Common Stock
Valuation
Chapter 10
Charles P. Jones, Investments: Analysis and
Management,
Ninth Edition, John Wiley & Sons
Prepared by
G.D. Koppenhaver, Iowa State University
10-1
Fundamental Analysis
Present value approach
– Capitalization of expected income
– Intrinsic value based on the discounted value
of the expected stream of cash flows
Multiple of earnings approach
– Valuation relative to a financial performance
measure
– Justified P/E ratio
10-2
Present Value Approach
Intrinsic value of a security is
n Cash Flows
Value of security
t 1 ( 1 k)t
Estimated intrinsic value compared to the
current market price
– What if market price is different than
estimated intrinsic value?
10-3
Required Inputs
Discount rate
– Required rate of return: minimum expected
rate to induce purchase
– The opportunity cost of dollars used for
investment
Expected cash flows
– Stream of dividends or other cash payouts
over the life of the investment
10-4
Required Inputs
Expected cash flows
– Dividends paid out of earnings
Earnings important in valuing stocks
– Retained earnings enhance future earnings
and ultimately dividends
Retained earnings imply growth and future
dividends
Produces similar results as current dividends in
valuation of common shares
10-5
Dividend Discount Model
Current value of a share of stock is the
discounted value of all future dividends
D1 D2 D
Pcs 1
2
...
( 1 kcs ) ( 1 kcs ) ( 1 kcs )
Dt
t
t 1 ( 1 kcs )
10-6
Dividend Discount Model
Problems:
– Need infinite stream of dividends
– Dividend stream is uncertain
Must estimate future dividends
– Dividends may be expected to grow over time
Must model expected growth rate of dividends and
need not be constant
10-7
Dividend Discount Model
Assume no growth in dividends
– Fixed dollar amount of dividends reduces the
security to a perpetuity
D0
P0
kcs
– Similar to preferred stock because dividend
remains unchanged
10-8
Dividend Discount Model
Assume a constant growth in dividends
– Dividends expected to grow at a constant
rate, g, over time
D1
P0
k g
– D1 is the expected dividend at end of the first
period
– D1 =D0 (1+g)
10-9
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
10-10
Dividend Discount Model
Multiple growth rates: two or more
expected growth rates in dividends
– Ultimately, growth rate must equal that of the
economy as a whole
– Assume growth at a rapid rate for n periods
followed by steady growth
t
n D0( 1 g1 ) Dn( 1 gc ) 1
P0 t
n
t 1 ( 1 k) k-g ( 1 k)
10-11
Dividend Discount Model
Multiple growth rates
– First present value covers the period of super-
normal (or sub-normal) growth
– Second present value covers the period of
stable growth
Expected price uses constant-growth model as of
the end of super- (sub-) normal period
Value at n must be discounted to time period zero
10-12
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
What About Capital Gains?
Is the dividend discount model only
capable of handling dividends?
– Capital gains are also important
Price received in future reflects
expectations of dividends from that point
forward
– Discounting dividends or a combination of
dividends and price produces same results
10-14
Intrinsic Value
“Fair” value based on the capitalization of
income process
– The objective of fundamental analysis
If intrinsic value >(<) current market price,
hold or purchase (avoid or sell) because
the asset is undervalued (overvalued)
– Decision will always involve estimates
10-15
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
10-16
P/E Ratio Approach
To estimate share value
Po estimated earnings
justified P/E ratio E1 Po /E1
P/E ratio can be derived from
D1 D1/E1
Po or Po /E1
k-g k-g
– Indicates the factors that affect the estimated
P/E ratio
10-17
P/E Ratio Approach
The higher the payout ratio, the higher the
justified P/E
– Payout ratio is the proportion of earnings that
are paid out as dividends
The higher the expected growth rate, g,
the higher the justified P/E
The higher the required rate of return, k,
the lower the justified P/E
10-18
Understanding the P/E Ratio
Can firms increase payout ratio to increase
market price?
– Will future growth prospects be affected?
Does rapid growth affect the riskiness of
earnings?
– Will the required return be affected?
– Are some growth factors more desirable than
others?
P/E ratios reflect expected growth and risk
10-19
P/E Ratios and Interest Rates
A P/E ratio reflects investor optimism and
pessimism
– Related to the required rate of return
As interest rates increase, required rates
of return on all securities generally
increase
P/E ratios and interest rates are indirectly
related
10-20
Which Approach Is Best?
Complementary approaches?
– P/E ratio can be derived from the constant-
growth version of the dividend discount model
– Dividends are paid out of earnings
– Using both increases the likelihood of
obtaining reasonable results
Dealing with uncertain future is always
subject to error
10-21
