Corporate Finance

Fifth Edition, Global Edition

Chapter 9
Valuing Stocks

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Chapter Outline
9.1 The Dividend-Discount Model
9.2 Applying the Dividend-Discount Model
9.3 Total Payout and Free Cash Flow Valuation Models
9.4 Valuation Based on Comparable Firms
9.5 Information, Competition, and Stock Prices

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Learning Objectives (1 of 4)
• Describe, in words, the Law of One Price value for a
common stock, including the discount rate that should be
used.
• Calculate the total return of a stock, given the dividend
payment, the current price, and the previous price.
• Use the dividend-discount model to compute the value of a
dividend-paying company’s stock, whether the dividends
grow at a constant rate starting now or at some time in the
future.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Learning Objectives (2 of 4)
• Discuss the determinants of future dividends and growth
rate in dividends, and the sensitivity of the stock price to
estimate those two factors.
• Given the retention rate and the return on new investment,
calculate the growth rate in dividends, earnings, and share
price.
• Describe circumstances in which cutting the firm’s dividend
will raise the stock price.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Learning Objectives (3 of 4)
• Assuming a firm has a long-term constant growth rate after
time N + 1, use the constant growth model to calculate the
terminal value of the stock at time N.
• Compute the stock value of a firm that pays dividends as
well as repurchasing shares.
• Use the discounted free cash flow model to calculate the
value of stock in a company with leverage.
• Use comparable firm multiples to estimate stock value.
• Explain why several valuation models are required to value
a stock.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Learning Objectives (4 of 4)
• Describe the impact of efficient markets hypothesis on
positive-N PV trades by individuals with no inside
information.
• Discuss why investors who identify positive-N PV trades
should be skeptical about their findings, unless they have
inside information or a competitive advantage. As part of
that, describe the return the average investor should
expect to get.
• Assess the impact of stock valuation on recommended
managerial actions.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

9.1 The Dividend-Discount Model (1 of 2)
• A One-Year Investor
– Potential Cash Flows
▪ Dividend
▪ Sale of Stock
– Timeline for One-Year Investor

• Since the cash flows are risky, we must discount them at

the equity cost of capital

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

9.1 The Dividend-Discount Model (2 of 2)
• A One-Year Investor
 Div1 + P1 
P0 =  
 1 + rE 
– If the current stock price were less than this amount,
expect investors to rush in and buy it, driving up the
stock’s price
– If the stock price exceeded this amount, selling it would
cause the stock price to quickly fall

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Dividend Yields, Capital Gains, and
Total Returns
Div1 + P1 Div1 P1 − P0
rE = − 1= +
P0 P0 P0
Dividend Yield Capital Gain Rate

• Dividend Yield
• Capital Gain
– Capital Gain Rate
• Total Return
– Dividend Yield + Capital Gain Rate
▪ The expected total return of the stock should equal the
expected return of other investments available in the market
with equivalent risk
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
Textbook Example 9.1 (1 of 2)
Stock Prices and Returns
Problem
Suppose you expect Walgreens Boots Alliance (a drugstore
chain) to pay dividends of $1.60 per share and trade for $70
per share at the end of the year. If investments with
equivalent risk to Walgreen’s stock have an expected return
of 8.5%, what is the most you would pay today for
Walgreen’s stock? What dividend yield and capital gain rate
would you expect at this price?

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Textbook Example 9.1 (2 of 2)
Solution
Using Eq. 9.1, we have

Div1 + p1 1.60 + 70.00

P0 = = = $65.99
1+ rE 1.085
Div1 1.60
At this price, Walgreen’s dividend yield is = = 2.42%.
P0 65.99
The expected capital gain is $70.00 − $65.99 = $4.01 per
share, for a capital gain rate of 4.01 = 6.08%.
65.99
Therefore, at this price, Walgreen’s expected total return is
2.42% + 6.08% = 8.5%, which is equal to its equity cost of
capital.
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
Alternative Example 9.1 (1 of 2)
Problem
– 3M (MMM) just paid a dividend of $4.50 per share.
– You expect the stock price to be $178.50 and the
dividend to be 5% higher by the end of the year.
– Investments with equivalent risk have an expected
return of 11%.
– Based on the Dividend-Discount Model, what would
you pay today for 3M stock?

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Alternative Example 9.1 (2 of 2)
Solution
– Dividend in one year
▪ $4.50 × 1.05 = $4.725
Div1 + P1 $4.725 + $178.50
P0 = = = $165.07
(1 + rE ) (1 .11)

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

A Multi-Year Investor
• What is the price if we plan on holding the stock for two
years?

