Chapter FOUR

Stock and equity valuation

5.1 Introduction

Firms obtain their long-term sources of equity financing by issuing common and preferred
stock. The payments of the firm to the holders of these securities are in the form of
dividends. Unlike interest payments on debt which are tax deductible, dividends must be
paid out of after-tax income either in the form of cash dividend or stock dividend. In
addition to the above, contrary to payments to bondholders, payments to common
stockholders are uncertain in both magnitude and timing. The common stockholders are the
owners of the firm. It represents equity in a corporation. They have the right to vote on
important matters to the firm such as the election of the Board of Directors. They have a residual
claim against the assets and cash flows of the firm. That is, the common stockholders have a
claim against whatever assets remain after the debt holders and preferred stockholders have been
paid. Moreover, the cash flow that remains after interest and preferred dividends have been paid
belongs to the common stockholders.
The priority of the claims against the assets of the firm belonging to debt holders, preferred
stockholders, and common stockholders differ. The owners of the firm's debt securities have the
first claim against the assets of the firm. This means that the debt holders must receive their
scheduled interest and principal payments before any dividends can be paid to the equity holders.
If these claims are not paid, the debt holders can force the firm into bankruptcy. The preferred
stockholders have the next claim. They must be paid the full amount of their scheduled dividends
before any dividends may be distributed to the common stockholders.
5.2 Characteristics of Stock
The number of shares of stock that a corporation is authorized to issue is stated in its
charter. The term issued refers to the shares issued to the stockholders. A corporation may
re-acquire some of the stock that it has issued. The stock remaining in the hands of
stockholders is then called outstanding stock. Upon request, corporations may issue stock
certificates to stockholders to document their ownership. Printed on a stock certificate is
the name of the company, the name of the stockholder, and the number of shares owned.
The stock certificate may also indicate a dollar amount assigned to each share of stock,
called par value. Stock may be issued without par, in which case it is called no-par stock.
Corporations have limited liability and, thus, creditors have no claim against stockholders’
personal assets. To protect creditors, however, some states require corporations to
maintain a minimum amount of paid-in capital. This minimum amount, called legal capital,
usually includes the par or stated value of the shares issued.

The most important characteristics of common stock as an investment are its residual
claim and its limited liability features.

Residual claim means stockholders are the last in line of all those who have a claim on the
assets and income of the corporation. In a liquidation of the firm’s assets, the shareholders
have claim to what is left after paying all other claimants, such as the tax authorities,
employees, suppliers, bondholders, and other creditors. In a going concern, shareholders
have claim to the part of operating income left after interest and income taxes have been
paid. Management either can pay this residual as cash dividends to shareholders or
reinvest it in the business to increase the value of the shares.

Limited liability means that the most shareholders can lose in event of the failure of the
corporation is their original investment. Shareholders are not like owners of
unincorporated businesses, whose creditors can lay claim to the personal assets of the
owner—such as houses, cars, and furniture. In the event of the firm’s bankruptcy,
corporate stockholders at worst have worthless stock. They are not personally liable for
the firm’s obligations: Their liability is limited.

The major rights that accompany ownership of a share of stock are as follows:

1. The right to vote in matters concerning the corporation.

2. The right to share in distributions of earnings.

3. The right to share in assets on liquidation.

These stock rights normally vary with the class of stock.

5.3 Balance sheet methods/ techniques

Balance sheet methods are the methods which utilize the balance sheet information to
value a company. These techniques consider everything for which accounting in the books
of accounts is done.

Book Value: In this method, book value as per balance sheet is considered the value of
equity. Book value means the net worth of the company. Net worth is calculated as follows:

Net Worth = Equity Share capital + Preference Share Capital + Reserves & Surplus –
Miscellaneous Expenditure (as per B/Sheet) – Accumulated Losses.
The book value of a firm is the result of applying accounting rules that spread the
acquisition cost of assets over a specified number of years, whereas the market price of a
stock takes account of the firm’s value as a going concern. In other words, the market price
reflects the present value of its expected future cash flows. It would be unusual if the
market price of a stock were exactly equal to its book value.

Liquidation Value: In this method, liquidation value is considered the value of equity.
Liquidation value is the value realized if the firm is liquidated today. A better measure of a
floor for the stock price is the firm’s liquidation value per share.

This represents the amount of money that could be realized by breaking up the firm, selling
its assets, repaying its debt, and distributing the remainder to the shareholders. The
reasoning behind this concept is that if the market price of equity drops below the
liquidation value of the firm, the firm becomes attractive as a takeover target. A corporate
raider would find it profitable to buy enough shares to gain control and then actually
liquidate because the liquidation value exceeds the value of the business as a going
concern.

Liquidation Value = Net Realizable Value of All Assets – Amounts paid to All Creditors
including Preference Shareholders.

