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Topics (Tentative): Pre-Readings (BD Chapters)
Financial Management
Stock Valuation
The price of a security should equal the present value of the
expected cash flows an investor will receive from owning it
To value a stock, we need to know the expected cash flows an
investor will receive and the appropriate cost of capital (or expected
return for the investor) with which to discount those cash flows
Both of these quantities can be challenging to estimate
Free Cash Flow
Free cash flow (FCF) measures the cash generated by the firm before
any payments to debt or equity holders are considered
FCF = EBIT (1 – Tax Rate) + Depreciation – Capex – ΔNWC
Enterprise value is the value of the firm’s underlying business
Enterprise Value = Equity + Debt – Cash
To estimate a firm’s enterprise value, compute present value of FCF
Enterprise Value, V = PV (Future FCF of the firm)
Topic 1: Type of Firms (BD: Chapter 1)
Topic 2: Time Value of Money (BD: Chapters 3-5)
Topic 5: Valuing Stocks
Topic 3: Valuation of Bonds (BD: Chapter 6)
BM: Chapter 9
Dividend Discount Model Topic 4: Capital Budgeting (BD: Chapters 7 and 8)
Total Payout Model Topic 5: Valuation of Stocks (BD: Chapter 9)
Free Cash Flow Valuation Models
Valuation Based on Comparable Firms Topic 6: Risk and Return (BD: Chapters 10-13)
Efficient Markets Topic 7: Capital Structure (BD: Chapters 14-16)
Topic 8: Valuations (BD: Chapters 2, 18-19)
Topic 9: Long-Term Financing (BD: Chapters 23 and 24)
Topic 10: Short-Term Financing (BD: Chapters 26 and 27)
Stock Valuation
Discounted free cash flows generated by the firm
Dividend Discount Model: Dividends and capital gains received by
investors who hold the stock for different periods
Using valuation multiples based on comparable firms
Discounted Free Cash Flow Valuation
This model focuses on the cash flows to all of the firm’s investors
(both debt and equity holders) and therefore determines total value
of the firm
To discount the FCF that will be paid to both debt and equity
holders, use firm’s weighted average cost of capital (WACC)
WACC is the total cost the firm must pay to all of its investors
WACC could be interpreted as an indicator of the average risk of all
of the firm’s investments
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Discounted Free Cash Flow Valuation Terminal Value - Example

The required terminal value is estimated by assuming a constant Let us say we expect free cash flow to grow at a constant rate after
long-run growth rate, for free cash flow beyond year N, so that 2025, we can compute terminal enterprise value:
𝐹𝐶𝐹 𝐹𝐶𝐹 1+𝑔
𝑉 = 𝑉 =
𝑟 −𝑔 𝑟 −𝑔
The long-run growth rate is typically based on the expected long-run
growth rate of the firm’s revenues

Discounted Free Cash Flow Valuation Discounted Free Cash Flow Valuation
Given the enterprise value, value of share is You expect CCM Corporation to generate the following free cash
𝑉 − (𝐷𝑒𝑏𝑡 − 𝐶𝑎𝑠ℎ) flows over the next five years:
𝑃 =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 Year 1 2 3 4 5
FCF ($ millions) 25 28 32 37 40

Following year five, you estimate that CCM's free cash flows will
grow at 5 percent per year and that CCM's weighted average cost of
capital is 13 percent

Discounted Free Cash Flow Valuation Discounted Free Cash Flow Valuation
Value of the Enterprise, 𝑉 Suppose CCM has $200 million of debt and 8 million shares of stock
outstanding
= + + + +
Equity value

Value of the Enterprise, 𝑉 = $396 - $200 (debt)

. . = $196 million/8 million shares

= + + + +
. . . . .
= $24.50
= $395.58 Million

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Dividend Discount Model Dividend Discount Model

