Stock Valuation

Expected Dividends, No Growth

A no-growth company would be expected to return high dividends under traditional finance theory.

Key Points

 Companies generally either retain earnings for investment, or distribute them as dividend, according to
their growth strategy.
 Clientele effects suggests that different dividend levels attract different types of investors.
 Value investors look for indications that a stock is undervalued. High dividends are one indication of
undervaluation.
 Knowing a firm’s cost of capital is needed in order to make better decisions. Managers make capital
budgeting decisions while capital providers make decisions about lending and investment.

Key Terms

 clientele: The body or class of people who frequent an establishment or purchase a service, especially when
considered as forming a more-or-less homogeneous group of clients in terms of values or habits.

The Dividend Decision

Whether to issue dividends and what amount is calculated mainly on the basis of the company’s unappropriated
profit and its earning prospects for the coming year. The amount is also often calculated based on expected free cash
flows, which means cash remaining after all business expenses, and capital investment needs have been met.

If there are no favorable investment opportunities–projects where return exceed the hurdle rate– finance theory
suggests that management will return excess cash to shareholders as dividends. However, there are exceptions. For
example, shareholders of a “growth stock,” expect that the company will, almost by definition, retain earnings so as
to fund growth internally.

Investing trade-offs: Value investors trade growth for dividends.

At the other end of the spectrum, investors of a “no growth,” or value stock will expect the firm to retain little cash
for investment, and to distribute a comparatively greater proportion to investors as a dividend.

Clientele Effects

This suggests that a particular pattern of dividend payments may suit one type of stock holder more than another;
this is sometimes called the “clientele effect. ” A retiree may prefer to invest in a firm that provides a consistently
high dividend yield, whereas a person with a high income from employment may prefer to avoid dividends due to
their high marginal tax rate on income. If clienteles exist for particular patterns of dividend payments, a firm may be
able to maximize its stock price and minimize its cost of capital by catering to a particular clientele. This model may
help to explain the relatively consistent dividend policies followed by mostlisted companies.

Value Investors

No growth, high dividend stocks may appeal to value investors. Value investing involves buying securities with
shares that appear underpriced by some form of fundamental analysis. As examples, such securities may be stock in
public companies that have high dividend yields, low price-to-earning multiples, or have low price-to-book ratios.
Thus, high dividends and low reinvestment of retained earnings can signal an appealing value stock to an investor.

Expected Dividends and Constant Growth

Valuations rely heavily on the expected growth rate of a company; past growth rate of sales and income provide
insight into future growth.

Key Points

 Companies are constantly changing, as well as the economy. Solely using historical growth rates to predict
the future is not an acceptable form of valuation. Calculating the future growth rate requires personal
investment research.
 A generalized version of the Walter model (1956), SPM considers the effects of dividends, earnings
growth, as well as the risk profile of a firm on a stock ‘s value.
 The Gordon model or Gordon’s growth model is the best known of a class of discounted dividend models.
It assumes that dividends will increase at a constant growth rate (less than the discount rate ) forever.

Key Terms

 Gordon Growth Model: Gordon Growth Model is also called the dividend discount model (DDM), which
is a way of valuing a company based on the theory that a stock is worth the discounted sum of all of its future
dividend payments.

Growth Rate

Valuations rely very heavily on the expected growth rate of a company. One must look at the historical growth rate
of both sales and income to get a feeling for the type of future growth expected. However, companies are constantly
changing, as well as the economy, so solely using historical growth rates to predict the future is not an acceptable
form of valuation. Instead, they are used as guidelines for what future growth could look like if similar
circumstances are encountered by the company. Calculating the future growth rate requires personal investment
research. This may take form in listening to the company’s quarterly conference call or reading a press release or
other another company article that discusses the company’s growth guidance. However, although companies are in
the best position to forecast their own growth, they are far from accurate. Unforeseen events could cause rapid
changes in the economy and in the company’s industry.

And for any valuation technique, it’s important to look at a range of forecast values.

