CHAPTER 4

COMMON STOCK VALUATION AND

ANALYSIS
Table of Contents
COMMON STOCK VALUATION AND ANALYSIS ................................................................ 43
Table of Contents ...................................................................................................................... 43
Learning Objectives: ................................................................................................................. 43
4.1 Common Stock Valuation ................................................................................................. 44
4.2 Dividend Discounted Model.............................................................................................. 46
Checklist .................................................................................................................................... 52
Study Questions ......................................................................................................................... 52
SUPPLEMENT TO CHAPTER FOUR ................................................................................... 53

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Chapter 4 Common stock valuation and analysis

Chapter Overview
Common Stock Valuation and Analysis

Common stock valuation

Approaches to valuation of
common stock

Dividend discounted model

Earnings multiplier model

Estimating the variables in the

valuation models

Learning Objectives:

After studying this chapter students should be able to:

1. apply the basic reduced form dividend discount model (DDM) to the valuation of the aggregate
stock market.
2. identify the two components involved in the two-part valuation procedure
3. list the steps involved in estimating the earnings per share for an aggregate market series.

4.1 Common Stock Valuation

In calculating the value of the common stock, all future cash flows expected to be received by the
shareholders must be discounted back to the present.

However, the common shareholders does not have a fixed income like the bondholder that
receives them at a specified time in the future.

The growth of future dividends is an important factor in finding the intrinsic value of common
stock.

The term ‘growth’ has many implications. A company can grow externally in many ways, i.e :

a. by investing in new projects through debt financing

b. by issuing shares

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Chapter 4 Common stock valuation and analysis

c. acquisition of another company that will increase the firm or

company’ s asset.

Therefore, there are different approaches of common stock valuation.

Approaches to Valuation of Common Stock

4.2 Approaches to Valuation Common Stock

Basically, valuation of common stock has two general approaches:

Discounted Cash Flow techniques

• Dividends Discounted Model
• Present Value of Operating Cash Flow
• Present Value of Free Cash Flow

Relative Valuation Techniques

• Earning Multiplier
• Price/Cash Flow Ratio
• Price/Book Value Ratio
• Price/Sales Ratio

The discounted cash flow valuation techniques are the obvious choices for valuation because they
are the epitome of how we describe value - that is, the present value of expected cash flows. The
major difference between the alternative techniques is how one specifies cash flow – that is, the
measure of cash flow used.

The most straightforward measure of cash flow is dividends because these are clearly cash flows
that go directly to the investor, which implies that you should used the cost of equity as the
discount rate. However, this dividend technique is difficult to apply to firms that do not pay
dividends. A potential difficulty with these cash flow techniques is that they are very dependent
on the two significant inputs: (1) the growth rates of cash flows (both the rate of growth and the
duration of growth), and (2) the estimate of the discount rate.

A potential problem with the discounted cash flow valuation models is that it is possible to derive
values that are substantially above or below prevailing prices depending how investors adjust
their estimated inputs to the prevailing environment. An advantage of the relative valuation
techniques is that they provide information about how the market is currently valuing stock at
several levels – that is, the aggregate market, alternative industries, and individual stocks within
industries. The relative valuation techniques are appropriate to consider under two conditions: (1)
investors have a good set of comparable entities – that is, either comparable industries or
companies that are similar in terms of industry, size and risk, and (2) the aggregate market is not a
valuation extreme – that is, it is not either seriously undervalued or overvalued.
Throughout this chapter, we will discuss two commonly used models (techniques):

1. Dividend Discounted Model

2. Earning Multiplier Model

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Chapter 4 Common stock valuation and analysis

4.3 Dividend Discounted Model

The discounted cash flow approach to common stock valuation suggests that the value of an asset
is the present value of all the cash flows an investor can expect from the asset. With common
stock the expected cash flows are the cash dividends and selling price. However, since common
stock can have an infinite life expectancy, the stock’s price can be expressed in terms of
dividends as follow:

Vi = D 1 + D2 + D3 + ……….. + D∞
(1+ k)1 (1+ k)2 (1+ k)3 (1+ k)∞

= ∑ D1/(1+k)t

where: Vi = value of common stock i

Dt = dividend during period t
k = required rate of return on stock i

With Holding Period. Assume an investor wants to buy the stock, hold it for one year, and then
sell it. This would imply the following formula:

Vi = D1 + SP1
(1+ k)1 (1+ k)1

where: SP1 = selling price of common stock at year one

Example

Assume the company we analyzing paid a dividend of RM1.00 per share and this dividend will
grows at 10% next year and projected sale of this share is RM22.00. The required rate of return is
14% and determine the value of stock today.