Consider an investor with a one-year investment horizon Future dividend payment (D1) and stock price (P1) are not known
with certainty, as they are based on the investor’s expectations at
When an investor buys a stock, he will pay the current market price the time the stock is purchased
for a share, 𝑃
0 1
There are two potential sources of cash flows from owning a stock -P0 D1 + P1

First, the firm might pay dividends
• Let 𝐷 be the total dividends paid per share of the stock during the year
Second, the investor may sell the share at the end of the year, at the
market price of 𝑃
Because these cash flows (D1 and P1) are risky, they cannot be
discounted using risk-free interest rate
Equity cost of capital (𝑟 ), which is the expected return of other
investments available in the market with equivalent risk to the firm’s
shares, is the appropriate discount rate to be used

Dividend Discount Model Dividend Discount Model - Example

Value of the share should be, 𝑃 = Suppose you expect Walgreen Company to pay dividend of $1.4 per
share and trade for $80 per share at the end of the year
Rearranging above equation, we get, total return
Investments with equivalent risk to Walgreen’s stock have an
𝐷 𝑃 𝐷 𝑃 −𝑃 expected return of 8.5 percent
𝑟 = + −1 ⇒𝑟 = +
𝑃 𝑃 𝑃 𝑃
The most you would pay today for Walgreen’s stock
Dividend Yield Capital Gain Yield
𝐷 +𝑃 1.4 + 80
𝑃 = = = $75.02
Total return (𝑟 ) is the expected return that the investor will earn for 1+𝑟 1.085
a one-year investment in the stock
It is the sum of the dividend yield and the capital gain

Dividend Discount Model - Example Dividend Discount Model

At this price, Walgreen’s dividend yield is
.
Capital gain yield = = 6.63 percent
.
Therefore, at this price, Walgreen’s expected total return is
1.87 + 6.63 = 8.5 percent
=
.
= 1.87 percent The firm must pay its shareholders a return commensurate with the
. return they can earn elsewhere while taking the same risk
If the stock offered a higher return than other securities with the
same risk, investors would sell those other investments and buy the
stock instead
The activity would drive up the stock’s current price, lowering its
dividend yield and capital gain yield
If the stock offered a lower expected return, investors would sell the
stock and drive down its current price

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Dividend Discount Model Dividend Discount Model

Suppose investor plans to hold the stock for two years We can continue this process for any number of years by replacing
the final stock price with the value that the next holder of the stock
Investor expects to receive dividends in both year 1 and year 2 would be willing to pay
Doing so leads to the general dividend-discount model for the stock
0 1 2 price, where the horizon is N
P0 D1 D2 + P2 𝐷 𝐷 𝐷 +𝑃
𝑃 = + + ⋯+
1+𝑟 1+𝑟 1+𝑟
𝐷 𝐷 +𝑃
𝑃 = + This equation applies to a single N-year investor, who will collect
1+𝑟 1+𝑟 dividends for N years and then sell the stock or to a series of
investors who hold the stock for shorter periods and then resell it

Dividend Discount Model Dividend Discount Model: Constant Dividend Growth

If an investor holds the shares forever, N → ∞ Assumption: In the long run, dividends will grow at a constant rate, g
𝐷 𝐷
𝑃 = + +⋯∞ 0 1 2 3
1+𝑟 1+𝑟 P0 D1 D1 (1 + g) D1 (1 + g)2

That is, the price of the stock is equal to the present value of the
expected future dividends it will pay 𝐷
𝑃 =
𝑟 −𝑔
However, estimating these dividends is difficult – especially for the
distant future

Dividend Discount Model - Example Dividend Discount Model

Consolidated Edison Inc is a regulated utility company that services Rearranging 𝑃 = , we can write, 𝑟 = +𝑔
the New York City area
It plans to pay $2.60 per share in dividends in the coming year The firm’s share price increases with the current dividend yield, 𝐷
and the expected growth rate, g
Equity cost of capital is 6 percent
To maximize its share price, a firm would like to increase both these
Dividends are expected to grow by 2 percent per year in the future quantities
. Increasing growth may require investment, and money spent on
Value of stock, 𝑃 = = = $65
. . investment cannot be used to pay dividends

