CORPORATE

FINANCE
EQUITY VALUATION
CFA STUDY NOTES (DISCOUNTED DIVIDEND VALUATION PDF PAGE 62)
•Stock valuation

Stock valuation is the process of valuing companies and

comparing the valuation to the current market price to see
whether a stock is over- or undervalued.

•Stock valuation can be classified into two categories: absolute

valuation and relative valuation.
 ABSOLUTE VALUATION

• Absolute, or intrinsic, stock valuation relies on the company’s

fundamental information.

• The method involves the analysis of various financial information

that can be found in, or derived from, a company’s financial
statements.

• Many techniques of absolute stock valuation primarily

investigate the company’s cash flows, dividends, and growth
rates.

• Notable absolute common stock valuation techniques include

the dividend discount model (DDM) and the
discounted cash flow model (DCF).
 RELATIVE VALUATION

• Relative stock valuation compares the potential investment

to similar companies.
• The relative stock valuation method calculates multiples of
similar companies and compares that valuation to the
current value of the target company.
• COMMON MULTIPLES USED ARE P/E , P/BV
• The best example of relative stock valuation is comparable
company analysis, sometimes called trading comps.
Dividend discount model (DDM)
The dividend discount model is one of the most basic techniques of
absolute stock valuation.
The DDM is based on the assumption that the company’s dividends
represent the company’s cash flows to its shareholders.
The model states that the intrinsic value of the company’s stock
price equals the present value of the company’s future
dividends.
Note that the dividend discount model is applicable only if a company
distributes dividends regularly and the distribution is predictable.

Discounted cash flow model (DCF)

Under the DCF approach, the intrinsic value of a stock is
calculated by discounting the company’s free cash flows to its
present value.
The main advantage of the DCF model is that it does not require any
assumptions regarding the distribution of dividends. Thus, it is suitable
Comparable companies analysis

Comparable companies analysis is an example of relative stock valuation.

Instead of determining the intrinsic value of a stock using the

company’s fundamentals, the comparable approach aims to derive a
stock’s theoretical price using the price multiples of similar companies.

The most commonly used multiples include the

price-to-earnings (P/E), and enterprise value-to-EBITDA
(EV/EBITDA) multiples.

The comparable companies analysis method is one of the simplest from a

technical perspective.

However, the most challenging part is the determination of truly

comparable companies.
ADVANTAGES AND DISADVANTAGES OF USING DIVIDEND AS A
MEASURE OF CASHFLOWS

The shareholder's investment today is worth the present value of the

future cash flows he expects to receive, and ultimately he will be repaid
for his investment in the form of dividends.

An additional advantage of dividends as a measure of cash flow is that

dividends are less volatile than other measures (earnings or free cash
flow), and therefore the value estimates derived from dividend discount
models are less volatile and reflect the long term earning potential of the
company.
DISADVANTAGES
The primary disadvantage of dividends as a cash flow measure is that it
is difficult to implement for firms that don't currently pay dividends.

It is possible to estimate expected future dividends by forecasting the

point in the future when the firm is expected to begin paying dividends.
The problem with this approach in practice is the uncertainty associated
with forecasting the fundamental variables that influence stock price
(earnings, dividend payout rate, growth rate, and required return) so far
into the future.

A second disadvantage of measuring cash flow with dividends is that it

takes the perspective of an investor who owns a minority stake in the
firm and cannot control the dividend policy.

If the dividend policy dictated by the controlling interests bears a

meaningful relationship to the firm's underlying profitability, then
dividends are appropriate.
Dividends are appropriate as a measure of cash flow in
the following cases:

• The company has a history of dividend payments.

• The dividend policy is clear and
• Related to the earnings of the firm.
Free Cash FLow.
Free cash flow to the firm (FCFF) is defined as the cash flow
generated by the firm's operations that is in excess of the capital
investment required to sustain the firm's current productive
capacity.

Free cash flow to equity (FCFE) is the cash available to

stockholders after funding capital requirements and expenses
associated with debt financing.
• ADVANTAGES AND DISADVANTAGES OF FREE CASH FLOW
METHOD

• One advantage of free cash flow models is that they can be

applied to many firms, regardless of dividend policies or
capital structures.

• However, there are cases in which the application of a free

cash flow model may be very difficult.

• Firms that have significant capital requirements may have

negative free cash flow for many years into the future. This
can be caused by a technological revolution in an industry
that requires greater investment to remain competitive or by
rapid expansion into untapped markets.
Free cash flow models are most appropriate:

• For firms that do not have a dividend payment history or have a

dividend payment history that is not clearly and appropriately
related to earnings.

• For firms with free cash flow that corresponds with their
profitability
Zero growth
For most companies, the Gordon growth model assumption of
constant dividend growth that continues into perpetuity is
unrealistic.

For example, many companies experience growth rates in

excess of the required rate of return for short periods of time as
a result of a competitive advantage they have developed.

We need more realistic multistage growth models to estimate

value for companies with several stages of future growth. The
appropriate model is the one that most closely matches the
firm's expected pattern of growth.
• We're still just forecasting dividends into the future and
discounting them back to today to find intrinsic value.

• • Over the long term, growth rates tend to revert to a

long-run rate approximately equal to the long-term
growth rate in real gross domestic product (GDP) plus
the long-term inflation rate.

• Historically, that number has been between 2% and 5%.

Anything higher than 5% as a long-run perpetual growth
rate is difficult to justifY.
Two stage model is designed to value Two-Stage DDM: The most
the equity in a firm with two stages basic multistage model is a
of growth, an initial period of higher
growth and a subsequent period of two-stage DDM in which we
stable growth. assume the company grows at
a high rate for a relatively
short period of time (the first
stage) and then reverts to a
long-run perpetual growth rate
(the second stage

An example in which the two-

stage model would apply is a
situation in which a company
has a patent that will expire.
For example, suppose a firm is
expected to grow at 15% until
patents expire in four years,
then immediately revert to a
long-run growth rate of 3% in
perpetuity. This stock should
H-Model: The problem with the
basic two-stage DDM is that it is
usually unrealistic to assume that
a stock will experience high
growth for a short period, then
immediately fall back to a long-run
level. The H-model utilizes a more
realistic assumption: the growth
rate starts our high and then
declines linearly over the high-
growth stage until it reaches the
long-run average growth rate. For
example, consider a firm that
generates high profit margins,
faces little competition from within
its industry, and is currently
growing at 15%. We might forecast
that the firm's growth rate will
decline by 3% per year as
competitors enter the marker until
While the basic GGM assumes constant growth, most firms
go through a pattern of growth that includes several
phases:

• An initial growth phase, where the firm has rapidly

increasing earnings, little or no dividends, and heavy
reinvestment.
• A transition phase, in which earnings and dividends are
still increasing but at a slower rate as competitive forces
reduce profit opportunities and the need for reinvestment.
• A mature phase, in which earnings grow at a stable but
slower rate, and payout ratios are stability
Short term growth Long term
growth
THE VALUE OF A
FIRM THAT DOESN'T
CURRENTLY PAY A
DIVIDEND
The value of a
firm that doesn't
currently pay a
dividend is a
simple version of
the two stage
DDM, where the
firm pays no
dividends in the
first stage.
Therefore, the
value of the firm
is just the
present value of
the dividends in
long term phase
VALUATION USING THE H-MODEL
The earnings growth of most firms does not abruptly change from a high
rate to a low rate as in the two-stage model but tends to decline over
time as competitive forces come into play. The H-model approximates
the value of a firm assuming that an initially high rate of growth decline