D1 = D0 (1 + g)
= 1.00 ( 1 + 0.10)
= 1.10

Vi = D1 + SP1
(1+ k)1 (1+ k)1
= 1.10 + 22.00
(1+ 0.14)1 (1+ 0.14)1

= RM20.26

Once we have calculated the stock’s value as RM 20.26, we can compare it to the market price
and apply the investment decision rule: Do not buy if the stock’s price is more than RM20.26 and
buy if it is equal to or less than RM20.26.

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Chapter 4 Common stock valuation and analysis

Example

Assume the expected holding period is three years and estimated dividend payments at the end of
each year as follow:

Year 1 RM1.10 per share

Year 2 RM1.20 per share
Year 3 RM1.35 per share

Assuming the expected share price for the stock three years from today is RM34.00 and the 14%
required rate of return. The value of the stock is

Vi = D1 + D 2 + D3 + SP3
(1+ k)1 (1+ k)2 (1+ k)3 (1+ k)3
= 1.10 + 1.20 + 1.35 + 34.00
1 2 3
(1+ 0.14) (1+ 0.14) (1+ 0.14) (1+ 0.14)3

= RM25.74

Again, to make an investment decision an investor would compare this estimated value for the
stock to its current price.

Infinite Period. This model assumes investors estimate future dividend payments for an infinite
number of periods and the future dividend stream will grow at a constant rate. This model is
generalized as follow:

Vi = Do (1 + g)1 + D0 (1 + g)2 + ……+ D0 (1 + g)n

(1+ k)1 (1+ k)2 (1+ k)n

where: Vi = value of common stock i

D0 = the dividend payment in the current period
k = required rate of return on stock i
g = the constant growth rate of dividends
n = the number of periods, which assume to be infinite

This Constant Growth Rate Model can be simplified to the following expression:

Vi = D1
k-g

Example.

Consider a stock with a current dividend of RM0.50 a share and dividends will continue to grow
at 8% perpetuity. If required rate of return on this stock is 12%, what will the value of the stock
today?
D1 = D0 (1 + g)
= 0.50( 1 + 0.08)

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Chapter 4 Common stock valuation and analysis

= 0.54

Vi = D1
k-g
= 0.54
0.12 – 0.08
= RM13.50

The Multiple Growth Model is combination of previous models. We have to examine each year
dividend individually and then, when the growth rate stabilizes, we compute the remaining value
by assuming constant growth.

Vi = D1 + D 2 + …….. + Dn + Vn
(1+ k)1 (1+ k)2 (1+ k)n (1+ k)n

where : Vn = Dn(1 + g)
k–g

Example.

The Rock Company has a current dividend (D0) of RM1.00 a share. The following are the
expected annual growth rates for dividends:

Dividend
Year Growth Rate
1-2 5%
3-4 8%
5 on 6%

The required rate of return for the stock is 10%. Calculate the value of the stock.

D1 = D0 (1 + g) = 1.00 (1 + 0.05) = 1.05

D2 = D1 (1 + g) = 1.05 (1 + 0.05) = 1.1025
D3 = D2 (1 + g) = 1.1025 (1 + 0.08) = 1.1907
D4 = D3 (1 + g) = 1.1907 (1 + 0.08) = 1.2860

V4 = D4(1 + g) = 1.2860 (1 + 0.06) = 34.079

k–g 0.10 – 0.06

Vi = D1 + D 2 + …….. + Dn + Vn
(1+ k)1 (1+ k)2 (1+ k)n (1+ k)n
= 1.05 + 1.1025 + 1.1907 + 1.2860 + 34.079
(1+ 0.10)1 (1+ 0.10)2 (1+ 0.10)3 (1+ 0.10)4 (1+ 0.10)4
= 0.9545 + 0.9112 + 0.8946 + 0.8784 + 23.2764
= RM26.92

The infinite period DDM has the following assumptions:

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Chapter 4 Common stock valuation and analysis

a. Dividends growth at a constant rate

b. The constant growth rate will continue for an infinite period
c. The required rate of return must greater than the infinite growth rate

Earnings Multiplier (P/E Ratio) Model

Many investors prefer to estimate the value of common stock using an earning multiplier model.
The reasoning for this approach, in the case of common stocks, the returns that investors are
entitled to receive are the net earning s of the firm. Therefore, one way investors can estimate
value is by determining how many dollars they are willing to pay a dollar of expected earnings.