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Dividend Discount Model
What determines the rate of growth of a firm’s dividend?
A firm can pay earnings to investors or reinvest them
Dividend paid each year is the firm’s earnings per share (EPS)
multiplied by its dividend payout rate
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠
𝐷= × 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡𝑒
𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
Where, dividend payout ratio is the fraction of firm earnings that the
firm pays as dividends each year
Dividend Discount Model
Suppose that the firm does not issue new shares (or buy back its
existing shares), so that the number of shares outstanding is fixed
By investing today, a firm can increase its future earnings and
dividends
Assuming, the firm does not grow if no new investment is made, the
level of earnings generated by the firm will remain constant
Dividend Discount Model
Crane Sporting Goods expects to have earnings per share of $6 in the
coming year
Firm plans to pay out all of its earnings as a dividend
With these expectations of no growth, current share price is $60
Crane’s equity cost of capital?
Currently, Crane plans to pay a dividend equal to its earnings of $6
per share
With no expected growth (g = 0), 𝑟 = + 𝑔 = 10 percent
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Dividend Discount Model
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠
𝐷= × 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡𝑒
𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
Thus, a firm can increase its dividend in three ways:
(1) Increase its earnings (net income)
(2) Increase its dividend payout rate
(3) Decrease its shares outstanding (repurchase or buy back shares)
Dividend Discount Model
If all increases in future earnings result exclusively from new
investment made with retained earnings then
Change in Earnings
= New Investment × Return on New Investment
= (Earnings × Retention Rate) × Return on New Investment
Change in Earnings/Earnings = Earnings Growth Rate
= Retention Rate × Return on New Investment
If the firm chooses to keep its dividend payment rate constant, then
the growth in dividends (g) will equal growth of earnings
g = Retention Rate × Return on New Investment
Dividend Discount Model
Suppose Crane plans to cut dividend payout rate to 75 percent for
the foreseeable future and use retained earnings to open new stores
Return on its investment in these stores is expected to be 12 percent
Assuming its equity cost of capital is unchanged, what effect would
this new policy have on Crane’s stock price?
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Dividend Discount Model Dividend Discount Model

Dividend this coming year Suppose Crane Sporting Goods decides to cut its dividend payout
rate to 75 percent to invest in new stores as in the previous example
𝐷 = 𝐸𝑃𝑆 × 0.75 = $6 × 0.75 = $4.5
𝑔 = 0.25 × 12 = 0.03 But now suppose that the return on these new investments is 8
percent rather than 12 percent
Share price would change to
Expected earnings per share this year is $6
𝐷 4.5
𝑃 = = = $64.29
𝑟 −𝑔 0.10 − 0.03 Equity cost of capital is 10 percent
These projects are positive NPV and so by taking them Crane has Crane’s current share price?
created value for its shareholders

Dividend Discount Model Dividend Discount Model

Crane’s dividend will fall to $6 × 0.75 = $4.5 The effect of reducing the firm’s dividend to grow crucially depends
on the return on new investment
Its growth rate under the new policy, 𝑔 = 0.25 × 0.08 = 2 𝑝𝑒𝑟𝑐𝑒𝑛𝑡
In the first example, the return on new investment of 12 percent
.
New share price, 𝑃 = = = $56.25 exceeds the firm’s equity cost of capital of 10 percent so the
. .
investment has a positive NPV
Thus, even though Crane will grow under the new policy, the new
investments have negative NPV In the second example, the return on new investment is only 8
percent so the new investment has a negative NPV (even though it
Can earn 10 percent on other investments with comparable risk will lead to earnings growth)
Thus, reducing the firm’s dividend to increase investment will raise
the stock price if and only if the new investment has a positive NPV