 For example, if the company being valued has been growing earnings between 5 and 10% each year for the
last five years, but believes that it will grow 15 – 20% this year, a more conservative growth rate of 10 –
15% would be appropriate in valuations.
  Another example would be for a company that has been going through restructuring. They may have been
growing earnings at 10 – 15% over the past several quarters / years because of cost cutting, but their sales
growth could be only 0 – 5%. This would signal that their earnings growth will probably slow when the cost
cutting has fully taken effect. Therefore, forecasting an earnings growth closer to the 0 – 5% rate would be
more appropriate rather than the 15 – 20%. Nonetheless, the growth rate method of valuations relies heavily
on gut feel to make a forecast. This is why analysts often make inaccurate forecasts. It is also why familiarity
with a company is essential before making a forecast.

Sum of Perpetuities Method

The PEG ratio is a special case in the Sum of Perpetuities Method (SPM) equation. A generalized version of the
Walter model (1956), SPM considers the effects of dividends, earnings growth, as well as the risk profile of a firm
on a stock’s value. Derived from the compound interest formula using the present value of a perpetuity equation,
SPM is an alternative to the Gordon Growth Model. The variables are:

 P is the value of the stock or business

 E is a company’s earnings
 G is the company’s constant growth rate
 K is the company’s risk adjusted discount rate
 D is the company’s dividend payment
P=E∗GK2+DKP=E∗GK2+DK

Constant Growth Approximation

The Gordon model or Gordon’s growth model is the best known of a class of discounted dividend models. It
assumes that dividends will increase at a constant growth rate (less than the discount rate) forever. The valuation is
given by the formula:

P=D∗∑∞i=1(1+g1+k)i=D∗1+gk−gP=D∗∑i=1∞(1+g1+k)i=D∗1+gk−g

Relationship Between Dividend Payments and the Growth Rate

The portion of the earnings not paid to investors is, ideally, left for investment in order to provide for future earnings
growth.

Key Points

 Investors take into account how much capital is distributed to investors, and conversely how much capital
is kept from investors.
 Investors hope that firms will use retained earnings to either maximize their current operations or invest in
such as a way as to lead to higher profits.
 Some firms are unable to distribute earnings, since their funds are tied up in maintenance, repairs, et cetera.
 On the other hand, some companies can retain earnings and put that money back to work – i.e., invest in
growth opportunities.
Key Terms

 capital gains: Profit that results from a disposition of a capital asset, such as stock, bond, or real estate due
to arbitrage.

 From an investor’s point of view, the fundamentals of a company are of the utmost importance. One such
fundamental that that investors take into account is how much capital is distributed to investors, and
conversely how much capital is kept from investors. Capital is distributed to investors via dividend
payments and, indirectly, through capital gains. Capital that is kept from investors is known as retained
earnings. Investors hope that firms will use retained earnings to either maximize their current operations or
invest in such as a way as to lead to higher profits. In other words, the portion of profits not paid out to
investors via dividends is, ideally, left for investment in order to provide for future earnings growth.

 Some companies require large amounts of new capital just to continue operations. Such firms are usually
unable to distribute earnings, since their funds are tied up in maintenance, repairs, et cetera. These
companies also provide limited growth opportunities, since earnings are not reinvested for the purpose of
growth. On the other hand, some companies can retain earnings and put that money back to work – i.e.,
invest in growth opportunities. Firms that can do this tend to retain more of their earnings. These firms are
attractive to investors, even though there is relatively low distribution of profits.

 Put succinctly, investors seeking high current income and limited capital growth prefer companies with a
high dividend payout ratio. However, investors seeking higher capital growth may prefer a lower payout
ratio because capital gains are taxed at a lower rate. High growth firms in early life generally have low or
zero payout ratios in order to reinvest as much of their earnings as possible. As they mature, they tend to
return more of the earnings back to investors. Note that dividend payout ratio is calculated as dividend per
share divided by earnings per share.