Earning Multiplier = Market Price

Earning Per Share

PE Ratio = MP
EPS

This computation of the current earnings multiplier (P/E Ratio) 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 earning 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, or for similar firms and stocks.

The infinite period DDM can be used to indicate the variables that should determine the value of
the P/E Ratio as follows:

Pi = D1
k-g

If we divide both side of the equation by E1 (Expected earning per share), the result is:

Pi = D1/E1
E1 k–g

Thus, the PE Ratio is determine by :

a. The expected dividend payout ratio (D/E)

b. The estimated required rate of return on the stock (k)
c. The expected growth rate of dividend for the stock (g)

Example.

Assume a stock has an expected dividend payout of 50 percent, a required rate of return of 12
percent, and an expected growth rate for dividends of 8 percent.

Pi/ E1 = D1/E1
k–g
= 0.50
0.12 – 0.08
= 12.5

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Chapter 4 Common stock valuation and analysis

A small change in either k or g or both will have a large impact on the earnings multiplier.
Although the dividend payout ratio has an impact, but the spread between k and g is the main
determinant of the size of the P/E ratio.

Assume required rate of return increase from 12% to 16%

Pi/ E1 = 0.50
0.16 – 0.08
= 6.25

Assume growth rate increase from 8% to 10% ( k at original rate 12%)

Pi/ E1 = 0.50
0.12 – 0.10
= 25

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

Example.

Given current earnings (E0) of RM1.50 and growth rate of 8 percent. Dividend payout ratio is 40
percent. Estimate the value of the stock if required rate of return is 12 percent.

E1 = E0 (1 + g)
= 1.50 ( 1 + 0.08)
= 1.62

Pi/ E1 = 0.40
0.12 – 0.08
= 10

Value of Stock = P/E Ratio X Expected Earnings

Vi = Pi/ E1 X E1
= 10 X 1.62
= RM16.20

As before, we would compare this estimated value of the stock to its current market price to
decide whether we should invest in it.

Estimating the variables in the Valuation Models

There are two important variables under the above valuation model:

a. The required rate of return, and

b. The expected growth rate

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Estimating Required Rate of Return. Three factors that influence an investor’s required rate of
return:

a. The economy’s real risk-free rate (RRFR)

b. The expected rate of inflation (I)
c. A risk premium (RP)

The economy’s real risk-free rate. This is absolute minimum rate that an investor should require.
It depends on the real growth rate of the investor’s home economy because capital invested
should grow at least as fast as the economy. This rate can be affected for short periods of time by
temporary tightness and ease in the capital markets.

The expected rate of inflation. Investors are interested in real rates of return that will allow them
to increase their rate of consumption. Therefore, if investors expect a given rate of inflation, they
should increase their required nominal risk-free rate of return (NRFR) to reflect any expected
inflation as follow:

NRFR = [ 1 + RRFR ][ 1 + E(I)] - 1

The risk premium. The risk premium cause differences in the required rates of return among
alternative investment that range from government bonds to corporate bonds to common stocks.
The RP also explain s the difference in the expected return among securities of the same type.

Estimating Expected Growth Rate. After arriving at a required rate of return, the investor must
estimate the growth rate of cash flows, earnings and dividends because the valuation models for
common stock depend heavily on good estimates of growth. The growth rate of dividends is
determined by the growth rate of earnings and the proportion of earning paid out in dividends (the
pay out ratio). Specifically, the growth rate (g) of equity earnings (that is, earning per share) is
equal to percentage of net earnings retained (the retention rate, 1 – DPR) times the rate of return
on equity capital.

g = Retention Rate X Return on Equity

= b X ROE

where: b = 1 – DPR
ROE = Net Income/Equity
or
= Net Income X Sales X Total Asset
Sales Total Asset Equity

= Profit Margin X Total Asset Turnover X Financial Leverage

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Checklist

Now are you able to:

apply the basic reduced form dividend discount model (DDM) to the valuation of the
aggregate stock market.

identify the two components involved in the two-part valuation procedure

describe the steps involved in estimating the earnings per share for an aggregate market
series.