Dividend Discount Model: Changing Growth Rates
Young firms often have very high initial earnings growth rates
During this period of high growth, firms often retain 100 percent of
their earnings to exploit profitable investment opportunities
As they mature, their growth slows to rates more typical of
established companies
At that point, their earnings exceed their investment needs and they
need to begin to pay dividends
Dividend Discount Model - Example
Small Fry has just invented a potato chip that looks and tastes like a
French fry
Given the phenomenal market response to this product, Small Fry is
reinvesting all of its earnings to expand its operations
Earnings were $2 per share this past year and are expected to grow
at a rate of 20 percent per until the end of year 4
At that point, other companies are likely to bring out competing
products

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Dividend Discount Model - Example Dividend Discount Model - Example

Analysts project at the end of year 4, Small Fry will cut investment Dividends = EPS × Dividend Payout
and begin paying 60 percent of its earnings as dividends
Its growth will slow to a long-run rate of 4 percent
If Small Fry’s equity cost of capital is 8 percent, what is the value of a
share today?

𝑃 = + + + + + +⋯
. . ( . ) . .
𝑃 = 0+0+0+ + + +⋯
. . .

Dividend Discount Model - Example Dividend Discount Model - Limitations

𝑃 =0+0+0+
.
+
. ( . )
+
. .
+⋯ The dividend-discount model values the stock based on a forecast of
. . . the future dividends paid to shareholders

. Forecasting dividends requires forecasting the firm’s earnings,

𝑃 = = $62.25 dividend payout rate, and future share count
. .

.
Because financing and repurchase decisions are at management’s
𝑃 = = $49.42 discretion, they can be difficult to forecast reliability
.

Dividend Discount Model - Limitations Dividend Discount Model - Limitations

Year Infosys Wipro HUL ITC Reliance IOC Year Infosys Wipro HUL ITC Reliance IOC
2002 2002 14.5 1.0 16.9 5.6 .
2003 2003 15.1 4.0 20.0 . 16.0
2004 2004 13.1 5.7 0.0 35.7 8.6 10.1
2005 2005 45.3 5.1 5.0 2.7 10.0 .
2006 2006 . 6.1 6.0 3.1 9.9 19.0
2007 2007 0.9 . . 3.5 11.2 5.5
2008 2008 0.5 4.0 7.5 3.7 13.7 7.5
2009 2009 0.5 6.0 6.5 4.5 7.0 13.0
2010 2010 0.7 . 6.5 2.8 8.0 9.5
2011 2011 0.7 . 7.5 4.5 8.5 5.0
2012 2012 0.8 . 10.5 5.3 8.9 6.2
2013 2013 1.2 . 13.0 6.0 9.5 8.7
2014 2014 0.6 12.0 15.0 6.3 10.0 6.6
2015 2015 0.4 . 16.0 6.5 10.5 14.0
2016 2016 0.5 . 17.0 4.8 11.0 19.5

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Total Payout Model Total Payout Model

Dividend-discount model assumes any cash paid out by the firm to
shareholders takes the form of a dividend
Firm may use excess cash to buy back its own stock in which case it
will have less cash available to pay dividends
Dividend-discount model values a share from the perspective of a
single shareholder, discounting the dividends the shareholders will
receive
𝑃 = 𝑃𝑉(𝐹𝑢𝑡𝑢𝑟𝑒 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒)

By repurchasing shares, the firm decreases its share count, which Total-payout model values all of the firm’s equity, discounting the
increases its earnings and dividends on a per-share basis total payouts (dividends and repurchase) that the firm makes to
shareholders
Total payout model considers both dividend payout and share 𝑃𝑉 𝐹𝑢𝑡𝑢𝑟𝑒 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑎𝑛𝑑 𝑅𝑒𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠
repurchase 𝑃 =
𝑁𝑜 𝑜𝑓 𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

