The Theory and Practice of Investment Management: Asset Allocation,

Valuation, Portfolio Construction, and Strategies, Second Edition

Edited by Frank J. Fabozzi and Harry M. Markowitz
Copyright © 2011 John Wiley & Sons, Inc.

CHAPTER 10
Approaches to
Common Stock Valuation
Pamela P. Drake, Ph.D., CFA
J. Gray Ferguson Professor Finance
College of Business
James Madison University

Frank J. Fabozzi, Ph.D., CFA, CPA

Professor in the Practice of Finance
Yale School of Management

Glen A. Larsen Jr., Ph.D., CFA

Professor of Finance
Indiana University Kelley School of Business–Indianapolis

I n this chapter, we discuss practical methods of valuing common stock

using two methods: discounted cash flow models and relative valuation
models. Both methods require strong assumptions and expectations about
the future. No one single valuation model or method is perfect. All valua-
tion estimates are subject to model error and estimation error. Nevertheless,
common stock analysts use these models to help form their expectations
about a fair market price. In later chapters, other valuation models and
approaches are discussed.

DISCOUNTED CASH FLOW MODELS

If an investor buys a common stock, he or she has bought shares that repre-
sent an ownership interest in the corporation. Shares of common stock are
a perpetual security—that is, there is no maturity. The investor who owns
shares of common stock has the right to receive a certain portion of any cash

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dividends—but dividends are not a sure thing. Whether or not a corpora-

tion pays dividends is up to its board of directors—the representatives of
the common shareholders. Typically, we see some pattern in the dividends
companies pay: Dividends are either constant or grow at a constant rate.
But there is no guarantee that dividends will be paid in the future. It is
reasonable to figure that what an investor pays for a share of stock should
reflect what he or she expects to receive from it—a return on the investor’s
investment. What an investor receives are cash dividends in the future. How
can we relate that return to what a share of common stock is worth? Well,
the value of a share of stock should be equal to the present value of all the
future cash flows an investor expects to receive from that share.
To value stock, therefore, common stock analysts must project future
cash flows, which, in turn, means projecting future dividends. This approach
to the valuation of common stock is referred to the discounted cash flow
approach. There are various discounted cash flow (DCF) models that we can
use to value common stock. We do not describe all of the models. Rather
our primary focus is on models that are referred to as dividend discount
models.

Dividend Discount Models

Most dividend discount models (DDM) use current dividends, some mea-
sure of historical or projected dividend growth, and an estimate of the re-
quired rate of return. Popular models include the basic dividend discount
model, which assumes a constant dividend growth, and the multiple-phase
models. Here we discuss these dividend discount models and their limita-
tions, beginning with a review of the various ways to measure dividends.
Then we look at how dividends and stock prices are related.

Dividend Measures
Dividends are measured using three different metrics: dividends per share,
dividend yield, and dividend payout ratio. The value of a share of stock to-
day is the market’s assessment of today’s worth of future cash flows for each
share. Because future cash flows to shareholders are dividends, we need a
measure of dividends for each share of stock to estimate future cash flows
per share.
The dividends per share is the dollar amount of dividends paid out dur-
ing the period per share of common stock:

Dividends paidtocommon shareholders

Dividends per share =
Number of shares of common stock outstanding
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Another measure of dividends is the dividend yield, which is the ratio of

dividends to the common stock’s current price:
Annual cash dividend per common share
Dividend yield =
Market price per common share

The dividend yield is also called the dividend-price ratio.1

Still another way of describing dividends paid out during a period is to
state the dividends as a portion of earnings for the period. This is the divi-
dend payout ratio:

Dividends paidtocommon shareholders

Dividend payout ratio =
Earnings available to common shareholders

The complement to the dividend payout ratio is the plowback ratio, which
is the percentage of earnings retained by the company during the period.
The proportion of earnings paid out in dividends varies by company
and industry. If the board of directors of companies focuses on maintaining
a constant dividends per share or a constant growth in dividends per share
in establishing their dividend policy, the dividend payout ratio will fluctu-
ate along with earnings. Typically corporate boards set the dividend policy
such that dividends per share grow at a relatively constant rate, resulting in
dividend payouts that fluctuate from year to year.