Div1 Div2 + P2
P0 = +
1 + rE (1 + rE ) 2

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

The Dividend-Discount Model Equation
(1 of 2)

• What is the price if we plan on holding the stock for N

years?
Div1 Div2 DivN PN
P0 = + +  + +
1 + rE (1 + rE ) 2
(1 + rE ) N
(1 + rE ) N

– This is known as the Dividend-Discount Model

▪ Note that the above equation (9.4) holds for any
horizon N
– Thus all investors (with the same beliefs) will
attach the same value to the stock, independent
of their investment horizons
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
The Dividend-Discount Model Equation
(2 of 2)


Div1 Div2 Div3 Divn
P0 = + 2
+ 3
+L= n
1 + rE (1 + rE ) (1 + rE ) n =1 (1 + rE )

• The price of any stock is equal to the present value of the

expected future dividends it will pay

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

9.2 Applying the Discount-Dividend
Model (1 of 2)
• Constant Dividend Growth
– The simplest forecast for the firm’s future dividends
states that they will grow at a constant rate, g, forever

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

9.2 Applying the Discount-Dividend
Model (2 of 2)
• Constant Dividend Growth Model
Div1
P0 =
rE − g

Div1
rE = +g
P0

– The value of the firm depends on the current dividend

level, the cost of equity, and the growth rate

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Textbook Example 9.2 (1 of 2)
Valuing a Firm with Constant Dividend Growth
Problem
Consolidated Edison, Inc. (Con Edison), is a regulated utility
company that services the New York City area. Suppose
Con Edison plans to pay $3.00 per share in dividends in the
coming year. If its equity cost of capital is 6% and dividends
are expected to grow by 2% per year in the future, estimate
the value of Con Edison’s stock.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Textbook Example 9.2 (2 of 2)
Solution
If dividends are excepted to grow perpetually at a rate of 2%
per year, we can use Eq. 9.6 to calculate the price of a share
of Con Edison stock:

Div1 $3.00
PO = = = $75
rE − g 0.06 − 0.02

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Alternative Example 9.2 (1 of 2)
Problem
– AT&T plans to pay $1.44 per share in dividends in the
coming year.
– Its equity cost of capital is 8%.
– Dividends are expected to grow by 4% per year in the
future.
– Estimate the value of AT&T’s stock.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Alternative Example 9.2 (2 of 2)
Solution

Div1 $1.44
P0 = = = $36.00
rE − g .08 − .04

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Dividends Versus Investment and
Growth (1 of 6)
• A Simple Model of Growth
– Dividend Payout Ratio
▪ The fraction of earnings paid as dividends each year

Earnings t
Divt = × Dividend Payout Rate t
Shares Outstanding t
EPSt

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Dividends Versus Investment and
Growth (2 of 6)
• A Simple Model of Growth
– Assuming the number of shares outstanding is
constant, the firm can do two things to increase its
dividend:
▪ Increase its earnings (net income)
▪ Increase its dividend payout rate

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Dividends Versus Investment and
Growth (3 of 6)
• A Simple Model of Growth
– A firm can do one of two things with its earnings:
▪ It can pay them out to investors
▪ It can retain and reinvest them

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Dividends Versus Investment and
Growth (4 of 6)
• A Simple Model of Growth

Change in Earnings = New Investment × Return on New Investment

New Investment = Earnings × Retention Rate

– Retention Rate
▪ Fraction of current earnings that the firm retains

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Dividends Versus Investment and
Growth (5 of 6)
• A Simple Model of Growth

Change in Earnings
Earnings Growth Rate =
Earnings
= Retention Rate × Return on New Investment

g = Retention Rate × Return on New Investment

– If the firm keeps its retention rate constant, then the
growth rate in dividends will equal the growth rate of
earnings

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Dividends Versus Investment and
Growth (6 of 6)
• Profitable Growth
– If a firm wants to increase its share price, should it cut
its dividend and invest more, or should it cut
investment and increase its dividend?
▪ The answer will depend on the profitability of the
firm’s investments
– Cutting the firm’s dividend to increase
investment will raise the stock price if, and only
if, the new investments have a positive NPV

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Textbook Example 9.3 (1 of 3)
Cutting Dividends for Profitable Growth
Problem
Crane sporting goods expect to have earnings per share of $6 in
the coming year. Rather than reinvest these earnings and grow,
the firm plans to pay out all of its earnings as a dividend. With
these expectations of no growth, Crane’s current share price is
$60.
Suppose crane could cut its dividend payout rate to 75% for the
foreseeable future and use the retained earnings to open new
stores. The return on its investment in these stores is expected to
be 12%. Assuming its equity cost of capital is unchanged, what
effect would this new policy have on Crane’s stock price?

