Common Stock Valuation

Lessons for All Investors

Chapter 10
Charles P. Jones, Investments: Principles and Concepts,
Twelfth Edition, John Wiley & Sons

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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

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Present Value Approach
 Intrinsic value of a security is
n Cash Flows
Value of security   t
t 1 ( 1  k)

 K = appropriate discount rate

 Estimated intrinsic value compared to the

current market price

 Can value equity of firm or entire firm

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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

D1 D2 D
V0  1  2 ... 
(1 k ) (1 k ) (1 k ) 
 Dt
 t
t 1 (1 k )

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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

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Dividend Discount Model
 Zero-Growth Rate Model
 Fixed dollar amount of dividends reduces the

security to a perpetuity
D0
V0 
k
◦ Similar to preferred stock because dividend remains
unchanged
◦ Values future stream of dividends from now to

infinity

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Problem 10-4
 Howe Poultry pays $1.5 a year in dividends,
which is expected to remain unchanged.
Investors require a 15 percent rate of return
on this stock. What is the estimated price?

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Dividend Discount Model
 Constant Growth Rate Model
◦ Dividends expected to grow at a constant rate, g,
over time
D1
V0 
k g
◦ 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

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Example 10-1
 Assume that Summa Corporation is currently
paying $1 per share in dividends to grow at
the rate of 7% a year for the foreseeable
future. For investments at this risk level ,
investors require a return of 15% a year .
 Find the estimated value of Summa

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Problem 10-1
 Assume that the investors expect Chance
Industries to have a dividend growth rate over
the foreseeable future of 8% a year and that
the required rate of return for this stock is
13%. The current dividend being paid is
$2.25. what is the estimated value of the
stock?

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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

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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
t
n D0(1 g1) Dn (1 gc ) 1
V0   t  n
t 1 (1 k) k-g (1 k)

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Example: Valuing equity with growth of
30% for 3 years, then a long-run constant
growth of 6%

0 k=16% 1 2 3 4
g = 30% g = 30% g = 30% g = 6%
D0 = 4.00 5.20 6.76 8.788 9.315
4.48
5.02
5.63
59.68 P3 = 9.315
74.81 = P0 .10
 Example 10-6: Valuing equity with growth of
12% for 5 years, then a long-run constant
growth of 6%

0 k=10% 1 2 3 4 5 6
g = 12% g = 12% g = 12% g = 12% g = 6%
D0 = 1.00 1.12 1.25 1.40 1.57 1.76 1.87

1.02
1.03
1.05
1.07
1.09
28.96 P = 1.87
Problem 10-1
 Buck Software Products is currently paying a
dividend of $1.20. This dividend is expected
to grow at the rate of 30 percent a year for
the next five years, followed by a growth rate
of 20 percent a year for the following five
years. After 10 years, the dividend is
expected to grow at the rate of 6 percent a
year. The required rate of return for this
stock is 21percent. What is its intrinsic value?

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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

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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

k  D1 /P0  g

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Problem 10-2

 Billingsley products is currently selling for

$45 a share with an expected dividend in the
coming year of $2 per share. If the growth
rate in dividends expected by investors is 9
percent, what is the required rate of return
for this stock?

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Problem 10-18
 Wilson Industries is currently paying a
dividend of $1 per share, which is not
expected to change in the future. The current
price of this stock is $12. What is the
expected rate of return on this stock?

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Problem 10-19
 Cascade Gas is currently selling for $40. Its
current dividend is $2 and this dividend is
expected to grow at a rate of 7 percent a year
. What is the expected rate of return for this
stock ?

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Problem 10-21

 General Foods is currently selling for $50 .It

is expected to pay a dividend of $2 next
period. If the required rate of return is 10
percent, What is the expected growth rate?

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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
Expected FCFE
V0 
k-g

 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
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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

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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

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P/E Ratio Approach
 By definition
◦ Current stock price is P0, EPS is E0
Po  E0 ( P0 / E0 )
 To value stock, must forecast EPS and P/E
ratio
◦ Can compound current earnings to forecast
expected earnings
PE  E1  PE / E1
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P/E Ratio Approach
 Explain how the payout ratio, the expected
growth rate, and the required rate of return
affect the P/E ratio.

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Problem 10-10
 The Parker Dental Supply Company sells at
$32per share, and Ray Parker, the CEO of this
well-known Research Triangle firm, estimates
that the latest 12-month earnings are $4 per
share with a dividend payout of 50%.
Dr.Parker’s earning estimates are very
accurate.
 a. What is Parker’s current P/E ratio
 b. If an investor expects earnings to grow by

10% a year, what is the projected price for

next year if the P/E ratio remains unchanged?
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Problem 10-10
 Dr.Parker analyzes the data and estimates
that the payout ratio will remain the same.
Assuming that the expected growth rate of
dividends is 10% and an investor has a
required rate of return of 16%, would this
stock be a good buy? Why or why not ?

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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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