Common Stock Valuation

• Stockholders expect to be compensated for their

investment in a firm’s shares through periodic
dividends and capital gains.
• Investors purchase shares when they feel they are
undervalued and sell them when they believe they are
overvalued.
 Common Stock Valuation
Market Efficiency
• Investors base their investment decisions on their
perceptions of an asset’s risk.
• In competitive markets, the interaction of many buyers
and sellers result’s in an equilibrium price – the market
value – for each security.
• This price is reflective of all information available to
market participants in making buy or sell investment
decisions.
 Common Stock Valuation
Market Adjustment to New Information
• The process of market adjustment to new information
can be viewed in terms of rates of return.
• Whenever investors find that the expected return is
not equal to the required return, price adjustment will
occur.
• If expected return is greater than required return,
investors will buy and bid up price until new
equilibrium price is reached.
• The opposite would occur if required return is greater
than expected return.
 Common Stock Valuation
The Efficient Market Hypothesis
• The efficient market hypothesis, which is the basic
theory describing the behavior of a “perfect” market
specifically states:
– Securities are typically in equilibrium, meaning they are
fairly priced and their expected returns equal their
required returns.
– At any point in time, security prices full reflect all public
information available about a firm and its securities and
these prices react quickly to new information.
– Because stocks are fairly priced, investors need not
waste time trying to find and capitalize on mis-priced
securities.
 Stock Valuation Models
The Basic Stock Valuation Equation
 Stock Valuation Models
The Zero Growth Model

 The zero dividend growth model assumes that

the stock will pay the same dividend each year,
year after year.
 Stock Valuation Models
The Zero Growth Model
What would an investor pay for a stock if she
expected to receive a dividend of $2.50 each year
indefinitely and her RRR is 15%

16.67
 Stock Valuation Models
The Constant Growth Model

• The constant dividend growth model assumes that the

stock will pay dividends that grow at a constant rate
each year -- year after year.
Constant Growth - Example:
The next Dividend for Rolta India will be Rs.4 per share.
Investors require a 16% return on companies such as Rolta
India. Rolta’s Dividend increases by 6% every year. Based on
the Dividend Growth Model, What is the value of Rolta India
stock today?, what is its value in four years?

P0 = D1/r-g = 4 / (0.16 - .06) = Rs.40

D4 = D1 (1+g)3 = Rs.4.764

P4 = D4 (1+g) / (r-g) = Rs.50.50

GROWTH?
 Stock Valuation Models
The Constant Growth Model
What would an investor be willing to pay for a stock if he just received a
dividend of $2.50, his RRR is 15% and he expects dividends to grow at 5%
per year?

26.25
 Stock Valuation Models
Variable Growth Model
• The non-constant
dividend or variable
growth model
assumes that the
stock will pay
dividends that grow
at one rate during
one period, and at
another rate in
another year or
thereafter.
 Stock Valuation Models
Variable Growth Model
W hat would an investor be willing to pay for a stock if she just received
dividend of $2.50, her required return is 15% , and she expected dividne
to grow at a rate of 10% per year for the first two years, and then at a r
5% thereafter.

S te p 1C:o m p u t e t h e e x p e c t e d d ivid e n d s d u rin g t h e firs

g 10.0%
D0 $ 2.50
D1 $ 2.75
D2 $ 3.03
 Stock Valuation Models
Variable Growth Model
W hat would an investor be willing to pay for a stock if she just received
dividend of $2.50, her required return is 15% , and she expected dividne
to grow at a rate of 10% per year for the first two years, and then at a r
5% thereafter.
Step 2: Compute the Estimated Value of the stock at the end of year 2
using the Constant Growth Model

D2 $ 3.03
k 15.00%
g 5.00%
V 2? $ 31.76
 Stock Valuation Models
Variable Growth Model
W hat would an investor be willing to pay for a stock if she just received
dividend of $2.50, her required return is 15% , and she expected dividne
to grow at a rate of 10% per year for the first two years, and then at a r
5% thereafter.
Step 3: Compute the Present Value of all expected cash flows
to find the price of the stock today.