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Textbook Example 9.3 (2 of 3)
Solution
First, let’s estimate Crane’s equity cost of capital. Currently, Crane plans to pay
a dividend equal to its earnings of $6 per share. Given a share price of $60,
Crane’s dividend yield is $6 =10%. With no expected growth (g = 0),
$60

we can use Eq. 9.7 to estimate rE:

Div1
rE = + g = 10% + 0% = 10%
P0
In other words, to justify Crane’s stock price under its current policy, the expected
return of other stocks in the market with equivalent risk must be 10%.
Next, we consider the consequences of the new policy. If Crane reduces its
dividend payout rate to 75%, then from Eq. 9.8 its dividend this coming year will
fall to Div1 = EPS1 × 75% = $6 × 75% = $4.50. At the same time, because the
firm will now retain 25% of its earnings to invest in new stores, from Eq. 9.12 its
growth rate will increase to
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
Textbook Example 9.3 (3 of 3)
g = Retention Rate × Return on New Investment = 25% × 12% =
3%
Assuming Crane can continue to grow at this rate, we can
compute its share price under the new policy using the constant
dividend growth model of Eq. 9.6:

Div1 $4.50
P0 = = = $64.29
rE − g 0.10 − 0.03

Thus, Crane’s share price should rise from $60 to $64.29 if it cuts
its dividend to invest in projects that offer a return (12%) greater
than their cost of capital (which we assume remains 10%). These
projects are positive NPV, and so by taking them Crane has
created value for its shareholders.
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
Textbook Example 9.4 (1 of 2)
Unprofitable Growth
Problem
Suppose Crane Sporting Goods decides to cut its dividend
payout rate to 75% to invest in new stores, as in Example
9.3 but now suppose that the return on these new
investments is 8%, rather than 12%. Given its excepted
earnings per share this year of $6 and its equity cost of
capital of 10%, what will happen to Crane’s current share
price in this case?

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Textbook Example 9.4 (2 of 2)
Solution
Just as in Example 9.3, Crane’s dividend will fall to $6 × 75%
= $4.50. Its growth rate under the new policy, given the lower
return on new investment, will now be g = 25% × 8% = 2%.
The new share price is there fore
Div1 $4.50
P0 = = = $56.25
rE − g 0.10 − 0.02
Thus, even though Crane will grow under the new policy, the
new investments have negative NPV. Crane’s share price
will fall if it cuts its dividend to make new investments with a
return of only 8% when its investors can earn 10% on other
investments with comparable risk.
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
Alternative Example 9.4 (1 of 3)
Problem
– Dren Industries is considering expanding into a new product
line.
– Earnings per share are expected to be $5 in the coming
year and are expected to grow annually at 5% without the
new product line but growth would increase to 7% if the new
product line is introduced.
– To finance the expansion, Dren would need to cut its
dividend payout ratio from 80% to 50%.
– If Dren’s equity cost of capital is 11%, what would be the
impact on Dren’s stock price if they introduce the new
product line? Assume the equity cost of capital will remain
unchanged.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Alternative Example 9.4 (2 of 3)
Solution
– First, calculate the current price for Dren if they do not
introduce the new product. To calculate the price, D1 is
needed. To find D1, EPS1 is required:
EPS1 = EPS0 × (1 + g ) = $5.00×1.05 = $5.25
D1 = EPS1 ×Payout Ratio = $5.25×0.8 = $4.20
D1 $4.20
P0 = = = $70.00
( rE − g ) ( 0.11 − 0.05)
– Thus, the current price without the new product should
be $70 per share.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Alternative Example 9.4 (3 of 3)
Solution
– Next, calculate the expected current price for Dren if they
introduce the new product:
EPS1 = EPS0 × (1 + g ) = $5.00×1.07 = $5.35
D1 = EPS1 ×Payout Ratio = $5.35×0.50 = $2.675
D1 $2.675
P0 = = = $66.875
( rE − g ) ( 0.11 − 0.07 )
– Thus, the current price is expected to fall from $70 to
$66.875 if the new product line is introduced.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Changing Growth Rates (1 of 3)
• We cannot use the constant dividend growth model to
value a stock if the growth rate is not constant
– For example, young firms often have very high initial
earnings growth rates
– During this period of high growth, these firms often
retain 100% of their earnings to exploit profitable
investment opportunities
– As they mature, their growth slows
– At some point, their earnings exceed their investment
needs, and they begin to pay dividends

