Chapter 6

Common Stock Valuation

Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 6-1
 The Stock Market

“If a business is worth a dollar and I can buy it for 40 cents,

something good may happen to me.”

–Warren Buffett

“Prediction is difficult, especially about the future.”

–Niels Bohr (among others)

6-2
 Learning Objectives
Separate yourself from the commoners
by having a good understanding of
these security valuation methods:

1. The basic dividend discount model.

2. The two-stage dividend growth model.
3. The residual income model and free cash flow model.
4. Price ratio analysis.

6-3
 Common Stock Valuation

Our goal in this chapter is to examine the methods

commonly used by financial analysts to assess
the economic value of common stocks.

These methods are grouped into four categories:

1. Dividend discount models

2. Residual Income model
3. Free Cash Flow model
4. Price ratio models

6-4
 Security Analysis: Be Careful Out There

• Fundamental analysis is a term for studying a company’s

accounting statements and other financial and economic
information to estimate the economic value of a company’s
stock.

• The basic idea is to identify “undervalued” stocks to buy and

“overvalued” stocks to sell.

• In practice however, such stocks may in fact be correctly

priced for reasons not immediately apparent to the analyst.

6-5
 The Dividend Discount Model

• The Dividend Discount Model (DDM) is a method to estimate

the value of a share of stock by discounting all expected future
dividend payments. The basic DDM equation is:
D1 D2 D3 DT
P0    
1  k  1  k  1  k 
2 3
1  k  T

• In the DDM equation:

― P0 = the present value of all future dividends
― Dt = the dividend to be paid t years from now
― k = the appropriate risk-adjusted discount rate
6-6
 Example: The Dividend Discount Model

• Suppose that a stock will pay three annual dividends of $200

per year; the appropriate risk-adjusted discount rate, k, is 8%.

• In this case, what is the value of the stock today?

D1 D2 D3
P0   
1  k  1  k  2 1  k  3

$200 $200 $200

P0     $515.42
1  0.08  1  0.08  1  0.08 
2 3

6-7
 The Dividend Discount Model:
the Constant Growth Rate Model

• Assume that the dividends will grow at a constant growth rate

g. The dividend in the next period, (t + 1), is:
D t 1  D t  1 g

So, D2  D1  (1  g)  D0  (1  g)  (1  g)

• For constant dividend growth for “T” years, the DDM formula
is:
D1 (1  g)   1  g  
T

P0  1     if k  g
k  g   1  k  

P0  T  D 0 if k  g
6-8
 Example: The Constant Growth Rate Model

• Suppose the current dividend is $10, the dividend growth rate is 10%,
there will be 20 yearly dividends, and the appropriate discount rate is
8%.

• What is the value of the stock, based on the constant growth rate
model?

D 0 (1  g)   1  g  
T

P0  1    
k  g   1  k  

$10  1.10    1.10  

20

P0  1      $243.86
.08  .10   1.08  

6-9
 The Dividend Discount Model:
the Constant Perpetual Growth Model

• Assuming that the dividends will grow forever at a

constant growth rate g.

• For constant perpetual dividend growth, the DDM

formula becomes:

D 0   1  g D1
P0   (Important : g  k)
kg kg

6-10
 Example: Constant Perpetual Growth Model

• Think about the electric utility industry.

• In 2012, the dividend paid by the utility company, DTE Energy
Co. (DTE), was $2.35.
• Using D0 =$2.35, k = 4.75%, and g = 2%, calculate an estimated
value for DTE.
$2.35  1.02 
P0   $87.16
.0475  .02
Note: the actual mid-2012 stock price of DTE was $56.34.

What are the possible explanations for the difference?

6-11
 The Dividend Discount Model:
Estimating the Growth Rate

The growth rate in dividends (g) can be

estimated in a number of ways:

• Using the company’s historical average growth rate.

• Using an industry median or average growth rate.

• Using the sustainable growth rate.