Basic Dividend Discount Models

As discussed, the basis for the dividend discount model is simply the ap-
plication of present value analysis, which asserts that the fair price of an
asset is the present value of the expected cash flows.2 The cash flows are the
expected dividends per share.
We can express the basic DDM mathematically as
D1 D2 D3
P
0
= + + +
(1 + r )11 (1 + r )22 (1 + r )3 3

or

1
Historically, the dividend yield for U.S. stocks has been a little less than 5% accord-
ing to a study by John Y. Campbell and Robert J. Shiller, “Valuation Ratios and the
Long-Run Stock Market Outlook,” Journal of Portfolio Management 24 (1998):
11–26.
2
This model was first suggested by John Burr Williams, The Theory of Investment
Value (Boston, Mass.: Harvard University Press, 1938).
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∞
D
P0 = ∑ t t
(10.1)
t =1 (1 + rt )

where

P0 = the current price of the stock

D t = the dividend per share in period t
rt = the discount rate appropriate for the cash flow in period t

In this model, the company is expected to pay dividends in the future.

If the company is never expected to pay a dividend, this model implies that
the stock would have no value. To reconcile the fact that stocks not paying
a current dividend do, in fact, have a positive market value with this model,
analysts assume that the company will pay cash someday, at some time N,
even if only a liquidating dividend.

The Finite-Life General Dividend Discount Model

We can modify the DDM given by equation (10.1) by assuming a finite life
for the expected cash flows. In this case, the expected cash flows are the ex-
pected dividends per share and the expected sale price of the stock at some
future date. We refer to this expected price in the future as the terminal price,
and it captures the future value of all subsequent dividends. This model is the
finite-life general DDM and which we can express mathematically as
D1 D2 NP
P0 = + + +
(1 + r1 ) 1 (1 + r2 ) 2 (1 + rN ) N

or
⎡ N
D ⎤ P
0 ∑ t N
t N
P =⎢ ⎥+
⎣ t =1 (1 + rt ) ⎦ (1 + rN )

where PN is the expected value of the stock at the end of period N.

Assuming a Constant Discount Rate A special case of the finite-life general DDM
that is more commonly used in practice assumes that the discount rate is
constant. That is, we assume each rt is the same for all t. Denoting this con-
stant discount rate by r, the value of a share of stock today becomes
D1 D2 PN
P
0 = + + +
(1 + r)1 (1 + r)2 (1 + r)N
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or
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N
⎡ D ⎤ P
0 ⎢∑ t
r)
⎥ ( r)N
(

t N
P = + (10.2)
⎣ t =1 1 + ⎦ 1+

Equation (10.2) is the constant discount rate version of the finite-life general
DDM, and is the more general form of the model.

Required Inputs The finite-life general DDM requires three sets of forecasts
as inputs to calculate the fair value of a stock:
Q Expected terminal price, PN.

Q Dividends up to the assumed horizon, D 1 to D N .

Q Discount rates, r 1 to rN , or r in the case of the constant discount rate

version.

Thus, the relevant issue is how accurately these inputs can be forecasted.
The terminal price is the most difficult of the three forecasts. Accord-
ing to theory, P N is the present value of all future dividends after N; that is,

N+2 '
D N+1 , D , . . . , D . Also, we must estimate the discount rate, r. I

tice, analysts make forecasts of either dividends (D N) or earnings (E N) first,

and then the price PN based on an “appropriate” requirement for yield,

price-earnings ratio, or capitalization rate. Note that the present value of the
expected terminal price PN ÷ (1 + r)N becomes very small if N is very large.

