Chapter 8

Stock Valuation
Stock Valuation

• Learning Goals
1. Explain the role that a company’s future plays in
stock valuation.
2. Develop a forecast of a stock’s cash flow, expected
dividends and share price.
3. Discuss the concepts of intrinsic value and required
rates of return, and note how they are used.
4. Determine the underlying value of a stock using
various dividend valuation models.

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Stock Valuation

• Learning Goals (cont’d)

5. Use other types of present-value-based models
to derive the value of a stock as well as
alternative price-relative procedures.
6. Gain a basic appreciation of the procedures
used to value different types of stocks, from
traditional dividend-paying shares to more
growth-oriented stocks.

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Valuing a Company and Its Future

• The single most important issue in the stock

valuation process is what a stock will do in
the future.
• Value of a stock depends upon its future returns
from dividends and capital gains/losses.
• We use historical data to gain insight into the
future direction of a company and its profitability.
• Past results are not a guarantee of future results.

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Steps in Valuing a Company

• Three steps are necessary to project key

financial variables into the future:
– Step 1: Forecast future sales & profits
– Step 2: Forecast future EPS and dividends
– Step 3: Forecast future stock price

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Step 1: Forecast Future
Sales and Profits
• Forecasted Future Sales based upon:
– “Naïve” approach based upon continued historical trends, or
– Historical trends adjusted for anticipated changes in operations
or environment

• Forecasted Net Profit Margin based upon:

– “Naïve” approach based upon continued historical trends, or
– Historical trends adjusted for anticipated changes in operations or
environment, or
– Earnings forecasts from brokerage houses, Value Line, Forbes, or
other sources

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Step 1: Forecast Future
Sales and Profits (cont’d)

Future after-tax Estimated sales Net profit margin

= 
earnings in year t for year t expected in year t

• Example: Assume last year’s sales were $100

million, revenue growth is estimated at 8% and the
net profit margin is expected to be 6%.

Future after-tax
= $108 million  0.06 = $6.5 million
earnings next year

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Step 2: Forecast Future EPS

• Forecasted outstanding shares of common stock

based upon:
– “Naïve” approach based upon continued historical
tends, or
– Historical trends adjusted for anticipated changes in
operations or environment
• Forecasted Earnings Per Share (EPS) based upon:
Future after-tax
Estimated EPS earnings in year t
=
in year t Number of shares of common stock
outstanding in year t

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Step 2: Forecast Future EPS (cont’d)

• Example: Assume estimated profits are $6.5

million, 2 million shares of common stock
are outstanding, and the dividend payout
ratio is estimated at 40%.

Estimated EPS $6.5 million

= = $3.25
next year 2 million

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Step 2: Forecast Future Dividends

• Forecasted Dividend Payout ratio

based upon:
– “Naïve” approach based upon continued
historical trends, or
– Historical trends adjusted for anticipated
changes in operations or environment
Estimated dividends Estimated EPS Estimated
= 
per share in year t in year t payout ratio

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Step 2: Forecast Future
Dividends (cont’d)
• Example: Assume estimated profits are $6.5
million, 2 million shares of common stock
are outstanding, and the dividend payout
ratio is estimated at 40%.

Estimated dividends
= $3.25  .40 = $1.30
per share next year

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Step 3: Forecast P/E Ratio

• Estimated P/E ratio based upon:

– “Average market multiple” of all stocks in the
marketplace, or
– “Relative P/E multiple” of individual stocks
– Adjust up or down based upon expectations of
economic conditions, general stock market
outlook in near term, or anticipated changes in
company’s operating results

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Step 3: Forecast Future Stock Price

Estimated share price Estimated EPS Estimated P/E

= 
at end of year t in year t ratio
• Example: Assume estimated EPS are $3.25 and
the estimated P/E ratio is 17.5 times.
Estimated share price
= $3.25  17.5 = $56.88
at the end of next year

• To estimate the stock price in three years, extend

the EPS figure for two more years and repeat the
calculations.