6-12
 The Historical Average Growth Rate
• Suppose the Broadway Joe Company paid the following dividends:

― 2008: $1.50 2011: $1.80

― 2009: $1.70 2012: $2.00
― 2010: $1.75 2013: $2.20

• The spreadsheet below shows how to estimate historical average growth

rates, using arithmetic and geometric averages.
Year: Dividend: Pct. Chg:
2013 $2.20 10.00%
2012 $2.00 11.11%
2011 $1.80 2.86% Grown at
2010 $1.75 2.94% Year: 7.96%:
2009 $1.70 13.33% 2008 $1.50
2008 $1.50 2009 $1.62
2010 $1.75
Arithmetic Average: 8.05% 2011 $1.89
2012 $2.04
Geometric Average: 7.96% 2013 $2.20
6-13
 The Sustainable Growth Rate
Sustainable Growth Rate  ROE  Retention Ratio

 ROE  (1 - Payout Ratio)

• Return on Equity (ROE) = Net Income / Equity

• Payout Ratio = Proportion of earnings paid out as dividends

• Retention Ratio = Proportion of earnings retained for

investment (i.e., NOT paid out as dividends)
6-14
 Example: Calculating and Using the
Sustainable Growth Rate

• In 2012, DTE Energy Co. (DTE) had an ROE of 10%, projected

earnings per share of $4.05, and had a dividend level of $2.35.
What was DTE’s:
― Retention rate?
― Sustainable growth rate?

• Payout ratio = $2.35/ $4.05 = .5802 or about 58%

• So, retention ratio = 1 – .58 = .42 or 42%

• Therefore, DTE’s sustainable growth rate = .10  .42 = .042, or

4.2%
6-15
 Example: Calculating and Using the
Sustainable Growth Rate, Cont.

• What is the value of DTE stock using the perpetual growth

model and a discount rate of 4.75%?
$2.35  1.042 
P0   $445.22
.0475  .042

The actual mid-2012 stock price of DTE was $56.34.

• In this case, using the sustainable growth rate to value the

stock gives an extremely poor estimate.

• What can we say about the values of g and k in this example?

6-16
 Analyzing ROE
• To estimate a sustainable growth rate, you need the (relatively stable)
dividend payout ratio and ROE.
• Changes in sustainable growth rate likely stem from changes in ROE.
• The DuPont formula separates ROE into three parts: profit margin,
asset turnover, and equity multiplier

Net Income Net Income Sales Assets

 ROE   
Equity Sales Assets Equity

• Managers can increase the sustainable growth rate by:

― Decreasing the dividend payout ratio
― Increasing profitability (Net Income / Sales)
― Increasing asset efficiency (Sales / Assets)
― Increasing debt (Assets / Equity)
6-17
 The Two-Stage Dividend Growth Model

• The two-stage dividend growth model assumes that

a firm will initially grow at a rate g1 for T years, and
thereafter, it will grow at a rate g2 < k during a
perpetual second stage of growth.

• The Two-Stage Dividend Growth Model formula is:

D 0 (1  g1 )   1  g1    1  g1  D 0 (1  g 2 )
T T

P0  1     
k  g1   1  k    1  k  k  g2

6-18
 Using the Two-Stage
Dividend Growth Model, I.
• Although the formula looks complicated, think of it as two
parts:
― Part 1 is the present value of the first T dividends (it is the same formula
we used for the constant growth model).
― Part 2 is the present value of all subsequent dividends.

• So, suppose MissMolly.com has a current dividend of

D0 = $5, which is expected to shrink at the rate, g1 = 10%, for 5
years but grow at the rate, g2 = 4%, forever.

• With a discount rate of k = 10%, what is the present value of

the stock?
6-19
 Using the Two-Stage
Dividend Growth Model, II.

D 0 (1  g1 )   1  g1    1  g1  D 0 (1  g 2 )
T T

P0  1     
k  g1   1  k    1  k  k  g2

$5.00(0.90 )   0.90    0.90  5 $5.00(1  0.04)

5

P0  1     
0.10  ( 0.10)   1  0.10    1  0.10  0.10  0.04

 $14.25  $31.78

 $46.03.

The total value of $46.03 is the sum of a $14.25 present value of the first five
dividends, plus a $31.78 present value of all subsequent dividends.

