 7 percent dividend
rate and a $100 par value. If an investor’s required return on Magna preferred is 8.5
percent, the investor’s estimated value, V0, for the stock is
V0 = = =$82.35
4. Growth Rate Cases For The DDM

• The constant-growth rate model

• A well‐known scenario in valuation in which dividends are expected to grow at a
constant‐growth rate over time

where D1 is the dividend expected to be received at the end of Year 1.

k is the required rate of return
g is the expected growth rate of dividends
4. Growth Rate Cases For The DDM

• The constant-growth rate model example

• Assume that Summa Corporation is currently paying $1 per share in dividends and
investors expect dividends to grow at the rate of 7 percent a year for the foreseeable
future. For investments at this risk level, investors require a return of 15 percent a
year. The estimated value of Summa today, V0 , is
V0 = =
4. Growth Rate Cases For The DDM

• Estimating k and g
• The capital asset pricing model (CAPM), which was discussed in Chapter 5, is commonly used
to derive the required return on equity (k).
• The growth rate of dividends (k) is usually estimated through past growth or by security
analysts. It can also be calculated using sustainable growth model
4. Growth Rate Cases For The DDM

• The constant growth rate limitations

• One of the limitations of the DDM is that the model is not robust—that is, the
estimated value is very sensitive to the exact inputs used. The value calculated from
the equation is quite sensitive to the estimates used by the investor.
4. Growth Rate Cases For The DDM

• The constant growth rate example

• For Summa, assume that the discount rate used, k, is 16 percent instead of 15 percent, with
other variables held constant:
V0 = =

A 1‐percentage‐point increase in k results in an 11.14 percent decrease in estimated value

from $13.38 to $11.89
4. Growth Rate Cases For The DDM

• The multiple growth rate model

• Multiple growth is defined as a situation in which a company’s expected future
growth in dividends is described using two or more growth rates.
• The distinguishing characteristic of multiple‐growth situations is that at least two
different growth rates are involved, one of which could be zero.
4. Growth Rate Cases For The DDM

• The two stage growth rate model

• This model assumes near‐term growth at a rapid rate for some period (typically, 2 to
10 years) followed by a steady long‐term growth rate that is sustainable
4. Growth Rate Cases For The DDM

• Example
The current dividend is $1 and is
expected to grow at the higher rate
(gs) of 12 percent a year for five
years, at the end of which time the
new growth rate (gc) is expected to
be a constant 6 percent a year. The
required rate of return is 10 percent.
Calculate the current stock price.
4. Growth Rate Cases For The DDM

• The two stage growth rate model limitations

• The model is very sensitive to the inputs.
• Determining the length of the abnormal growth period is quite difficult to do in
practice.
• The model as described previously assumes an immediate transition from unusual
growth to constant growth, while in reality the transition may not take place that
quickly.
5. Other Discounted Cash Flow Approaches

• Free cash flow to equity

• It differs from the DDM in that FCFE measures what a firm could pay out as
dividends, rather than what they actually do pay out.
• FCFE is defined as the cash flow available to the firm’s owners (stockholders).
FCFE = net income + depreciation - fixed capital expenditures
– operating working capital expenditures + net borrowing
5. Other Discounted Cash Flow Approaches

• Implementing FCFE
• To implement this model for a firm whose cash flows are growing at a stable rate, an
analyst could apply the constant‐growth format discussed with the DDM. This
results in the following equation
5. Other Discounted Cash Flow Approaches

• Free cash flow to firm

• FCFF is defined as the cash flows available to all the firm’s claimholders (common
and preferred stock and bonds) after making fixed and operating working capital
expenditures.
FCFF = net income + depreciation - fixed capital expenditures
– operating working capital expenditures + interest expense x (1- tax rate)
6. The Multiplier Approach

• Earning multiplier (P/E Ratio)

• The P/E ratio (multiple) is one of the most widely mentioned and discussed variables
pertaining to a common stock.
• The typical P/E ratio is calculated as the current stock price divided by the firm’s
latest 12‐month EPS. This P/E ratio is frequently referenced as the trailing P/E
because it uses trailing 12‐month EPS.
• For valuing a stock, analysts generally make a forecast of next year’s EPS and
project an appropriate P/E ratio they expect is relevant for the firm
6. The Multiplier Approach