 Understanding Future Stock Value

 There are many different ways to appraise the future value of stocks, including fundamental criteria and
stock valuation methods.

Key Points

 Earnings Per Share is the total net income of the company divided by the number of shares outstanding; the
Profits/Earnings ratio is the stock price divided by the annual EPS figure.
 Return on Invested Capital measures how much money the company makes each year per dollar of invested
capital and approximates the expected level of growth; Return on Assets measures the company’s ability to
make money from its assets.
 To measure Market Capitalization (the value of all of a company’s stock), multiply the current stock price
by the fully diluted shares outstanding; Enterprise Value is equal to the total value the company is trading for
on the stock market.
 Enterprise Value (EV) to earnings before interest, taxes, depreciation and amortization (EBITDA) is one of
the best measurements of whether or not a company should be valued as cheap or expensive.
Key Terms

 risk premium: A risk premium is the minimum amount of money by which the expected return on a risky
asset must exceed the known return on a risk-free asset, or the expected return on a less risky asset, in order
to induce an individual to hold the risky asset rather than the risk-free asset.
 GAAP: Generally Accepted Accounting Principles refer to the standard framework of guidelines,
conventions, and rules accountants are expected to follow in recording, summarizing, and preparing financial
statements in any given jurisdiction.

 In financial markets, stock valuation involves calculating theoretical values of companies and their stocks.
The main use of stock valuation is to predict future market prices and profit from price changes. Stocks that
are judged as undervalued (with respect to their theoretical value) are bought, while stocks that are
perceived to be overvalued are sold, in the expectation that undervalued stocks will, on the whole, rise,
while overvalued stocks will, on the whole, fall.

 Stock Valuation: Stock valuation involves many methods.

 Fundamental Criteria (Fair Value)

 The soundest stock valuation method, the discounted cash flow (DCF) method of income valuation,
involves discounting the profits (dividends, earnings, or cash flows) the stock will bring to stockholders in
the foreseeable future, and calculating a final value on disposal. The discounted rate normally includes a
risk premium which is often based on the capital asset pricing model.

 Stock Valuation Methods

 There are many different ways to value stocks. The key is to take each approach into account while
formulating an overall opinion of the stock. If the valuation of a company is lower or higher than other
similar stocks, then the next step would be to determine the reasons for the discrepancy.

 1. Earnings Per Share (EPS)

 EPS is the total net income of the company divided by the number of shares outstanding. Numbers are
usually reported as a GAAP EPS number (which means it is computed using mutually agreed upon
 accounting rules) and a Pro Forma EPS figure (income is adjusted to exclude any one time items as well as
some non-cash items like amortization of goodwill or stock option expenses).

 2. Price to Earnings (P/E)

 Once one has several EPS figures (historical and forecasts), the most common valuation technique used by
analysts is the price to earnings ratio, or P/E. To compute this figure, the stock price is divided by the
annual EPS figure.

 3. Price Earnings to Growth (PEG) Ratio

 This valuation technique has become more popular over the past decade or so. It is better than just looking
at a P/E because it takes three factors into account: the price, earnings, and earnings growth rates. To
compute the PEG ratio, divide the Forward P/E by the expected earnings growth rate (historical P/E and
historical growth rate are also used to see where the stock has traded in the past).

 4. Return on Invested Capital (ROIC)

 This valuation technique measures how much money the company makes each year per dollar of invested
capital. Invested capital is the amount of money invested in the company by both stockholders and debtors.
The ratio is expressed as a percent and Return on Invested Capital ratio should have a percent that
approximates the expected level of growth. In its simplest definition, this ratio measures the investment
return that management is able to get for its capital. The higher the number, the better the return.

 5. Return on Assets (ROA)

 Similar to ROIC, ROA, expressed as a percent, measures the company’s ability to make money from its
assets. To measure the ROA, take the pro forma net income divided by the total assets. However, because
of very common irregularities in balance sheets (due to things like goodwill, write-offs, discontinuations,
etc. ) this ratio is not always a good indicator of the company’s potential. If the ratio is higher or lower than
expected, be sure to look closely at the assets to see what could be overstating or understating the figure.