Study Questions

1. Tadamas Bhd has consistently paid out 25% of its earnings in dividend and the company’s
return on equity is 8 percent.

i. estimate the dividend growth rate

ii. if the required rate of return is 6%, calculate the company’s price-
earnings ratio.

iii. What will happen to the price-earnings ratio if the company

decides to increase its dividend payout by 10%?

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2. The share of Digimon Corporation sells at RM52 per share, and its latest 12 month earnings
were RM8 per share, of which RM4.20 per share were paid as dividends.

i. What is Digimon’s current P/E ratio?

ii. If Digimon earnings are expected to grow by 9% per year, what is the projected price
for next year assuming that P/E remains constant?

iii. If the required rate of return were 15%, would you buy this stock? Explain your
answer.

SUPPLEMENT TO CHAPTER FOUR

STOCK MARKET ANALYSIS

Applying The DDM Valuation Model to the Market

To apply this model, we have to estimate :

(1) the required rate of return (k)

(2) the expected growth rate of dividends (g).

The NRFR should be a zero-coupon, default-free asset with a time of maturity approximates
investor’s holding period. The range of suggested maturities varies from a three-month T-Bill to
an intermediate government bond and to the long-term government bond.

Yields
3-month T-Bill 4.4%
10-year Treasury 5.5%
30-year Treasury 5.7%

For this purpose, we will employ three alternative risk premiums (RP): 2, 4 and 6 percent. If we
combine NRFR with RP, we derive the following matrix of required rates of return (k) for the
market.

Risk Premium
Nominal RFR 0.02 0.04 0.06
0.044 0.064 0.084 0.104
0.055 0.075 0.095 0.115
0.057 0.077 0.097 0.117

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Chapter 4 Common stock valuation and analysis

The matrix indicates a range of k from 0.064 (6.4%) to 0.117 (11.7%). For the purpose of our
estimate, we will use diagonal values from this matrix: 0.064, 0.095 and 0.117.

Here we assume the retention rate of firms is 55 percent and their ROE is 14 percent. Therefore,
growth rate is equal to:

g = b X ROE
= 0.55 X 0.14
= 0.077 = 7.7%

If we combine the several estimates above, (assume current dividend for market is RM20.00), we
get as follows:

D0 = RM20.00
k = 0.064, 0.095 and 0.117
g = 0.077
D1 = 20.00 ( 1 + 0.077) = RM21.54

Using these values in the DDM indicates the following estimates:

a. 21.54 = 21.54 (meaningless)

0.064 – 0.077 -0.013
. b. 21.54 = 21.54 = 1196.67
0.095 – 0.077 0.018
. c. 21.54 = 21.54 = 538.50
0.117 – 0.077 0.04

These latter two estimate values are below the prevailing index value ( assume 1580). Let
assuming the dividend value of RM21.54 is reasonable, one need to consider what k – g spread is
necessary to justify the prevailing market value. Consider the following values:

21.54 = 1436.00
0.015
21.54 = 1538.57
0.014
21.54 = 1656.92
0.013
21.54 = 1795.00
0.012
21.54 = 1958.18
0.011
21.54 = 2154.00
0.010

It appears that the current market value implies (require) a k – g spread approaching 0.013 percent
(1.3%), which means either a k below 0.095 or an expected growth rate above 0.077. The most
likely would be a lower k approaching 0.09, which implies about a 3 percent RP with a long term
NRFR or a 4 percent RP with a short-term NRFR.

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Chapter 4 Common stock valuation and analysis

Estimating The Expected Earnings Per Share For a Stock Market Series

We use the earning multiplier version of the DDM to value the stock market because it is a
theoretically correct model of value assuming a constant growth of dividends for an infinite time
period, which is reasonable assumption for the aggregate stock market. Also this valuation
technique is consistently used in practice.

They are two important estimation inputs that being used in this process:

1. Estimating the future EPS for the stock market series.

2. Estimating a future earning multiplier for the stock market series.

The estimate of expected EPS for the market series will consider the outlook for the aggregate
economy and corporate sector. This require the following steps:

1. Estimate sale per share for a stock market series, such as the S & P 400. This
estimate sale involves a prior estimate of Gross Domestic Product (GDP).
2. Estimates the operating profit margin for the series.
3. Estimate depreciation per share for the next year.
4. Estimate interest expense per share for the next year.
5. Estimate the corporate tax-rate for the next year.

