Common Stock

Valuation
Ch ap ter 10
Ch arles P. Jo n es, In vestm en ts: An alysis an d
Man ag em en t,
Nin th E d itio n , Jo h n W iley & So n s

Prep ared b y
G.D. K o p p en h aver, Iow a State Un iversity

10-1
 FundamentalAnalysis
 Present value approach
– Capitalization of expected income
– Intrinsic value based on the discounted value of
the expected stream of cash flows
 Multiple of earnings approach
–Valuation relative to a financial performance
measure
– Justified P/E ratio

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 Present V
alueApproach
 Intrinsic value of a security is
n Cash Flows
Value of security  
t 1 ( 1  k)t
 Estimated intrinsic value compared to the
current market price
– What if market price is different than estimated
intrinsic value?

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 Required Inputs
 Discount rate
– Required rate of return: minimum expected rate
to induce purchase
– The opportunity cost of dollars used for
investment
 Expected cash flows
– Stream of dividends or other cash payouts over
the life of the investment

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 Required Inputs
 Expected cash flows
– Dividends paid out of earnings
 Earnings important in valuing stocks
– Retained earnings enhance future earnings and
ultimately dividends
 Retained earnings imply growth and future dividends
 Produces similar results as current dividends in
valuation of common shares

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 Dividend Discount Model
 Current value of a share of stock is the
discounted value of all future dividends

D1 D2 D
Pcs  1
 2
 ...  
( 1  kcs ) ( 1  kcs ) ( 1  kcs )
 Dt
  t
t 1 ( 1  kcs )

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 Dividend Discount Model
 Problems:
– Need infinite stream of dividends
– Dividend stream is uncertain
 Must estimate future dividends
– Dividends may be expected to grow over time
 Must model expected growth rate of dividends and
need not be constant

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 Dividend Discount Model
 Assume no growth in dividends
– Fixed dollar amount of dividends reduces the
security to a perpetuity

D0
P0 
kcs
– Similar to preferred stock because dividend
remains unchanged

10-8
 Dividend Discount Model
 Assume a constant growth in dividends
– Dividends expected to grow at a constant rate,
g, over time
D1
P0 
k g
– D1 is the expected dividend at end of the first
period
– D1 =D0  (1+g)

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 Dividend Discount Model
 Implications of constant growth
– Stock prices grow at the same rate as the
dividends
– Stock total returns grow at the required rate of
return
 Growth rate in price plus growth rate in dividends
equals k, the required rate of return
– Alower required return or a higher expected
growth in dividends raises prices

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 Dividend Discount Model
 Multiple growth rates: two or more expected
growth rates in dividends
– Ultimately, growth rate must equal that of the
economy as a whole
– Assume growth at a rapid rate for n periods
followed by steady growth
t
n D0( 1  g1 ) Dn( 1  gc ) 1
P0   t
 n
t 1 ( 1  k) k-g ( 1  k)
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 Dividend Discount Model
 Multiple growth rates
– First present value covers the period of super-
normal (or sub-normal) growth
– Second present value covers the period of
stable growth
 Expected price uses constant-growth model as of the
end of super- (sub-) normal period
Value at n must be discounted to time period zero

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 Example: Valuing equity with growth of
30% for 3 years, then a long-run constant
growth of 6%

0 k=16% 1 2 3 4
g = 30% g = 30% g = 30% g = 6%
D0 = 4.00 5.20 6.76 8.788 9.315
4.48
5.02
5.63
59.68 P3 = 9.315
74.81 = P0 .10
 WhatAbout Capital Gains?
 Is the dividend discount model only capable
of handling dividends?
– Capital gains are also important
 Price received in future reflects expectations
of dividends from that point forward
– Discounting dividends or a combination of
dividends and price produces same results

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 Intrinsic V
alue
 “Fair” value based on the capitalization of
income process
– The objective of fundamental analysis
 If intrinsic value >(<) current market price,
hold or purchase (avoid or sell) because the
asset is undervalued (overvalued)
– Decision will always involve estimates

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 P/E Ratio or
Earnings MultiplierApproach
 Alternative approach often used by security
analysts
 P/E ratio is the strength with which
investors value earnings as expressed in
stock price
– Divide the current market price of the stock by
the latest 12-month earnings
– Price paid for each $1 of earnings

10-16
 P/E RatioApproach
 o estimate share value
T
Po  estimated earnings
 justified P/E ratio  E1  Po /E1
 P/E ratio can be derived from
D1 D1/E1
Po  or Po /E1 
k-g k-g
– Indicates the factors that affect the estimated
P/E ratio
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 P/E RatioApproach
 The higher the payout ratio, the higher the
justified P/E
– Payout ratio is the proportion of earnings that
are paid out as dividends
 The higher the expected growth rate, g, the
higher the justified P/E
 The higher the required rate of return, k, the
lower the justified P/E

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Understanding the P/E Ratio
 Can firms increase payout ratio to increase
market price?
– Will future growth prospects be affected?
 Does rapid growth affect the riskiness of earnings?
– Will the required return be affected?
– Are some growth factors more desirable than others?
 P/E ratios reflect expected growth and risk

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 P/E Ratios and Interest Rates
 AP/E ratio reflects investor optimism and
pessimism
– Related to the required rate of return
 As interest rates increase, required rates of
return on all securities generally increase
 P/E ratios and interest rates are indirectly
related

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 WhichApproach Is Best?
 Best estimate is probably the present value
of the (estimated) dividends
– Can future dividends be estimated with
accuracy?
– Investors like to focus on capital gains not
dividends
 P/E multiplier remains popular for its ease
in use and the objections to the dividend
discount model
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 WhichApproach Is Best?
 Complementary approaches?
– P/E ratio can be derived from the constant-
growth version of the dividend discount model
– Dividends are paid out of earnings
– Using both increases the likelihood of obtaining
reasonable results
 Dealing with uncertain future is always
subject to error

10-22
 Other Multiples
 Price-to-book value ratio
– Ratio of share price to stockholder equity as
measured on the balance sheet
– Price paid for each $1 of equity
 Price-to-sales ratio
– Ratio of a company’s total market value (price
times number of shares) divided by sales
– Market valuation of a firm’s revenues

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