Replacement Cost: Here, the value of equity is the replacement value. It means the cost
that would be incurred to create a duplicate firm is the value of the firm. This concept
assumes that interest in valuing a firm is the replacement cost of its assets less its
liabilities. Some analysts believe the market value of the firm cannot get too far above its
replacement cost for long because, if it did, competitors would try to replicate the firm. The
competitive pressure of other similar firms entering the same industry would drive down
the market value of all firms until they came into equality with replacement cost. It is
assumed that the market value and replacement value will coincide in the long run. This
idea is popular among economists, and the ratio of market price to replacement cost is
known as Tobin’s q, after the Nobel Prize–winning economist James Tobin. In the long run,
according to this view, the ratio of market price to replacement cost will tend toward 1, but
the evidence is that this ratio can differ significantly from 1 for very long periods of time.

Equity Value = Replacement Cost of Assets – Liabilities.

If the role of management is to increase the shareholder value, then managers can make
better decisions if they can predict the impact of those decisions on the firm's value. By
observing the difference in the firm's equity value at different points in time, one can better
evaluate the effectiveness of financial decisions. A rudimentary way of valuing the equity of
a company is simply to take its balance sheet and subtract liabilities from assets to arrive at
the equity value. However, this book value has little resemblance to the real value of the
company. First, the assets are recorded at historical costs, which may be much greater than
or much less their present market values. Second, assets such as patents, trademarks, loyal
customers, and talented managers do not appear on the balance sheet but may have a
significant impact on the firm's ability to generate future profits. So while the balance sheet
method is simple, it is not accurate; there are better ways of accomplishing the task of
valuation.

Intrinsic value versus market price

The most popular model for assessing the value of a firm as a going concern starts from the
observation that the return on a stock investment comprises cash dividends and capital
gains or losses. We begin by assuming a one-year holding period and supposing that ABC
stock has an expected dividend per share, E(D1), of $4; that the current price of a share, P 0,
is $48; and that the expected price at the end of a year, E(P 1), is $52. For now, don’t worry
about how you derive your forecast of next year’s price. At this point we ask only whether
the stock seems attractively priced today given your forecast of next year’s price. The
expected holding-period return is E(D1) plus the expected price appreciation, E(P1) - P0,
all divided by the current price P0.

E ( D1 ) +[E ( P 1 ) − P 0]
Expected HPR = E(r) =
P0

4+[52− 48]
48

= 0.167 = 16.7%

Note that E( ) denotes an expected future value. Thus, E (P1) represents the expectation
today of the stock price one year from now. E(r) is referred to as the stock’s expected
holding period return. It is the sum of the expected dividend yield, E(D1)/P0, and the
expected rate of price appreciation, the capital gains yield, [E(P1) - P0]/P0.

But what is the required rate of return for ABC stock? We know from the capital asset
pricing model (CAPM) that when stock market prices are at equilibrium levels, the rate of
return that investors can expect to earn on a security is rf + [E(rM) - rf]. Thus, the CAPM
may be viewed as providing the rate of return an investor can expect to earn on a security
given its risk as measured by beta. This is the return that investors will require of any other
investment with equivalent risk. We will denote this required rate of return as k. If a stock
is priced “correctly,” it will offer investors a “fair” return, i.e., its expected return will equal
its required return. Of course, the goal of a security analyst is to find stocks that are
mispriced.
For example, an underpriced stock will provide an expected return greater than the
required return.

Suppose that rf = 6%, E(rM) - rf = 5%, and the beta of ABC is 1.2. Then the value of k is

k = 6% + 1.2 * 5% = 12%

The rate of return the investor expects exceeds the required rate based on ABC’s risk by a
margin of 4.7%. Naturally, the investor will want to include more of ABC stock in the
portfolio than a passive strategy would dictate. Another way to see this is to compare the
intrinsic value of a share of stock to its market price. The intrinsic value, denoted V0, of a
share of stock is defined as the present value of all cash payments to the investor in the
stock, including dividends as well as the proceeds from the ultimate sale of the stock,
discounted at the appropriate risk-adjusted interest rate, k.

Whenever the intrinsic value, or the investor’s own estimate of what the stock is really
worth, exceeds the market price, the stock is considered undervalued and a good
investment. In the case of ABC, using a one-year investment horizon and a forecast that the
stock can be sold at the end of the year at price P1 = $52, the intrinsic value is

E ( D1 ) + E (P1) ¿ 4+ 52
V= = $ 50
1+ k 1.12

Equivalently, at a price of $50, the investor would derive a 12% rate of return just equal to
the required rate of return on an investment in the stock. However, at the current price of
$48, the stock is underpriced compared to intrinsic value. At this price, it provides better
than a fair rate of return relative to its risk. In other words, using the terminology of the
CAPM, it is a positive-alpha stock, and investors will want to buy more of it than they would
follow a passive strategy.

In contrast, if the intrinsic value turns out to be lower than the current market price,
investors should buy less of it than under the passive strategy.