The forecasting of dividends is somewhat easier. Usually, information

on past dividends is readily available and we can estimate cash flows for a
given scenario. The discount rate, r, is the required rate of return, and fore-
casting this rate is more complex. In practice for a given company, analysts
assume that r is constant for all periods, and typically estimate this rate from
the capital asset pricing model (CAPM). The CAPM can be used to estimate
the expected return for a company based on the expected risk-free rate, the
expected market risk premium, and the stock’s systematic risk, its beta.3

Assessing Relative Value Once analysts have an estimate of a stock’s value

from using the DDM, they then compare their estimate of the stock’s
value with the observed price of the stock, if this price is readily avail-
able. If the market price is below the fair price derived from the model,
the stock is undervalued or cheap. The opposite holds for a stock whose
market price is greater than the model-derived price. In this case, the stock
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is said to be overvalued or expensive. A stock trading equal to or close to

its fair price is fairly valued.
3
Using the CAPM, the expected return is the sum of the risk-free rate of interest and
a premium for bearing risk. The premium for bearing risk of a specific asset is the
product of the asset’s beta and the market’s risk premium.
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The use of the DDM tells the analyst the relative value but does not
indicate when the price of the stock should be expected to move to its fair
price. That is, the model says that based on the inputs generated by the
analyst, the stock may be cheap, expensive, or fair. However, it does not tell
the analyst, if the stock is mispriced, how long it will take before the market
recognizes the mispricing and corrects it. As a result, an investor may hold
onto a stock perceived to be cheap for an extended period of time and may
underperform during that period.
While a stock may be mispriced, an analyst must also consider how
mispriced it is in order to take the appropriate action (that is, buy a cheap
stock and expect to sell it when the price rises, or sell short an expensive
stock expecting its price to decline). This will depend on (1) how much the
stock is trading from its fair value, and (2) transactions costs. An analyst
should also consider that a stock may look as if it is mispriced (based on the
estimates and the model), but this may be the result of estimates that may
introduce error in the valuation.

Constant Growth Dividend Discount Model If we assume that future dividends

grow at a constant rate, g, and we use a single discount rate, r, the finite-
life general DDM assuming a constant growth rate given by equation
(10.2) becomes

D (1 + g)1 D (1 + g)2 D (1 + g)N P

0 0 0 N
P0 = + + + +
(1 + r)1 (1 + r)2 (1 + r)N (1 + r)N

It can be shown that if N is assumed to approach infinity, this equation

is equal to
P0 = D0 (1 + g) (10.3)
r−g

Equation (10.3) is the constant growth dividend discount model.4 There-

fore, the greater the expected growth rate of dividends, the greater the esti-
mated value of a share of stock.
In estimating g, if the analyst believes that dividends will grow in the
future at a similar rate as they grew in the past, the dividend growth rate
can be estimated by using the compounded rate of growth of historical divi-
dends. The compound growth rate, g, is found using the following formula:5

4
Myron Gordon and Eli Shapiro, “Capital Equipment Analysis: The Required Rate
of Profit,” Management Science 3 (1956): 102–110.
5
This formula is equivalent to calculating the geometric mean of 1 plus the percent-
age change over the number of years.
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⎛ NumberLast year’sdividend ⎞
g= (10.4)
⎜ of years ⎟ −1
⎝ First year’s dividend ⎠

What if an analyst estimates a stock’s value, and the estimated value is

considerably off the mark when compared to the stock’s actual price? The
reasons for this discrepancy may include:

Q The market’s expectations of the company’s dividend growth pattern

may not be for constant growth.
Q The growth rate of dividends in the past may not be representative of
what investors expect in the future.

Another problem that arises in using the constant growth rate model is that
the estimated growth rate of dividends may exceed the discount rate, r.
Therefore, there are some cases in which it is inappropriate to use the con-
stant rate DDM.

Multiphase Dividend Discount Models The assumption of constant growth may

be unrealistic and can even be misleading. Instead, most practitioners
modify the constant growth DDM by assuming that companies will go
through different growth phases, but within a given phase, it is assumed
that dividends grow at a constant rate.6
The most popular multiphase model employed by practitioners appears
to be the three-stage DDM. This model assumes that all companies go
through three phases, analogous to the concept of the product life cycle. In
the growth phase, a company experiences rapid earnings growth as it pro-
duces new products and expands market share. In the transition phase, the
company’s earnings begin to mature and decelerate to the rate of growth of
the economy as a whole. At this point, the company is in the maturity phase
in which earnings continue to grow at the rate of the general economy.
A three-phase model can be designed to fit different growth patterns.
For example, an emerging growth company would have a longer growth
phase than a more mature company. Some companies are considered to
have higher initial growth rates and hence longer growth and transition
phases. Other companies may be considered to have lower current growth
rates and hence shorter growth and transition phases.

