Chapter Four

Stock and Equity Valuation

4.1 Common Stock Characteristics
Firms obtain their long-term sources of equity financing by issuing common and preferred stock.
The payments of the firm to the holders of these securities are in the form of dividends. Unlike
interest payments on debt which are tax deductible, dividends must be paid out of after-tax
income either in the form of cash dividend or stock dividend. In addition to the above, contrary
to payments to bondholders, payments to common stockholders are uncertain in both magnitude
and timing.
The common stockholders are the owners of the firm. It represents equity in a corporation. They
have the right to vote on important matters to the firm such as the election of the Board of
Directors. They have a residual claim against the assets and cash flows of the firm. That is, the
common stockholders have a claim against whatever assets remain after the debt holders and
preferred stockholders have been paid. Moreover, the cash flow that remains after interest and
preferred dividends have been paid belongs to the common stockholders. The priority of the
claims against the assets of the firm belonging to debt holders, preferred stockholders, and
common stockholders differ. The owners of the firm's debt securities have the first claim against
the assets of the firm. This means that the debt holders must receive their scheduled interest and
principal payments before any dividends can be paid to the equity holders. If these claims are not
paid, the debt holders can force the firm into bankruptcy. The preferred stockholders have the
next claim. They must be paid the full amount of their scheduled dividends before any dividends
may be distributed to the common stockholders.
In general, common stock has the following three important characteristic:
 Residual claim - common stockholders have claim to firm’s cash flows and assets after
all obligations to creditors and preferred stockholders are met.
 Limited liability - common stockholders may lose their investments, but no more
4.2 Voting rights - Common stockholders are entitled to vote for the board of directors and on
other matters.
4.3 Preferred Stock Characteristics
Preferred stock is defined as equity with priority over common stock with respect to the payment
of dividends and the distribution of assets in liquidation. Preferred stock is a hybrid security
which shares features with both common stock and debt. Preferred stock is similar to common
stock in that it entitles its owners to receive dividends which the firm must pay out of after-tax

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income. Moreover, the use of preferred stock as a source of financing does not increase the
probability of bankruptcy for the firm. However, like the coupon payments on debt, the
dividends on preferred stock are generally fixed. Also, the claims of the preferred stockholders
against the assets of the firm are fixed as the claims of the debt holders. Preferred stock has the
following contents:
Par Value: represents the claim of the preferred stockholder against the value of the firm.
Preferred Dividend/Preferred Dividend Rate:the preferred dividend rate is expressed as a
percentage of the par value of the preferred stock. The annual preferred dividend is determined
by multiplying the preferred dividend rate times the par value of the preferred stock.

4.4 Equity Valuation Models

Equity valuation methods can be broadly classified into balance sheet methods, discounted cash
flow methods, and relative valuation methods. Balance sheet methods comprise of book value,
liquidation value, and replacement value methods. Discounted cash flow methods include
dividend discount models and free cash flow models. Lastly, relative valuation methods are a
price to earnings ratios, price to book value ratios, price to sales ratios etc.
A financial analyst primarily conducts two types of analysis for evaluation of equity investment
decisions viz. fundamental and technical analysis. All the above methods are part of the
fundamental analysis conducted by a financial analyst. The technical analysis analyses the charts
and graphs of the market prices of a stock to understand the sentiments of the market. It believes
in a fact that history repeats itself. Many believe that it is used to decide the entry and exit time
from the market. On the other hand, fundamental equity valuations methods attempt to find the
fair market value of equity share. it involves a study of the assets, earning potential, future
prospects, future cash flows, magnitude and probability of dividend payments etc.
4.5 Classification/Types of Equity Valuation Models
Fundamental equity valuation methods are explained in brief under the following categories.

4.5.1 Balance Sheet Methods/Techniques

Balance sheet methods are the methods which utilize the balance sheet information to value a
company. These techniques consider everything for which accounting in the books of accounts is
done.

a) Book Value Method: In this method, book value as per balance sheet is considered the value
of equity. Book value means the net worth of the company. Net worth is calculated as
follows:
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 Net Worth = Equity Share capital + Preference Share Capital + Reserves & Surplus –
Miscellaneous Expenditure (as per B/Sheet) – Accumulated Losses.
b) Liquidation Value Method: Here, in liquidation cost method liquidation value is considered
the value of equity. Liquidation value is the value realized if the firm is liquidated today.
Liquidation Value = Net Realizable Value of All Assets – Amounts paid to All Creditors
including Preference Shareholders.
c) Replacement Cost Method: Here, in replacement cost method the value of equity is the
replacement value. It means the cost that would be incurred to create a duplicate firm is the
value of the firm. It is assumed that the market value and replacement value will coincide in
the long run. The famous ratio by James Tobin is Tobin q which tends to become 1. Tobin q
is the ratio of market value to replacement cost.
Equity Value = Replacement Cost of Assets – Liabilities.

