Chapter 5: Stock and equity valuation

In finance, valuation is the process of estimating what something is worth. Items that are usually valued
are a financial asset or liability. Valuations can be done on assets (for example, investments in
marketable securities such as stocks, options, business enterprises, or intangible assets such as patents
and trademarks) or on liabilities.
Investors who are considering multiple investments or outlining an investment strategy may request
equity valuations of a company, to make the most informed investment decision. Valuation methods
based on the equity of a company typically include a thorough analysis of cash accounts, as well as a
forecast or projection of future dividends, future earnings (revenue) and the distribution of dividends.
The total equity of a company is the sum of both tangible assets and intangible qualities. Tangible assets
include working capital, cash, inventory, and shareholder equity. Intangible qualities, or intangible
"assets," may include brand potential, trademarks and stock valuations.
There are different methods/techniques of equity valuation. The majors are:
1. Balance Sheet Valuation
2. Dividend discount model
3. Free cash flow model
4. Earning Multiplier Approach

5.1 Balance Sheet Valuation

In balance sheet valuation approach, there are four measures derived from it. These are; book value,
liquidation, replacement cost, and Tobin’s Q ratio.
Book Value Method: it is Net worth (Equity share capital plus reserve and surplus) of a company
divided by total number of outstanding equity shares. Thus this form of valuation is based on the books
of a business, where owners' equity, is determined by a simple equation of total assets minus total
liabilities and this is used to set a price. The company whose stocks sell for less than book value are
generally considered to be undervalued, or having less risk than companies selling for greater than book
value. Because most companies sell for much more than book value, a company selling for less than book
value may well have considerable upside potential. But the basic limitation of this value is that the book
value doesn’t reflect the true current economic value of the share. It also doesn’t consider the future
earnings potential of the company.
Liquidation Value Method: This approach is similar to the book valuation method, except that the
liquidation values of assets are used instead of the book value of the assets. Using this approach, the
liabilities of the business are deducted from the liquidation value of the assets to determine the
liquidation value of the business.
In simple words, the liquidation value of a company is equal to what remains after all assets have been
sold and all liabilities have been paid. Liquidation value of an equity share is calculated by dividing
liquidation value of the business by total no. of outstanding equity shares.
Replacement Cost Method: is one of the interesting in valuing a firm is the replacement cost of its
assets less its liabilities. Some analysts believe the market value of the firm cannot get too far above its
replacement cost because, if it did, competitors would try to replicate the firm. The competitive pressure
of other similar firms entering the same industry would drive down the market value of all firms until
they came into equality with replacement cost.

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Tobin’s Q: This idea is popular among economists, and the ratio of market price to replacement cost is
known as Tobin’s Q, after the Nobel Prize winning economist James Tobin. Tobin's Q Ratio is the
market value of a company's assets divided by their replacement value. Replacement value is being the
current cost of replacing the firm’s assets. In other words, the ratio of all the combined stock market
valuations to the combined replacement costs should be around one. The formula is the following:
For an individual company, the Q ratio is equal to the market price of the firm divided by its replacement
cost.
Tobin's Q Ratio = Market Capitalization / Average Total Assets
or
Q Ratio = Market Price of Firm
Replacement Cost
If individuals or companies want to enter a business, certainly it would be an important consideration
whether they could buy a business for less than what it would take to replicate the company by starting
from scratch, especially since bought out established company has revenue generation since day one.
If the Q ratio is significantly less than 1, then it would be cheaper for potential competitors to buy the
firm rather than start a new business, so this would tend to increase its market price. If it is sold for
significantly more than the Q ratio of 1, then competitors would enter the market, and drive down the
price of the firm until it is approximately equal to 1.
As the replacement cost of a company would be difficult to ascertain quickly, the Q ratio cannot be a
driving force in determining daily stock prices for companies. However, it could be an indicator for long-
term trends and as a potential takeover target if the company’s Q ratio is less than 1.
5.2 Dividend discount model
The most theoretically sound stock valuation method, called income valuation or the discounted cash
flow (DCF) method, involves discounting of the profits (dividends, earnings, or cash flows) the stock will
bring to the stockholder in the foreseeable future, and a final value on disposal.
Dividend valuation model is conceptually a very sound approach. According to this approach the value of
an equity share is equal to the present value of dividends expected from its ownership plus the present
value of the sale price expected when the equity share is sold.
Financial theory states that the value of a stock is the worth all of the future cash flows expected to be
generated by the firm discounted by an appropriate risk-adjusted rate. We can use dividends as a measure
of the cash flows returned to the shareholder. There are several dividend discount models (DDMs) from
all the stable model and the two-stage model are the major one.
5.2.1. Inputs into the DDM
Several inputs are required to estimate the value of an equity using the DDM.
 D1 = Dividends expected to be received in one year.
 g = Growth rate in dividends
 K = the required rate of return for the investment. The required rate of return can be estimated
using the following formula:
K= Risk-free rate + (Market risk premium x Beta).
The rate on treasury bills can be used to determine the risk-free rate. The market risk premium is the
expected return of the market in excess of the risk-free rate. Beta can be thought of as the sensitivity of
the stock compared with the market.
5.2.2. Stable Model /Constant growth DDM