6
For a pioneering work that modified the DDM to accommodate different growth
rates, see Nicholas Molodovsky, CatherineMay, and Sherman Chattiner, “Common-
Stock Valuation—Principles, Tables, and Applications,” Financial Analysts Journal
21 (1965): 104–123.
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Expected Returns and Dividend Discount Models

Thus far we have seen how to calculate the fair price of a stock given the
estimates of dividends, discount rates, terminal prices, and growth rates.7
An analyst then compares the model-derived price to the actual price and
the appropriate action is taken.
We can recast the model in terms of expected return. This is found by
calculating the interest rate that will make the present value of the expected
cash flows equal to the market price. Mathematically, we can express this as

D0 (1 + g) D1
r= +g = +g (10.5)
P0 P0

In other words, the expected return is the discount rate that equates
the present value of the expected future cash flows with the present value
of the stock. The higher the expected return—for a given set of future cash
flows—the lower the current value.
This rearrangement of the dividend discount model provides a perspec-
tive on the expected return: the expected return is the sum of the dividend
yield (that is, D 1/P 0) and the expected rate of growth of dividends. The latter
represents the appreciation (or depreciation, if negative) anticipated for the
stock. Therefore, this is the expected capital gain or loss (or, simply, capital
yield) on the stock.
Given the expected return and the required return (that is, the value
for r), any mispricing can be identified. If the expected return exceeds the
required return, then the stock is undervalued; if it is less than the required
return then the stock is overvalued. A stock is fairly valued if the expected
return is equal to the required return.
With the same set of inputs, the identification of a stock being mispriced
or fairly valued will be the same regardless of whether the fair value is deter-
mined and compared to the market price or the expected return is calculated
and compared to the required return.

RELATIVE VALUATION METHODS

Although stock and company valuation is very strongly tilted toward the
use of DCF methods, it is impossible to ignore the fact that many analysts
use other methods to value equity and entire companies. The primary al-
ternative valuation method is the use of multiples (that is, ratios) that have
7
The formula for this model can be found in Eric Sorensen and Williamson, “Some
Evidence of the Value of Dividend Discount Models,” Financial Analysts Journal 41
(1985): 60–69.
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price or value as the numerator and some form of earnings or cash flow
generating performance measure for the denominator and that are observ-
able for other similar or like-kind companies.
These multiples are sometimes called “price/X ratios,” where the denom-
inator “X” is the appropriate cash flow generating performance measure and
the numerator is either a market value per share or a total market value. For
example, the price/earnings (P/E) ratio is a popular multiple used for relative
valuation, where an earnings estimate is the cash flow generating perfor-
mance measure. Keep in mind that the terms relative valuation and valuation
by multiples are used interchangeably here as are the terms price and value.
The essence of valuation by multiples assumes that similar or compa-
rable companies are fairly valued in the market. As a result, the scaled price
or value (the present value of expected future cash flows) of similar compa-
nies should be much the same. That is, comparable companies should have
similar price/X ratios. The key for the analyst is to find the comparable
companies that can be used for valuing a target company using valuation
by multiples.
Valuation by multiples, or simply relative valuation, is quick and con-
venient. The simplicity and convenience of valuation by multiples, how-
ever, constitute both the appeal of this valuation method and the problems
associated with its use. Simplicity, however, means that too many facts are
swept under the carpet and too many questions remain unasked. Multiples
should never be an analyst’s only valuation method and preferably not even
the primary focus because no two companies, or even groups of companies,
are exactly the same. The term “similar” entails just as much uncertainty
as the concept of “expected future cash flows” in DCF valuation methods.
Actually, when an analyst has more than five minutes to value a company,
the DCF method, which forces an analyst to consider the many aspects of an
ongoing concern, is the preferred valuation method and the use of multiples
should be secondary.
Having said this, valuation by multiples can provide a valuable “sanity
check.” If an analyst has completed a thorough valuation, he can compare
his predicted multiples, such as the P/E ratio or market value to book value
(MV/BV) ratio, to representative multiples of similar companies. In the MV/
BV ratio, the book value of assets is the cash flow generating performance
measure. That is, each dollar of book value of assets is assumed to generate
cash flow for the company. If an analyst’s predicted multiples are compa-
rable, he can, perhaps, feel more assured of the validity of his analysis. On
the other hand, if an analyst’s predicted multiples are out of line with the
representative multiples of the market, the analyst should reexamine the
assumptions, the appropriateness of the comparables, and the appropriate-
ness of the multiple to the situation at hand.
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When using relative valuation, an analyst does not attempt to explain