4.5.2 Discounted Cash Flow Models

Discounted cash flow methods are based on the fact that present value all future dividends and
the future price represent the market value of equity. Discounted cash flow methods include
dividend discount models and free cash flow models.

4.5.2.1 Dividend Discount Model (DDM)

This dividend discount model finds the present value of future dividends of a company to derive
the present market value of equity. There are various models with different assumptions of a
period of dividends and growth in dividends.
 Zero Growth Model
 Constant Growth Model
 Non-constant (Two Stage) Growth Model

Common Stock Valuation Using the DDM

A stock provides two kinds of cash flows. First, most stocks pay dividends on a regular basis.
Second, the stockholder receives the sale price when they sell the stock. In valuing the common
stock, we have made two assumptions:
 We know the dividends that wil
 l be paid in the future.
 We know how much you will be able to sell the stock for in the future.
Both of these assumptions are unrealistic, especially knowledge of the future selling price.
Furthermore, suppose that you intend on holding on to the stock for twenty years, the
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calculations would be very tedious! We cannot value common stock without making some
simplifying assumptions. These assumptions will define the path of the future cash flows so that
we can derive a present value formula to value the cash flows.
If we make the following assumptions, we can derive a simple model for common stock
valuation:
 Your holding period is infinite (i.e., you will never sell the stock so you don’t have to
worry about forecasting a future selling price).
 The dividends will grow at a constant rate forever.
Note that the second assumption allows us to predict every future dividend, as long as we know
the most recent dividend and the growth rate.
Thus, in order to value common stocks, we need to answer an interesting question: Is the value
of a stock equal to:
1. The discounted present value of the sum of next period’s dividend plus next
period’s stock price, or
2. The discounted present value of all future dividends?
To see that (1) and (2) are the same, let’s start with an individual who will buy the stock and hold
it for one year. How do we value a share of common stock? Suppose you consider purchasing a
share of stock today, and sell it a year from today. Let P 1 be the price that you expect you can sell
the share at a year from today. Then, the value of the share of the stock today (P0) is given by:
D1 D2 P2
P0 = + +
1+ r ( 1 +r )2 ( 1 +r )2

Then, how P1 should be determined? There must be a buyer who is willing to pay P 1 at date 1. If
the buyer intend to keep the stock only one year and sell at the end of the year (like you do), P 1
should be determined by:
D2 P 2
P1 = + . .. .. . .. .. . .. .. . .. .. . .. ..(2 )
1+r 1+r
Dn+1 Pn+1
Pn= +
1+r 1+r
Now, plug (2) into (1) then you will have the following relationship between the value of the
share of stock and dividend. If you plug (2) into (1), you will have:
D1 D2 P2
P0 = + +
1+ r ( 1+r )2 ( 1+r )2
Note that P2 is again determined by similar way, so on and so forth.
D1 D2 D3 D4 Dt Pt
P0 = + + + +⋯+ +
4 1+ r ( 1+r )2 ( 1+r )3 ( 1+r )4 ( 1+r )t ( 1+r )t
P0 = Present value of the expected dividends, the current price of the common stock
D1, D2, D3, etc. = Common stock dividends expected to be received at the end of periods 1, 2, 3,
and so on until the stock is sold
Pt = Anticipated selling price of the stock in t periods
r = required rate of return per period on this common stock investment

Therefore, it can be seen that, if we repeat this process, we will have:

