Reading 41: Equity Valuation: Concepts and

Basic Tools
 Security Analysis
Securities are mispriced or incorrectly priced by the market when their market prices are
different from their intrinsic values.

• If the estimate for a security’s intrinsic value is lower than the market price, the security is
overvalued by the market.

• If the estimate for a security’s intrinsic value is greater than the market price, the security is
undervalued by the market.

• If the estimate for a security’s intrinsic value equals the market price, the security is fairly
valued.
 Categories of Equity Valuation Models
The three major categories of equity valuation models are:

1. Present value models (also known as discounted cash flow models)

2. Multiplier models

3. Asset-based valuation models

 Types of Dividends
Companies pay regular cash dividends at regular, known intervals.
Other types include:
• Special (or extra) dividends
• Stock dividends
• Stock splits
• Reverse stock splits
• Share repurchases
Dividend Payment Chronology
 Dividend Discount Model
The dividend discount model (DDM) values a share of common stock as the present value of
its expected future cash flows (dividends).

• The value of the stock at any point in time is still determined by its expected future dividends.

• If a company pays no dividends currently, still there is an expectation that after a certain
period of time the firm will start making dividend payments.

• If the company does not make positive earnings going forward, there will still be an
expectation of a liquidating dividend.
 Dividend Discount Model
One-Year Holding Period

Example: One-Period DDM

An analyst gathered the following information about a company:
• Current dividend per share (D0) of common stock = $ 4.00
• Expected growth rate for the year (g) = 20%
• Risk-free rate of return = 6%
• Expected return on the market portfolio = 11%
• Beta of the company’s common stock = 1.2

Given that it is estimated that the stock will sell for $15.40 at the end of the year, calculate the value
of the company’s common stock.
 Dividend Discount Model
Solution
 Dividend Discount Model
Multiple-Year Holding Period DDM

If we assume that dividends are growing at a constant rate every year, then:
 Dividend Discount Model
Example: DDM for Multiple Holding Periods

Assume that a stock currently pays a dividend of $1.00, has an expected growth rate of
6%, and has a required rate of return of 14.1%. Calculate the value of the stock today if
we expect to sell it for $15.30 in two years.
 Dividend Discount Model
Solution

The value of the stock based on the investor’s expectations equals $13.54.
 Gordon Growth Model
It is useful for valuing companies that have historically been raising their dividend at a stable
rate.

The long‐term (constant) growth rate is usually calculated as:

The DDM can be extended to numerous stages.

 Gordon Growth Model
Applying the DDM is relatively difficult if the company is not currently paying out a
dividend.

A company may not pay out a dividend because:

• It has a lot of lucrative investment opportunities available and it wants to retain
profits to reinvest them in the business.
• It does not have sufficient excess cash flow to pay out a dividend.
 Gordon Growth Model
Example: Applying the Gordon Growth Model
An analyst obtained the following information regarding Global Transporters Inc.:

Current share price = $28

Recent dividend per share = $1.95
Earnings per share = $4.25
Return on equity = 25%
Required rate of return = 20%

1. Use the Gordon growth model to estimate Global’s intrinsic value.

2. How much does the dividend growth assumption add to the intrinsic value estimate?
3. Based on the intrinsic value estimate, is the company’s share undervalued, fairly valued, or overvalued?
4. Calculate the intrinsic value if the growth rate estimate is lowered to 12%.
5. Calculate the intrinsic value if the growth rate estimate is lowered to 12% and the required rate of
return estimate is increased to 22%.
 Gordon Growth Model
Solution
1. Dividend payout ratio = 1.95/4.25 = 45.88%

Therefore, earnings retention rate = 100% – 45.88% = 54.12%

Dividend growth rate = Retention rate × ROE = 0.5412 × 0.25 = 13.53%

2. Effect of the dividend growth assumption = 34.21 – (1.95/0.2) = $24.46

3. Global’s current market price ($28) is lower than its intrinsic value ($34.21). Therefore, its stock is
undervalued.
 Gordon Growth Model
Solution (Cont.)