6-20
 Example: Using the DDM to Value a Firm Experiencing
“Supernormal” Growth, I.

• Chain Reaction, Inc., has been growing at a phenomenal rate of

30% per year.

• You believe that this rate will last for only three more years.

• Then, you think the rate will drop to 10% per year.

• Total dividends just paid were $5 million.

• The required rate of return is 20%.

• What is the total value of Chain Reaction, Inc.?

6-21
 Example: Using the DDM to Value a Firm Experiencing
“Supernormal” Growth, II.

• First, calculate the total dividends over the “supernormal” growth period:

Year Total Dividend: (in $millions)

1 $5.00 x 1.30 = $6.50
2 $6.50 x 1.30 = $8.45
3 $8.45 x 1.30 = $10.985
• Using the long run growth rate, g, the value of all the shares at Time 3 can
be calculated as:

P3 = [D3 x (1 + g)] / (k – g)

P3 = [$10.985 x 1.10] / (0.20 – 0.10) = $120.835

6-22
 Example: Using the DDM to Value a Firm Experiencing
“Supernormal” Growth, III.

• To determine the present value of the firm today, we need the present
value of $120.835 and the present value of the dividends paid in the first
3 years: D1 D2 D3 P3
P0    
1  k  1  k  2 1  k  3 1  k  3

$6.50 $8.45 $10.985 $120.835

P0    
1  0.20  1  0.20  1  0.20  1  0.20  3
2 3

 $5.42  $5.87  $6.36  $69.93

 $87.58 million.

If there are 20 million shares outstanding, the price per share is $4.38.

6-23
 The H-Model, I.

• For Chain Reaction, Inc., we assumed a supernormal growth

rate of 30 percent per year for three years, and then growth
at a perpetual 10 percent.

• The growth rate is more likely to start at a high level and then
fall over time until reaching its perpetual level.

• Many possible ways to assume how the growth rate declines

• A popular way is the H-model: which assumes a linear growth

rate decline
6-24
 The H-Model, II.

• Let’s revisit Chain Reaction, Inc.

― Suppose the growth rate begins at 30% and reaches 10% in year 4 and beyond.
― Using the H-model, we would assume that the company’s growth rate would decline
by 20% from the end of year 1 to the beginning of year 4.

• If we assume a linear decline:

― the growth rate falls by 6.67% per year (20%/3 years).
― Growth estimates would be: 30%, 23.33%, 16.66%, and 10%

• Using these growth estimates, you will find that the firm value is
$75.93 million, or $3.80 per share.

• The value is lower than before because of the lower growth

rates in years 2 and 3.
6-25
 Discount Rates for
Dividend Discount Models

• The discount rate for a stock can be estimated using the

capital asset pricing model (CAPM ).
• We will discuss the CAPM in a later chapter.
• We can estimate the discount rate for a stock with this
formula:

Discount rate = time value of money + risk premium

= U.S. T-bill Rate + (Stock Beta x Stock Market Risk Premium)

T-bill Rate: return on 90-day U.S. T-bills

Stock Beta: risk relative to an average stock
Stock Market Risk Premium: risk premium for an average stock

6-26
 Observations on Dividend
Discount Models, I.

Constant Perpetual Growth Model:

• Simple to compute
• Not usable for firms that do not pay dividends
• Not usable when g > k
• Is sensitive to the choice of g and k
• k and g may be difficult to estimate accurately.
• Constant perpetual growth is often an unrealistic assumption.

6-27
 Observations on Dividend
Discount Models, II.

Two-Stage Dividend Growth Model:

• More realistic in that it accounts for two stages of growth

• Usable when g > k in the first stage
• Not usable for firms that do not pay dividends
• Is sensitive to the choice of g and k
• k and g may be difficult to estimate accurately.

6-28
 Residual Income Model (RIM), I.

• We have valued only companies that pay dividends.

―But, there are many companies that do not pay dividends.

―What about them?
―It turns out that there is an elegant way to value these companies, too.

• The model is called the Residual Income Model (RIM).

