CHAPTER FOUR

Stock and Equity Valuation

Equity Instruments

• Firms obtain their long-term sources of equity

financing by issuing common and preferred
stock.
• The payments of the firm to the holders of
these securities are in the form of dividends.
• Unlike interest payments on debt which are
tax deductible, dividends must be paid out of
after-tax income either in the form of cash
dividend or stock dividend.
Common Stock Characteristics

• The common stockholders are the owners of the firm.

• It represents equity in a corporation.
• They have the right to vote on important matters to the
firm such as the election of the BoD.
• They have a residual claim against the assets and
cash flows of the firm.
• They have limited liability – that common stockholders
may lose their investments, but no more.
• High risk, but historically also high return.
Preferred Stock Characteristics

• Preferred stock is a hybrid having some

features similar to debt and other features
similar to equity.
• Claim on assets and cash flow senior to
common stock.
• Preferred stockholders usually do not have
voting rights.
• As equity security, dividend payments are not
tax deductible for the corporation.
Cont…

• Promises a fixed annual dividend payment,

but not legally enforceable.
• Firms cannot pay common stock dividends if
preferred stock is in arrears (i.e. preferred
stock is typically “cumulative”)
• May be convertible to common stock.
Equity Valuation

• In finance, valuation is a process of determining

the fair market value of an asset.
• Equity valuation therefore refers to the process
of determining the fair market value of equity
securities.
• However, equity valuation is not so simple.
• As such, it represents an attempt to value cash
flows which are uncertain and unpredictable.
Intrinsic Value and Market Price

• Intrinsic Value (IV)

Self assigned Value
Variety of models are used for estimation
• Market Price (MP)
Consensus value of all potential traders
• Trading Signal
 IV > MP: Buy
 IV < MP: Sell or Short Sell
 IV = MP: Hold or Fairly Priced
Equity Valuation Models

• Balance Sheet Models

Book Value Method
Liquidation Value Method
Replacement Cost Method
• Discounted Cash Flow Models
Dividend Discount Models
Free Cash Flow Models
• Relative valuation methods
Balance Sheet Models

1. Book Value: Net worth of equity according

to a firm’s balance sheet.
2. Liquidation value: Net amount realized by
selling assets of firm and paying off debt
3. Replacement cost: Cost to replace firm’s
assets.
Discounted Cash Flow (DCF)
Models
• Like other assets in finance, the value of a stock is the PV
of its CF’s.
• Stocks are typically valued as perpetual securities as
corporations potentially have an infinite life, and thus can
pay dividends forever.
• Discounted cash flow (DCF) valuation views the intrinsic
value of a security as the present value of its expected
future cash flows.
• When applied to dividends, the DCF model is the
discounted dividend approach (DDA) or dividend discount
model (DDM).
Common Stock Valuation

• Suppose you consider purchasing a share of

stock today, and sell it a year from today. Let P1
be the price that you expect you can sell the
share at a year from today. Then, the value of the
share of the common stock today (P0) is given by:

• D1 P1 D1  P1
Where:
Po  V0   
1 r 1 r 1 r
 Po = Price of Common Stock (V0 = Value of Common Stock)
 D1 = the expected dividend at end of the first period
 r = required rate of return
Example: Stock valuation with a
one year holding period
• You expect that JK Corp stock will sell for $25 one
year from today. You expect to receive $1.20 in
dividends over the year you hold this stock. For a
15% required rate of return for this stock, how much
should you pay for it? What is your projected capital
gain?
Cont…

• Then, how P1 should be determined? There

must be a buyer who is willing to pay P1 at
date 1. If the buyer intend to keep the stock
only one year and sell at the end of the year
(like you do), P1 should be determined by:
D2 P2 D2  P2
P1   
1 r 1 r 1 r

Dn1 Pn1
Pn  
1 r 1 r
Cont…

• Now, plug (2) into (1) then you will have the
following relationship between the value of the
share of stock and dividend.
• If you plug (2) into (1), you will have:
D1 D2 P2
Po   
1 r 1 r 2 1 r 2
Example: Stock valuation with a
two year holding period
• You expect to sell MyCo for $28 two years
from today. You expect to receive $1 dividend
the first year, and a $1.10 dividend the
second year. For a 16% discount rate, what is
the maximum you should pay for this stock?
Cont…