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The stable model is best suited for firms experiencing long-term stable growth. Generally, stable firms
are assumed to grow at the rate equal to the long-term nominal growth rate of the economy (inflation plus
real growth in GDP). In other words, the model assumes it is impossible to grow at 30% forever;
otherwise, the company would be larger than the economy.
Value of stock = D1 / K-g
If the growth rate of the firm exceeded the required rate of return, you could not calculate the value of the
stock. This is because if g > K, the result would be negative, and stocks do not have a negative value.
Another caution is that models are often very sensitive to the assumptions made regarding growth rates,
time frame, or the required rate of return.
Finally, the dividend discount model generally understates the intrinsic value of the firm. Important
considerations such as the value of patents, brand name, and other intangible assets should be used in
conjunction with the DDM to assess the value of a firm's equity. These intangibles should be added to the
result of a DDM calculation to arrive at a more appropriate valuation.
To make the DDM practical, we need to introduce some simplifying assumptions. A useful and common
first pass at the problem is to assume that dividends are trending upward at a stable growth rate that we
will call g. Then if g = 0.05, and the most recently paid dividend was D0 = 3.81, expected future
dividends are:
D1 = D0(1+g) = 3.81 x1.05 = 4.00
D2 = D0(1+g)2 = 3.81 x (1.05)2 = 4.20
D3 = D0(1+g)3 = 3.81 x (1.05)3 = 4.41 etc
Using these dividend forecasts in Equation, we solve for intrinsic value as:

This equation can be simplified to:

Note: we divide D1 (but not D0) by k - g to calculate intrinsic value. If the market capitalization rate for
Steady State is 12%, we can use the above equation to show that the intrinsic value of a share of Steady
State stock is:
V0 =
The above equation is called the constant growth DDM or the Gordon model, after Myron J. Gordon,
who popularized the model. It should remind you of the formula for the present value of perpetuity. If
dividends were expected not to grow, then the dividend stream would be a simple perpetuity, and the
valuation formula for such a non growth stock would be V0 = D1/k. As g increases, the stock price also
rises.
The constant growth DDM is valid only when g is less than k. If dividends were expected to grow forever
at a rate faster than k, the value of the stock would be infinite. If an analyst derives an estimate of g that is
greater than k, that growth rate must be unsustainable in the long run. The appropriate valuation model to
use in this case is a multistage DDM. The constant growth DDM is so widely used by stock market
analysts that it is worth exploring some of its implications and limitations. The constant growth rate
DDM implies that a stock’s value will be greater:
(i) The larger its expected dividend per share.
(ii) The lower the market capitalization rate, k.
(iii)The higher the expected growth rate of dividends.
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Another implication of the constant growth model is that the stock price is expected to grow at the same
rate as dividends. To see this, suppose Steady State stock is selling at its intrinsic value of $57.14, so that
V0 = P0. Then:

Note that price is proportional to dividends. Therefore, next year, when the dividends paid to Steady State
stockholders are expected to be higher by g = 5%, price also should increase by 5%. To confirm this, note
D2 = $4(1.05) = $4.20
P1 = D2/(k - g) = $4.20/(0.12 - 0.05) = $60.00
Note, $60.00 is 5% higher than the current price of $57.14.
To generalize:

P1 = P0(1 + g)
Therefore, the DDM implies that, in the case of constant expected growth of dividends, the expected rate
of price appreciation in any year will equal that constant growth rate, g. Note that for a stock whose
market price equals its intrinsic value (V0 = P0) the expected holding period return will be
E(r) = Dividend yield + Capital gains yield