• Major Assumption (known as the Clean Surplus Relationship, or CSR): The

change in book value per share is equal to earnings per share minus dividends.

6-29
 Residual Income Model (RIM), II.
• Inputs needed:
― Earnings per share at time 0, EPS0
― Book value per share at time 0, B0
― Earnings growth rate, g
― Discount rate, k

• There are two equivalent formulas for the Residual Income Model:
EPS 0 (1  g)  B 0  k
P0  B 0  BTW, it turns out that the
kg
RIM is mathematically the
same as the constant
or perpetual growth model.

EPS1  B 0  g
P0 
kg
6-30
 Using the Residual Income Model

• Duckwall—Alco Stores, Inc. (DUCK)

• It is July 1, 2010—shares are selling in the market for $10.94.
• Using the RIM:
― EPS0 = $1.20
― DIV = 0 EPS0  (1  g)  B 0  k
P0  B 0 
― B0 = $5.886 kg
― g = 0.09
― k = .13 $1.20  (1  .09)  $5.886  .13
P0  $5.886 
.13  .09

• What can we say $1.308  $.7652

P0  $5.886   $19.46.
about the market .04
price of DUCK?

6-31
 The Growth of DUCK

Using the information from the EPS0  (1  g)  B 0  k

P0  B 0 
previous slide, what growth rate kg
results in a DUCK price of $10.94?
$1.20  (1  g)  $5.886  .13
$10.94  $5.886 
.13  g

$5.054  (.13  g)  1.20  1.20g  .7652

$.6570  5.054g  1.20g  .4348

.2222  6.254g

g  .0355 or 3.55%.

6-32
 Free Cash Flow, I.

• We can value companies that do not pay dividends using the residual income
model.

• Note: We assume positive earnings when we use the residual income model.

• But, there are companies that do not pay dividends and have negative earnings.

• Do negative earnings imply little value?

―We calculate earnings based on accounting rules and tax codes.
―It is possible that a company has:
o negative earnings
o positive cash flows
o a positive value.

6-33
 Free Cash Flow, II.

• Depreciation—the key to understand how a company can have negative earnings and
positive cash flows

• Depreciation reduces earnings because it is counted as an expense (more expenses =

lower taxes paid).

• Most stock analysts, however, use a relatively simple formula to calculate Free Cash
Flow, FCF:
 
FCF = Net Income + Depreciation – Capital Spending

• We can see that it is possible for: Net Income < 0 and FCF > 0

Depreciation and Capital Spending matter in FCF.

6-34
 DDMs Versus FCF

• The DDMs calculate a value of the equity only.

―DDMs use dividends, a cash flow only to equity holders
―DDMs use the CAPM to estimate required return
―DDMs use an equity beta to account for risk

• Using the FCF model, we calculate a value for the firm.

―Free cash flow can be paid to debt holders and to stockholders.
―We can still calculate the value of equity using FCF
o Calculate the value of the entire firm
o Subtract out the value of debt
―We need a beta for assets, not the equity, to account for risk

6-35
 Asset Betas
• Asset betas measure the risk of the company’s industry.
― Firms in an industry should have about the same asset betas.
― Their equity betas can be quite different.
o Investors can increase portfolio risk by borrowing money.
o A business can increase risk by using debt.
• So, to value the company, we must “convert” reported equity betas
into asset betas by adjusting for leverage.
• The following conversion formula is widely used:

Debt
BEquity  BAsset  [1  (1  t )]
Equity
What happens when a firm has no debt? tax rate.

6-36
 The FCF Approach, Example
• Inputs
―An estimate of FCF:
o Net Income
o Depreciation
o Capital Expenditures
―The growth rate of FCF
―The proper discount rate
―Tax rate
―Debt/Equity ratio
―Equity beta

• Calculate value using a “DDM” formula

• “DDM” because we are using FCF, not dividends.