In market equilibrium, the current market price will reflect the intrinsic value estimates of
all market participants. This means the individual investor whose V 0 estimate differs from
the market price, P0, in effect must disagree with some or all of the market consensus
estimates of E(D1), E(P1), or k. A common term for the market consensus value of the
required rate of return, k, is the market capitalization rate.

5.4 Dividend discount model

An asset’s value is determined by the present value of its future cash flows. A stock provides two
kinds of cash flows. First, most stocks pay dividends on a regular basis. Second, the stockholder
receives the sale price when they sell the stock. In valuing the common stock, we have made two
assumptions:
o We know the dividends that will be paid in the future.
o We know how much you will be able to sell the stock for in the future.
Both of these assumptions are unrealistic, especially knowledge of the future selling price.
Furthermore, suppose that you intend on holding on to the stock for twenty years, the
calculations would be very tedious! We cannot value common stock without making some
simplifying assumptions. These assumptions will define the path of the future cash flows so that
we can derive a present value formula to value the cash flows.
If we make the following assumptions, we can derive a simple model for common stock
valuation:
 Your holding period is infinite (i.e., you will never sell the stock so you don’t have to
worry about forecasting a future selling price).
 The dividends will grow at a constant rate forever.
Note that the second assumption allows us to predict every future dividend, as long as we know
the most recent dividend and the growth rate.
Thus, in order to value common stocks, we need to answer an interesting question: Is the value
of a stock equal to
1. The discounted present value of the sum of next period’s dividend plus next period’s
stock price, or
2. The discounted present value of all future dividends?
To see that (1) and (2) are the same, let’s start with an individual who will buy the stock and hold
it for one year.
How do we value a share of common stock? Suppose you consider purchasing a share of stock
today, and sell it a year from today. Let P1 be the price that you expect you can sell the share at a
year from today. Then, the value of the share of the stock today (P0) is given by
` Div 1 P1
P0 = + (1 )
1+ r 1+r
Then, how P1 should be determined? There must be a buyer who is willing to pay P 1 at date 1. If
the buyer intend to keep the stock only one year and sell at the end of the year (like you do), P 1
should be determined by
 Div 2 P2
P1 = + (2)
1+r 1+ r

Div n+1 Pn+1

Pn= +
1+r 1+r
Now, plug (2) into (1) then you will have the following relationship between the value of the
share of stock and dividend. If you plug (2) into (1), you will have
Div 1 Div 2 P2
P0 = + +
1+ r (1+ r )2 ( 1+r )2
Note that P2 is again determined by similar way. Therefore, it can be seen that, if we repeat this
process, we will have
Div 1 Div 2 Div 3 Div 4
P0 = + + + +⋯
1+ r (1+ r )2 ( 1+r )3 ( 1+ r )4
∞ Div t
po = ∑
t =1 ( 1+r )t

Therefore, the value of a share of common stock is the present value of all the dividend
payments. That is, the value of a firm’s common stock to the investor is equal to the present
value of all the expected future value.
Example5.4: Assume that you are considering the purchase of a stock which will pay dividends
of $2 (D1) next year, and $2.16 (D2) the following year. After receiving the second dividend, you
plan on selling the stock for $33.33. What is the intrinsic value of this stock if your required
return is 15%?
2 . 00 2 .16 +33 .33
po = + =28 . 57
Solution: ( 1+.15 )1 ( 1+. 15 )2
The above discussion shows that the value of a firm’s common stock to the investor is equal to
the present value of all the expected future value. In the following, we consider the valuation of
commons stock for three simple cases: (1) Zero growth, (2) Constant growth and (3) No constant
growth rate.
Case 1: Valuation of common stock - Zero Growth
Assume that dividends will remain at the same level forever. It assumes that the dividend does
not grow at all; therefore, this is an extreme case.
Div 1 =Div 2 =Div 3 =⋯=Div
Since future cash flows are constant, the value of a zero growth stock is the present value of
perpetuity: P =Div 1 + Div 2 + Div 3 +⋯
0
( 1+r )1 ( 1+r )2 ( 1+r )3
Div
P0 =
r
Example 5.5: Suppose Amsalu purchase stock which will pay divided of $4 for next four year
and sell to $40 after collecting forth year dividend. The stock required rate of return is 10%.
a. Compute intrinsic value of the stock
b. Assume he hold the stock for infinite period and compute intrinsic value of the stock
Case 2: Valuation of common stock - Constant Growth
A constant growth stock is a stock whose dividends are expected to grow at a constant rate in the
foreseeable future. This condition fits many established firms, which tend to grow over the long
run at the same rate as the economy, fairly well. To come up with the formula for this case, let’s
assume that dividends will grow at a constant rate, g, forever. i.e.
Div 1 =Div
Div 2 =Div
. 1 (1+ g )=Div(1+ g )
Div 3 =Div 2 (1+ g )=Div (1+ g )2
Example 5.6: Assume that Hampshire Products will pay a dividend of $4 per share a year from
now. Financial analysts believe that dividends will rise at 6 percent per year for the foreseeable
future. What is the dividend per share at the end of each of the first five years?
End of year: 1 2 3 4 5____
Dividend: $4 $4 X (1.06) $4 X (1.06)2 $4 X (1.06)3 $4 X (1.06)4
=$4.24 =$4.4944 =$4.7641 =$5.0499
Therefore, the value of the commons stock for Case 2 is given by the growing perpetuity formula
Div Div (1+g ) Div (1+g )2
P0 = + +
(1+r )1 (1+r )2 (1+r )3 …