observed prices of companies. Instead, an analyst uses the appropriately
scaled average price of similar companies to estimate values without speci-
fying why prices are what they are. That is, the average price of similar
companies is scaled by the appropriate “price/X” ratio. In addition, there is
nothing to say that multiple price/X ratios can be used or is appropriate for
the situation and that each one will generally provide a different estimate
of value. Hence, the trick in valuing with multiples is selecting truly compa-
rable companies and choosing the appropriate scaling bases—the appropri-
ate “X” measure.

The Basic Principles of Relative Valuation

To use the word “multiples” is a fancy name for market prices divided (or
“scaled”) by some measure of performance, a Price/X ratio where X is the
measure of performance that is highly correlated with cash flow. In a typi-
cal valuation with multiples, the average multiple—the average price scaled
(that is, divided) by some measure of performance—is applied to a perfor-
mance measure of the target company that an analyst is attempting to value.
For example, suppose an analyst chooses earnings as the scaling mea-
sure; that is, the analyst chooses earnings to be the performance measure
by which prices of similar companies will be scaled. To scale the observed
prices of companies by their earnings, the analyst computes for each com-
pany the ratio of its price to its earnings—its P/E ratio or its earnings mul-
tiple. He then averages the individual P/E ratios to estimate a “representa-
tive” P/E ratio, or a representative earnings multiple. To value a company,
an analyst multiplies the projected profits of the company being valued by
the representative earnings multiple, the average P/E.
When valuing with multiples, the analyst is agnostic regarding what
determines prices. This means that there is no theory to guide the analyst
on how best to scale observed market prices by one of the following: net
earnings, earnings before interest and taxes (EBIT), sales, or book value of
assets. In practice, this means that valuation with multiples requires the use
of several scaling factors or, in other words, several multiples.
Often the best multiples for one industry may not be the preferred mul-
tiples in another industry. This implies, for example, that the practice of
comparing P/E ratios of companies in different industries is problematic
(and in many cases inappropriate altogether). This further implies that when
the analyst performs a multiple-based valuation, it is important first to find
what the industry considers as the best measure of relative values.
Although valuation by multiples differs from valuation by discount-
ing cash flows, its application entails a similar procedure—first projecting
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EXHIBIT 10.1 The Process of Relative Valuation

Determine the Calculate the multiple

Choose comparable
appropriate multiple for the comparable
companies
companies

Value of the Apply the multiple Estimate the base of

company to the subject the multiple for the
company’s base subject company

performance, and then converting projected performance to values using

market prices, as we detail in Exhibit 10.1. Specifically, if an analyst believes,
based on a study of comparable companies, that an appropriate forward-
looking P/E (or any price/X ratio) for a subject company is 17 and expects
earnings to be $3.00 per share in the next period, an estimate of a fair mar-
ket price based on relative valuation assumptions is

Appropriate P/E ratio × Expected earnings = 17 × $3 = $51 per share

Choose Comparable Companies

The whole idea is to estimate a value of the subject company using the
multiple implicit in the pricing of the comparable companies. Therefore, we
want to select comparable companies that are as similar as possible to the
company being valued. The flip-side of this argument, however, is that by
specifying too stringent criteria for similarity, the analyst ends up with too
few companies to compare. With a small sample of comparable companies,
the idiosyncrasies of individual companies affect the average multiples too
much so that the average multiple is no longer a representative multiple. In
selecting the sample of comparable companies, an analyst has to balance
these two conflicting considerations. The idea is to obtain as large a sample
as possible so that the idiosyncrasies of a single company do not affect the
valuation by much, yet not to choose so large a sample that the “compa-
rable companies” are not comparable to the one being valued.
Financial theory states that assets that are of equivalent risk should be
priced the same, all else equal. The key idea here is that we assume that
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comparable companies are of equivalent risk. Thus, the concept of being

able to find comparable companies is the foundation for valuation by mul-
tiples. If there are no comparable companies, then valuation by multiples is
not an option.