4.

5.
 Practice Question
Alpha Inc. just paid a dividend of $4.00 per share, which is expected to grow at a rate of 3% in
perpetuity. The stock has a beta of 1, the risk-free rate is 5%, and the market risk premium is 7%.

The value of the company’s stock today is closest to:

A. $44.44.
B. $45.78.
C. $46.48.
 Practice Question
Alpha Inc. just paid a dividend of $4.00 per share, which is expected to grow at a rate of 3% in
perpetuity. The stock has a beta of 1, the risk-free rate is 5%, and the market risk premium is 7%.

The value of the company’s stock today is closest to:

A. $44.44
B. $45.78
C. $46.48

Answer B
Required return = 5% + 1[7%] = 12%
D1 = 4.0(1.03) = 4.12
Value = 4.12/[0.12 – 0.03] = $45.78
 Supernormal Growth Scenario
Valuation of Common Stock with Temporary Supernormal Growth

Growth companies are firms that are able to earn returns on investment that are
consistently above their required rates of return.

• In order to take advantage of such opportunities, these companies tend to retain a

very high proportion of their earnings and reinvest them in the business.

• These high retention rates translate into high growth rates.

 Supernormal Growth Scenario
Valuation of Common Stock with Temporary Supernormal Growth

The correct valuation model to value such “supernormal growth” companies is the
multistage dividend discount model that combines the multiperiod and infinite-period
dividend discount models.
 Supernormal Growth Scenario
• Estimate the amount and duration of dividends during the supernormal growth phase.

• Forecast the normal, constant growth rate in dividends that will occur once the supernormal
growth period ends.

• Project the first dividend after the commencement of normal growth.

• Calculate the price of the stock at the end of the supernormal growth period using the
infinite-period DDM. The first dividend after commencement of normal growth will be the
numerator.

• Determine the cost of equity, ke.

• Calculate the present value of supernormal-growth-period dividends and the terminal stock
price (the stock price at the end of supernormal growth).
 Supernormal Growth Scenario
• If a company has two or three stages of supernormal growth, each year’s
dividend must be calculated during supernormal growth separately.

• Once the growth rate stabilizes below the required rate of return, the
terminal value of the firm can be computed by using the constant-growth
DDM.
 Supernormal Growth Scenario
Example: Valuation with Temporary Supernormal Growth
A company is expected to experience a dividend growth rate of 20% for the next three
years, 15% for the subsequent two years, and a constant growth rate of 6% thereafter.
The last dividend paid out by the company was $1.49 per share, and its cost of equity is
12%. Calculate the value of the company’s stock.
 Supernormal Growth Scenario
Solution
First calculate the dividends for each year during the supernormal growth
phase:

D1 = D0 (1 + g1)1 = (1.49)(1.20)1 = $1.80

D2 = D0 (1 + g1)2 = (1.49)(1.20)2 = $2.16
D3 = D0 (1 + g1)3 = (1.49)(1.20)3 = $2.59
D4 = D3 (1 + g2)1 = (2.59)(1.15)1 = $2.98
D5 = D3 (1 + g2)2 = (2.59)(1.15)2 = $3.43
 Supernormal Growth Scenario
Solution (Cont.)
After Year 5, growth falls to a constant rate of 6%. The dividend for the sixth year will be:

We use D6 to calculate the value of the stock as of the beginning of the constant, infinite-growth
period (end of Year 5),

Finally, we add the present values of the high-growth-period dividends and the terminal value of
the stock at the end of Year 5 to determine the intrinsic value of the stock:

Value = 1.61 + 1.72 + 1.84 + 1.89 + 1.95 + 34.36 = $43.37

 Supernormal Growth Scenario
Example: Delayed Dividend Payment
A firm is expected to have 3 years of extraordinary growth during which no dividends will be paid.
Beginning in Year 4, earnings will stabilize and grow at a sustainable 5% rate indefinitely, and the
firm will pay out 45% of its earnings in dividends. Given that earnings in Year 4 (E4) are expected to
be $3.45 and the required return on equity is 10%, calculate the value of this stock today.
 Supernormal Growth Scenario
Example: Delayed Dividend Payment
A firm is expected to have 3 years of extraordinary growth during which no dividends will be paid.
Beginning in Year 4, earnings will stabilize and grow at a sustainable 5% rate indefinitely, and the
firm will pay out 45% of its earnings in dividends. Given that earnings in Year 4 (E4) are expected to
be $3.45 and the required return on equity is 10%, calculate the value of this stock today.