Total Payout Model - Example Total Payout Model - Example

Titan Industries has 217 million shares outstanding Total payout for this year
50 percent × $860 million = $430 million
It expects earnings at the end of this year to be $860 million
Present value of Titan’s future payouts, which represents the total
Titan plans to pay out 50 percent of its earnings in total, paying 30
value of Titan’s equity (i.e., its market capitalization) is
percent as a dividend and using 20 percent to repurchase shares
𝑃𝑉 𝐹𝑢𝑡𝑢𝑟𝑒 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑎𝑛𝑑 𝑅𝑒𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠
Titan’s earnings are expected to grow by 7.5 percent per year and
these payout rates are expected to remain constant = = $17.2 billion
. .
Equity cost of capital is 10 percent $ .
Share price, 𝑃 = = $79.26 per share
Determine Titan’s share price

Total Payout Model - Example Total Payout Model - Example

https://economictimes.indiatimes.com/markets/stocks/news/nalco-
board-approves-rs-749-cr-share-buyback-
plan/articleshow/80480722.cms
State-owned National Aluminium Company Ltd approved buyback of
13.02 crore shares for about Rs 749.10 crore at a price of Rs 57.50
per equity share (Rs 51.10)
https://economictimes.indiatimes.com/markets/stocks/news/tcs-
buyback-offer-tata-sons-tenders-shares-worth-
9997cr/articleshow/80140197.cms
Tata Sons tendered shares worth nearly Rs 10,000 crore in the Rs
16,000-crore buyback offer of Tata Consultancy Services (TCS)

https://economictimes.indiatimes.com/markets/stocks/news/gail-
announces-rs-1046-35-cr-share-buyback/articleshow/80284336.cms
State-run gas utility GAIL will spend up to Rs 1,046 crore to buy back
1.55% of its total shares at a rate of Rs 150/share (8% premium to
Friday’s price of Rs 139)
Life Insurance Corporation of India (LIC) tendered around 16.69 lakh
shares of TCS
TCS offered Rs 3,000 per share in the buyback

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Different Valuation Methods
In the dividend-discount model, value of the stock is determined by
the present value of its future dividends
In the total-payout model, total market capitalization of the firm’s
equity is obtained from the present value of the firm’s total payouts,
which includes dividends and share repurchases
Discounted FCF model determines the firm’s enterprise value, by
calculating the present value of the firm’s FCF (cash available to
make payments to equity or debt holders)
Valuation Based on Comparable Firms
Estimate the value of the firm based on the value of other,
comparable firms or investments that we expect will generate very
similar cash flows in the future
For example, to determine the value of the new firm we can use the
value of the existing company , if the two firms will generate
identical cash flows
Valuation Based on Comparable Firms
P/E Ratio: Share price divided by its earnings per share
When you buy a stock, you are buying the rights to the firm’s future
earnings
Investor are willing to pay proportionally more for a stock with
higher current earnings
Value of a firm’s share could be estimated by multiplying its current
earnings per share by the average P/E ratio of comparable firms
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Different Valuation Methods
Valuation Based on Comparable Firms
Difficult to find “identical” companies
Although they may be similar in many respects even two firms in the
same industry selling the same types of products are likely to be of a
different size or scale
Need to adjust for scale differences to use comparable to value firms
with similar business, by expressing their value in terms of a
valuation multiple such as
• Price-Earnings Ratio
• Enterprise Value Multiples
Valuation Based on Comparable Firms
Forward P/E: Computed based on its forecast earnings (expected
earnings over the next twelve months)
Trailing P/E: Compute using trailing earnings (earnings over the prior
12 months)
For valuation purposes, the forward P/E is generally preferred, as we
are most concerned about future earnings
Firms and industries with high growth rates and that generate cash
well in excess of their investment needs so that they can maintain
high payout rates should have high P/E multiples
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Valuation Based on Comparable Firms Valuation Based on Comparable Firms