Div o ( 1+ g) Div 1 (1+ g )2

P0 = =
(r−g ) (1+r )3
Where:
 P0 = the stock price at time 0,
 Divo = the current dividend,
  Div1 = the next dividend (i.e., at time 1),
 g = the growth rate in dividends, and
 r = the required return on the stock, and
 g < r.
Example 5.7: Find the stock price given that the current dividend is $2 per share, dividends are
expected to grow at a rate of 6% in the foreseeable future, and the required return is 12%.

1. Dividend Yield and Capital Gains Yield

The constant growth stock equation can be rearranged to obtain an expression for the expected return
on the stock as follows:

When expressed in this manner, it is apparent that the expected return on the stock equals the
expected dividend yield plus the expected capital gains yield where the dividend yield and capital
gains yield are defined as follows:

A more general form of the Constant Growth Stock Valuation formula which can be used to find
the price of the stock at any period t in the future is given by the following:

Exercise: Suppose an investor is considering the purchase of a share of the Utah Mining
Company. The stock will pay a $3 dividend a year from today. This dividend is expected to grow
at 10 percent per year for the foreseeable future (g=0.1). The stock holder thinks that required
return on this stock is 15 percent (r=0.15). What is the value of a share of Utah Mining
Company’s stock?
Case 3: Non-constant Growth Stock Valuation
Many firms enjoy periods of rapid growth. These periods may result from the introduction of a
new product, a new technology, or an innovative marketing strategy. However, the period of
rapid growth cannot continue indefinitely. Eventually, competitors will enter the market and
catch up with the firm.
These firms cannot be valued properly using the Constant Growth Stock Valuation approach.
This section presents a more general approach which allows for the dividends/growth rates
during the period of rapid growth to be forecast. Then, it assumes that dividends will grow from
that point on at a constant rate which reflects the long-term growth rate in the economy.
Stocks which are experiencing the above pattern of growth are called non-constant, supernormal,
or erratic growth stocks.
The value of a non-constant growth stock can be determined using the following equation:

Where:
 P0 = the stock price at time 0,
 Dt = the expected dividend at time t,
 T = the number of years of non-constant growth,
 gc = the long-term constant growth rate in dividends, and
 r = the required return on the stock, and
 gc < r.
Example 5.8: The current dividend on a stock is $2 per share and investors require a rate of return of
12%. Dividends are expected to grow at a rate of 20% per year over the next three years and then at a
rate of 5% per year from that point on. Find the price of the stock.
Solution:
There are 3 years of non-constant growth, thus, T = 3. Before substituting into the formula given above
it is necessary to calculate the expected dividends for years 1 through 4 using the provided growth rates.

Preferred Stock and their Valuation

Preferred Stock Valuation
Preferred stock is defined as equity with priority over common stock with respect to the payment
of dividends and the distribution of assets in liquidation. Preferred stock is a hybrid security
which shares features with both common stock and debt.
Preferred stock is similar to common stock in that it entitles its owners to receive dividends
which the firm must pay out of after-tax income. Moreover, the use of preferred stock as a source
of financing does not increase the probability of bankruptcy for the firm.
However, like the coupon payments on debt, the dividends on preferred stock are generally
fixed. Also, the claims of the preferred stockholders against the assets of the firm are fixed as the
claims of the debt holders. Preferred stock has the following contents:
Par Value
The par value represents the claim of the preferred stockholder against the value of the firm.
Preferred Dividend / Preferred Dividend Rate
The preferred dividend rate is expressed as a percentage of the par value of the preferred stock.
The annual preferred dividend is determined by multiplying the preferred dividend rate times the
par value of the preferred stock.
Since the preferred dividends are generally fixed, preferred stock can be valued as a constant
growth stock with a dividend growth rate equal to zero. Thus, the price of a share of preferred
stock can be determined using the following equation:

Where:
 Pp = the preferred stock price,
 Dp = the preferred dividend, and
 r = the required return on the stock.

Example 5.9: Find the price of a share of preferred stock given that the par value is $100
per share, the preferred dividend rate is 8%, and the required return is 10%.
Solution:
Stock Prices and Investment Opportunities

Consider two companies, Cash Cow, Inc., and Growth Prospects, each with expected
earnings in the coming year of $5 per share. Both companies could in principle pay out all
of these earnings as dividends, maintaining a perpetual dividend flow of $5 per share. If the
market capitalization rate were k = 12.5%, both companies would then be valued at D1/k =
$5/.125 = $40 per share. Neither firm would grow in value, because with all earnings paid
out as dividends, and no earnings reinvested in the firm, both companies’ capital stock and
earnings capacity would remain unchanged over time; earnings and dividends would not
grow.

