1. Common Stock Valuation
Chapter 10
Charles P. Jones, Investments: Analysis and Management,
Twelfth Edition, John Wiley & Sons

2. Fundamental Analysis Discounted Cash Flow Techniques
Intrinsic value based on the discounted value of the expected stream of cash flows
Dividend Discount Model often emphasized in textbooks
Often not used by practitioners
Earnings Multiplier Approach
Relative Valuation Metrics
Emphasizes selecting stocks to buy rather than valuation

3. Present Value Approach
Intrinsic value of a security is
K = appropriate discount rate
Estimated intrinsic value compared to the current market price
Can value equity of firm or entire firm

4. Dividend Discount Model
Special case of valuing equity
Current value of a share of stock is the discounted value of all future dividends
Required rate of return is minimum return that induces investor to buy stock

5. Implementing the DDM
Dividends must be valued for infinitely long time period
Not as large a practical problem as it may seem
Dividend stream is uncertain
Dividends expected to grow over time
Estimated growth in dividends can be included in DDM
Three growth cases: zero, constant, multiple

6. Dividend Discount Model
Zero-Growth Rate Model
Fixed dollar amount of dividends reduces the security to a perpetuity
Similar to preferred stock because dividend remains unchanged
Values future stream of dividends from now to infinity

7. Dividend Discount Model
Constant Growth Rate Model
Dividends expected to grow at a constant rate, g, over time
D1 is the expected dividend at end of the first period
D1 = D0  (1+g)
D0 is current dividend
Accounts for all future cash flows from now to infinity

8. Dividend Discount Model
Implications of constant growth
Stock prices grow at the same rate as the dividends
Stock total returns grow at the required rate of return
Growth rate in price plus growth rate in dividends equals k, the required rate of return
A lower required return or a higher expected growth in dividends raises prices
Model is very sensitive to small variations in inputs

9. Dividend Discount Model
Multiple-Growth Rate Model
Two or more expected growth rates in dividends
One could be zero
Two-stage model assumes growth at a rapid rate for n periods followed by steady growth

10. Dividend Discount Model
Multiple growth rates
First present value covers the period of abnormal growth
Second present value covers the period of stable growth
Limitations
Very sensitive to inputs
Difficult to determine how long abnormal growth will last
Assumes immediate transition to constant growth

11. What About Capital Gains?
Investors very interested in capital gains
DDM does account for capital gains
Price received in future reflects expectations of dividends from that point forward
Discounting dividends or a combination of dividends and price produces same results
Can use DDM to select stocks

12. Other Discounted Cash Flows
Free Cash Flow to Equity (FCFE): What could firm pay in dividends?
FCFE = Net Inc. + Deprec. – Debt Repayments – Capital Expend. – Change in Working Cap. + Debt Issuance
Free Cash Flow to the Firm (FCFF): What cash is available before any financing considerations?
FCFF = FCFE + Interest Exp. (1-tax rate) + Principal Repayments – Debt Issuance – Preferred Dividends

13. Intrinsic Value Estimated value of stock today
Derived from estimating and discounting future cash flows
If intrinsic value >(<) current market price, hold or purchase (avoid or sell) because the asset is undervalued (overvalued)
Decision will always involve estimates, be subject to error
Some analysts use 15% rule

14. P/E Ratio or Earnings Multiplier Approach
Alternative approach often used by security analysts
P/E ratio is the strength with which investors value earnings as expressed in stock price
Divide the current market price of the stock by the latest 12-month earnings
Price paid for each $1 of earnings
One of the most widely discussed variable of a stock

15. P/E Ratio Approach By definition
Current stock price is P0, EPS is E0
To value stock, must forecast EPS and P/E ratio
Can compound current earnings to forecast expected earnings

16. Relative Valuation Compare company relative to peers, the market
P/E ratios
High P/E ratios can result from several factors, not all equally desirable for investor
Best used to make specific comparisons
Price/Book value
Price/Stockholders’ Equity
Best suited for companies with hard assets

17. Relative Valuation Price/Sales Ratio (PSR) Economic Value Added (EVA)
Can be used to value companies without earnings
Price/Revenues per share over four most recent quarters
Important to interpret within industry norms
Economic Value Added (EVA)
Difference between operating profits and company’s capital cost
Emphasizes return on capital
10-17 17

18. Which Approach Is Best? Discounted cash flow theoretically best
May be unrealistic because accurate estimates difficult
P/E multiplier serves dual role
Estimating intrinsic value of stock
Relative valuation
All methods subject to estimation error
Traditional methods do apply to “new economy” stocks: revenues and profits matter

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