∞ Dt
po = ∑
t =1 ( 1+r )t
Therefore, the value of a share of common stock is the present value of all the dividend
payments. That is, the value of a firm’s common stock to the investor is equal to the present
value of all the expected future value.
Example: Assume that you are considering the purchase of a stock which will pay dividends of
$2 (D1) next year, and $2.16 (D2) the following year. After receiving the second dividend, you
plan on selling the stock for $33.33. What is the intrinsic value of this stock if your required
return is 15%?
2 . 00 2 .16 +33 .33
po = + =28 . 57
Solution: ( 1+.15 )1 ( 1+. 15 )2
The above discussion shows that the value of a firm’s common stock to the investor is equal to
the present value of all the expected future value. In practice, however, using the above formula
to value shares of common stock is problematic because an estimate of the future selling price of
a share of stock is often speculative. This severely limits the usefulness of the model. Instead,
some analysts use models that are a variation of the above formula that do not rely on an estimate
of a stock’s future selling price. Common stock dividends can grow at different rates. In the
following, we consider the valuation of commons stock for three simple cases: (1) Zero growth,
(2) Constant growth and (3) No constant growth rate.
Case 1: Valuation of Common Stock – Zero Growth
Assume that dividends will remain at the same level forever. It assumes that the dividend does
not grow at all; therefore, this is an extreme case.
D1 =D2 =D3 =⋯=D
Since future cash flows are constant, the value of a zero growth stock is the present value of
perpetuity:
D D D
P0 = 1 1 + 2 2 + 3 3 +⋯
( 1+r ) ( 1+r ) ( 1+r )
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D
P0 =
r
Example: Suppose Jone purchase stock which will pay divided of $4 for next four year and sell
to $40 after collecting forth year dividend. The stock required rate of return is 10%.
A. Compute intrinsic value of the stock
B. Assume he hold the stock for infinite period and compute intrinsic value of the stock

Case 2: Valuation of common stock - Constant Growth

A constant growth stock is a stock whose dividends are expected to grow at a constant rate in the
foreseeable future. This condition fits many established firms, which tend to grow over the long
run at the same rate as the economy, fairly well. The constant growth dividend model assumes
common stock dividends will be paid regularly and grow at a constant rate. The constant growth
dividend model, also known as the Gordon growth model, because financial economist Myron
Gordon helped develop and popularize it. To come up with the formula for this case, let’s
assume that dividends will grow at a constant rate, g, forever. i.e.
D1 =D0 ( 1+ g )1
D2 =D0 ( 1+ g ).2 =D1 ( 1+ g )1
D3 =D0 ( 1+g )3 =D1 (1+g )2 =D2 ( 1+g )1
Example: Assume that Hampshire Products will pay a dividend of $4 per share a year from now.
Financial analysts believe that dividends will rise at 6 percent per year for the foreseeable future.
What is the dividend per share at the end of each of the first five years?
End of year: 1 2 3 4 5____
Dividend: $4 $4 X (1.06) $4 X (1.06)2 $4 X (1.06)3 $4 X (1.06)4
=$4.24 =$4.4944 =$4.7641 =$5.0499
Therefore, the value of the commons stock for Case 2 is given by the growing perpetuity formula
D D D3
P0 = 1 + … 2 2 + +⋯
1+ r ( 1+r ) ( 1+r )3

D 0 ( 1+ g )1 D 0 ( 1+ g )2 D 0 ( 1+ g )3
P0 = + +
( 1+ r )1 ( 1+ r )2 ( 1+r )3
Do (1+ g ) D1
P0 = =
(r−g ) ( r−g )
Where:
 P0 = the current common stock price at time 0,
 Do = the current dividend,

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  D1 = Dollar amount of the common stock dividend expected one period from now (the
next dividend i.e., at time 1),
 g = Expected constant growth rate per period of the company’s common stock dividends,
and
 r = the required rate of return on the stock, and
 g<r
Example: Find the stock price given that the current dividend is $2 per share, dividends are
expected to grow at a rate of 6% in the foreseeable future, and the required return is 12%.

Example: assume your required rate of return (r) for Wendy’s common stock is 10 percent.
Suppose your research leads you to believe that Wendy’s Corporation will pay a $0.25 dividend
in one year (D1), and for every year after the dividend will grow at a constant rate (g) of 8
percent a year. Using the above equation we can calculate the present value of Wendy’s common
stock dividends as follows:

We find that with a common stock dividend in one year of $0.25, a constant growth rate of 8
percent, and a required rate of return of 10 percent, the value of the common stock is $12.50.
In a no-growth situation, g, in the denominator of the equation becomes zero.