Now suppose one of the firms, Growth Prospects, engages in projects that generate a return
on investment of 15%, which is greater than the required rate of return, k = 12.5%. It
would be foolish for such a company to pay out all of its earnings as dividends. If Growth
Prospects retains or plows back some of its earnings into its highly profitable projects, it
can earn a 15% rate of return for its shareholders, whereas if it pays out all earnings as
dividends, it forgoes the projects, leaving shareholders to invest the dividends in other
opportunities at a fair market rate of only 12.5%. Suppose, therefore, Growth Prospects
chooses a lower dividend payout ratio (the fraction of earnings paid out as dividends),
reducing payout from 100% to 40%, and maintaining a plowback ratio (the fraction of
earnings reinvested in the firm) of 60%. The plowback ratio also is referred to as the
earnings retention ratio.

The dividend of the company, therefore, will be $2 (40% of $5 earnings) instead of $5. Will
the share price fall? No, it will rise! Although dividends initially fall under the earnings
reinvestment policy, subsequent growth in the assets of the firm because of reinvested
profits will generate growth in future dividends, which will be reflected in today’s share
price. The dividend streams which should be generated by Growth Prospects under two
dividend policies. A low reinvestment rate plan allows the firm to pay higher initial
dividends but results in a lower dividend growth rate. Eventually, a high reinvestment rate
plan will provide higher dividends. If the dividend growth generated by the reinvested
earnings is high enough, the stock will be worth more under the high reinvestment
strategy.

How much growth will be generated? Suppose Growth Prospects starts with plant and
equipment of $100 million and is all-equity-financed. With a return on investment or
equity (ROE) of 15%, total earnings are ROE x $100 million = 0.15 x $100 million = $15
million. There are 3 million shares of stock outstanding, so earnings per share are $5, as
posited above. If 60% of the $15 million in this year’s earnings is reinvested, then the value
of the firm’s capital stock will increase by 0.60 x $15 million = $9 million, or by 9%. The
percentage increase in the capital stock is the rate at which income was generated (ROE)
times the plowback ratio (the fraction of earnings reinvested in more capital), which we
will denote as b.

Now endowed with 9% more capital, the company earns 9% more income and pays out 9%
higher dividends. The growth rate of the dividends, therefore, is

g = ROE x b = 15% x 0.60 = 9%

If the stock price equals its intrinsic value, and this growth rate can be sustained (i.e., if the
ROE and payout ratios are consistent with the long-run capabilities of the firm), then the
stock should sell at

D1 2
P0 = = = 57.14
k − g 0.125 −0.09

When Growth Prospects pursued a no-growth policy and paid out all earnings as dividends,
the stock price was only $40. Therefore, you can think of $40 as the value per share of the
assets the company already has in place.

When Growth Prospects decided to reduce current dividends and reinvest some of its
earnings in new investments, its stock price increased. The increase in the stock price
reflects the fact that planned investments provide an expected rate of return greater than
the required rate. In other words, the investment opportunities have positive net present
value. The value of the firm rises by the NPV of these investment opportunities. This net
present value is also called the present value of growth opportunities, or PVGO.

Therefore, we can think of the value of the firm as the sum of the value of assets already in
place, or the no-growth value of the firm, plus the net present value of the future
investments the firm will make, which is the PVGO. For Growth Prospects, PVGO = $17.14
per share:

Price = No-growth value per share + PVGO

P0 = E1/k + PVGO = 57.14 = 40 + 17.14

It is important to recognize that growth per share is not what investor’s desire. Growth
enhances company value only if it is achieved by investment in projects with attractive
profit opportunities (i.e., with ROE > k). To see why, let’s now consider Growth Prospects’
unfortunate sister company, Cash Cow. Cash Cow’s ROE is only 12.5%, just equal to the
required rate of return, k. Therefore, the NPV of its investment opportunities is zero. We’ve
seen that following a zero growth strategy with b = 0 and g = 0, the value of Cash Cow will
be E1/k = $5/.125 = $40 per share. Now suppose Cash Cow chooses a plowback ratio of b =
0.60, the same as Growth Prospects’ plowback. Then g would be
g =ROE x b = .125 x .60 = .075

But the stock price is still;

D1 2
P0 = = = $40
k − g 0.125 −0.075

No different from the no-growth strategy.

In the case of Cash Cow, the dividend reduction that frees funds for reinvestment in the
firm generates only enough growth to maintain the stock price at the current level. This is
as it should be: If the firm’s projects yield only what investors can earn on their own, then
NPV is zero, and shareholders cannot be made better off by a high reinvestment rate policy.
This demonstrates that “growth” is not the same as growth opportunities. To justify
reinvestment, the firm must engage in projects with better prospective returns than those
shareholders can find elsewhere. Notice also that the PVGO of Cash Cow is zero: PVGO = P0
- E1/k = 40 - 40 = 0. With ROE = k, there is no advantage to plowing funds back into the
firm; this shows up as PVGO of zero. In fact, this is why firms with considerable cash flow,
but limited investment prospects, are called “cash cows.” The cash these firms generate is
best taken out of or “milked from” the firm.