• Note that P2 is again determined by similar

way as.
D3 P3 D3  P3
P2   
1 r 1 r 1 r

• If you plug (3) into (2), you will have:

D1 D2 D3 P3
Po    
1 r 1 r 2 1 r 3 1 r 3
Example: Stock valuation with a
three year holding period
• What you be willing to pay for a stock which
pays a $2 dividend the first year, a $2.10
dividend the second year, and $2.21 in the
third year if you will sell the stock for $40 after
three years? Discount rate is 13%.
Cont…

• Therefore, it can be seen that, if we repeat

this process, we will have:
 Dt
D1 D2 D3
Po 
1 r 1

1 r 2

1 r 3
 ... Po   1 r t
t 1

• Therefore, the value of common stock is the

PV of all the dividend payments.
• That is, the value of a firm’s common stock to
the investor is equal to the PV of all the
expected future value.
Cont…

• In the following, we consider the valuation of

commons stock for three simple cases:
1) Zero Growth Rate
2) Constant Growth Rate
3) Non-constant Growth Rate
Case 1: DDM of Zero Growth

• It assume no growth in dividends.

• The no growth model would work for common
stocks that have earnings and dividends that
are expected to remain constant.
D1  D 2  D3  D 4  D
Cont…

• Since future cash flows are constant, the

value of a zero growth stock is the PV of
perpetuity:
D1 D2 D3
Po     ...
1 r 1 1 r 2 1 r 3

D
P0 
r
Example: DDM of Zero Growth

• Suppose Jone purchase stock which will pay

divided of $4 each year and sell to $40 after
collecting fourth year dividend. The stock
required rate of return is 10%. Compute
intrinsic value of the stock.
• And now assume he decided to hold the stock
for infinite period. Compute intrinsic value of
the stock.
Cont…

• The no growth model is similar to preferred

stock because dividend remains unchanged.
• Hence, a good example of a claim that has
constant dividends is preferred stock.
Case 2: DDM of Constant –
Growth (Gordon Model)
• A constant growth stock is a stock whose
dividends are expected to grow at a constant
rate in the foreseeable future.
• This condition fits many established firms,
which tend to grow over the long run at the
same rate as the economy, fairly well.
Cont…

• To come up with the formula for this case,

let’s assume that dividends will grow at a
constant rate, g, forever. i.e.

D1  D 0 1 g 1

D 2  D 0 1 g 2 
 D1 1 g 1

D3  D 0 1 g 3 
 D1 1 g 2 
 D 2 1 g 1
Example: Dividends Grow at a
Constant Rate
• Assume that Hampshire Products will pay a
dividend of $4 per share a year from now.
Financial analysts believe that dividends will
rise at 6 percent per year for the foreseeable
future. What is the dividend per share at the
end of each of the first five years?
Cont…

• The formula for DDM that assumes dividends will grow at

constant rate is:
D1 D2 D3 D1 D1 1 g 1 D1 1 g 2
Po  1  2  3  ... Po  1    ...
1 r  1 r  1 r  1 r  1 r 2
1 r 3

D0 1 g 1 D0 1 g 2 D0 1 g 3 D0 1 g  D1

Po     ... P0  P0 
1 r  1
1 r 
2
1 r 
3 r  g  r  g 
• Where:
 g = growth rate
 r = required rate return
 r>g
 D1 = the expected dividend at end of the first period
 D0 = the current dividend
Example: DDM Constant –
Growth (Gordon Model)
• Find the stock price given that the current
dividend is $2 per share, dividends are
expected to grow at a rate of 6% in the
foreseeable future, and the required return is
12%.
2 1 0.06 
P0 
0.12  0.06   $35.33
Example: DDM Constant –
Growth (Gordon Model)
• assume your required rate of return (r) for
Wendy’s common stock is 10 percent.
Suppose your research leads you to believe
that Wendy’s Corporation will pay a $0.25
dividend in one year (D1), and for every year
after the dividend will grow at a constant rate
(g) of 8 percent a year. Calculate the present
value of Wendy’s common stock dividends.
Dividend Yield and Capital
Gains Yield
• The constant growth stock equation can be
rearranged to obtain an expression for the
expected return on the stock as follows:
D1
r   g
P0

