Chapter Five: Stock and

equity valuation
What is a Stock? (Institute of corporate Finance)
When an investor buys a stock, part ownership in the form
of a share is bought.
If the business or enterprise happens to do well, the investor
benefits by seeing an increase in the value of the share.
The share can either be held or sold at a profit on the stock
exchange.
If the business does poorly, the value of the share declines,
and the investor may lose some or all of the investment.
Stocks are usually riskier than bonds as there is no guarantee
that the stock will do well.

However, there is potential to earn higher returns when it

comes to stock trading.

Companies sell their stock for various reasons, such as

developing new products, expanding into new markets, or
even paying off debt.

The first time a company sells stock is called an initial

public offering (IPO).
What are stocks?( Investopedia)
A stock, also known as equity, is a security that represents the
ownership of a fraction of the issuing corporation.

Units of stock are called shares, which entitle the owner to a

proportion of the corporation’s assets and profits equal to how much
stock they own.

• A stock is a form of security that indicates the holder has

proportionate ownership in the issuing corporation and is
sold predominantly on stock exchanges.
• Corporations issue stock to raise funds to operate their
businesses.
• There are two main types of stock: common and
preferred.
Security analysis is a pre-requisite for making investments.

Investment was defined as a commitment of funds for a period of time to derive a

rate of return that would compensate the investor for
the time during which the funds are invested,
for the expected rate of inflation during the investment horizon, and
for the uncertainty involved.

From this definition, we know that the first step in making an investment is
determining your required rate of return.

Once you have determined this rate, you must estimate a value for the investment
using the expected future cash flows discounted at the required rate of return to
determine if its current market price is consistent with your estimated intrinsic
value.
After you have completed estimating a security’s
intrinsic value, you compare this estimated intrinsic
value to the prevailing market price to decide
whether or not you want to buy the security- this
whole process is called security valuation.
Dividend Discount Model
Assumes that the current fair price of a stock equals the sum
of all company’s future dividends discounted back to their
present value.
What is the Dividend Discount Model?
The Dividend Discount Model (DDM) is a quantitative
method of valuing a company’s stock price based on the
assumption that the current fair price of a stock equals the
sum of all of the company’s future dividends discounted
back to their present value.
Breaking Down the Dividend Discount Model

The dividend discount model was developed under the

assumption that the intrinsic value of a stock reflects the
present value of all future cash flows generated by a
security.

At the same time, dividends are essentially the positive cash

flows generated by a company and distributed to the
shareholders.

Depending on the variation of the dividend discount model,

an analyst requires forecasting future dividend payments, the
growth of dividend payments, and the cost of equity capital.
Formula for the Dividend Discount Model
The dividend discount model can take several variations
depending on the stated assumptions. The variations include
the following:

1. Gordon Growth Model

The Gordon Growth Model (GGM) is one of the most
commonly used variations of the dividend discount model.
The model is called after American economist Myron J.
Gordon, who proposed the variation.
The GGM assists an investor in evaluating a stock’s intrinsic
value based on the potential dividend’s constant rate of
growth.
The GGM is based on the assumption that the stream of future dividends will grow
at some constant rate in the future for an infinite time.

The model is helpful in assessing the value of stable businesses with strong cash
flow and steady levels of dividend growth.

It generally assumes that the company being evaluated possesses a constant and
stable business model and that the growth of the company occurs at a constant rate
over time.

Mathematically, the model is expressed in the following way:

Where:
V0 – The current fair value of a stock
D1 – The dividend payment in one period from now
r – The estimated cost of equity capital
g – The constant growth rate of the company’s dividends for an infinite time
2. One-Period Dividend Discount Model
The one-period discount dividend model is used much
less frequently than the Gordon Growth model.
The former is applied when an investor wants to
determine the intrinsic price of a stock that he or she will
sell in one period (usually one year) from now.

