Corporate Finance

Fifth Edition

Chapter 9
Valuing Stocks

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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

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Siemens AG Dividends
SIEMENS AG Dividend Payment

Type Div. Rate Tax XD Date Pay Date

YR E 3.80 +3 % (G) 31.01.2019 04.02.2019
YR E 3.70 +3 % (G) 01.02.2018 05.02.2018
YR E 3.60 +3 % (G) 02.02.2017 06.02.2017
YR E 3.50 +6 % (G) 27.01.2016 27.01.2016
YR E 3.30 +10% (G) 28.01.2015 28.01.2015
YR E 3.00 +0 % (G) 29.01.2014 29.01.2014
YR E 3.00 +0 % (G) 24.01.2013 24.01.2013
YR E 3.00 +11% (G) 25.01.2012 25.01.2012
YR E 2.70 +69% (G) 26.01.2011 26.01.2011
YR E 1.60 +0 % (G) 27.01.2010 27.01.2010
YR E 1.60 +0 % (G) 28.01.2009 28.01.2009
YR E 1.60 +10% (G) 25.01.2008 25.01.2008
YR E 1.45 +7% (G) 26.01.2007 26.01.2007
YR E 1.35 +8% (G) 27.01.2006 27.01.2006
YR E 1.25 +14% (G) 28.01.2005 28.01.2005
YR E 1.10 +10% (G) 23.01.2004 23.01.2004
YR E 1.00 (G) 24.01.2003 24.01.2003
YR E 1.00 (G) 18.01.2002 18.01.2002
SPL E 1.00 (G) 23.02.2001 23.02.2001
YR E 1.40 (G) 23.02.2001 23.02.2001
YR E 1.00 (G) 25.02.2000 25.02.2000
YR DM1.50 (G) 19.02.1999 19.02.1999
YR DM1.50 (G) 20.02.1998 20.02.1998
YR DM1.50 (G) 14.02.1997 14.02.1997
YR DM13.00 (G) 23.02.1996 23.02.1996
YR DM13.00 (G) 24.02.1995 24.02.1995

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 Mc Donalds Dividends
Type Div. Rate Tax XD Date Pay Date Type Div. Rate Tax XD Date Pay Date
QTR U$1.25 +8% (G) 29.11.2019 16.12.2019 QTR U$1.16 +15% (G) 30.11.2018 17.12.2018
QTR U$1.16 (G) 30.08.2019 17.09.2019 QTR U$1.01 (G) 31.08.2018 18.09.2018
QTR U$1.16 (G) 31.05.2019 17.06.2019 QTR U$1.01 (G) 01.06.2018 18.06.2018
QTR U$1.16 (G) 28.02.2019 15.03.2019 QTR U$1.01 (G) 28.02.2018 15.03.2018
QTR U$1.01 +7 % (G) 30.11.2017 15.12.2017
QTR U$1.16 (G) 30.11.2018 17.12.2018
QTR U$0.94 (G) 30.08.2017 18.09.2017
QTR U$0.94 (G) 01.06.2017 19.06.2017
QTR U$0.94 (G) 27.02.2017 15.03.2017
QTR U$0.94 +6 % (G) 29.11.2016 15.12.2016
QTR U$0.89 (G) 30.08.2016 16.09.2016
QTR U$0.89 (G) 02.06.2016 20.06.2016
QTR U$0.89 (G) 26.02.2016 15.03.2016
QTR U$0.89 +5 % (G) 27.11.2015 15.12.2015
QTR U$0.85 (G) 28.08.2015 16.09.2015
QTR U$0.85 (G) 28.05.2015 15.06.2015
QTR U$0.85 (G) 26.02.2015 16.03.2015
QTR U$0.85 +5 % (G) 26.11.2014 15.12.2014
QTR U$0.81 (G) 28.08.2014 16.09.2014
QTR U$0.81 (G) 29.05.2014 16.06.2014
QTR U$0.81 (G) 27.02.2014 17.03.2014
QTR U$0.81 +5 % (G) 27.11.2013 16.12.2013
QTR U$0.77 (G) 29.08.2013 17.09.2013
QTR U$0.77 (G) 30.05.2013 17.06.2013
QTR U$0.77 (G) 27.02.2013 15.03.2013
QTR U$0.77 +10 % (G) 29.11.2012 17.12.2012
QTR U$0.70 (G) 30.08.2012 18.09.2012
QTR U$0.70 (G) 31.05.2012 15.06.2012
QTR U$0.70 (G) 28.02.2012 15.03.2012
QTR U$0.70 +15 % (G) 29.11.2011 15.12.2011

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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.