Solution

The value of this stock today equals the present value of the terminal value (P3), which equals
$23.32.
 Practice Question
Alpha Inc. just paid a dividend of $4.00 per share, which is expected to grow at a rate of 20% per
year for two years and then at a rate of 3% in perpetuity. If the required return on the stock is 12%,
the value of the company’s stock today is closest to:
A. $61.43.
B. $65.43.
C. $65.92.
 Practice Question
Alpha Inc. just paid a dividend of $4.00 per share, which is expected to grow at a rate of 20% per
year for two years and then at a rate of 3% in perpetuity. If the required return on the stock is 12%,
the value of the company’s stock today is closest to:
A. $61.43.
B. $65.43.
C. $65.92.

Answer: A
D1= 4(1.20) = 4.80;
D2 = 4.80(1.20) = 5.76; D3 = 5.76(1.03) = 5.9328
P2 = 5.9328/[0.12-0.03] = 65.92
4.80 5.76 + 65.92
𝑉𝑎𝑙𝑢𝑒 = + = 61.43
1.12 1.122
 Free-Cash-Flow-to-Equity (FCFE) Model
FCFE is a measure of dividend-paying capacity and can also be used to value
companies that currently do not make any dividend payments.

Analysts may calculate the intrinsic value of the company’s stock by discounting their
projections of future FCFE at the required rate of return on equity.
 Noncallable, Nonconvertible Preferred Stock
When a preferred stock is noncallable, is nonconvertible, has no maturity date, and pays dividends
at a fixed rate, the value of the preferred stock can be calculated using the perpetuity formula:

For a noncallable, nonconvertible preferred stock with maturity at time n, the value of the stock
can be calculated using the following formula:

Preferred shares may also be callable or putable or retractable term.

 A Noncallable, Nonconvertible Preferred Stock
Example: Preferred Share Valuation: Two Cases
Aramis International issued perpetual preferred shares with a par value of $20 and pay an annual
dividend of $3.65. Given a required rate of return of 8%, answer the following questions:

1. Calculate the intrinsic value of the shares if they are noncallable, nonconvertible.
2. Calculate the intrinsic value of the shares if they are retracted at par value after 3 years.
 A Noncallable, Nonconvertible Preferred Stock
Example: Preferred Share Valuation: Two Cases
Aramis International issued perpetual preferred shares with a par value of $20 and pay an annual
dividend of $3.65. Given a required rate of return of 8%, answer the following questions:

1. Calculate the intrinsic value of the shares if they are noncallable, nonconvertible.
2. Calculate the intrinsic value of the shares if they are retracted at par value after 3 years.

Solution
1. Intrinsic value = Dividend/Required rate of return = 3.65/0.08 = $45.63

2. Retractable term preferred shares specify a retraction date, at which the preferred shareholders have
the option to sell back the shares to the issuer at a predetermined price. The intrinsic value in such cases
is calculated as follows:

Intrinsic value = [(3.65/1.08) + (3.65/1.082) + (3.65/1.083) + (20/1.083)] = $25.28

 Price Multiples
Price multiples are ratios that compare the price of a stock to some sort of value. Price
multiples allow an analyst to evaluate the relative worth of a company’s stock.

Popular multiples used in relative valuation include price-to-earnings, price-to-sales, price-to-

book, and price-to-cash flow.

A common criticism of price multiples is that they do not consider the future in that their values are
calculated from trailing or current values of the divisor.