• P/E ratio formula

6. The Multiplier Approach

• P/E ratio example

• In early 2012, Standard & Poor’s estimated 2012 earnings for Cliff’s Natural
Resources (CLF) of $12.18 . S&P estimated an appropriate P/E for CLF to be 7.8.
• Multiplying these two numbers together produced a target price for CLF of $95.
6. The Multiplier Approach

• Price to book (P/B)

• The P/B ratio equals price per share divided by book value of equity per share.
• If the ratio is less than 1.0, the stockholders’ equity contribution exceeds the market
price and some would argue the firm has destroyed value.
6. The Multiplier Approach

• Price to sales (P/S)

• The P/S ratio is calculated as price per share divided by annual sales (revenue) per
share.
• Investors prefer to rely on the P/S ratio because sales are much less susceptible to
being manipulated or “managed” by a firm’s managers.
6. The Multiplier Approach

• Price to cash flow (P/CF)

• The P/CF ratio is calculated as price per share divided by annual cash flow per
share.
• It measures the price that investors attach to a firm’s cash flows.
• P/CF is popular among many investors due to the recognized importance of cash
flows in determining firm value.
6. The Multiplier Approach

• Enterprise value to EBITDA (EV/EBITDA)

• EV/EBITDA is derived as enterprise value (EV) divided by EBITDA.
• EV = market value of common and preferred stock + market value of debt – cash
equivalents.
• This ratio has gained increased use among some investors because, relative to the
other multipliers, it uses a broader measure of market value in the numerator.
7. Relative Valuation Metrics

• Rather than try to estimate the current or future value of a stock, investors may
use the price multiples to perform a comparative analysis of stocks as a guide
to stock selection.
• Performing an appropriate comparative analysis across firms requires the
investor to focus on firms operating in approximately the same line of
business.
• The relative value metrics are frequently applied to individual firms; however,
they can also be used to assess industries, sectors, and entire markets.
Problems

• Q1: Baddour Legal Services is currently paying a dividend of $2 per

share, which is expected to grow at a constant rate of 7 percent per year.
Investors require a rate of return of 16 percent. Phil Baddour, CEO, has
asked you to calculate the estimated value of his company.
• Q2: Bibbins Software is currently selling for $60 per share and is
expected to pay a dividend of $3. The expected growth rate in dividends is
8 percent for the foreseeable future. Calculate the expected return for this
stock.
Problems

• Q3: Grieb Electronics has been undergoing rapid growth for the last few
years. The current dividend of $2 per share is expected to grow at the
rapid rate of 20 percent a year for the next three years. After that time,
Grieb’s dividend growth is expected to slow to a more normal rate of 7
percent a year for the indefinite future. Because of the risk involved in
such rapid growth, the required rate of return on this stock is 22 percent.
Calculate the implied price for Grieb Electronics.
Problems

• Q4: Runyon Industries is expected to enjoy a very rapid growth rate in dividends of 30 percent a year for the next
three years. This growth rate is then expected to slow to 20 percent a year for the next five years. After that time, the
growth rate is expected to be 6 percent a year. D0 is $2. The beta for this stock is 1.5. The expected return on the
market is 11 percent, and the risk‐free rate is 5 percent. What is the estimated price of the stock?
K = rf + B*(rm – rf) = 0.05 + 1.5*(0.11-0.05) = 0.14
• D0 = 2
D1 = 2*1.3 = 2.6
• First 3 years growth rate = 30%
D2 = 2.6*1.3 = 3.38
• Growth rate for y4 and t5 = 20% D3 = 3.38 * 1.3 = 4.39
• Constant growth rate from y6 = 6% D4 = 4.39*1.2 = 5.27
• Beta = 1.5 D5 = 5.27*1.2 = 6.33
• E(m) = 11% Þ P5 = (6.33*1.06)/(0.14-0.06) = 83.87
Þ P0 = 2.6/1.14+3.38/1.12^2 + 4.39/1.12^3 + 5.27/1.12^4 +
• Rf = 5%
6.33/1.12^5 + 83.87/1.14^5 = 57.81
Problems

• Q5: Ammermann Components just paid a dividend of $1 per share. This

dividend is expected to grow at a rate of 25 percent a year for the next five
years, after which it is expected to grow at a rate of 7 percent a year. The
required rate of return for this stock is 18 percent. What is the estimated price
of the stock?
• Q6: Swanton Industries is expected to pay a dividend of $10 per year for 10
years and then increase the dividend to $15 per share for every year thereafter.
The required rate of return on this stock is 20 percent. What is the estimated
stock price for Swanton?