The one-period DDM generally assumes that an investor

is prepared to hold the stock for only one year. Because of
the short holding period, the cash flows expected to be
generated by the stock are the single dividend payment
and the selling price of the respective stock.
Hence, to determine the fair price of the stock, the
sum of the future dividend payment and that of the
estimated selling price, must be computed and
discounted back to their present values.
The one-period dividend discount model
uses the following equation:

Where:
V0 – The current fair value of a stock
D1 – The dividend payment in one period
from now
P1 – The stock price in one period from
now
r – The estimated cost of equity capital
3. Multi-Period Dividend Discount Model
The multi-period dividend discount model is an
extension of the one-period dividend discount model
wherein an investor expects to hold a stock for
multiple periods.

The main challenge of the multi-period model

variation is that forecasting dividend payments for
different periods is required.
In the multiple-period DDM, an investor expects to
hold the stock he or she purchased for multiple time
periods.
The intrinsic value of a stock (via the Multiple-
Period DDM) is found by estimating the sum value
of the expected dividend payments and the selling
price, discounted to find their present values.

The model’s mathematical formula is below:

Valuing Common Stocks
 Expected Return: The percentage yield that
an investor forecasts from a specific
investment over a set period of time.
Sometimes called the market capitalization
rate.

Div1  P1  P0
Expected Return r 
P0
Valuing Common Stocks
The formula can be broken into two parts.

 Dividend Yield + Capital Appreciation

Div1 P1  P0
Expected Return r  
P0 P0
Valuing Common Stocks
 Capitalization Rate can be estimated using
the perpetuity formula, given minor
algebraic manipulation.
Div1
Capitalization Rate P0 
r g
Div1
r  g
P0
Valuing Common Stocks
 Dividend Discount Model: Computation of today’s
stock price which states that share value equals
the present value of all expected future
dividends.

Div1 Div2 Div H  PH

P0  1
 2
... H
(1  r ) (1  r ) (1  r )

H - Time horizon for your investment

Example
 Current forecasts are for XYZ Company to pay
dividends of $3, $3.24, and $3.50 over the next
three years, respectively. At the end of three
years you anticipate selling your stock at a
market price of $94.48. What is the price of the
stock given a 12% expected return?

3.00 3.24 .  94.48

350
PV  1
 2
 3
(1.12) (1.12) (1.12)
PV $75.00
Valuing Common Stocks
If we forecast no growth, and plan to hold
out stock indefinitely, we will then value
the stock as a PERPETUITY.

Div1 EPS1
Perpetuity  P0  or
r r
Assumes all earnings are
paid to shareholders.
Valuing Common Stocks
Constant Growth DDM: A version of the
dividend growth model in which dividends
grow at a constant rate (Gordon Growth
Model).
 Example (Continued)
 Ifstock that is expected to pay $3.00 at the
end of the year is selling for $100 in the stock
market, what might the market be assuming
about the growth in dividends?
Answer
The market is
$3.00
$100  assuming the dividend
.12  g will grow at 9% per
year, indefinitely.
g .09
Valuing Common Stocks
 Ifa firm elects to pay a lower dividend, and
reinvest the funds, the stock price may
increase because future dividends may be
higher.

 Payout Ratio: Fraction of earnings paid out as

dividends
 Plowback Ratio(Retention ratio/rate): Fraction
of earnings retained by the firm.
Valuing Common Stocks
Growth can be derived from applying the
return on equity to the percentage of
earnings plowed back into operations.

g =Return on Assets X Retention Rate

Example
Our company forecasts to pay a $5.00 dividend next
year, which represents 100% of its earnings. This
will provide investors with a 12% expected return.
Instead, we decide to plow back 40% of the
earnings at the firm’s current return on equity of
20%. What is the value of the stock before and
after the plowback decision?
With Growth
No Growth g .20 .40 .08
0.6($5) $3( Dividend )
5
P0  $41.67 P0 
3
$75.00
.12 .12  .08
Example (Continued)
If the company did not plowback some
earnings, the stock price would remain at
$41.67. With the plowback, the price rose
to $75.00.