Takeover Target is run by entrenched management that insists on reinvesting 60% of its
earnings in projects that provide an ROE of 10%, despite the fact that the firm’s
capitalization rate is k = 15%. The firm’s year-end dividend will be $2 per share, paid out of
earnings of $5 per share. At what price will the stock sell? What is the present value of
growth opportunities? Why would such a firm be a takeover target for another firm?

Given current management’s investment policy, the dividend growth rate will be

g = ROE x b = 10% x .6 = 6%

And the stock price should be

P0 = $2/0.15 – 0.06 = $22.22

The present value of growth opportunities is

PVGO = Price per share - No-growth value per share

= $22.22 - E1 / k = $22.22 - $5/.15 = -$11.11

PVGO is negative. This is because the net present value of the firm’s projects is negative:
The rate of return on those assets is less than the opportunity cost of capital. Such a firm
would be subject to takeover, because another firm could buy the firm for the market price
of $22.22 per share and increase the value of the firm by changing its investment policy.
For example, if the new management simply paid out all earnings as dividends, the value of
the firm would increase to its no-growth value, E1/k = $5/.15 = $33.33.

5.5 Free cash flow model

The dividend discount model is based upon the premise that the only cash flows received
by stockholders are dividends. Even if we use the modified version of the model and treat
stock buybacks as dividends, we may mis-value firms that consistently return less or more
than they can afford to their stockholders.

This section uses a more expansive definition of cash flows to equity as the cash flows left
over after meeting all financial obligations, including debt payments, and after covering
capital expenditure and working capital needs. It discusses the reasons for differences
between dividends and free cash flows to equity, and presents the discounted free cash
flow to equity model for valuation.

Measuring what firms can return to their stockholders

Given what firms are returning to their stockholders in the form of dividends or stock
buybacks, how do we decide whether they are returning too much or too little? We
measure how much cash is available to be paid out to stockholders after meeting
reinvestment needs and compare this amount to the amount actually returned to
stockholders.

Free Cash Flows to Equity

To estimate how much cash a firm can afford to return to its stockholders, we begin with
the net income the accounting measure of the stockholders’ earnings during the period and
convert it to a cash flow by subtracting out a firm’s reinvestment needs.

First, any capital expenditures, defined broadly to include acquisitions, are subtracted from
the net income, since they represent cash outflows. Depreciation and amortization, on the
other hand, are added back in because they are non-cash charges. The difference between
capital expenditures and depreciation is referred to as net capital expenditures and is
usually a function of the growth characteristics of the firm. High-growth firms tend to have
high net capital expenditures relative to earnings, whereas low-growth firms may have low
and sometimes even negative, net capital expenditures.

Second, increases in working capital drain a firm’s cash flows, while decreases in working
capital increase the cash flows available to equity investors. Firms that are growing fast, in
industries with high working capital requirements (retailing, for instance) typically have
large increases in working capital. Since we are interested in the cash flow effects, we
consider only changes in non-cash working capital in this analysis.
Finally, equity investors also have to consider the effect of changes in the levels of debt on
their cash flows. Repaying the principal on existing debt represents a cash outflow; but the
debt repayment may be fully or partially financed by the issue of new debt, which is a cash
inflow. Again, netting the repayment of old debt against the new debt issues provides a
measure of the cash flow effects of changes in debt.

Allowing for the cash flow effects of net capital expenditures, changes in working capital
and net changes in debt on equity investors, we can define the cash flows left over after
these changes as the free cash flow to equity (FCFE).

Free Cash Flow to Equity (FCFE) = Net Income - (Capital Expenditures - Depreciation) -
(Change in Non-cash Working Capital) + (New Debt Issued - Debt Repayments)

This is the cash flow available to be paid out as dividends or stock buybacks.

This calculation can be simplified if we assume that the net capital expenditures and
working capital changes are financed using a fixed mix of debt and equity. If d is the
proportion of the net capital expenditures and working capital changes that is raised from
debt financing, the effect on cash flows to equity of these items can be represented as
follows:

Equity Cash Flows associated with Capital Expenditure Needs = – (Capital Expenditures -
Depreciation) (1 - d)

Equity Cash Flows associated with Working Capital Needs = - (D Working Capital)(1-d)

Accordingly, the cash flow available for equity investors after meeting capital expenditure
and working capital needs, assuming the book value of debt and equity mixture is constant,
is:

Free Cash Flow to Equity = Net Income - (Capital Expenditures - Depreciation)(1 - d) - (D

Working Capital)(1-d)

Note that the net debt payment item is eliminated, because debt repayments are financed
with new debt issues to keep the debt ratio fixed. It is particularly useful to assume that a
specified proportion of net capital expenditures and working capital needs will be financed
with debt if the target or optimal debt ratio of the firm is used to forecast the free cash flow
to equity that will be available in future periods. Alternatively, in examining past periods,
we can use the firm’s average debt ratio over the period to arrive at approximate free cash
flows to equity.
What about preferred dividends?