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Mc Donalds Dividends
Type Div. Rate Tax XD Date Pay Date
QTR U$0.61 (G) 30.08.2011 16.09.2011
QTR U$0.61 (G) 27.05.2011 15.06.2011
QTR U$0.61 (G) 25.02.2011 15.03.2011
QTR U$0.61 +11 % (G) 29.11.2010 15.12.2010
QTR U$0.55 (G) 30.08.2010 16.09.2010
QTR U$0.55 (G) 27.05.2010 15.06.2010
QTR U$0.55 (G) 25.02.2010 15.03.2010
QTR U$0.55 +10 % (G) 27.11.2009 15.12.2009
QTR U$0.50 (G) 28.08.2009 15.09.2009
QTR U$0.50 (G) 04.06.2009 22.06.2009
QTR U$0.50 (G) 26.02.2009 16.03.2009
QTR U$0.50 (G) 26.11.2008 15.12.2008
QTR U$0.375 (G) 28.08.2008 16.09.2008
QTR U$0.375 (G) 05.06.2008 23.06.2008
QTR U$0.375 (G) 28.02.2008 17.03.2008
YR U$1.50 (G) 13.11.2007 03.12.2007
YR U$1.00 (G) 13.11.2006 01.12.2006
YR U$0.67 (G) 10.11.2005 01.12.2005
YR U$0.55 (G) 10.11.2004 01.12.2004
YR U$0.40 (G) 12.11.2003 01.12.2003
YR U$0.235 (G) 13.11.2002 02.12.2002
YR U$0.225 (G) 13.11.2001 03.12.2001
YR U$0.215 (G) 13.11.2000 01.12.2000
QTR U$0.04875 (G) 29.11.1999 15.12.1999
QTR U$0.04875 (G) 30.08.1999 15.09.1999
QTR U$0.04875 (G) 27.05.1999 15.06.1999
QTR U$0.0488 (G) 11.03.1999 31.03.1999
QTR U$0.09 (G) 25.11.1998 11.12.1998
QTR U$0.09 (G)

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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.

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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.

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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.

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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

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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

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Dividend Yields, Capital Gains, and
Total Returns
D iv1  P1 D iv1 P1  P0
rE =  1 
P0 P0 P
 0
D iv id e n d Y ie ld C a p ita l G a in R a te

• 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
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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?

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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.
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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

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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
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 The Dividend-Discount Model Equation
(2 of 2)

Div1 Div2 Div3 Divn
P0 
1  rE

(1  rE ) 2

(1  rE ) 3
   
n 1 (1  rE ) n

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

expected future dividends it will pay

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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

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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

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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.

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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

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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

Earnings per Share

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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

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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

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 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

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

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

Notice: Dividend Payout Ratio = 1 – Retention Rate

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Dividends Versus Investment and
Growth (5 of 6) Change in Earnings = Earnings
× Retention Rate
• A Simple Model of Growth × Return on New Investment

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

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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?

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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
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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.
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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?

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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.
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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

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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

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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  N  
1 + rE (1 + rE ) 2
(1 + rE ) N
(1 + rE )  rE  g 

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Textbook Example 9.5 (1 of 3)
Valuing a Firm with Two Different Growth Rates
• Problem
– Small Fry, Inc., has just invented a potato chip that looks
and tastes like a french fry. Given the phenomenal market
response to this product, Small Fry is reinvesting all of its
earnings to expand its operations. Earnings were $2 per
share this past year and are expected to grow at a rate of
20% per year until the end of year 4. At that point, other
companies are likely to bring out competing products.
Analysts project that at the end of year 4, Small Fry will cut
investment and begin paying 60% of its earnings as
dividends and its growth will slow to a long-run rate of 4%. If
Small Fry’s equity cost of capital is 8%, what is the value of
a share today?
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Textbook Example 9.5 (2 of 3)
Solution
We can use Small Fry’s projected earnings growth rate and payout rate
to forecast its future earnings and dividends as shown in the following
spreadsheet:

Starting from $2.00 in year 0, EPS grows by 20% per year until year 4,
after which growth slows to 4%. Small Fry’s dividend payout rate is zero
until year 4, when competition reduces its investment opportunities and
its payout rate rises to 60%. Multiplying EPS by the dividend payout ratio,
we project Small Fry’s future dividends in line 4.
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Textbook Example 9.5 (3 of 3)
From year 4 onward, Small Fry’s dividends will grow at the
expected long-run rate of 4% per year. Thus, we can use the
constant dividend growth model to project Small Fry’s share price
at the end of year 3. Given its equity cost of capital of 8%,
Div1 $2.49
P3    $62.25
rE  g 0.08  0.04
We then apply the dividend-discount model (Eq. 9.4) with this
terminal value:
Div4 Div2 Div3 P3 $62.25
P0   2
 3
 3
 3
 $49.42
1 + rE (1 + rE ) (1 + rE ) (1 + rE ) (1.08)

As this example illustrates, the dividend-discount model is flexible

enough to handle any forecasted pattern of dividends.
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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

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9.3 Total Payout and Free Cash Flow
Valuation Models (1 of 3)
• Share Repurchases and the Total Payout Model
– Share Repurchase
 When the firm uses excess cash to buy back its own
stock
– Implications for the Dividend-Discount Model
 The more cash the firm uses to repurchase shares,
the less it has available to pay dividends
 By repurchasing, the firm decreases the number of
shares outstanding, which increases its earnings
and dividends per share

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Copyright © 2020, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved.
9.3 Total Payout and Free Cash Flow
Valuation Models (2 of 3)
• Share Repurchases and the Total Payout Model

PV0 = PV (Future Dividends per Share)

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9.3 Total Payout and Free Cash Flow
Valuation Models (3 of 3)
• Share Repurchases and the Total Payout Model
– Total Payout Model

PV (Future Total Dividends and Repurchases)

PV0 
Shares Outstanding 0

 Values all of the firm’s equity, rather than a single

share. You discount total dividends and share
repurchases and use the growth rate of earnings
(rather than earnings per share) when forecasting
the growth of the firm’s total payouts.
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Textbook Example 9.6 (1 of 3)
Valuation with Share Repurchases
Problem
– Titan industries has 217 million shares outstanding and
expects earnings at the end of this year of $860 million.
Titan plans to pay out 50% of its earnings in total,
paying 30% as a dividend and using 20% to
repurchase shares. If Titan’s earnings are excepted to
grow by 7.5% per year and these payout rates remain
constant, determine Titan’s share price assuming an
equity cost of capital of 10%.

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Textbook Example 9.6 (2 of 3)
Solution
Titan will have total payouts this year of 50% × $860 million =
$430 million. Based on the equity cost of capital of 10% and an
expected earnings growth rate of 7.5%, the present value of
Titan’s future payouts can be computed as a constant growth
perpetuity:
$430 million
Pv (Future Total Dividends and Repurchases)   $17.2 billion
0.10  0.075
This present value represents the total value of Titan’s equity (i.e.,
its market capitalization). To compute the share price, we divide by
the current number of shares outstanding:
$17.2 billion
P0   $79.26 per share
217 million shares
Copyright © 2020, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 45
Textbook Example 9.6 (3 of 3)
Using the total payout method, we did not need to know the firm’s
split between dividends and share repurchases. To compare this
method with the dividend-discount model, note that Titan will pay a
dividend of
30%×$860 million
 $1.19 per share,
(217 million shares)
1.19
for a dividend yield of  1.50%. From Eq. 9.7, Titan’s expected
79.26
Div1
EPS, dividend, and share price growth rate is g  rE  = 8.50%.
P0

These “per share” growth rates exceed the 7.5% growth rate of
total earnings because Titan’s share count will decline over time
due to share repurchases.
Copyright © 2020, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 46
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 = V0)
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

Assets Liabilities + Equity

Cash Debt
V0 Equity

Market Value of Equity0 = V0 + Cash0 – Debt0

Copyright © 2020, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 47
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 48
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
– Notice:
rWACC = E/(E + D)  rE + D/(E + D)  rD  (1 - c)

Assets Liabilities + Equity

Net Debt -> rD  (1 - c)
V0 -> rWACC Equity -> rE

Net Debt = Debt – Cash

Copyright © 2020, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 49
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 50
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 51
Kenneth Cole Stock Price