6-37
 Valuing Landon Air: A New Airline
• An estimate of FCF:
― EBIT: $45 million Assume:
― Depreciation: $10 million No dividends
Risk-free rate = 4%
― Capital Expenditures: $3 million
Market risk premium = 7%
― Growth rate of FCF: 3%
― Tax rate: 35%
― Debt/Equity ratio: .40 Using Basic DDM :
― Equity beta: 1.2
[45  (1- .35)  10 - 3]  (1.03)
Landon Air Value   $488.07 million
.1065 - .03
• Asset Beta:
If Landon Air has $100 in debt,
1.2 = BAsset x [1+.4 x (1-.35)]
the value of the equity is $388.07 million.
1.2 = BAsset x 1.26
BAsset = 0.95
Value per share  $388.07 million / number of shares.

• The proper discount rate: k = 4.00 + (7.00 × 0.95) = 10.65%

6-38
 Price Ratio Analysis, I.

• Price-earnings ratio (P/E ratio): Current stock price

per share divided by annual earnings per share (EPS)

• Earnings yield: Inverse of the P/E ratio, i.e., earnings

per share (EPS) divided by price per share (E/P)

• High-P/E stocks are often referred to as growth

stocks, while low-P/E stocks are often referred to as
value stocks.
6-39
 Price Ratio Analysis, II.

• Price-cash flow ratio (P/CF ratio)

― Current stock price divided by current cash flow per share
― In this context, cash flow is usually taken to be net income plus
depreciation.

• Most analysts agree that in examining a company’s financial

performance, cash flow can be more informative than net
income.

• Earnings and cash flows that are far from each other may be a
signal of poor quality earnings.

6-40
 Price Ratio Analysis, III.

• Price-sales ratio (P/S ratio)

― Current stock price divided by annual sales per share
― A high P/S ratio suggests high sales growth, while a low P/S ratio
suggests sluggish sales growth.

• Price-book ratio (P/B ratio)

― Market value of a company’s common stock divided by its book
(accounting) value of equity
― A ratio bigger than 1.0 indicates that the firm is creating value for its
stockholders.

6-41
 Price/Earnings Analysis, Intel Corp.

Intel Corp (INTC) - Earnings (P/E) Analysis

5-year average P/E ratio 17.10

Current EPS $2.31
EPS growth rate 7.6%

Expected stock price = historical P/E ratio  projected EPS

$42.50 = 17.10  ($2.31  1.076)

Mid-2012 stock price = $26.98

6-42
Price/Cash Flow Analysis, Intel Corp.
Intel Corp (INTC) - Cash Flow (P/CF) Analysis

5-year average P/CF ratio 8.00

Current CFPS $3.65
CFPS growth rate 7.0%

Expected stock price = historical P/CF ratio  projected CFPS

$31.24 = 8.00  ($3.65  1.07)

Mid-2012 stock price = $26.98

6-43
 Price/Sales Analysis, Intel Corp.
Intel Corp (INTC) - Sales (P/S) Analysis

5-year average P/S ratio 3.00

Current SPS $9.99
SPS growth rate 4.5%

Expected stock price = historical P/S ratio  projected SPS

$31.32 = 3.14  ($6.76  1.07)

Mid-2012 stock price = $19.40

6-44
 Enterprise Value Ratios, Overview
•The PE ratio is an equity ratio: numerator is price per share of stock
and denominator is earnings per share of stock.

•Practitioners often use ratios involving both debt and equity.

•Perhaps the most common one is the enterprise value (EV) to EBITDA
ratio.

•Enterprise value is equal to the market value of the firm’s equity plus
the market value of the firm’s debt minus cash.

•EBITDA stands for earnings before interest, taxes, depreciation, and

amortization.
6-45
 Enterprise Value Ratios, Example
• Kourtney’s Kayaks has equity worth $800 million, debt worth $300 million,
and cash of $100 million.
• The enterprise value is $1 billion (= 800 + 300 - 100).
• Suppose Kourtney’s Kayaks’ income statement is:

Any income
statement item
below EBITDA is
not included in the
EV to EBITDA ratio.

• The EV to EBITDA ratio is 5 (= $1 billion / $200 million).

6-46
Using Enterprise Value Ratio to Estimate Stock Price

• Analysts often assume that similar firms have similar EV/EBITDA ratios (and similar
PE ratio, too).