The difference between these two

numbers (75.00-41.67=33.33) is called the
Present Value of Growth Opportunities
(PVGO).
Valuing Common Stocks
 Present Value of Growth Opportunities
(PVGO): Net present value of a firm’s
future investments.

 SustainableGrowth Rate: Steady rate at

which a firm can grow: plowback ratio X
return on equity.
FCF and PV
 Free Cash Flows (FCF) should be the
theoretical basis for all PV calculations.
 FCF is a more accurate measurement of
PV than either Div or EPS.
 The market price does not always reflect
the PV of FCF.
 When valuing a business for purchase,
always use FCF.
FCF and PV
 Valuing a Business:
The value of a business is usually computed as
the discounted value of FCF out to a valuation
horizon (H).
 The valuation horizon is sometimes called the
terminal value and is calculated like PVGO.

FCF1 FCF2 FCFH PVH

PV  1
 2
 ...  H

(1  r ) (1  r ) (1  r ) (1  r ) H
 FCF and PV
 Valuing a Business:

FCF1 FCF2 FCFH PVH

PV  1
 2
 ...  H

(1  r ) (1  r ) (1  r ) (1  r ) H

PV (free cash flows) PV (horizon value)

 Example
Given the cash flows for Concatenator
Manufacturing Division, calculate the PV of near
term cash flows, PV (horizon value), and the total
value of the firm. r=10% and g= 6%
Year
1 2 3 4 5 6 7 8 9 10
Asset Value 10.00 12.00 14.40 17.28 20.74 23.43 26.47 28.05 29.73 31.51
Earnings 1.20 1.44 1.73 2.07 2.49 2.81 3.18 3.36 3.57 3.78
Investment 2.00 2.40 2.88 3.46 2.69 3.04 1.59 1.68 1.78 1.89
Free Cash Flow - .80 - .96 - 1.15 - 1.39 - .20 - .23 1.59 1.68 1.79 1.89
.EPS growth (%) 20 20 20 20 20 13 13 6 6 6
 Example (Continued)
1  1.59 
PV(horizon value)  6   22.4
1.1  .10  .06 
.80 .96 1.15 1.39 .20 .23
PV(FCF) -     
1.1 1.1 1.1 1.1 1.1 1.16
2 3 4 5

  3 .6
PV(busines s) PV(FCF)  PV(horizon value)
-3.6  22.4
$18.8
 DECISION MAKING….CONT’D
Stock valuation process:
1) Forecasting of future cash flows for the stock.
2) Forecasting of the stock price.
3) Calculation of Present value of these cash
flows. This result is intrinsic (investment) value of
stock.
4) Comparison of intrinsic value of stock and
current market price of the stock and
5) Decision making: to buy or to sell the stock.
Valuation methods:
(1) Method of income capitalization.
(2) Discounted dividend models.
(3) Valuation using multiples.
 1) Method of Income Capitalization
 This method is based on the use of Present &
Future value concept well known in finance.
 The value of any investment could be
estimated as PV of future cash flows
generated by this investment, using formula:
V = CF1 / (1 + k) + CF2/ (1 + k) 2 + … + CFn / (1 +
k)ⁿ =
= ΣCFt/ (1 + k)t
…………………………………………………………….. (1)
Where;
CF - expected cash flows from the investment
during period t;
k - discount rate (capitalization rate or required
 2) Discounted Dividend Models
 The discounted dividends models (DDM) is
based on the method of income
capitalization & considers the stock price
as the discounted value of future
dividends, at the risk adjusted required
return of equity, for dividend paying firms.
 Important assumption behind the DDM:
the only way a corporation can transfer
wealth to its stockholders is through the
payment of dividend, because dividends
are the only source of cash payment to a
common stock investor.
 DDM….Cont’d
Common stock value using DDM:

= ΣDt/(1 + k)t ………………………………………………….

