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Chapter 18
Equity Valuation Models

INVESTMENTS
THIRTEENTH EDITION
BODIE, KANE, MARCUS

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 Overview
• Fundamental analysts use information concerning the
current and prospective profitability of a company to
assess its fair market value.
• Alternative measures of a company’s value.
• Dividend discount models.
• P/E ratios.
• Free cash flow models.

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 Valuation by Comparables
• Fundamental analysis identifies stocks that are mispriced
relative to some measure of “true” value that can be
derived from observable financial data.
• Valuation ratios are commonly used to assess the
valuation of one firm compared to others in the same
industry.

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 Table 18.1 Financial Highlights of Microsoft

Microsoft GDP growth (%)

Price per share 287.12
Common shares outstanding 7.51
(billion)
Market capitalization ($ billion) 2.157
Latest 12 Months
Sales ($ billion) 168.09
EBITDA {$ billion) 80.82
Net income ($ billion) 61.27
Earnings per share 8.05
Valuation
Price/Earnings 35.66 59.23
Price/Book 15.20 14.07
Price/Sales 13.00 11.40
PEG 2.63 1.73
Profitability
ROE (%) 47.08 28.09
ROC{%} 23.94 6.66
Operating profit margin (%) 41.60 23.27
Net profit margin (%) 36.45 19.99

Source: Microsoft data finance.yahoo.com, August 4, 2021; Industry data courtesy of Professor Aswath Damodaran,
http://pages.stern.nyu.edu/--adamodar/.

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 Limitations of Book Value
• Shareholders are sometimes called “residual claimants”.
• Book values are based on historical cost, while market
values measure the current values of assets and liabilities.
• Market values generally will not match historical values.

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 Liquidation Value and Tobin’s Q
Liquidation value: Net amount that could be realized by
selling the assets of a firm after paying its debt.
• Good representation of a “floor” for the stock’s price.

Tobin’s q: Ratio of market value of the firm to replacement

cost.
• Replacement cost is the cost to replace a firm’s assets.
• Tobin’s q trends toward.

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 Intrinsic Value Versus Market Price
The return on a stock is composed of cash dividends and
capital gains or losses.

E ( D1 )  [ E ( P1 )  P0 ]
Expected HPR  E ( r ) 
P0

The expected HPR may be more or less than the required

rate of return.
• Variation based on the stock’s risk.

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 Required Return
CAPM is one way to generate the required return, k:

k  rf  β  [ E (rM )  rf ]

• If the stock is priced correctly, expected return will equal

required return.
• k is the required rate of return.

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 Intrinsic Value and Market Price
The intrinsic value  V0  is the “true” value, according
to a model.

If intrinsic value > market value, the stock is considered

undervalued and a good investment.
Trading signal.
• IV > MV → Buy.

• IV < MV → Sell.
• IV = MV → Hold.

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 Dividend Discount Models (DDM)

D1 D2 D3
V0    
1  k (1  k ) (1  k )
2 3

V0 = current value
Dt = dividend at time t
k = required rate of return
DDM says V0 = the present value of all expected future
dividends into perpetuity.

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 Constant Growth DDM 1

Suppose the dividend growth rate, g, is expected to be

constant for the foreseeable future.
D1 D2 D3
V0    
1  k (1  k ) (1  k )
2 3

D0  (1  g )1 D0  (1  g ) 2 D0  (1  g )3
   
1 k (1  k ) 2
(1  k ) 3

V0 = current value

Dt = dividend at time t
k = appropriate risk-adjusted interest rate.
g = constant dividend growth rate.
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 Constant Growth DDM 2

If g < k, the constant-growth equation can be simplified to:

D0  (1  g )1 D0  (1  g ) 2 D0  (1  g )3
V0    
1 k (1  k ) 2
(1  k ) 3


D0 (1  g ) D1
V0  
kg kg

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 Constant Growth DDM: Example
• A stock just paid an annual dividend of $3/share.
• Dividend is expected to grow at 8% indefinitely.
• Market capitalization rate is 14%.

D1 $3.24
V0    $54
k  g .14  .08

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 DDM Implications
The constant growth rate DDM implies that a stock’s value
will be greater:
1. The larger its expected dividend per share.
2. The lower the market capitalization rate, k.
3. The higher the expected growth rate of dividends.

The stock price is expected to grow at the same rate as

dividends.

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 Expected Return as a Function of Dividend
Yield and Capital Gains Yield

E (r )  Dividend yield  Capital gains yield

D1 P1  P0
 
P0 P0

D1
 g
P0

• DCF formula often used in rate hearings for regulated

public utilities.
• Focus on “fair” profit.

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 Figure 18.1 Dividend Growth for Two
Earnings Reinvestment Policies

Access the text alternative for slide images.

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 Life Cycles and Multistage Growth Models
Firms typically move through life cycles with different dividend profiles.

Early Years Later Years

• Ample opportunities for • Attractive opportunities for
profitable reinvestment in reinvestment may become harder
the company. to find.
• Payout ratios are low. • Production capacity is enough to
• Growth is correspondingly meet market demand.
rapid. • Competitors enter the market.
• Firms may choose to pay out a
higher fraction of earnings as
dividends.