To counter this criticism, analysts make forecasts of fundamental values (e.g., earnings) into the
future and use forward-looking or leading multiples.
 Price Multiples
Multiples Based on Fundamentals
A price multiple may be related to fundamentals through a dividend discount model, such as the Gordon
growth model.
The expressions developed in such an exercise are interpreted as the justified (or based on fundamental)
values for a multiple.

P/E Ratio

• The P/E ratio is inversely related to the required rate of return.

• The P/E ratio is positively related to the growth rate.
• The P/E ratio appears to be positively related to the dividend payout ratio.
• Justified forward P/E estimates are very sensitive to small changes in the assumptions used to
compute them.
 Price Multiples
Example: Justified P/Es

Assume that a stock has an expected payout ratio of 40% and a required return on
equity of 10%. With an expected growth rate of dividends of 8%, calculate the stock’s
justified P/E multiple.
 Price Multiples
Example: Justified P/Es

Assume that a stock has an expected payout ratio of 40% and a required return on
equity of 10%. With an expected growth rate of dividends of 8%, calculate the stock’s
justified P/E multiple.

Solution
 Multiples Based on Comparables
This method compares relative values estimated using multiples to determine whether
an asset is undervalued, overvalued, or fairly valued.

The benchmark multiple can be any of:

• A multiple of a closely matched individual stock.

• The average or median multiple of a peer group or the firm’s industry.

• The average multiple derived from trend or time-series analysis.

Analysts should be careful to select only those companies that have similar size, product
lines, and growth prospects to the company being valued as comparables.
 Price-to-Earnings Ratio
Advantages
• Earnings are key drivers of stock value.
• The ratio is simple to calculate and widely used in the industry.
• According to empirical research, differences in P/E ratios are significantly related to
long-term stock returns.
Disadvantages
• Companies that make losses have negative EPS and P/Es. Negative P/E ratios are
useless as far as relative valuation is concerned.
• Earnings of some companies are very volatile, which makes the task of determining a
fundamental stock value very challenging.
• Management can use different accounting assumptions to prepare their financial
statements. This reduces the comparability of P/E ratios across companies.
 Price-to-Cash Flow
Advantages:
• Cash flows are less prone to management manipulation than earnings.
• P/CF is more stable than the P/E ratio.
• Using the price-to-cash flow ratio gets around the problem related to differences in the
quality of earnings reported by companies.
• Research has shown that differences in price-to-cash flow ratio over time are related to
differences in long-term average returns on stocks.

Disadvantages:
• When “EPS plus noncash charges” is used as the definition for cash flow, noncash revenue
and changes in working capital items are ignored.
• FCFE is more appropriate for valuing a company than operating cash flow, but it is more
volatile and more frequently negative than operating cash flow.
• Management may be able to inflate reported CFO by securitizing accounts receivable and
outsourcing payments of accounts payable (to delay outflows of cash).
 Price-to-Cash Flow
Example: Calculating P/CF
ABC Company reported net income of $2.3 million for the year 2008. It recorded noncash charges of
$0.4 million for the year and has 2 million shares outstanding. The market price of the company’s
stock is currently $40. Compute its price-to-cash flow ratio.
 Price-to-Cash Flow
Example: Calculating P/CF
ABC Company reported net income of $2.3 million for the year 2008. It recorded noncash charges of
$0.4 million for the year and has 2 million shares outstanding. The market price of the company’s
stock is currently $40. Compute its price-to-cash flow ratio.

Solution

Cash flow = $2,300,000 + $400,000 = $2,700,000

Cash flow per share = $2,700,000/2,000,000 = $1.35
Price-to-cash flow = $40/$1.35 = 29.63
 Price-to-Sales
Advantages:
• Sales are less prone to manipulation by management than earnings and book values.
• Sales are positive even when earnings are negative.
• The P/S ratio is usually more stable than the P/E ratio, as earnings reflect operational and financial
leverage.
• It is especially appropriate for valuing mature, cyclical, and loss-making companies.
• Studies have shown that differences in price-to-sales ratios are related to differences in long-term average
returns on stocks.