V = D1 /(1 + k) + D2 / (1 + k)2 + … + Dn/(1 + k)ⁿ
(2)
 Where;
D1,2 …,t = stock dividend for the period t.
 The forecasted dividends during long-term
valuation period of dividends are the key
factor influencing the stock value.
 Expected growth rate in dividends (g) is
calculated by formula:
g = (Dt - Dt-1)/ Dt-1 ……………………………………………… (3)
 DDM….Cont’d
 Various types of DDM, depending upon the
assumptions about the expected growth
rate in dividends (g):
– “Zero” growth DDM
– Constant growth DDM
– Multistage growth DDM
(i) “Zero” growth DDM
 Assumption: D1 = D2 = D3 = ... = D∞, that
means Dt = Dt-1 and g = 0.
 The basic DDM formula for stock valuation
using “zero” growth model becomes as follows:
V = D1/ K or D0 / K0, ……………………… (4)
 DDM….Cont’d
(ii) Constant growth DDM
 Assumption: if last year (t0) firm was paying
D0 dividends, then in period t=1 its
dividends will grow at growth rate g:
 D1 = D0 (1 + g) or Dt = Dt-1 (1 + g) = D0(1 + g)
 The basic DDM formula for stock valuation
using constant growth model becomes as
follows:
V = (1 + g)/(1 + k)t (continuing series)
Or, V = D1/(k - g) (Gordon formula)
 DDM….Cont’d
Example:
 A Firm currently pays a dividend of $4
per share. That dividend is expected to
grow at a 5 % rate indefinitely. Stocks
with similar risk provide a 10 %
expected return.
 Estimate the intrinsic value of the firm’s
stock based on the assumption that the
stock will be sold after 2 years from now
at its expected intrinsic value.
 DDM….Cont’d
(iii) Multistage growth DDM
 Assumption: after some defined period in the
future T dividends expected each year will
grow at the constant growth rate g. Dividends
before period T (D1, D2, D3,…Dt) are
forecasted individually. Investor individually
defines then the period T will start.
 Future dividend cash flows for the stock, using
this model:
 Before period T: VT1 = / (1 + k )t;
 After period T: VT2 = DT + 1/( k – g )( 1 + k )T
 DDM….Cont’d
Stock value using multistage growth
method:
V = VT1 + VT2 = /(1 + k )t + DT+1/(k – g) (1 + k)T
Valuation, when the stock keeping period is fixed
 Example for 1 year:
V = (D1 + P1) / (1 + k) = + P1 / (1 + k),
Where P1 - Selling price for the stock after 1 year:
P1 = D2/(1 + k) + D3/(1 + k)2 + … + Dt/(1 + k)t-1
And value of the stock will be:
V = D1/(1 + k) + [D2/(1 + k) + D3/(1 + k)2 + … + Dt/(1 + k)t-
1
]/(1 + k)
V = / (1 + k) t
 DDM….Cont’d
Decisions for the investor in stocks:
 If Pm < V - decision to buy the stock,
because it is under valuated;
 If Pm > V - decision to sell the stock,
because it is over valuated;
 If Pm = V - stock is valuated at the
same range as in the market and its
current market price shows the
intrinsic value.
 DDM….Cont’d
Example
 The new little known firm is analyzed from the
prospect of investments in its shares by two
friends. The firm paid dividends last year $3
per share. Tomas and Aron examined the
prices of similar stocks in the market and
found that they provide 12 % expected return.
The forecast of Tomas is as follows: 4 % of
growth in dividends indefinitely. The forecast
of Aron is as follows: 10% of growth in
dividends for the next two years, after which
the growth rate is expected to decline to 3 %
for the indefinite period.
a)
DDM….Cont’d
What is the intrinsic value of the stock of
the firm according to Tomas forecast?
b) What is the intrinsic value of the stock of
the firm according to Aron forecast?
c) If the stocks of this firm currently are
selling in the market for $40 per share,
what would be the decisions of Tomas
and Aron, based on their forecasting: is
this stock attractive investment? Explain.
Assume that the growth periods for a hypothetical
firm are as follows:

= 3 years (growing at 13 percent a year)

= 6 years (during this period it is assumed that the
growth rate declines 1 percent per year for 6 years)
= constant perpetual growth of 6 percent

Suppose dividends were $0.62 for 2011, compute

the present value of the firm’s stock.
Further assume that the market price of the stock in
2011 as about $43.00
The estimated value based on the DDM ($47.41)
is above the market price in 2011 of about $43.00.
The stock is worthy if bought.
 Present Value of Free Cash Flow to Equity

The specific definition of free cash flow to equity (FCFE) is:

Net Income + Depreciation Expense - Capital Expenditures

- Δ in Working Capital - Principal Debt Repayments
+ New Debt Issues

This technique attempts to determine the free cash flow that is

available to the stockholders after payments to all other capital
suppliers and after providing for the continued growth of the firm.
where:
FCFE = the expected free cash flow to equity in
Period 1
k = the required rate of return on equity for the
firm
gFCFE = the expected constant-growth rate of free
cash flow to equity for the firm
Suppose the estimates for the components of FCFE during 2011 are as follows:
Net Income 2,300
Depreciation 1,100
Capital Expenditures -1,000
Working Capital -1,200
Principal Repayment 0
New Debt Issued 150
Total FCFE $1,350

Three-stage growth valuation model :

g1 = 9 percent for the three years after 2011
g2 = a steady declining growth rate to a constant 6 percent in 2017 and beyond

k = 8 percent cost of equity

The specific estimates of annual FCFE beginning
with the estimated value of 2011 of $1,350 are as
follows:
 The total value of the stock is the sum of the three present value
streams discounted at 8 percent:

Assuming the outstanding average shares in 2011 were 939

million, the per-share value based on the present value of FCFE is
$84.93 ($79,747/939). In this case, the estimated value is
substantially above the prevailing market price of about $43.00.
Relative Valuation Ratio Techniques/
Valuation using multiples

 Practitioners value stock price using

multiples.
 The most commonly used multiple is the
Price Earning Ratio (PER):
PER = P/EPS,
Where: P – market price of the stock;
EPS - earnings per share
 Given PER and EPS, price