Dividend Yield and Capital Gains Yield

The constant growth stock equation can be rearranged to obtain an expression for the expected
return on the stock as follows:

When expressed in this manner, it is apparent that the expected return on the stock equals the
expected dividend yield plus the expected capital gains yield where the dividend yield and
capital gains yield are defined as follows:

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A more general form of the constant growth common stock model formula which can be used to
find the price of the stock at any period t in the future is given by the following:

Exercise: suppose an investor is considering the purchase of a share of the U Mining Company.
The stock will pay a $3 dividend a year from today. This dividend is expected to grow at 10
percent per year for the foreseeable future (g=0.1). The stock holder thinks that required return
on this stock is 15 percent (r=0.15). What is the value of a share of U Mining Company’s stock
after one?
Solution
P1 = $3(1+0.1)
0.15-0.1
= 3.3
0.05
= $66
Case 3: Non-constant Growth Stock Valuation
Many firms enjoy periods of rapid growth. These periods may result from the introduction of a
new product, a new technology, or an innovative marketing strategy. However, the period of
rapid growth cannot continue indefinitely. Eventually, competitors will enter the market and
catch up with the firm. These firms cannot be valued properly using the Constant Growth Stock
Valuation approach.
This section presents a more general approach which allows for the dividends/growth rates
during the period of rapid growth to be forecast. Then, it assumes that dividends will grow from
that point on at a constant rate which reflects the long-term growth rate in the economy. Stocks
which are experiencing the above pattern of growth are called non-constant, supernormal, or
erratic growth stocks.
The value of a non-constant growth stock can be determined using the following equation:

Where:
 P0 = the stock price at time 0,
 Dt = the expected dividend at time t,
 T = the number of years of non-constant growth,
 gc = the long-term constant growth rate in dividends, and
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  r = the required return on the stock, and
 gc< r.
Example: The current dividend on a stock is $2 per share and investors require a rate of return of
12%. Dividends are expected to grow at a rate of 20% per year over the next three years and then
at a rate of 5% per year from that point on. Find the price of the stock.
Solution:
There are 3 years of non-constant growth, thus, T = 3, Before substituting into the formula given
above it is necessary to calculate the expected dividends for years 1 through 4 using the provided
growth rates.

Preferred Stock Valuation Using the DDM

Since the preferred dividends are generally fixed, preferred stock can be valued as a constant
growth stock with a dividend growth rate equal to zero.
Preferred stock has no maturity date, so it has no maturity value. Its future cash payments are
dividend payments that are paid to preferred stockholders at regular time intervals for as long as
they (or their heirs) own the stock. Cash payments from preferred stock dividends are scheduled
to continue forever. To value preferred stock, then, we must adapt the discounted cash flow
model to reflect that preferred stock dividends are perpetuity.
The preferred stock valuation calculations require that we find the present value (P P) of preferred
stock dividends (Dp), discounted at required rate of return, r. Thus, the price of a share of
preferred stock can be determined using the following equation:

Where:
 PP = Current market value of the preferred stock(the preferred stock price)
 Dp = Amount of the preferred stock dividend per period
 r = Required rate of return per period for this issue of preferred stock

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Example: Find the price of a share of preferred stock given that the par value is $100 per share,
the preferred dividend rate is 8%, and the required return is 10%.
Solution:

Example: Suppose investors expect an issue of preferred stock to pay an annual dividend of $2
per share. Investors in the market have evaluated the issuing company and market conditions and
have concluded that 10 percent is a fair rate of return on this investment. The present value for
one share of this preferred stock, assuming a 10 percent required rate of return follows:

We find that for investors whose required rate of return (r) is 10 percent; the value of each share
of this issue of preferred stock is $20.