D1
DividendYi eld  ; CapitalGainYield  g
P0
Cont…

• A more general form of the constant growth

common stock model formula which can be
used to find the price of the stock at any
period t in the future is given by the following:
Dt 1 g  Dt 1
Pt  
rg rg
Example:

• Suppose an investor is considering the

purchase of a share of the U Mining
Company. The stock will pay a $3 dividend a
year from today. This dividend is expected to
grow at 10 percent per year for the
foreseeable future (g=0.1). The stock holder
thinks that required return on this stock is 15
percent (r=0.15). What is the value of a share
of U Mining Company’s stock after one year?
Case 3: DDM of Non-Constant
Growth
• Many firms enjoy periods of rapid growth.
• These periods may result from the introduction of a
new product, a new technology, or an innovative
marketing strategy.
• However, the period of rapid growth cannot continue
indefinitely.
• Eventually, competitors will enter the market and catch
up with the firm.
• These firms cannot be valued properly using the
constant growth stock valuation model.
Cont…

• Stocks which are experiencing the above pattern of

growth are called non-constant, supernormal, or
erratic growth stocks.
• The value of a non-constant growth stock can be
determined using the following equation:
T  D 
Po  
DT
  T 1   T
 1 r
t 1 1 r t  r  g c 

• D = the expected dividend at time t,
T

• T = the number of years of non-constant growth,

• gc = the long-term constant growth rate in dividends, and

• gc < r.
Example: DDM of Non-Constant
Growth
• The current dividend on a stock is $2 per
share and investors require a rate of return of
12%. Dividends are expected to grow at a
rate of 20% per year over the next three years
and then at a rate of 5% per year from that
point on. Find the price of the stock.
Cont…

• Solution:
• There are 3 years of non-constant growth,
thus, T = 3. Before substituting into the
formula given above it is necessary to
calculate the expected dividends for years 1
through 4 using the provided growth rates.
Preferred Stock Valuation

• Because preferred stock pay a constant dividend, they

are easy to value because the dividends are a
perpetuity.
• Recall the present value of a perpetuity is:
Dp
Pp 
r

• Where: PP = Current market value of the preferred stock

• Dp = Amount of the preferred stock dividend per period
• r = Required rate of return per period
Example: Preferred Stock
Valuation
• Suppose investors expect an issue of
preferred stock to pay an annual dividend of
$2 per share. Investors in the market have
evaluated the issuing company and market
conditions and have concluded that 10
percent is a fair rate of return on this
investment. What is the present value for one
share of this preferred stock?
Solution

$2
Pp   $20
0.10

• We find that for investors whose required rate

of return (r) is 10 percent, the value of each
share of this issue of preferred stock is $20.
Example: Preferred Stock
Valuation
• Find the price of a share of preferred stock
given that the par value is $100 per share, the
preferred dividend rate is 8%, and the
required return is 10%.
• Solution:
0.8$100 $80
Pp    $80
0.10 0.10
Free Cash Flow Valuation
Approaches
• The free cash flow valuation extends DCF
analysis to value a company and its equity
securities by valuing free cash flow to the firm
(FCFF) and free cash flow to equity (FCFE).
• Free cash flows are the cash flows available
for distribution to shareholders.
• Free cash flows provide an economically
sound basis for valuation.
Cont…

• Free cash flow to the firm (FCFF) and free

cash flow to equity (FCFE) are the cash flows
available to, respectively, all of the investors
in the company and to common stockholders.
Free Cash Flow to the Firm
(FCFF)
T
FirmValue   1WACC t
FCFFt

PT
1WACC T
t 1

FCFFT 1
PT 
WACC  g

• FCFF = EBIT(1 − tc) + Depreciation − Capital

expenditures − Increase in NWC
• EBIT = Earnings before interest and taxes
• tc = Corporate tax rate
• NWC = Net working capital
Free Cash Flow to Equity
Holders (FCFE)
T
EquityValu e   FCFEt

PT
1 r t 1 r T
t 1

FCFET 1
PT 
rg

• FCFE = FCFF − Interest expense × (1 − tc) +

Increase in net debt
Example: FCFF

• Suppose FCFF = $1 million for years 1 – 4

and then is expected to grow at a rate of 3%.
Assume WACC = 15%
T
FCFF PT
FirmValue   
t 1 (1  WACC ) t
(1  WACC )T