Suppose furniture manufacturer Herman Miller Inc has earnings per What are the assumptions underlying this estimate?
share of $1.38
This estimate assumes that Herman Miller will have similar future
Average P/E of comparable furniture stocks is 21.3 risk, payout rates, and growth rates to comparable firms in the
industry
Estimate a value for Herman Miller using the P/E as a valuation
multiple 𝑃 𝑃
=
𝐸 𝐸
𝑃 𝑃 𝑃 𝑃
= ⇒ =
𝐸 𝐸 𝐸 𝐸

Share price for Herman Miller, 𝑃 = $1.38 × 21.3 = $29.39

Valuation Based on Comparable Firms Valuation Based on Comparable Firms

Enterprise value represents the total value of the firm’s underlying Capital expenditure can vary substantially from period to period
business rather than just the value of equity
For example, a firm may need to add capacity and build a new plant
Using the enterprise value is advantageous if we want to compare one year, but then not need to expand further for many years
firms with different amounts of leverage
Therefore, most practitioners rely on enterprise value to EBITDA
We divide enterprise value by a measure of earnings or cash flows multiples
before interest payments are made
Common multiples to consider are enterprise value to EBIT, EBITDA,
and free cash flow

Valuation Based on Comparable Firms Valuation Based on Comparable Firms

If expected free cash flow growth is constant, then Rocky Shoes and Boots (RCKY) has earnings per share of $2.30 and
𝐹𝐶𝐹 EBITDA of $30.7 million
𝑉 𝑟 −𝑔
= RCKY has 5.4 million shares outstanding and debt of $125 million
𝐸𝐵𝐼𝑇𝐷𝐴 𝐸𝐵𝐼𝑇𝐷𝐴 (net of cash)
As with the P/E multiple, this multiple is higher for firms with high Deckers Outdoor Corporation is comparable to RCKY in terms of its
growth rates and low capital requirements (so that free cash flow is underlying business, but Deckers has little debt
high in proportion to EBITDA)
Deckers has a P/E ratio of 13.3 and an enterprise value to EBITDA
multiple of 7.4
Estimate the value of RCKY’s shares using both multiples

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Valuation Based on Comparable Firms Financing a Firm with Equity

Using Decker’s P/E, share price for RCKY is
𝑃 = $2.30 × 13.3 = $30.59
Using enterprise value to EBITDA multiple, RCKY’s enterprise value is Shareholders’ return:
𝑉 = $30.7 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 × 7.4 = $227.2 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 Either 40 or -10 percent
.
RCKY’s share price, 𝑃 = = $18.93
.

Because of large difference in leverage between the firms, estimate

based on enterprise value is expected to be more reliable
Expected Return
0.5 (40) + 0.5 (-10) = 15 percent
Standard Deviation of Returns
 
0.5 (40−15)2 + 0.5 (−10−15)2 = 25 percent
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Financing a Firm with Equity and Debt Valuation Based on Comparable Firms
Many other valuation multiples are possible
For firms with substantial tangible assets, the ratio of price to book
value of equity per share is sometimes used
Some multiples are specific to an industry
• In the cable TV industry, for example, enterprise value per subscriber may
be reasonable

Expected Return Standard Deviation of Returns

 
0.5 (75) + 0.5 (-25) = 25 percent 0.5 (75−25)2 + 0.5 (−25−25)2 = 45.28 percent

63

Valuation Based on Comparable Firms: Limitations
If comparable firms were identical, their multiples would match
precisely
Differences in the multiples are most likely due to differences in their
expected future growth rates, profitability, and risk (cost of capital)
When valuing a firm using multiples, there is no clear guidance
about how to adjust for these differences
Usefulness of a valuation multiple will depend on the nature of the
differences between firms and the sensitivity of the multiples to
these differences
Valuation Based on Comparable Firms: Limitations
This method provide information regarding the value of the firm
relative to the other firms in the comparison set
Rely on the market’s assessment of the value of other firms with
similar future prospects
Using multiples will not help us determine enterprise value, if an
entire industry, for example, is overvalued