• Suppose the average EB/EBITDA ratio in an industry is 6.

• Qwerty Corporation, a firm in the industry, has EBITDA of $50 million.

• If Qwerty Corporation is judged to be similar to the rest of the industry, its

enterprise value is estimated at $300 million (= 6 × $50 million).

• If Qwerty Corporation has $75 million of debt and $25 million of cash, the EV
estimate provides an estimate of it stock value, $250 million (= $300 - $75 + $25).

Consult the textbook: There are four important questions

concerning enterprise value ratios.
6-47
 An Analysis of the
Procter and Gamble Company

The next few slides contain a financial analysis of

Procter & Gamble, using data from the Value Line
Investment Survey.

6-48
The Procter & Gamble Company Analysis, I.

6-49
The Procter & Gamble Company Analysis, II.

6-50
 The Procter & Gamble Company Analysis, III.

• Based on the CAPM, k = 4.0% + (0.6  7%) = 8.2%

• Retention ratio = 1 – $2.15/$4.00 = .46

• Sustainable g = .46  17% = 7.82% Value Line reports a

projected ROE of 17%

• Using the constant dividend growth rate model, we get:

$2.15  1.0782  Stock price observed at

P0   $610.03 the time we made this
.082  .0782 calculation: $67.21.

6-51
 The Procter & Gamble Company Analysis
(Using the Residual Income Model, I.)

• Let’s assume that “today” is January 1, 2012, g =11.5%, and k = 8.2%.

• Using the Value Line Investment Survey (VL), we can fill in column two (VL) of the table.

• We use column one and our growth assumption for column three (CSR) of the table.

End of 2012 2013 (VL) 2013 (CSR)

Beginning BV per share NA $25.80 $25.80

EPS $4.00 $4.35 $4.46
DIV $2.15 $2.33 $1.493
Ending BV per share $25.80 $27.65 $28.767

4.00  1.115 25.80  1.115

" Plug"  4.46 - (28.767 - 25.80)
6-52
 The Proctor and Company Analysis
(Using the Residual Income Model, II.)
EPS0  (1  g)  B 0  k
P0  B0 
k g
• Using the CSR assumption:
$4.46  $25.80  .082
Stock price at the time, about $51.82. P0  $25.80 
.082  .115
What can we say?
P0  $45.24.

EPS0  (1  g)  B 0  k
• Using Value Line numbers: P0  B0 
k g

Note: The growth $4.35  ($27.55 - 25.80)

P0  $25.80 
rate is higher than .082  .115

the discount rate, P0  $49.96

causing a negative
stock value.
6-53
The Procter & Gamble Company Analysis, IV.

6-54
 Useful Internet Sites
• www.nyssa.org (The New York Society of Security Analysts)
• www.aaii.com (The American Association of Individual Investors)
• www.cfainstitute.org (the web site of the CFA Institute)
• www.valueline.com (the home of the Value Line Investment Survey)
• jmdinvestments.blogspot.com (reference for recent financial news)

Websites for some companies analyzed in this chapter:

• www.aep.com
• www.dteenergy.com
• www.americanexpress.com
• www.pepsico.com
• www.sbux.com
• www.gm.com
• www.intel.com
• www.disney.go.com
• www.pg.com
6-55
 Chapter Review, I.

• Security Analysis: Be Careful Out There

• The Dividend Discount Model

― Constant Dividend Growth Rate Model
― Constant Perpetual Growth
― Applications of the Constant Perpetual Growth Model
― The Sustainable Growth Rate

• The Two-Stage Dividend Growth Model

― Discount Rates for Dividend Discount Models
― Observations on Dividend Discount Models
6-56
 Chapter Review, II.

• Residual Income Model (RIM)

• Free Cash Flow Model

• Price Ratio Analysis

―Price-Earnings Ratios
―Price-Cash Flow Ratios
―Price-Sales Ratios
―Price-Book Ratios
―Applications of Price Ratio Analysis

• An Analysis of the Procter & Gamble Company

6-57