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Changing Growth Rates (2 of 3)
• Although we cannot use the constant dividend growth
model directly when growth is not constant, we can use the
general form of the model to value a firm by applying the
constant growth model to calculate the future share price
of the stock once the expected growth rate stabilizes

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Changing Growth Rates (3 of 3)

DivN + 1
PN =
rE − g

• Dividend-Discount Model with Constant Long-Term Growth

Div1 Div2 DivN 1  DivN +1 

P0 = + +L+ +  
1 + rE (1 + rE ) 2
(1 + rE ) N
(1 + rE ) N  rE − g 

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Limitations of the Dividend-Discount
Model
• There is a tremendous amount of uncertainty associated
with forecasting a firm’s dividend growth rate and future
dividends
• Small changes in the assumed dividend growth rate can
lead to large changes in the estimated stock price

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Alternative Example 9.6 (1 of 2)
Problem
– Montalvan Inc., expects to have $125 million in
earnings for the year and earnings are expected to
grow at 6% annually.
– The firm does not pay any dividends, but it intends to
use 25% of its earnings for stock repurchases.
– Motalvan’s cost of equity is 15%, and it has 25 million
shares outstanding.
– What is Montalvan’s stock price?

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Alternative Example 9.6 (2 of 2)
Solution
– Amount dedicated to stock repurchases
▪ 25% × $125 million = $31.25 million

$31.25 million
PV (Future Total Dividends and Repurchases) = == $347.22 million
.15 − .06

$347.22 million
P0 = = $13.89 / share
25 million shares

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

The Discounted Free Cash Flow Model (1 of 5)

• Discounted Free Cash Flow Model

– Determines the value of the firm to all investors,
including both equity and debt holders

Enterprise Value = Market Value of Equity + Debt − Cash

– The enterprise value can be interpreted as the net cost

of acquiring the firm’s equity, taking its cash, paying off
all debt, and owning the unlevered business

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

The Discounted Free Cash Flow Model (2 of 5)

• Valuing the Enterprise

Unlevered Net Income

Free Cash Flow = EBIT × (1 − τ c ) + Depreciation

− Capital Expenditures − Increases in Net Working Capital
– Free Cash Flow
▪ Cash flow available to pay both debt holders and equity
holders
– Discounted Free Cash Flow Model
V0 = PV (Future Free Cash Flow of Firm)
V0 + Cash 0 − Debt 0
P0 =
Shares Outstanding 0

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

The Discounted Free Cash Flow Model (3 of 5)

• Implementing the Model

– Since we are discounting cash flows to both equity
holders and debt holders, the free cash flows should
be discounted at the firm’s weighted average cost of
capital, rwacc. If the firm has no debt, rwacc = rE

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

The Discounted Free Cash Flow Model (4 of 5)

• Implementing the Model

FCF1 FCF2 FCFN VN

V0 = + +    + +
1 + rwacc (1 + rwacc ) 2 (1 + rwacc ) N (1 + rwacc ) N

– Often, the terminal value is estimated by assuming a

constant long-run growth rate gFCF for free cash flows
beyond year N, so that

FCFN + 1  1 + g FCF 
VN = =  × FCFN
rwacc − g FCF  (rwacc − g FCF ) 

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Textbook Example 9.7 (1 of 3)
Valuing Kenneth Cole Using Free Cash Flow
Problem
– Kenneth Cole (KCP) had sales of $518 million in 2005. Suppose you
expect its sales to grow at a 9% rate in 2006, but that this growth rate will
slow by 1% per year to a long –run growth rate for the apparel industry of
4% by 2011. Based on KCP’s past profitability and investment needs, you
expect EBITto be 9% of sales, increases in net working capital
requirements to be 10% of any increase in sales, and net investment
(capital expenditures in excess of depreciation) to be 8% of any increase
in sales. If KCPhas $100 million in cash, $3 million in debt, 21 million
shares outstanding, a tax rate of 37%, and a weighted average cost of
capital of 11%, what is your estimate of the value of KCP’s stock in early
2006?