P = PER x EPS
Observed PER
 Prices of stock and earnings measures, from
which observed PERs are derived, are publicly
available. Earnings per share are observed or
estimates of analysts.
 The observed PERs for a firm, a group of
firms, an industry, of the index derives
directly from such data. What should be the
PER, according to analysts, might differ from
observed PER.
 It is important to make a distinction between
observed PER with normative PER*, or what
the PER should be.
PER* = V/EPS0,
 Where;
PER* - normative PER
V - intrinsic value of the stock;
EPS0 - earnings per share for the last period.
 Investor might consider that the PER* that should apply
to the firm, of which stock value has to be estimated,
should be in line with peer firms selected or the
industry average.
Decision making for investment in stocks, using PER:
– If PER* > PER - decision to buy or to keep the stock,
because it is under valued;
– If PER* < PER - decision to sell the stock, because it is over
valued;
– If PER* = PER - stock is valued at the same range as in the
market. In this case the decision depends on the additional
observations of investor.
 There are remarkable variations of PERs across
firms, industries, etc.
 This is because PERs are a synthetic measure
combining all effects of different equity value
drivers: growth, profitability, risk.
 PER is increasing, then the profitability of the firm
and its growth rates are increasing.
 PER is decreasing then the risk of the firm is
increasing. Interest rates are correlated with
inverse of PER, because PER increases when risk
free rate decreases.
 When using these multiplies investors usually
consider that the PER* that should apply to the
firm, of which stock value has to be estimated,
should be in line with peer firms selected or the
industry average.
 FORMATION OF STOCK
PORTFOLIOS
 In this section we review the important
principles behind the stock selection
process that are relevant in the
formation and management of the stock
portfolios.
 We focus on the explanation of the
principal categories of common stock,
especially the investment
characteristics that make a category of
stock suitable for one portfolio but not
for another.
 FORMATION OF….CONT’D
 Themost widely used categories of
stocks are:
– blue chip stocks;
– income stocks;
– cyclical stocks;
– defensive stocks;
– growth stocks;
– speculative stocks;
– Penny stocks.
 FORMATION OF….CONT’D
(i) Blue chip stock
 is the best known of all the categories of
stocks presented above.
 These stocks represent the best-known firms
among the investment community.
 Blue Chip firm is that it has long continuous
history of divided payments. For example,
Coca Cola has a history of dividend
payments more than for 100 years.
 FORMATION OF….CONT’D
 Younger successful companies running
business for some decades and paying
dividends can also be categorized as
“blue chips” in the specific investment
environment.
 It is a practice that brokerage firms
recommend for their clients – individual
investors the list of blue chip stock as
high quality ones in their understanding,
based on the analysis of information
about the firm.
 FORMATION OF….CONT’D
(ii) Income stocks
 are the stocks, the earnings of which are
mainly in the form of dividend income, as
opposed to capital gains.
 It is considered a conservative, dependable
investment, suitable to supplement other
income.
 Well-established corporations with a
consistent record of paying dividends are
usually considered income stock.
 FORMATION OF….CONT’D
 In addition, income stocks usually are those
that historically have paid a larger-than-
average percentage of their net income after
taxes as dividends to their shareholders and
 the payout ratio for these companies are
high.
 The common examples of income stocks are
the stocks of public utilities, such as
telecommunication companies, electric
companies, etc.
 FORMATION OF….CONT’D
(iii) Cyclical stocks
 are the securities that go up and down in value with
the trend of business & economy,
 rising faster in the periods of rapidly improving
business conditions and sliding very noticeably
when business conditions deteriorate.
 During a recession they do poorly.
 They are cyclical because they follow business cycle.
 The examples of cyclical stocks can be industrial
chemicals, construction industry, automobile
producers, etc.
 FORMATION OF….CONT’D
(iv) Defensive stocks (synonymous – protective
stocks)
 are opposite to cyclical stocks.
 These stocks shift little in price movements &
rarely catch the interest of speculators.
 The defensive stocks have low Betas and thus
are assigned to the stocks with lower risk.
 Held by long-term investors seeking stability,
these stocks frequently withstand selling
pressure in a falling market.
 FORMATION OF….CONT’D
 The best examples of defensive stocks
are food companies, tobacco and
alcohol companies and utilities.
 Other defensive products include
cosmetics, drugs, and health care
products.
 They continue to sell their products
regardless of changes in
macroeconomic indicators.
 FORMATION OF….CONT’D
(v) Growth stocks (synonymous – performance
stocks)
 are stocks of firms whose existing & projected
earnings are sufficiently positive
 There is a constant increase in the stock’s
market value over the extended time period.
 The rate of increase in market value for these
stocks is larger than those of most corporate
stock.
 FORMATION OF….CONT’D
 These stocks do not pay dividends.
 Instead, the company reinvests its earnings
into profitable investment opportunities that
are expected to increase the value of the firm,
 Many firms have never paid a dividend
and publicly state they have no plans to
do so.
 It is not very attractive investment.
 FORMATION OF….CONT’D
(vi) Speculative stocks
 are stocks issued by relatively new firms of
unproven financial status and by firms with less
than average financial strength.
 are those that have a potential to make their owners
a lot of money quickly.
 At the same time they carry an unusually high
degree of risk.
 Some new established technological firms that paid
no dividends and had short history would probably
be considered a speculative rather than a growth
stock.
END