In both the long and short formulations of free cash flows to equity described in the section
above, we have assumed that there are no preferred dividends paid. Since the equity that
we value is only common equity, you would need to modify the formulae slightly for the
existence of preferred stock and dividends. In particular, you would subtract out the
preferred dividends to arrive at the free cash flow to equity:

Free Cash Flow to Equity (FCFE) = Net Income - (Capital Expenditures - Depreciation) -
(Change in Non-cash Working Capital) – (Preferred Dividends + New Preferred Stock
Issued) + (New Debt Issued - Debt Repayments)

In the short form, you would obtain the following:

Free Cash Flow to Equity = Net Income - Preferred Dividend - (Capital

Expenditures - Depreciation)(1 - d) - (D Working Capital)(1-d)

The non-equity financial ratio (d) would then have to include the expected financing from
new preferred stock issues.

This is the cash flow that accrues from the firm’s operations, net of investments in capital
and net working capital. It includes cash flows available to both debt and equity holders.

Alternatively, we can focus on cash flow available to equity holders. This will differ from
free cash flow to the firm by after-tax interest expenditures, as well as by cash flow
associated with net issuance or repurchase of debt (i.e., principal repayments minus
proceeds from issuance of new debt).

FCFE = FCFF - Interest expense x (1 - corporate tax rate) + Increases in net debt

The free cash flow to the firm approach discounts year-by-year cash flows plus some
estimate of terminal value, PT. In Equation below, we use the constant growth model to
estimate terminal value. The appropriate discount rate is the weighted average cost of
capital

Where
To find equity value, we subtract the existing market value of debt from the derived value
of the firm.

Alternatively, we can discount free cash flows to equity (FCFE) at the cost of equity, kE,

Where

5.6 Earning multiplier approach

The earnings multiplier, also called the price-to-earnings ratio (P/E), is a valuation
method used to compare a company’s current share price to its per-share earnings. Many
investors prefer to estimate the value of common stock using an earnings multiplier model.
Basic Concept: The value of any investment is the present value of future returns. In the
case of common stocks, the returns that investors are entitled to receive are the net
earnings of the firm. Therefore, one way investors can estimate value is by determining
how many dollars they are willing to pay for a dollar of expected earnings (typically
represented by the estimated earnings during the following 12-month period).

Example: If investors are willing to pay 10 times expected earnings, they would value a
stock they expect to earn $ 2 a share during the following year at $20.

COMPUTATION OF THE CURRENT EARNINGS MULTIPLIER

price current market price

Earnings multiplier = =
earnings ratio expected 12 −montℎ earnings

What does this indicate? It indicates the prevailing attitude of investors toward a stock’s
value. Investors must decide if they agree with the prevailing P/E ratio (that is, is the
earnings multiplier too high or too low?) based upon how it compares to the P/E ratio for
the aggregate market, for the firm’s industry, and for similar firms and stocks. To answer
this question, we must consider what influences the earnings multiplier (P/E ratio) over
time. Example For any Industry Index, over time the aggregate stock market P/E ratio may
vary from about 6 times earnings to about 30 times earnings.D1

FACTORS AFFECTING P/E RATIO The infinite period dividend discount model can be
used to indicate the variables that should determine the value of the P/E ratio as follows:
 D1
Pi =
k −g

If we divide both sides of the equation by E1 (expected earnings during the next12
pi D1 /E 1
months), the result is: =
E1 k −g

Thus, the P/E ratio is determined by:

1. The expected dividend payout ratio (dividends divided by earnings)

2. The estimated required rate of return on the stock (k)

3. The expected growth rate of dividends for the stock (g)

Example (The spread between k and g is the main determinant of the size of the P/E
ratio.)If we assume a stock has an expected dividend payout of 50 % a required rate of
return of 12%, and an expected growth rate for dividends of 8 %, this would imply the
following: D/E = 0.50: k = 0.12: g = 0.08

pi D1 /E 1 0.50
: = p/E = = 0.50/0.04 =12.5
E1 k −g 0.12− 0.08

A small difference in either k or g or both will have a large impact on the earnings
multiplier….and What about Dividend Payout Ratio?

0.50 0.50 0.50

p/E = = 10: p/E = = 16.7: p/E = = 25
0.13 −0.08 0.12− 0.09 0.11−0.08

HOW WOULD YOU DO YOUR STOCK VALUATION?

After estimating the earnings multiple, you would apply it to your estimate of earnings for
the next year (E1) to arrive at an estimated value.