Determine an Appropriate Multiple

To convert market prices of comparable companies to a value for the com-
pany being analyzed, an analyst has to scale the valued company relative to
the comparable companies. This is typically done by using several bases of
comparison. Some generic measures of relative size often used in valuation
by multiples are sales, gross profits, earnings, and book values.
Often, however, industry-specific multiples are more suitable than
generic multiples. Examples of industry-specific multiples are price per res-
taurant for fast-food chains, paid miles flown for airlines, and price per
square foot of floor space for retailers. In general, the higher-up that the
scaling basis is in the income statement, the less it is subject to the vagaries
of accounting principles. Thus, scaling basis of sales is much less depen-
dent on accounting methods than earnings per share (EPS). For example,
depreciation or treatment of convertible securities critically affect EPS cal-
culations, but hardly affect sales. On the other hand, the higher-up that
the scaling basis is in the income statement, the less it reflects differences in
operating efficiency across companies—differences that critically affect the
values of the comparable companies as well as the value of the company
being analyzed.

Calculate the Multiple for the Comparable Companies

Once an analyst has a sample of companies that he is considering similar to
the company being valued, an average of the multiples provides a measure
of what the market is willing to pay for comparable companies in order to
estimate a “fair” price for the subject company. For example, after divid-
ing each comparable company’s share price by its EPS to get individual P/E
ratios, the analyst can average the P/E ratios of all comparable companies
to estimate the earnings multiple that analysts think is fair for companies
with these characteristics. The same thing can be done for all the scaling
bases chosen, calculating a “fair price” per dollar of sales, per restaurant,
per square foot of retail space, per dollar of book value of equity, and so on.
Note that we put “fair price” in quotation marks because there is no
market for either EPS or sales or any other scaling measure. The computa-
tion of average multiples is merely a scaling exercise and not an exercise in
finding “how much the market is willing to pay for a dollar of earnings.”
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Investors do not want to buy earnings; they only want cash flows (in the
form of either dividends or capital gains). Earnings (or sales) are paid for
only to the extent that they generate cash. In computing average ratios for
various bases, an analyst implicitly assumes that the ability of companies to
convert each basis (e.g., sales, book value, and earnings) to cash is the same.
Keep in mind that this assumption is more tenable in some cases than in
others and for some scaling factors than for others.
Realize that we use the word “average” to mean the appropriate value
that is determined by the average company in the comparable group. It may
not be the strict average. It may be a mean, median, or mode. The analyst is
also free to throw out outliers that do not seem to conform to the majority
of companies in the group. Outliers are most likely so because the market
has determined that they are different for any number of reasons.

Estimate to Base of the Multiple for the Subject Company

Once we have the multiple for the comparable, we apply it to the project-
ed performance of the company that we are valuing. Therefore, an analyst
needs to project the same measures of the relative size used in scaling the
prices of the comparable companies for the company being valued.
Consider an example in which we want to value Company X, using the
comparables A, B, and C. And suppose we estimate the average P/E of com-
panies A, B, and C to be 15. If we project earnings per share of Company X
as $2, then applying the comparables’ multiple of 15 gives us an estimate of
the value per share for Company X of $30.
The simplest application of valuation with multiples is by projecting the
scaling bases one year forward and applying the average multiple of compa-
rable companies to these projections. For example, the comparable compa-
nies’ average P/E ratio to the projected next year’s earnings of the company
being valued is applied. Clearly, by applying the average multiple to the next
year’s projections, an analyst overemphasizes the immediate prospects of
the company and gives no weight to more distant prospects.
To overcome this weakness of the one-step-ahead projections, an ana-
lyst can use a more sophisticated approach, applying the average multiples
representative projections—projections that better represent the long-term
prospects of the company. For example, instead of applying the average P/E
ratio to next year’s earnings, we can apply the comparable P/E ratio to the
projected average EPS over the next five years. In this way, the representa-
tive earnings’ projections can also capture some of the long-term prospects
of the company, while next year’s figures (with their idiosyncrasies) do not
dominate valuations.
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Apply the Multiple to the Subject Company’s Base