Cash PV at
Flow 15%
1 D1 $ 2.75 $ 2.39
2 D2 $ 3.03 $ 2.29
3 V 2? $ 31.76 $ 24.02
V0 ? $ 28.69
 A common stock just paid a dividend of
Rs.2. The dividend is expected to grow at
8% for 3 years, then it will grow at 4% in
perpetuity. What is the stock worth if the
required rate of return is 12%?
  D n +1 

 

D1  (1 + g1 )   r − g 2 
t
P= 1 − t 
+
r − g1  (1 + r )  (1 + r ) n

 2(1.08) (1.04) 
3
 
2 × (1.08)  (1.08)   .12 − .04 
3
P= 1 − 3
+
.12 − .08  (1.12)  (1.12) 3

P = 54 × [1 − .8966] +
( 32.75)
3
(1.12)

P = 5.58 + 23.31 P = 28.89

Other Approaches to Stock Valuation
Book Value
• Book value per share is the amount per share that
would be received if all the firm’s assets were sold for
their exact book value and if the proceeds remaining
after paying all liabilities were divided among common
stockholders.
• This method lacks sophistication and its reliance on
historical balance sheet data ignores the firm’s
earnings potential and lacks any true relationship to
the firm’s value in the marketplace.
Other Approaches to Stock Valuation
Liquidation Value
• Liquidation value per share is the actual amount per
share of common stock to be received if al of the firm’s
assets were sold for their market values, liabilities
were paid, and any remaining funds were divided
among common stockholders.
• This measure is more realistic than book value
because it is based on current market values of the
firm’s assets.
• However, it still fails to consider the earning power of
those assets.
Other Approaches to Stock Valuation
Valuation Using P/E Ratios
• Some stocks pay no dividends. Using P/E ratios are
one way to evaluate a stock under these
circumstances.
• The model may be written as:
– P = (m)(EPS)
– where m = the estimated P/E multiple.
For example, if the estimated P/E is 15, and a
stock’s earnings are $5.00/share, the estimated
value of the stock would be P = 15*5 =
$75/share.
Other Approaches to Stock Valuation
Weaknesses of Using P/E Ratios
 Determining the appropriate P/E ratio.
◦ Possible Solution: use the industry average P/E ratio
 Determining the appropriate definition of
earnings.
◦ Possible Solution: adjust EPS for extraordinary items
 Determining estimated future earnings
◦ forecasting future earnings is extremely difficult
 Stock Valuation Models
Free Cash Flow Model
• The free cash flow model is based on the same
premise as the dividend valuation models except that
we value the firm’s free cash flows rather than
dividends.
 Stock Valuation Models
Free Cash Flow Model
• The free cash flow valuation model estimates the
value of the entire company and uses the cost of
capital as the discount rate.
• As a result, the value of the firm’s debt and preferred
stock must be subtracted from the value of the
company to estimate the value of equity.
 Stock Valuation Models
Free Cash Flow Model
Dewhurst Inc. wishes to value its stock using the
free cash flow model. To apply the model, the
firm’s CFO developed the data given in Table.
 Stock Valuation Models
Free Cash Flow Model
Step 1: Calculate the present value of the free cash
flow occurring from the end of 2009 to infinity,
measured at the beginning of 2009.
 Stock Valuation Models
Free Cash Flow Model

Step 2: Add the PF of the FCF found in step 1 to

the FCF for 2008.

Total FCF2008 = $600,000 + $10,300,000 = $10,900,000

Step 3: Find the sum of the present values of the

FCFs for 2004 through 2008 to determine VC. This
is shown in Table 7.4 on the following slide.
Stock Valuation Models
Free Cash Flow Model
 Stock Valuation Models
Free Cash Flow Model

Step 4: Calculate the value of the common stock

using equation 7.8.

VS = $8,628,620 - $3,100,000 = $4,728,620