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Valuation Based on Comparable Firms: Limitations
Internet boom of the late 1990s
Because many of these firms did not have positive cash flows or
earnings, new multiples were created to value them (e.g., price to
“page views”)
Difficult to justify the stock prices of many of these firms using a
realistic estimate of cash flows and the discounted free cash flow
approach
Discounted Cash Flow versus Multiples
Discounted cash flow method allows us to incorporate specific
information about the firm’s profitability, cost of capital, or future
growth potential, as well as perform sensitivity analysis
Because the true driver of value for any firm is its ability to generate
cash flows for its investors
More accurate and insightful than the use of valuation multiple
Valuing a Stock
Recent financial statements
Trends in the industry
Forecast firm’s future earnings, dividends, and free cash flows
The way we use a valuation model will depend on the quality of
information
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Different Valuation Methods
Range of Valuation Methods for KCP Stock Using Alternative
Valuation Methods (consider different parameters such as cost of
capital)
Information in Stock Prices
Firm’s expected future cash flows, its cost of capital (determined by
its risk), and the value of its shares– linked
Actual market price of a stock and our estimated value – consistent?
Stock is mispriced or we made a mistake in our risk and future cash
flow estimates?
Efficient Markets
Markets aggregate the information of many investors, and that this
information is reflected in security prices
When a buyer seeks to buy a stock, the willingness of other parties
to sell the same stock suggests that they value the stock differently
Investors with information that buying a stock had a positive NPV
would choose to buy the stock, driving up the stock’s price
Investors with information that selling a stock had a positive NPV
would sell it and the stock’s price would fall
Thus, the information that others are willing to trade should lead
buyers and sellers to revise their valuations
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Efficient Markets
Investors trade until they reach a consensus regarding the value of
the stock
In this way, stock markets aggregate the information and views of
many different investors
Efficient market hypothesis: Securities are fairly priced, based on
their future cash flows, given all information that is available to
investors
Private or Difficult to Interpret Information
This information is not available to all investors
For example, an analyst spends time and effort gathering
information from a firm’s employees, competitors, suppliers, or
customers, that is relevant to the firm’s future cash flows
Sometimes even when information is publicly available, it may be
difficult to interpret, for example,
• Some investors may find it difficult to evaluate research reports on new
technologies
• It may be difficult to fully understand the consequences of a highly
complicated business transaction
Private or Difficult to Interpret Information
If the profit opportunities from having this type of information are
large, other individuals will attempt to gain the expertise and devote
the resources needed to acquire it
As more individuals become better informed, competitions to exploit
this information will increase
Thus, in the long run, the degree of “inefficiency” in the market will
be limited by the costs of obtaining the information
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Public Information
Information that is available to all investors such as news reports,
financial statements, corporate press release, or in other public data
sources
Stock price react nearly instantaneously to such news
Most investors would find that the stock price already reflects the
new information before they were able to trade on it
Private or Difficult to Interpret Information
In these cases, while the fundamental information may be public,
the interpretation of how that information will affect the firm’s
future cash flows is itself private information
Some investors may be able to profit by trading on their information
However, as these informed traders begin to trade, they will tend to
move prices, so over time prices will begin to reflect their
information as well
Summary
Price of a security = PV (expected cash flows an investor will receive)
• Expected cash flows an investor will receive
• Appropriate cost of capital (to discount cash flows)
Discounted free cash flows method
• Enterprise value, equity value, share price
Dividend Discount Model
• Payout ratio, earnings growth, new investments, return on investments
Total Payout Method
• Dividends and repurchase of shares
Multiples based on comparable firms
• P/E, Enterprise value multiples (V/EBITDA)
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Summary
Information in Stock Prices
Efficient markets
Public information
Private or difficult to interpret information

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