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Textbook Example 9.7 (2 of 3)
Solution
Using Eq. 9.20, we can estimate KCP’s future free cash flow
based on the estimates above as follows:

Because we expect KCP’s free cash flow to grow at a constant

rate after 2011, we can use Eq. 9.24 to compute a terminal
enterprise value:
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
Textbook Example 9.7 (3 of 3)

 1 + g FCF   1.04 
V2011 =  × FCF =  0.11 − 0.04  × 37.6 = $558.6 million
 rwacc − g FCF
2011
  

From Eq. 9.23, KCP’s current enterprise value is the present

value of its free cash flows plus the terminal enterprise
value:
23.6 26.4 29.3 32.2 35.0 37.6 + 558.6
V0 = + + + + + = $424.8 million
1.11 1.112 1.113 1.114 1.115 1.116
We can now estimate the value of a share of KCP’s stock
using Eq. 9.22:
424.8 +100 − 3
P0 = = $24.85
21
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
Alternative Example 9.7 (1 of 3)
Problem
– At the end of 2019, Newerks Inc. forecasts that its free
cash flow will be $50 million in 2020, $60 million in
2021, and $72 million in 2022.
– After 2022, Newerks expects its free cash flow
earnings to grow at an annual rate of 6%.
– Newerks has $75 million in debt and $25 million in
cash.
– If Newerks has 5 million shares outstanding and a cost
of capital of 14%, what is Newerks stock price at the
end of 2019?

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Alternative Example 9.7 (2 of 3)
Solution
– The terminal enterprise value at the end of 2022 is
calculated as

 1 + g FCF 
V2022 =  × FCF2022
 rWACC − g FCF 
 1.06 
V2022 =  × $72 million = $954 million
 .14 − .06 

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Alternative Example 9.7 (3 of 3)
Solution
– The present value of its free cash flows plus the
terminal enterprise value is calculated as

$50 $60 $72 + $954

V2019 = 1
+ 2
+ 3
= $782.55 million
1.14 1.14 1.14

$782.55 + $75 − $25

P2019 = = $166.51
5

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

The Discounted Free Cash Flow Model (5 of 5)

• Connection to Capital Budgeting

– The firm’s free cash flow is equal to the sum of the free
cash flows from the firm’s current and future
investments, so we can interpret the firm’s enterprise
value as the total NPV that the firm will earn from
continuing its existing projects and initiating new ones.
▪ The NPV of any individual project represents its
contribution to the firm’s enterprise value. To
maximize the firm’s share price, we should accept
projects that have a positive NPV.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Textbook Example 9.8 (1 of 3)
Sensitivity Analysis for Stock Valuation
Problem
In example 9.7, KCP’s revenue growth rate was assumed to
be 9% in 2006, slowing to a long term growth rate of 4%.
How would your estimate of the stock’s value change if you
expected revenue growth of 4% from 2006 on? How would it
change if in addition you expected EBIT to be 7% of sales,
rather than 9%?

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Textbook Example 9.8 (2 of 3)
Solution
With 4% revenue growth and a 9% EBIT margin, K C P will have
2006 revenues of 518 × 1.04 = $538.7 million, and EBIT of
9%(538.7) = $48.5 million. Given the increase in sales of 538.7 −
518.0 = $20.7 million, we expect net investment of 8%(20.7) =
$1.7 million and additional net working capital of 10%(20.7) = $2.1
million. Thus, KCP’s expected FCF in 2006 is

FCF06 = 48.5(1 − 0.37) − 1.7 − 2.1 = $26.8 million

Because growth is expected to remain constant at 4%, we can
estimate KCP’s enterprise value as a growing perpetuity:
$26.8
V0 = = $383million
(0.11 − 0.04)
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
Textbook Example 9.8 (3 of 3)
(383+100 − 3)
for an initial share value of P0 = = $22.86.
21

Thus, comparing this result with that of Example 9.7, we see that a
higher initial revenue growth of 9% versus 4% contributes about $2 to the
value of KCP’s stock.
If, in addition, we expect KCP’s EBIT margin to be only 7%, our FCF
estimate would decline to
FCF06 = (.07 × 538.7)(1 − .37) − 1.7 − 2.1 = $20.0 million
$20
for an enterprise value of V0 = = $286 million and a share
(0.11 − 0.04)
(286 +100 − 3)
value of P0 = = $18.24.
21
Thus, we can see that maintaining an EBIT margin of 9%versus 7%
contributes more than $4.50 to KCP’s stock value in this scenario.
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
Alternative Example 9.8 (1 of 3)
Problem
– How would the stock price of Newerks Inc., change if
the expected revenue growth rate in Alternative
Example 9.7 was increased from 6% to 7%?

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Alternative Example 9.8 (2 of 3)
Solution
– The terminal enterprise value at the end of 2022 is
calculated as

 1 + g FCF 
V2022 =  × FCF2022
 rWACC − g FCF 
 1.07 
V2022 =  × $72 million = $1,101 million
 .14 − .07 

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Alternative Example 9.8 (3 of 3)
Solution
– The present value of its free cash flows plus the
terminal enterprise value is calculated as

$50 $60 $72 + $1,101

V2019 = 1
+ 2
+ 3
= $881.77 million
1.14 1.14 1.14

$881.77 + $75 − $25

P2019 = = $186.35
5

– Thus, the increase in the growth rate by 1% increased the

stock price by $19.84 or 11.9%

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Figure 9.1 A Comparison of Discounted
Cash Flow Models of Stock Valuation

Present value of… At the … Determines the..