E1 is based on the earnings for the current year (E0) and your expected growth rate of
earnings. Using these two estimates, you would compute an estimated value of the stock
and compare this estimated value to its market price. Consider the following estimates for
an example firm:

D/E = 0.50 g = 0.09

K = 0.12 E0 = $2.00

Your Earnings Multiple:

 0.50
= = 0.50/0.03 = 16.7
0.12− 0.09

Given current earnings (E0) of $ 2.00 and a g of 9%, you would expect E1 to be $ 2.18.

: Therefore, you would estimate the value (price) of the stock as: V = 16.7 x $ 2.18 = $ 36.41

As before, you would compare this estimated value of the stock to its current market price
to decide whether you should invest in it. This is a two-step process.

The value of the stock is obtained by multiplying projected earnings per share by a forecast
of the P/E ratio. This procedure seems simple, but its apparent simplicity is deceptive.
First, forecasting earnings is challenging. It is known that, the earnings will depend on
international, macroeconomic, and industry as well as firm-specific factors, many of which
are highly unpredictable. Second, forecasting the P/E multiple is even more difficult. P/E
ratios vary across industries and over time. Nevertheless, our discussion of stock valuation
provides some insight into the factors that ought to determine a firm’s P/E ratio.

Growth opportunities, in which we compared two firms, Growth Prospects and Cash Cow,
each of which had earnings per share of $5 and growth Prospects reinvested 60% of its
earnings in prospects with an ROE of 15%, while Cash Cow paid out all of its earnings as
dividends. Cash Cow had a price of $40, giving it a P/E multiple of 40/5 = 8.0, while Growth
Prospects sold for $57.14, giving it a multiple of 57.14/5 = 11.4. This observation suggests
the P/E ratio might serve as a useful indicator of expectations of growth opportunities. We
can see this explicitly by rearranging P0 = E1/k + PVGO

1 PVGO
P0/E1 = ⌈ 1+ ⌉
k E 1/k

When PVGO = 0, the above Equation shows that P0 = E1/k. The stock is valued like a non-
growing perpetuity of EPS. The P/E ratio is just 1/k. However, as PVGO becomes an
increasingly dominant contributor to price, the P/E ratio can rise dramatically. The ratio of
PVGO to E/k has a simple interpretation. It is the ratio of the component of firm value
reflecting growth opportunities to the component of value reflecting assets already in place
(i.e., the no-growth value of the firm, E/k). When future growth opportunities dominate the
estimate of total value, the firm will command a high price relative to current earnings.
Thus, a high P/E multiple appears to indicate that a firm is endowed with ample growth
opportunities.

Return again to Takeover Target, the firm we first encountered in Example above. Earnings
are $5 per share, and the capitalization rate is 15%, implying that the no-growth value of
the firm is E1/k = $5/.15 = $33.33. The stock price actually is $22.22, implying that the
present value of growth opportunities equals -$11.11. This implies that the P/E ratio
should be

1 PVGO 1 − 11.11
P0/E1 = ⌈ 1+ ⌉ = ⌈ 1+ ⌉ = 4.44
k E 1/k k 15 33.3

In fact, the stock price is $22.22 and earnings are $5 per share, so the P/E ratio is
$22.22/$5 = 4.44.

Other Comparative Valuation Ratios

The price–earnings ratio is an example of a comparative valuation ratio. Such ratios are
used to assess the valuation of one firm versus another based on a fundamental indicator
such as earnings. For example, an analyst might compare the P/E ratios of two firms in the
same industry to test whether the market is valuing one firm “more aggressively” than the
other. Other such comparative ratios are commonly used.

Price-to-book ratio

This is the ratio of price per share divided by book value per share. As we noted earlier in
this chapter, some analysts view book as a useful measure of value and therefore treat the
ratio of price-to-book value as an indicator of how aggressively the market values the firm.

Price-to-cash flow ratio

Earnings as reported on the income statement can be affected by the company’s choice of
accounting practices and thus are commonly viewed as subject to some imprecision and
even manipulation. In contrast, cash flow which tracks cash actually flowing into or out of
the firm is less affected by accounting decisions. As a result, some analysts prefer to use the
ratio of price to cash flow per share rather than price to earnings per share. Some analysts
use operating cash flow when calculating this ratio; others prefer free cash flow, that is,
operating cash flow net of new investment.

Price-to-sales ratio

Many start-up firms have no earnings. As a result, the P/E ratio for these firms is
meaningless. The price-to-sales ratio (the ratio of stock price to the annual sales per share)
is sometimes taken as a valuation benchmark for these firms. Of course, price-to-sales
ratios can vary markedly across industries, since profit margins vary widely.

Be creative

Sometimes a standard valuation ratio will simply not be available, and you will have to
devise your own. In the 1990s, some analysts valued retail Internet firms based on the
number of Web hits their sites received. In retrospect, they valued these firms using too
generous “price-to-hits” ratios. Nevertheless, in a new investment environment, these
analysts used the information available to them to devise the best valuation tools they
could.