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Stock Valuation

Stock valuation involves discounting future cash flows, mainly dividends and terminal value, to determine the current stock price. Unlike bonds, stocks have no maturity date so their future cash flows are less predictable. The required rate of return used to discount cash flows is also difficult to determine for stocks since there are no interest rate curves. Common valuation models include the dividend discount model which values a stock based on future dividend payments, and multiples valuation which uses industry average price-earnings or price-sales ratios to estimate the stock price.

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236 views7 pages

Stock Valuation

Stock valuation involves discounting future cash flows, mainly dividends and terminal value, to determine the current stock price. Unlike bonds, stocks have no maturity date so their future cash flows are less predictable. The required rate of return used to discount cash flows is also difficult to determine for stocks since there are no interest rate curves. Common valuation models include the dividend discount model which values a stock based on future dividend payments, and multiples valuation which uses industry average price-earnings or price-sales ratios to estimate the stock price.

Uploaded by

ZinebCherkaoui
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Stock Valuation

Future Cash Flows of a Stock


 As with bonds, common stock valuation is about discounting future

cash flows. In practice, however, these future cash flows are not as
easily predictable as for bonds
 Future Cash flows of a stock mainly consist of dividends and the

terminal value at which we can sell the stock at the end of the
investment horizon


Bear in mind that another major difference between bonds and stocks is the
fact that these later have no maturity. The life of a stock is essentially forever

 In stock markets, there are no interest rates curves! Therefore, there is

no easy way to determine the investors Required Rate of Return (RRR)


 Moreover, some companies may decide to entirely reinvest the net

income. Therefore, they never distribute dividends. In such cases, a


different valuation approach is used

From a simple case


 You consider to buy a stock today and you believe that:



The stock will pay a dividend of 10 at the end of the year


You can sell the stock at a price of 87 at the end of the year

 You require a RRR of 12%. What is the value that you would assign to

this stock?
The value is: =

(%)

= 86,61


, where R is the RRR


 Similarly, we can also write that : =
, meaning that the stock

 The general case is:

price at the end of year 1 depends on the cash flows that will be received
at the end of year 2
 The logic could be applied indefinitely to P2, P3, P4, P5.

Special Cases
 Zero Growth: dividends (D) are constant through time (like in the case of

preferred stocks). The per-share value is:

 Constant Growth: in the case of a company growing at a steady rate g,

the general formula to calculate a dividend at a period t is:

= (1 + )
 Growing Perpetuity: when a company is growing at a steady rate, g,

forever, the general formula to determine its per-share value, at any


period t, is:

This model is called the Dividend Growth Model

Non constant growth (1/2)


 There are many cases non-constant growth common stock:

Dividends growing at a rate g starting from period t:

1.

 We first determine the price at period t using the Dividend Growth Model

()
P = =

We then discount this price, Pt , along with all intermediate dividends:


=

1+

1+

++

+
(1 + ) (1 + )

Two-stage growth model:

2.


In this case, a company will grow at a rate g1 for a number of years t, then it
will grow at a rate g2 forever
Thus, we have a growing annuity for the first period and a growing
perpetuity for the second one. We then use the corresponding formulas

Non constant growth (2/2)


The general formula a two-stage growth company is:

()

where

(1 + ) (1 + )

=
=


 Components of the Required Rate of Return:


= , can be rewritten as follows:

D
R=
+g
P

The formula defined earlier, P

The Required Rate of Return = Dividend yield + Capital gains yield

Stock valuation using multiples


 When companies do not pay dividends, a common approach to value

their stock is to use a benchmark price-to-earnings ratio, or PE ratio,


and multiply it by the companys earnings to determine a per-share
price:
Pt = Benchmark PE ratio x EPSt
 The PE ratio could come from sources such as the companys industry

average, or median, or the companys own historical values


 When the PE ratio is based on future earnings, it is called forward PE
 When the PE ratio is applied to next years earnings, the price

calculated is called target price


 Another common ratio used is Price-to-sales ratio

Pt = Price-to-sales ratio x sales-per-sharet

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