Dividend Payments Equity cost of capital Stock Price
Total Payouts (All dividends Equity cost of capital Equity Value
and repurchases)
Free Cash Flow (Cash Weighted average cost Enterprise Value
available to pay all security of capital
holders)

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

9.4 Valuation Based on Comparable
Firms
• Method of Comparables (Comps)
– Estimate the value of the firm based on the value of
other, comparable firms or investments that we expect
will generate very similar cash flows in the future

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Valuation Multiples (1 of 5)
• Valuation Multiple
– A ratio of firm’s value to some measure of the firm’s
scale or cash flow
• The Price-Earnings Ratio
– P/E Ratio
▪ Share price divided by earnings per share

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Valuation Multiples (2 of 5)
• Trailing Earnings
– Earnings over the last 12 months
• Trailing P/E
• Forward Earnings
– Expected earnings over the next 12 months
• Forward P/E

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Valuation Multiples (3 of 5)

P0 Div1 / EPS1 Dividend Payout Rate

Forward P /E = = =
EPS1 rE − g rE − g

• Firms with high growth rates, and which generate cash

well in excess of their investment needs so that they can
maintain high payout rates, should have high P/E multiples

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Textbook Example 9.9 (1 of 2)
Valuation Using the Price-Earnings Ratio
Problem
Suppose furniture manufacturer Herman Miller, Inc., has
earnings per share of $1.99. If the average P/E of
comparable furniture stocks is 24.6, estimate a value for
Herman Miller using the P/E as a valuation multiple. What
are the assumptions underlying this estimate?

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Textbook Example 9.9 (2 of 2)
Solution
We estimate a share price for Herman Miller by multiplying
its EPS by the P/E of comparable firms. Thus, P0 = $1.99 ×
24.6 = $48.95. This estimate assumes that Herman Miller
will have similar future risk, payout rates, and growth rates to
comparable firms in the industry.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Alternative Example 9.9 (1 of 2)
Problem
– Best Buy Co. Inc. (BBY), has earnings per share of
$2.57.
– The average P/E of comparable companies’ stocks is
19.7.
– Estimate a value for Best Buy using the P/E as a
valuation multiple.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Alternative Example 9.9 (2 of 2)
Solution
– The share price for Best Buy is estimated by
multiplying its earnings per share by the P/E of
comparable firms.
– P0 = $2.57 × 19.7 = $50.62

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Valuation Multiples (4 of 5)
• Enterprise Value Multiples

V0 FCF1 / EBITDA1
=
EBITDA1 rwacc − g FCF

– This valuation multiple is higher for firms with high

growth rates and low capital requirements (so that free
cash flow is high in proportion to EBITDA)

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Textbook Example 9.10 (1 of 2)
Valuation Using an Enterprise Value Multiple
Problem
Suppose Rocky Shoes and Boots (RCKY) has earnings per
share of $2.30 and EBITDAof $30.7 million. RCKY also has
5.4 million shares outstanding and debt of $125 million (net
of cash). You believe Deckers Outdoor Corporation is
comparable to RCKY in terms of its underlying business, but
Deckers has little debt. If Deckers has a P/E of 13.3 and an
enterprise value to EBITDAmultiple of 7.4, estimate the
value of RCKY’s shares using both multiples. Which
estimate is likely to be more accurate?

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Textbook Example 9.10 (2 of 2)
Solution
Using Decker’s P/E, we would estimate a share price for
RCKY of P0 = $2.30 × 13.3 = $30.59. Using the enterprise
value to EBITDAmultiple, we would estimate RCKY’s
enterprise value to be V0 = $30.7 million × 7.4 = $227.2
million. We then subtract debt and divide by the number
of shares to estimate RCKY’s share price:
(227.2 −125)
P0 = = $18.93.
5.4
Because of the large difference in leverage between the
firms, we would expect the second estimate, which is based
on enterprise value, to be more reliable.
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
Alternative Example 9.10 (1 of 2)
Problem
– Best Buy Co. Inc. (BBY), has EBITDAof
$2,550,000,000 and 300 million shares outstanding.
– Best Buy also has $1,358,000,000 in debt and
$1,300,000,000 in cash.
– If Best Buy has an enterprise value to EBITDA
multiple of 7.7, estimate the value for a share of
Best Buy stock.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Alternative Example 9.10 (2 of 2)
• Solution
– Using the enterprise value to EBITDA multiple, Best
Buy’s enterprise value is $2,550 million × 7.7 =
$19,635.00 million.
– Subtract out the debt, add the cash, and divide by the
number of shares to estimate the Best Buy’s share
price.