Disadvantages:
• Using sales reveals no information about the operating profitability of a company.
• Using the P/S ratio does not reflect differences in cost structure and operating efficiency between
companies.
• There is a logical mismatch when price is compared with sales.
• Management can come up with ways to manipulate revenue figures. They may not reflect a sudden
change in a key indicator.
 Price-to-Sales
Example: Calculating P/S
Krivya Chemicals reported net sales of $4,649,000 for the year ended 2008. It currently has 225,000
shares outstanding, and its stock price is $14.35. Calculate Krivya’s P/S ratio.
 Price-to-Sales
Example: Calculating P/S
Krivya Chemicals reported net sales of $4,649,000 for the year ended 2008. It currently has 225,000
shares outstanding, and its stock price is $14.35. Calculate Krivya’s P/S ratio.

Solution

Sales per share = $4,649,000/225,000 = $20.67

Price-to-sales ratio = $14.35/$20.67 = 0.69
 Price-to-Book Value
Advantages:
• Can be used for loss-making companies.
• Book value is typically more stable over time compared to reported earnings.
• Useful for financial sector companies that have significant holdings of liquid assets.
• Useful in valuing distressed companies.
• Differences in P/BV ratios over time are related to differences in long-term average returns on stocks.

Disadvantages:
• Ignores nonphysical assets (e.g., quality of a company’s human capital, brand image).
• Misleading when comparing firms with significantly different levels of assets.
• Accounting differences can impair the comparability.
• Inflation and changes in technology may result in significant differences between accounting book
values and actual market values.
• Share repurchases or issuances can distort historical P/BV comparisons.
 Price-to-Book Value
Example: Calculating P/BV

The following table contains the equity portion of ADF Company’s balance sheet:

The current market price of ADF stock is $14.35. Calculate its P/BV ratio.
 Price-to-Book Value
Solution

Common shareholders’ equity = Total shareholders’ equity – Total value of equity claims
that are senior to common stock = $269,875 – $25,000 = $244,875

Book value per share = $244,875/20,000 = $12.24

P/BV = $14.35/$12.24 = $1.17

 Enterprise Value Multiples
Enterprise value (EV) can be thought of as the cost of taking over a company.

EV = MV Common Equity + MV Preferred Stock + MV Debt + Minority interest –

Cash & ST Investments

• The most widely used EV multiple is the EV/EBITDA multiple.

• The EV/EBITDA multiple is often used when comparing two companies with different
capital structures.
• Loss-making companies usually have a positive EBITDA, which allows analysts to use
the EV/EBITDA multiple to value them.
 Enterprise Value Multiples
Example: EV/Operating Income (OI)
An analyst gathered the following information regarding five companies operating in
the same industry:

1. Based on the information given, calculate each company’s EV/OI.

2. Which company is the most undervalued?
 Enterprise Value Multiples
Solution
1. The following table shows the EV/OI for each company:

2. Company E has the lowest positive EV/OI ratio and, therefore, is the most undervalued or
favorably priced stock. Note the negative EV/OI ratio of Company C. Negative EV/OI ratios are
difficult to interpret, so the analyst must use some other means to evaluate such companies.
 Asset-Based Valuation Models
Asset-based valuation uses market values of a company’s assets and liabilities to determine
the value of the company as a whole.

Asset-based valuation works well for:

• Companies that do not have a significant number of intangible or “off-the-book” assets and
have a higher proportion of current assets and liabilities.
• Private companies, especially if applied together with multiplier models.
• Financial companies, natural resource companies, and companies that are being liquidated.

Asset-based valuation may not be appropriate when:

• Market values of assets and liabilities cannot be easily determined.
• The company has a significant amount of intangible assets.
• Asset values are difficult to determine (e.g., in periods of very high inflation).
• Market values of assets and liabilities significantly differ from their carrying values.