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 Multistage Growth Models
Growth Stock:
P0  Extraordinary Growth Period   Sustainable Growth 

 D1 DH   PH 
  ...     (1  k ) H 
 (1  k ) (1  k ) H
  
where
D1 through DH  Dividends during the period of extraordinary growth
DH  (1  g )
PH  = Price at the end of the extraordinary growth period  horizon 
kg
g  Sustainable growth rate

k  Required rate of return

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 Multistage Growth Models: Example
Suppose you believe Toyota will experience rapid growth of averaging
7.6% for 4 years with expected dividends in the coming years of $4.45,
$4.81, $5.18, and $5.55 (assume annual dividends for simplicity). In Year
5, the growth rate falls to a sustainable rate of 6%. If the capitalization
rate is 8.4%, what is price of Toyota’s stock in 4 years (the horizon value)
and the price of Toyota’s stock today?

D4  (1  g ) $5.55 1.06
P4    $245.13 
kg .084  .06
 D DH   PH 
P0   1  ...     (1  k ) H 
 (1  k ) (1  k ) H   

 $4.45 $4.81 $5.18 $5.55   $245.13 

 1
 2
 3
 4 
 4 
 $193.81
 (1.084) (1.084) (1.084) (1.084)   (1.084) 

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 Table 18.2 Financial Ratios in Two Industries
Growth Rate
Return on Payout 2022 to 2025
Ticker Capital (%) Ratio (%) (%)
Computer Software
Adobe Systems ADBE 21.0 0.0 15.0
Citrix CTXS 22.0 22.0 12.3
Cognizant CTSH 17.0 25.0 9.7
Intuit INTU 19.5 25.0 14.5
Microsoft MSFT 32.5 28.0 11.4
Oracle ORCL 20.5 25.0 12.2
Norton LifeLock NLOK 24.5 37.0 7.9
SAP SAP 17.0 32.0 11.5
Median 20.8 25.0 11.9
Electric Utilities (East Coast)
Dominion Resources D 6.0 68.0 5.0
Consolidated Edison ED 5.0 64.0 4.5
Duke Energy DUK 5.5 66.0 6.0
Eversource ES 5.5 63.0 5.8
First Energy FE 7.0 57.0 6.4
Nextera Energy NEE 6.5 70.0 9.7
Public Service Enterprise PEG 6.0 57.0 9.7
Southern Company SO 6.5 70.0 5.2
Exelon EXC 5.5 53.0 6.7
Median 6.0 64.0 6.0

Source: Value Line Investment Sun/ey, 2021. Reprinted with permission of Value Line Investment Survey. © 2021 Value
Une Publishing. Inc. All rights reserved.

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 Present Value of Growth Opportunities 1

Present value of growth opportunities (PVGO) is the net

present value of a firm’s future investments.
The value of the firm is the sum of the following:
• Value of assets already in place (no-growth value).
• Net present value of the future investments the firm will
make, or PVGO.

E1
P0   P V G O
k

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 Present Value of Growth Opportunities 2

• Suppose a stock selling for $54 just paid an annual

dividend of $3/share, which was 60% of earnings.
• Dividend is expected to grow at 8% indefinitely.
• Market capitalization rate is 14%.

E1
P0   P V G O
k
$3 / .6
$54   P V G O  $35.71  P V G O 
.14
P V G O  $18.29

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 Price–Earnings Ratio and Growth
Opportunities 1

The ratio of PVGO to E/k is equivalent to the component of

firm value due to growth opportunities (PVGO) to the value
reflecting assets already in place (E/k).

P0 1  1  PVGO 
  
E1 k  E / k 

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 Price–Earnings Ratio and Growth
Opportunities 2

When PVGO  0, P0  E1 / k
• The stock is valued like a nongrowing perpetuity.
• As PVGO becomes an increasingly dominant contributor to
price, the P/E ratio can rise dramatically.
• P/E ratio reflects the market’s optimism concerning a firm’s
growth prospects.

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 Price–Earnings Ratio and Growth
Opportunities 3

P/E increases:
• As ROE increases.
• As plowback, b, increases, if ROE > k.
• As plowback decreases, if ROE < k.
• As k decreases.

P0 1 b

E1 k  ROE  b

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 Table 18.3 Effect of ROE and Plowback on
Growth and the P/E Ratio

Assumption: k = 12% per year.

Access the text alternative for slide images.

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 P/E and Growth Rate
Wall Street rule of thumb suggests the growth rate ought to
be roughly equal to the P/E ratio
“If the P/E ratio of Coca Cola is 15, you’d expect the
company to be growing at about 15% per year, and so on . etera

But if the P/E ratio is less than the growth rate, you may have
found yourself a bargain.”

Peter Lynch in One Up on Wall Street

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 P/E R=batios and Stock Risk
• Holding all else equal, riskier stocks will have lower P/E
multiples.
• Riskier firms will have higher required rates of return, that
is, higher values of k, which means the P/E multiple will be
lower.