$19, 635 − $1,358 + $1,300

P0 = = $62.26
300

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Valuation Multiples (5 of 5)
• Other Multiples
– Multiple of sales
– Price to book value of equity per share
– Enterprise value per subscriber
▪ Used in cable TV industry

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Limitations of Multiples
• When valuing a firm using multiples, there is no clear
guidance about how to adjust for differences in expected
future growth rates, risk, or differences in accounting
policies
• Comparables only provide information regarding the value
of a firm relative to other firms in the comparison set
– Using multiples will not help us determine if an entire
industry is overvalued

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Comparison with Discounted Cash
Flow Methods
• Discounted cash flows methods have the advantage that
they can incorporate specific information about the firm’s
cost of capital or future growth
– The discounted cash flow methods have the potential
to be more accurate than the use of a valuation
multiple

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Table 9.1 Stock Prices and Multiples for
the Footwear Industry, January 2006

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Stock Valuation Techniques: The Final
Word
• No single technique provides a final answer regarding a
stock’s true value
• All approaches require assumptions or forecasts that are
too uncertain to provide a definitive assessment of the
firm’s value
– Most real-world practitioners use a combination of
these approaches and gain confidence if the results
are consistent across a variety of methods

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Figure 9.2 Range of Valuations for KCP
Stock Using Alternative Valuation
Methods

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

9.5 Information, Competition, and Stock
Prices (1 of 2)
• Information in Stock Prices
– Our valuation model links the firm’s future cash flows,
its cost of capital, and its share price
– Given accurate information about any two of these
variables, a valuation model allows us to make
inferences about the third variable

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Figure 9.3 The Valuation Triad

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

9.5 Information, Competition, and Stock
Prices (2 of 2)
• Information in Stock Prices
– For a publicly traded firm, its current stock price should
already provide very accurate information, aggregated
from a multitude of investors, regarding the true value
of its shares
▪ Based on its current stock price, a valuation model
will tell us something about the firm’s future cash
flows or cost of capital

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Textbook Example 9.11 (1 of 2)
Using the Information in Market Prices
Problem
Suppose Tecnor Industries will pay a dividend this year of $5
per share. Its equity cost of capital is 10%, and you except
its dividends to grow at a rate of about 4% per year, though
you are somewhat unsure of the precise growth rate. If
Tecnor’s stock is currently tradings for $76.92 per share, how
would you update your beliefs about its dividend growth
rate?

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Textbook Example 9.11 (2 of 2)
Solution
If we apply the constant dividend growth model based on a 4% growth
rate, we would estimate a stock price of
5
P0 = = $83.33 per share. The market price of $76.92,
(0.10 − 0.04)
however, implies that most investors except dividends to grow at a
somewhat slower rate. If we continue to assume a constant growth rate,
we can solve for the growth rate consistent with the current market price
using Eq. 9.7:
Div1 5
g = rE − =10% − = 3.5%
P0 76.92
Thus, given this market price for the stock, we should lower our
expectations for the dividend growth rate unless we have very strong
reasons to trust our own estimate.
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
Alternative Example 9.11 (1 of 3)
Problem
– FitOne Company plans to pay a dividend this year of
$3.50 per share.
– Its equity cost of capital is 12%, and you expect its
dividends to grow at a rate of about 3% per year,
though you are somewhat unsure of the precise growth
rate.
– If FitOne’s stock is currently trading for $45.00 per
share, how would you update your beliefs about its
dividend growth rate?

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Alternative Example 9.11 (2 of 3)
Solution
– Applying the constant dividend growth model based on
a 3% growth rate, we would estimate a stock price of

$3.50
P0 = = $38.89 per share.
(0.12 − 0.03)

– The market price of $45.00, however, implies that most

investors expect dividends to grow at a somewhat
faster rate.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Alternative Example 9.11 (3 of 3)
Solution
– If we continue to assume a constant growth rate, we
can solve for the growth rate consistent with the current
market price using Eq. 9.7:

Div1 $3.50
g = rE − =12% − = 4.22%
P0 $45

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Competition and Efficient Markets
(1of 4)

• Efficient Markets Hypothesis

– Implies that securities will be fairly priced, based on
their future cash flows, given all information that is
available to investors.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Competition and Efficient Markets
(2 of 4)