4.5.2.2 Free Cash Flow Valuation Model

This model is based on free cash flows of the company. Similar to above model, it discounts the
free future cash flows of the company to arrive at an enterprise value. To find the value of equity,
value of debt is deducted from enterprise value. Discounted cash flow (DCF) valuation views the
intrinsic value of a security as the present value of its expected future cash flows. When applied
to dividends, the DCF model is the discounted dividend approach or dividend discount model
(DDM). The free cash flow valuation extends DCF analysis to value a company and its equity
securities by valuing free cash flow to the firm (FCFF) and free cash flow to equity (FCFE).
Whereas dividends are the cash flows actually paid to stockholders, free cash flows are the cash
flows available for distribution to shareholders.
Unlike dividends, FCFF and FCFE are not readily available data. Analysts need to compute these
quantities from available financial information, which requires a clear understanding of free cash
flows and the ability to interpret and use the information correctly. Forecasting future free cash
flows is also a rich and demanding exercise. The analyst’s understanding of a company’s
financial statements, its operations, its financing, and its industry can pay real “dividends” as he
or she addresses that task. Many analysts consider free cash flow models to be more useful than
DDMs in practice. Free cash flows provide an economically sound basis for valuation.
Common equity can be valued directly by using FCFE or indirectly by first using a FCFF model
to estimate the value of the firm and then subtracting the value of non-common-stock capital
(usually debt) from FCFF to arrive at an estimate of the value of equity. Discounted cash flow
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models are widely used by analysts to value companies. Free cash flow to the firm (FCFF) and
free cash flow to equity (FCFE) are the cash flows available to, respectively, all of the investors
in the company and to common stockholders.
Analysts like to use free cash flow (either FCFF or FCFE) as the return:
 if the company is not paying dividends;
 if the company pays dividends but the dividends paid differ significantly from the
company’s capacity to pay dividends;
 if free cash flows align with profitability within a reasonable forecast period with which
the analyst is comfortable; or
 if the investor takes a control perspective.
The FCFF valuation approach estimates the value of the firm as the present value of future FCFF
discounted at the weighted average cost of capital:
∞ FCFF t
FirmValue=∑
t =1 ( 1+WACC )t
FCFF = EBIT (1 − tc) + Depreciation − Capital expenditures − Increase in NWC
The value of equity is the value of the firm minus the value of the firm’s debt:
Equity Value = Firm value – Market value of debt
Dividing the total value of equity by the number of outstanding shares gives the value per share.
The WACC formula is:
MVDebt MVEquity
WACC = r d ( 1−T ) +
MVDebt + MVEquity MVDebt + MVEquity
The value of the firm if FCFF is growing at a constant rate is:
FCFF 1 FCFF 0 (1+ g )
FirmValue= =
( WACC−g ) (WACC −g )
With the FCFE valuation approach, the value of equity can be found by discounting FCFE at the
required rate of return on equity, r:
∞ FCFEt
EquityValue=∑
t =1 ( 1+ r )t
FCFE = FCFF − Interest expense × (1 − tc) + Increase in net debt
FCFE = NI + NCC – FCInv – WCInv + Net borrowing
Dividing the total value of equity by the number of outstanding shares gives the value per share.
The value of equity if FCFE is growing at a constant rate is:

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 FCFE1 FCFE 0 ( 1+ g )
FirmValue= =
( r−g ) ( r−g )
A general expression for the two-stage FCFF valuation model is:
T FCFF t PT
FirmValue=∑ +
t =1 ( 1+WACC )t ( 1+WACC )T
FCFFT +1
PT =
WACC −g
A general expression for the two-stage FCFE valuation model is:
T FCFEt PT
EquityValue=∑ +
t =1 ( 1+ r )t ( 1+r )T
FCFE T +1
PT =
r −g
4.5.3 Earnings Multiplier Approach
Earnings multiple or Relative Valuation methods are also called comparable methods because
they use peers or competitors value to derive the value of the equity. The importance here is of
deciding which factor to be considered for comparison and which companies should be
considered peers. Following are the well-known methods used for such comparison.

Price-to-earnings Ratio/Earnings Multiple

One of the quickest ways to check how highly valued a stock is, to look at its price-to-earnings
ratio (P/E), also known as an earnings multiple. The earnings multiple is the stock price divided
by earnings per share (EPS), and the units are expressed in years- how many years of those
earnings it would take to equal that stock price.
For example, if a stock is $50, and its EPS is $2.50, then the earnings multiple is 20. The stock
price is expressed in dollars; the EPS is expressed in dollars per year, so the earnings multiple of
20 is expressed in years- it would take twenty years of $2.50 each year to get $50.
Of course, the earnings multiple alone doesn’t tell us much. If the company is growing its EPS
each year, then in reality it will take less than that number of years for cumulative EPS to sum to
the current stock price. Therefore, what constitutes“fair” earnings multiple depends on several
factors like growth and stability.

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