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Using Stock Valuation

• Once we have an estimated future stock

price, we can compare it to the current
market price to see if it may be a good
investment candidate:
current price < estimated price undervalued
current price = estimated price fairly valued
current price > estimated price overvalued

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The Valuation Process

• Valuation is a process by which an investor uses risk and

return concepts to determine the worth of a security.
– Valuation models help determine what a stock ought to be worth
– If expected rate of return equals or exceeds our target yield, the
stock could be a worthwhile investment candidate
– If the intrinsic worth equals or exceeds the current market value,
the stock could be a worthwhile investment candidate
– There is no assurance that actual outcome will match
expected outcome

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Required Rate of Return

• Required Rate of Return is the return

necessary to compensate an investor for the
risk involved in an investment.
– Used as a target return to compare forecasted
returns on potential investment candidates
Required Risk-free Stock's  Market Risk-free 
= +    −  
rate of return rate  beta  return rate 

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Required Rate of Return (cont’d)

• Example: Assume a company has a beta of

1.30, the risk-free rate is 5.5% and the
expected market return is 15%. What is the
required rate of return for this investment?

Required return = 5.5% + 1.30  (15.0% − 5.5%) = 17.85%

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Other Stock Valuation Methods

• Dividend Valuation Model

– Zero growth
– Constant growth
– Variable growth
• Dividend and Earnings Approach
• Price/Earnings Approach
• Other Price-Relative Approaches
– Price-to-cash-flow ratio
– Price-to-sales ratio
– Price-to-book-value ratio

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Dividend Valuation Model:
Zero Growth
• Uses present value to value stock
• Assumes stock value is capitalized value of
its annual dividends
• Potential capital gains are really based upon
future dividends to be received
• Assumes dividends will not grow over time
Value of a Annual dividends
=
share of stock Required rate of return

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Dividend Valuation Model:
Constant Growth
• Uses present value to value stock
• Assumes stock value is capitalized value of its
annual dividends
• Assumes dividends will grow at a constant rate
over time
• Works best with established companies with
history of steady dividend payments
Value of a Next year's dividends
=
share of stock Required rate Constant rate of
−
of return growth in dividends

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Dividend Valuation Model:
Variable Growth
• Uses present value to value stock
• Assume stock value is capitalized value of its
annual dividends
• Allows for variable growth in dividend
growth rate
• Most difficult aspect is specifying the appropriate
growth rate over an extended period of time
Present value of
Present value of the price
Value of a share future dividends
= + of the stock at the end of
of stock during the initial
the variable-growth period
variable-growth period

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Dividends-and-Earnings Approach

• Very similar to variable-growth DVM

• Uses present value to value stock
• Assumes stock value is capitalized value of its
annual dividends and future sale price
• Works well with companies who pay little or
no dividends
Present value of
Present value of Present value of
= + the price of the stock
a share of stock future dividends
at date of sale

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Price/Earnings (P/E) Approach

• Future price is based upon the appropriate

P/E ratio and forecasted EPS
• Simple to use and easy to understand
• Widely used in stock valuation

Stock price = EPS  P/E ratio

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Price-to-Cash-Flow (P/CF) Approach

• Similar to P/E approach, but substitutes

projected cash flow for earnings
• Widely used by investors
• Many consider cash flow to be more
accurate than profits to evaluate a stock
Market price of common stock
P/CF ratio =
Cash flow per share

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Price-to-Sales (P/S) Approach

• Similar to P/E approach, but substitutes

projected sales for earnings
• Useful for companies with no earnings or
erratic earnings

Market price of common stock

P/S ratio =
Sales per share

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Price-to-Book-Value
(P/BV) Approach
• Similar to P/E approach, but substitutes
book value for earnings

Market price of common stock

P/BV =
Book value per share

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Chapter 8 Review

• Learning Goals
1. Explain the role that a company’s future plays in
stock valuation.
2. Develop a forecast of a stock’s cash flow, expected
dividends and share price.
3. Discuss the concepts of intrinsic value and required
rates of return, and note how they are used.
4. Determine the underlying value of a stock using
various dividend valuation models.

8-27
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
Chapter 8 Review (cont’d)

• Learning Goals (cont’d)

5. Use other types of present-value-based models
to derive the value of a stock as well as
alternative price-relative procedures.
6. Gain a basic appreciation of the procedures
used to value different types of stocks, from
traditional dividend-paying shares to more
growth-oriented stocks.

8-28
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.