• Public, Easily Interpretable Information

– If the impact of information that is available to all
investors (news reports, financials statements, etc.)
on the firm’s future cash flows can be readily
ascertained, then all investors can determine the
effect of this information on the firm’s value
▪ In this situation, we expect the stock price to react
nearly instantaneously to such news

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Textbook Example 9.12 (1 of 2)
Stock Price Reactions to Public Information
Problem
Myox labs announces that due to potential side effects, it is
pulling one of its leading drugs from the market. As a result,
its future excepted free cash flow will decline by $85 million
per year for the next 10 years. Myox has 50 million shares
outstanding, no debt, and equity cost of capital of 8%. If this
news came as a complete surprise to investors, what should
happen to myox’s stock price upon the announcement?

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Textbook Example 9.12 (2 of 2)
Solution
In this case, we can use the discounted free cash flow method.
With no debt, rwacc = rE = 8%. Using the annuity formula, the decline
in expected free cash flow will reduce Myox’s enterprise value by

1  1 
$85 million ×  1 − 10 
= $570 million
0.08  1.08 

$570
Thus, the share price should fall by = $11.40 per share.
50
Because this news is public and its effect on the firm’s expected
free cash flow is clear, we would expect the stock price to drop by
this amount nearly instantaneously.
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
Competition and Efficient Markets
(3 of 4)

• Private or Difficult-to-Interpret Information

– Private information will be held by a relatively small
number of investors
– These investors may be able to profit by trading on
their information
▪ In this case, the efficient markets hypothesis will not
hold in the strict sense
▪ However, as these informed traders begin to trade,
they will tend to move prices, so over time prices will
begin to reflect their information as well

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Competition and Efficient Markets
(4 of 4)

• Private or Difficult-to-Interpret Information

– If the profit opportunities from having private
information are large, others will devote the resources
needed to acquire it
▪ In the long run, we should expect that the degree of
“inefficiency” in the market will be limited by the
costs of obtaining the private information

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Textbook Example 9.13 (1 of 2)
Stock Price Reactions to Private Information
Problem
Phenyx Pharmaceuticals has just announced the
development of a new drug for which the company is
seeking approval from the Food and Drug Administration
(FDA). If approved, the future profits from the new drug will
increase Phenyx’s market value by $750 million, or $15 per
share given its 50 million shares outstanding. If the
development of this drug was a surprise to investors, and if
the average likelihood of FDAapproval is 10%, what do you
expect will happen to Phenyx’s stock price when this news is
announced? What may happen to the stock price over time?
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
Textbook Example 9.13 (2 of 2)
Solution
Because many investors are likely to know that the chance of FDA
approval is 10%, competition should lead to an immediate jump in the
stock price of 10% × $15 = $1.50 per share. Over time, however,
analysts and experts in the field are likely to do their own assessments of
the probable efficacy of the drug. If they conclude that the drug looks
more promising than average, they will begin to trade on their private
information and buy the stock, and the price will tend to drift higher over
time. If the experts conclude that the drug looks less promising than
average, they will tend to sell the stock, and its price will drift lower over
time. Examples of possible price paths are shown in Figure 9.4. While
these experts may be able to trade on their superior information and earn
a profit, for uninformed investors who do not know which outcome will
occur, the stock may rise or fall and so appears fairly priced at the
announcement.

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Figure 9.4 Possible Stock Price Paths
for Example 9.13

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Lessons for Investors and Corporate
Managers (1 of 2)
• Consequences for Investors
– If stocks are fairly priced, then investors who buy
stocks can expect to receive future cash flows that
fairly compensate them for the risk of their investment
▪ In such cases, the average investor can invest with
confidence, even if he is not fully informed

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Lessons for Investors and Corporate
Managers (2 of 2)
• Implications for Corporate Managers
– Focus on NPV and free cash flow
– Avoid accounting illusions
– Use financial transactions to support investment

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

The Efficient Markets Hypothesis
Versus No Arbitrage
• The efficient markets hypothesis states that securities with
equivalent risk should have the same expected return
• An arbitrage opportunity is a situation in which two
securities with identical cash flows have different prices

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Chapter Quiz
1. What discount rate do you use to discount the future
cash flows of a stock?
2. Does an investor’s expected holding period affect the
amount they would be willing to pay for a stock?
3. How can a firm increase its future dividend per share?
4. What is the enterprise value of a firm?
5. What are the implicit assumptions made when valuing a
firm using multiples?
6. What is the efficient market hypothesis? What are its
implications for corporate managers?

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.