Example:

S & P Industrial sales increase by 6% from an estimated RM760 to RM805 per share. This is due
to nominal GDP growth by about 5%. There also a small increase in operating profit margin from
16% to 16.2%. The depreciation and interest expenses were approximately RM43.26 and
RM14.80 per share respectively. Corporate tax around 35%. The estimated EPS as follows:

Sales RM805
EBITAD 130.41 (0.162)
Depn Expenses 43.26
EBIT 87.15
Interest Expenses 14.80
EBT 72.35
Taxes 25.32 (0.35)
Net Income (EPS) 47.03

Estimating The Earnings Multiplier For A Stock Market Series

The next step is to estimate an earning multiplier. A combination of the earning per share
estimate times the estimate earnings multiplier provides an estimate of the future value for the
stock market series.

There are two ways to estimate the earnings multiplier. The first approach begins with the current
earnings multiplier and attempts to estimate the direction and amount any change based on our
expectations for changes in the three major components (k , g and D1/E1 ). This approach is called
Direction of Change Approach. Another approach, we estimate a specific value for the earnings
multiplier by deriving specific estimates for each of the three components in the P/E Ratio
equation. When using this approach, most analyst derive several estimates based on alternative

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Chapter 4 Common stock valuation and analysis

optimistic or pessimistic scenarios. We will can this the Specific Estimate Approach. (Here we
only discuss about the second approach).

The specific estimate approach derives specific estimates for the earnings multiplier based on a
range of estimates for the three variables: Dividend Payout (D/E), required rate of return (k), and
growth rate (g).

Based on the example above, we could conceive the following possibilities:

Expected at
Year-End
A. 5-year Govt. Bond 5.7%
Historical RP 6.0
Estimated k 11.7%

B. 5-year Govt. Bond 5.7%

Low RP 2.0
Estimated k 7.7%

C. 5-year Govt. Bond 5.7%

Medium RP 4.0
Estimated k 9.7%

The required rate of return (k) could be in the range of 7 to almost 12. Other data can be
summarized as follows:

Dividend/Earnings 0.35 - 0.55

Govt. Securities 0.045 - 0.057
Equity Risk Premium 0.020 - 0.060
Required return (k) 0.07 - 0.12
ROE 0.12 - 0.16
Sustainable growth 0.06 - 0.08

By combining the most optimistic figures, we can derive a reasonably generous estimate. Using
the pessimistic estimates, we can derive a very conservative estimate.

High estimate: D/E = 0.45

k = 0.09
g = 0.077

P/E = 0.45 = 34.6x

0.09 – 0.077

Low estimate: D/E = 0.60

k = 0.11
g = 0.06

P/E = 0.60 = 12x

0.11 – 0.06

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Therefore, these data imply a range of earnings multiplier from about 12 times to 35 times, with a
mid range of about 24 times.

At this point we have to develop several estimates for the earnings multiplier that varies from
about 12 to 35, and combine with the estimate EPS (RM47.00) in order to derive the value of
market series.

12.0 x RM47 = 564.00

18.0 x RM47 = 846.00
24.0 x RM47 = 1128.00
30.0 x RM47 = 1410.00
36.0 x RM47 = 1692.00

Calculating the Expected Rate of Return

Having estimated the expected value for the stock market series, we can estimated the expected
rate of return using the following equation:

Rates of return = (Ending Value – Beginning Value) + Income X 100

Beginning Value

r = (EV – BV) + DIV X 100

BV
where: r = the expected rate of return during period t
EV = the ending value for the stock-market series
BV = the beginning value for the stock-market series
DIV = the expected dividend payment on the stock-market series during
the investment horizon

We will compute five rate of return estimates based on the five values computed above. We
assume the beginning value of 1479 and estimated dividend per share during the next 12-month is
RM23.00. Therefore, the five estimates of expected rate of return are

564 - 1479 + 23.00 = -60.31%

1479
846 - 1479 + 23.00 = -41.24%
1479

1128 - 1479 + 23.00 = -22.18%

1479

1410 - 1479 + 23.00 = -3.11%

1479

1692 - 1479 + 23.00 = 15.96%

1479

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Estimate Estimated Required Investment Decision

Rate of Rate of
Return Return
1 -60.30% 9.5% Significant underweight
2 -41.24 9.5 Significant underweight
3 -22.18 9.5 Significant underweight
4 -3.11 9.5 Underweight
5 15.96 9.5 Overweight

We might want to compute the market value that would provide the desire return as follows:

x + 23.00 = 1.095
1479
x = 1596.51

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