Copyright © 2020, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 52
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 53
Textbook Example 9.7 (3 of 3)

 1 + g FCF   1.04 
V2011   × FCF2011   0.11  0.04  × 37.6  $558.6 million
 rwacc  g FCF   

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   2
 3
 4
 5
 6
 $424.8 million
1.11 1.11 1.11 1.11 1.11 1.11
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 54
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 55
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%?
t0 t1 T2 … 
V0 = ? FCF06 FCF06 (1 + g) … FCF06 (1 + g)( - 1)

Copyright © 2020, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 56
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 57
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 58
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 59
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 60
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 61
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 62
Valuation Multiples (3 of 5)

P0 Div1 / EPS1 Dividend Payout Rate

Forward P /E   
EPS1 rE  g rE  g

Div1
Note : P0 
rE  g

• If two stocks have the same payout and EPS growth rates,
as well as equivalent risk (rE), then they should have the
same P/E.
• 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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 63
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 64
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 65
Valuation Multiples (4 of 5)
• Enterprise Value Multiples

V0 FCF1 1 FCF1 / EBITDA1

  
EBITDA1 rwacc  g FCF 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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 66
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 67
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 68
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 69
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 70
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

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

Copyright © 2020, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 72
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 73
Figure 9.2 Range of Valuations for KCP
Stock Using Alternative Valuation
Methods

Copyright © 2020, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 74
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 75
Figure 9.3 The Valuation Triad

Copyright © 2020, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 76
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 77
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 78
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 79
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 80
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 81
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 82
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.
Stock
price 11.40

time
Copyright © 2020, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 83
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 84
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 85
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?
Stock
price
$1.50

announcement time
date
Copyright © 2020, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 86
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 87
Figure 9.4 Possible Stock Price Paths
for Example 9.13

Copyright © 2020, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 88
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 89
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 90
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, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 91
Copyright © 2020, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved.
ACS bid for Hochtief
67 66,5

66
66,5
65,5

66 65

64,5
Aktienkurs in EUR

65,5
64

65 63,5

63
64,5
12,3

12,5

12,7

12,9

64

63,5

63
11
9

10

12

13

14

15

16

17

18
Uhrzeit

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 17.22.26,46
Copyright © 2020, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 94

17.07.07,60
16.52.25,36
16.42.01,29
Hochtief Trading Volume XETRA

16.26.31,12
16.09.06,51
15.59.39,58
15.35.17,12
15.16.59,55
15.14.05,48
15.04.54,35
14.34.23,82
14.15.49,19
Volumen

13.50.20,06
13.39.29,07
13.13.33,22
12.55.19,33
12.50.14,31
12.47.39,50
12.43.31,89
12.29.13,36
11.29.55,25
10.52.07,29
10.11.27,69
09.42.03,67
09.02.10,00

90000

80000

70000

60000

50000

40000

30000

20000

10000

0
100000
Stock Exchanges in Germany
Siemens
Sep 29
2015
9:38 a.m.

Copyright © 2020, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 95
Stock Trading overview
Nationaler Aktienhandel (Kassamarkt)

Elektronischer Handel
Parketthandel Telefonhandel

börslich außerbörslich
(ATS/ECN)

Regionalbörsen XETRA, Tradegate Handel zw.

Frankfurt Institutionelle
n

Copyright © 2020, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 96
Indexes after Sep. 24 2018

HDAX DAX Midcap Market-Index

(90 - 120) (30) (60 - 90)

MDAX
(60) TecDAX
(30)
SDAX
(70)

Prime Standard

General Standard

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Trading Time XETRA

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Copyright © 2020, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved.
Copyright © 2020, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved.
Floor Trading
Continuous trading

8 Uhr 22 Uhr
Opening auction End of trading

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German Stocks since 1870 nominal
1E+15
1E+14
1E+13
1E+12
1E+11
1E+10
1E+09
1E+08
1E+07
1E+06
100000
10000
1000
100
1870

1880

1890
1900

1910
1920

1930
1940

1950
1960

1970

1980
1990

2000
2010
Copyright © 2020, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved 102
German Stocks real values
100000

10000

1000

100
1870

1880

1890

1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

2010
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