In the final step, an analyst combines the average multiples of comparable
companies to the projected parameters of the subject company (i.e., the com-
pany to be valued) to obtain an estimated value. On the face of it, this is
merely a simple technical step. Yet often it is not. The values that we obtain
from various multiples (i.e., by using several scaling bases) are typically not
the same; in fact, frequently they are quite different. This means that this step
requires some analysis of its own—explaining why valuation by the average
P/E ratio yields a lower value than the valuation by the sales multiple (e.g., the
valued company has higher than normal selling, general, and administrative
expenses) or why the MV/BV ratio yields a relatively low value. The combi-
nation of several values into a final estimate of value, therefore, requires an
economic analysis of both “appropriate” multiples and how multiple-based
values should be adjusted to yield values that are economically reasonable.

KEY POINTS
Q The basis for the dividend discount model is simply the application of
present value analysis, which asserts that the fair price of an asset is the
present value of its expected cash flows.
Q Most dividend discount models use current dividends, some measure of
historical or projected dividend growth, and an estimate of the required
rate of return. The three most common dividend measures are dividends
per share, dividend yield, and dividend payout.
Q Variations of the dividend discount models allow an analyst to vary
assumptions regarding dividend growth to accommodate different pat-
terns of dividends. Popular models include the finite-life general divi-
dend discount model, the constant growth dividend discount model,
and multiphase dividend discount model.
Q A dividend discount model can be recast in terms of expected return. The
expected return is found by calculating the interest rate that will make
the present value of the expected cash flows equal to the market price.
Q An alternative valuation method to the dividend discount model is the
use of multiples that have price or value as the numerator and some form
of earnings or cash flow generating performance measure for the denomi-
nator and that are observable for other similar or like-kind companies.
These multiples are sometimes called “price/X ratios,” where the denom-
inator X is the appropriate cash flow generating performance measure.
Q The essence of valuation by multiples assumes that similar or compa-
rable companies are valued fairly in the market. When using relative
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Approaches to Common Stock ValuationEQUITY ANALYSIS AND PORTFOLIO MANAGEMENT

valuation, no attempt is made by an analyst to explain observed prices

of companies. Rather, an analyst employs suitably scaled average price
of similar companies to estimate values without specifying why prices
are what they are.
Q Despite the fact that valuation by multiples differs from valuation by
discounting cash flows, the application entails a similar procedure,
which involves first forecasting performance, and then converting pro-
jected performance to values using market prices.

QUESTIONS
1. Consider three companies, A, B, and C. Suppose that a common stock
analyst estimates that the market risk premium is 5% and the risk-free
rate is 4.63%. The analyst estimated the beta for each company to be as
follows: Company A, 0.9; Company B, 1.0, and; Company C, 1.2. The
analyst uses to CAPM to estimate the discount rate. The CAPM says
that the expected return is equal to the risk-free rate plus the product of
the market risk premium and the company’s beta. What is the estimated
discount rate for each company?
2. Estimate the value of a share of stock for each of the following compa-
nies using the constant growth model and estimating the average annual
growth rate of dividends from 20X1 through 20X6 as given below as
the basis for estimated growth beyond 20X6:
Dividends per Share
Company 20X1 20X6 Discount Rate
1 $1.00 $1.20 8%
2 $2.00 $1.80 9%
3 $0.50 $0.60 7%
4 $0.25 $0.30 12%

3. Estimate the expected return for each of the following companies:

Current Dividends Expected Growth Value of
Company per Share Rate of Dividends the Stock
T $1.00 2% $25
U $0.50 3% $20
V $1.25 1% $10
W $0.25 2% $15