 6. Price to Sales (P/S)

 This figure is useful because it compares the current stock price to the annual sales. In other words, it tells
you how much the stock costs per dollar of sales earned.

 7. Market Cap

 Market Cap, which is short for Market Capitalization, is the value of all of the company’s stock. To
measure it, multiply the current stock price by the fully diluted shares outstanding.

 8. Enterprise Value (EV)

 Enterprise Value is equal to the total value of the company, as trading on the stock market. To compute it,
add the Market Cap (see above) and the total net debt of the company.
  9. EBITDA

 EBITDA stands for earnings before interest, taxes, depreciation and amortization. It is one of the best
measures of a company’s cash flow and is used for valuing both public and private companies.

 10. EV to EBITDA

 This is perhaps one of the best measurements of whether or not a company should be valued as cheap or
expensive. To compute, divide the EV by EBITDA (see above for calculations). The higher the number, the
more expensive the company is.

 Valuing Nonconstant Growth Dividends

 Limited high-growth approximation, implied growth models, and the imputed growth acceleration ratio are
used to value nonconstant growth dividends.

Key Points

 Limited high-growth approximation: When a stock has a significantly higher growth rate than its peers, it is
sometimes assumed that the earnings growth rate will be sustained for a short time (say, 5 years), and then
the growth rate will revert to the mean.
 Implied Growth Models: One can use the Gordon model or the limited high-growth period approximation
model to impute an implied growth estimate.
 Imputed growth acceleration ratio: Subsequently, one can divide this imputed growth estimate by recent
historical growth rates.

Key Terms

 break-even: Break-even (or break even) is the point of balance between making either a profit or a loss.
 DCF models: Valuation using discounted cash flows is a method for determining the current value of a
company using future cash flows adjusted for time value. The future cash flow set is made up of the cash
flows within the determined forecast period and a continuing value that represents the cash flow stream after
the forecast period.

Limited high-growth period approximation

When a stock has a significantly higher growth rate than its peers, it is sometimes assumed that the earnings growth
rate will be sustained for a short time (say, 5 years), and then the growth rate will revert to the mean. This is
probably the most rigorous approximation that is practical.

While these DCF models are commonly used, the uncertainty in these values is hardly ever discussed. Note that the
models diverge for and hence are extremely sensitive to the difference of dividend growth to discount factor. One
might argue that an analyst can justify any value (and that would usually be one close to the current price supporting
his call) by fine-tuning the growth/discount assumptions.
Implied Growth Models

One can use the Gordon model or the limited high-growth period approximation model to impute an implied growth
estimate. To do this, one takes the average P/E and average growth for a comparison index, uses the current (or
forward) P/E of the stock in question, and calculates what growth rate would be needed for the two valuation
equations to be equal. This gives you an estimate of the “break-even” growth rate for the stock’s current P/E ratio.
(Note: we are using earnings not dividends here because dividend policies vary and may be influenced by many
factors including tax treatment).

Imputed growth acceleration ratio

Subsequently, one can divide this imputed growth estimate by recent historical growth rates. If the resulting ratio is
greater than one, it implies that the stock would need to experience accelerated growth relative to its prior recent
historical growth to justify its current P/E (higher values suggest potential overvaluation). If the resulting ratio is less
than one, it implies that either the market expects growth to slow for this stock or that the stock could sustain its
current P/E with lower than historical growth (lower values suggest potential undervaluation). Comparison of the
IGAR across stocks in the same industry may give estimates of relative value. IGAR averages across an industry
may give estimates of relative expected changes in industry growth (e.g. the market’s imputed expectation that an
industry is about to “take-off” or stagnate). Naturally, any differences in IGAR between stocks in the same industry
may be due to differences in fundamentals, and would require further specific analysis.