P 1 b

E kg

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 Pitfalls in P/E Analysis
Denominator in the P/E ratio is accounting earnings, which
are influenced somewhat by arbitrary accounting rules.
Inflation: High inflation → historic cost depreciation and
inventory costs underrepresent true economic values since
replacement costs rise with the general level of prices.
Earnings management: Using flexibility in accounting rules
to improve the apparent profitability of the firm.
• Pro forma earnings.
• Choices on GAAP.

Reported earnings fluctuate around the business cycle.

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 Figure 18.3 P/E Ratios of the S&P 500
Index and Inflation, 1955 to 2020

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 Figure 18.4 Earnings Growth for Two
Companies

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 Figure 18.5 Price–Earnings Ratios

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 Figure 18.6 P/E Ratios for Different
Industries

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 CAPE models
Cyclically adjusted P/E ratio.
Shiller suggests a “cyclically adjusted” P/E ratio (CAPE) to
avoid the problems associated with using P/E ratios over
different phases of the business cycle.
Idea is to divide the stock price by an estimate of sustainable
long-term earnings rather than current earnings.
• Proposed using average inflation-adjusted earnings over
an extended period, such as 10 years.

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 Figure 18.7 CAPE Versus Conventional P/E
Ratio for S&P 500

Source: Graph constructed using data obtained from Prof. Robert Shiller’s website, www.econ.yale.edu/-shlller/data.htm

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 Other Comparative Valuation Ratios
Price-to-book ratio
• Ratio of price per share divided by book value per share.

Price-to-cash-flow ratio
• Cash flow is less affected by accounting decisions than are
earnings.
• Ratio of price to cash flow per share.

Price-to-sales ratio
• Useful for start-up firms that do not have earnings.
• Ratio of stock price to the annual sales per share.

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 Figure 18.8 Valuation Ratios for the S&P 500

Source: Shiller, R. J. (2015). Irrational Exhuberance, 3rd edition. Princeton University Press. updated data downloaded
from www.murtpl.com.

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 Free Cash Flow for the Firm (FCFF) 1

• FCFF is the after-tax cash flow generated by the firm’s

operations, net of investments in fixed and working capital.
• Discount the FCFF at the weighted-average cost of capital
to find the value of entire firm.
• Subtracting the value of debt results in the value of equity.

FCFF  EBIT  (1  tc )  Depreciation  Capital Expenditures  NWC

where
EBIT = Earnings before interest and taxes
tc  Corporate Tax Rate

NWC = Net Working Capital

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 Free Cash Flow for the Firm (FCFF) 2

Value of the Firm

T
FCFFt Vt
Firm Value   
t 1 (1  WACC ) (1  WACC )T
t

Where:

FCFFT 1
Vt 
WACC  g

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 Free Cash Flow to Equity (FCFE) 1

• Alternative approach is to focus on FCFF, discounting

those directly at the cost of equity to obtain the market
value of equity.
• Differs from FCFF by after-tax expenditures, as well as by
cash flow associated with net issuance or repurchase of
debt.

FCFE  FCFF  Interest  (1  tC )  Debt

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 Free Cash Flow to Equity (FCFE) 2

Intrinsic value of equity

T
FCFFt Vt
Firm Value   
t 1 (1  WACC ) (1  WACC )T
t

Where:

FCFET 1
ET 
kE  g

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 Spreadsheet 18.2 Comparing the Valuation
Models, Toyota

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 Comparing the Valuation Models
In practice
• Values from the FCF and DDM models may differ.
• Analysts are always forced to make simplifying
assumptions.

Problems with DCF Models

• Calculations are sensitive to small changes in inputs.
• Growth opportunities and growth rates are hard to pin
down.

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 Comparing the Valuation Models: Toyota

Model Intrinsic Value

Two-stage dividend discount model $140.41
DDM with earnings multiple terminal value 158.38
Three-stage DDM 157.00
Free cash flow to the firm 137.87
Free cash flow to equity 128.56
Market price (from Value Line) 152.23

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 The Aggregate Stock Market
• Most popular approach to valuing the overall stock market
is the earnings multiplier approach applied at the
aggregate level.
• Some analysts use aggregate version of DDM rather than
an earnings multiplier approach.
• S&P 500 taken as leading economic indicator.

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 Figure 18.9 Earnings Yield, S&P 500
Versus 10-Year Treasury Bond

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 Table 18.4 S&P 500 Index Forecasts Under
Various Scenarios

Pessimistic Most Likely Optimistic

Scenario Scenario Scenario
Treasury bond yield 2.25% 1.75% 1.25%
Earnings yield 4.25% 3.75% 3.25%
Resulting P/E ratio 23.53 26.67 30.77
EPS forecast $196.36 $196.36 $196.36
Forecast for S&P 500 4,620 5,236 6,042

Forecast for the earnings yield on the S&P 500 equals Treasury bond
yield plus 2.0%. The P/E ratio is the reciprocal of the forecast earnings
yield.

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