 $1, 000, 000  1.03 

4
$1, 000, 000  .15  .03 
 
t 1 (1  .15) t
(1  .15) 4
 $ 7, 762, 527
Cont…

• If 500,000 shares are outstanding, what is the

predicted price of this common stock if the
firm has $5,000,000 of debt?
$7,762,527  $5,000,000
P0 = = $5.53
500,000
Example: FCFE

• Suppose FCFE = $900,000 for years 1 – 4

and then is expected to grow at a rate of 3%.
Assume ke = 18%
T
FCFE PT
Market Value of Equity =  t
+
t =1 (1+ k e ) (1+ ke )t
$900,000×1.03
4
$900,000 .18  .03
= t
+
t =1 (1+.18) (1+.18)4
= $ 2,500,851
Cont’d

• If there are 500,000 shares outstanding, what

is the predicted price of this common stock?
Why can debt be ignored?

$ 2,500,851
P0 = = $5.00
500,000
Relative Valuation Models

• Earnings multiple or Relative Valuation

methods are also called comparable methods
because they use peers or competitors value
to derive the value of the equity.
• The importance here is of deciding which
factor to be considered for comparison and
which companies should be considered
peers.
Cont…

• Relative valuation technique uses comparisons to

determine a stock’s value.
• By calculating measures such as P/E ratio and
making comparisons to some benchmark(s) such
as the market, an industry or other stocks history
over time, analyst can avoid having to estimate g
and k parameters of DDM.
• In relative valuation, investors use several different
ratios such as P/E, P/B, P/S etc in an attempt to
assess value of a stock through comparison with
benchmark.
Price-to-earnings (P/E)
Ratio/Earnings Multiple
• It is the stock price divided by earnings per
share (EPS), and the units are expressed in
years – how many years of those earnings it
would take to equal that stock price.
• If a stock is $50, and its EPS is $2.50, then
the earnings multiple is 20. It would take
twenty years of $2.50 each year to get $50.
• This model is the best-known and most widely
used model for stock valuation. Analysts are
more comfortable taking about earning per share
(EPS) and P/E ratios, and this is how their
reports are worded.
• P/E ratio simply means the multiples of earnings
at which the stock is selling. For example, if a
stock’s most recent 12 months earning is Tk 5
and its is selling now at Tk 150, then it is said
that the stock is selling for a multiple of 30.
 Determinants of P/E Ratio

• For a constant growth model of DDM,

Price of a stock, P=D1/(k - g)
Or, P/E=(D1/E)/(k - g)
This indicates that P/E depends on:
1. Expected dividend payout ratio, D1/E
2. Required rate of return, k, which is to be estimated
3. Expected growth rate of dividends

© 2012 Pearson Prentice Hall. All rights reserved. 8-53

 Thus following relationship should hold, being
other things equal:
1. The higher the expected payout ratio, the
higher the P/E ratio
2. The higher the expected growth rate, the
higher the P/E ratio
3. The higher the required rate of return, the
lower the P/E ratio

© 2012 Pearson Prentice Hall. All rights reserved. 8-54

Valuation Using P/E Ratio

• To use the earnings multiplier model for valuation of a stock,

investors must look ahead because valuation is always forward
looking. They can do this by making a forecast of next year’s
earnings per share E1, assuming a constant growth model, as
• Next years earning per share, E1=Eo(1+g)
• where, g=ROE X (1 - Payout ratio)
• Then calculate the forward P/E ratio as
• Forward P/E ratio= Po/E1, where E1 is expected earning for next
year
• In practice, analysts often recommend stocks on the basis of this
forward P/E ratio or multiplier by making a relative judgment with
some benchmark.
Other Relative Valuation Ratios

• Price to Book Value(P/B): This is the ratio of

stock price to per share stockholders’ equity.
Analysts recommend lower P/B stock
compared to its own ratio over time, its industry
ratio, and the market ratio as a whole.
• Price to Sales Ratio(P/S): A company’s stock
price divided by its sales per share.
A PSR 1.0 is average for all companies but it is
important to interpret the ratio within industry
bounds and its own historical average.
End of Chapter Four

• Questions???