This formula offers a means to infer the market capitalization rate of a stock, for if the stock is selling at
its intrinsic value, then E(r) = k, implying that k = D1/P0 + g. By observing the dividend yield, D1/P0,
and estimating the growth rate of dividends, we can compute k. This equation is known also as the
discounted cash flow (DCF) formula. This is an approach often used in rate hearings for regulated public
utilities. The regulatory agency responsible for approving utility pricing decisions is mandated to allow
the firms to charge just enough to cover costs plus a “fair” profit, that is, one that allows a competitive
return on the investment the firm has made in its productive capacity. In turn, that return is taken to be
the expected return investors require on the stock of the firm. The D1/P0 + g formula provides a means to
infer that required return.
5.2.3 The Two-Stage Model
The two-stage model attempts to cross the chasm from theory to reality. The two-stage model assumes
that the company will experience a period of high-growth followed by a decline to a stable growth
period.
The first issue to deal with when using the two-stage model is to estimate how long the high growth
period should last. Should it be 5 years, 10 years, or maybe longer?
The next requirement is that the model makes an unexpected transition from high growth to slow growth.
In other words, the model assumes that the firm may be growing at 9% for five years only to then grow at
6% (stable growth) until eternity. Is this realistic? Probably not. Most firms experience a gradual decline
in growth rates as their business matures (hence, using a three-stage dividend discount model may be
more appropriate).
Finally, just like the stable growth model, the two-stage dividend discount model is very sensitive to the
inputs used to determine the value of the equity.
Example: Assume that the first growth rate is 9% and pertains to the next five year and the second
growth rate is 6% for all years following with the current dividend of $1.30 and K=12.39%.
D0 = $1.30
K = 12.39%
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 g1 = 9%
g2 =6%

D1 = $1.30 * 1.09 = $1.42

D2 = $1.42 * 1.09 = $1.54
D3 = $1.54 * 1.09 = $1.68
D4 = $1.68 * 1.09 = $1.84
D5 = $1.84 * 1.09 = $2.00
Now, we must discount the dividends by the appropriate rate to determine their present value.
P1 = $1.42 / (1.1239) = $1.26
P2 = $1.54 / (1.1239)2 = $1.22
P3 = $1.68 / (1.1239)3 = $1.19
P4 = $1.84 / (1.1239)4 = $1.15
P5 = $2.00 / (1.1239)5 = $1.12
$5.94.
Next, we value the stable growth period:
D0 = $2.00 (1.06) = $2.12
K = 12.8%
g2 = 6%
$2.12 / (0.128 - 0.06) = $31.18
Next, we must calculate the present value of the dividends.
$31.18 / (1.1239)5 = $17.39
When calculating the present value of the dividends of the stable growth period, we use the same
required rate of return as the high-growth phase and raise it to the fifth power for a five-year example like
the one above. Adding the two values, we get: $17.39 + $5.94 = $23.33. Again, our result is quite a bit
lower than the current market price.

5.2.4 Problems with dividend discounting model

Problems with dividend discount models include the difficult of forecasting dividends and potential
benefits of owning a share other than dividends.
Forecasting: One problem with dividend discount models is that long term forecasting is difficult, and
the valuation is very sensitive to the inputs used: the discount rate and any growth rates in particular. This
much is true for any DCF, but a dividend discount model adds an extra layer of difficulty to the forecasts
by requiring forecasts of dividends, which means anticipating the dividend policy a company will adopt.
As with other DCF models, the discount rate is most likely to be calculated using CAPM. It can be
argued that changes to the dividend policy do not matter, as the money belongs to shareholders however
it is used. However, in this case, one might as well use a free cash flow discount valuation.
Omissions: Dividend discounts also omit cash flows other than discounts, for example:
(i) the potential benefits from a takeover bid which gives shareholders a one-off cash flow which
usually comfortably exceeds the value of the dividend stream that would be expected without the
takeover, and,
(ii) Other benefits that may be gained through having a say in the running of a company.
This is well illustrated by the price differences between shares of different classes entitled to the same
dividends but with different voting rights.

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 5.2 Free cash flow model
An alternative approach to the dividend discount model values the firm using free cash flow, that is, cash
flow available to the firm or its equity holders net of capital expenditures. This approach is particularly
useful for firms that pay no dividends, for which the dividend discount model would be difficult to
implement. But free cash flow models may be applied to any firm and can provide useful insights about
firm value beyond the DDM.
One approach is to discount the free cash flow for the firm (FCFF) at the weighted-average cost of capital
to obtain the value of the firm, and subtract the then-existing value of debt to find the value of equity.
Another is to focus from the start on the free cash flow to equity holders (FCFE), discounting those
directly at the cost of equity to obtain the market value of equity.
The free cash flow to the firm is the after-tax cash flow that accrues from the firm’s operations, net of
investments in capital and net working capital. It includes cash flows available to both debt- and equity
holders.
It is given as follows:
FCFF = EBIT (1-t) + Depreciation - Capital expenditures - Increase in NWC
where
EBIT = earnings before interest and taxes
t = tax rate
NWC = net working capital
Alternatively, we can focus on cash flow available to equity holders. This will differ from free cash flow
to the firm by after-tax interest expenditures, as well as by cash flow associated with net issuance or
repurchase of debt (i.e., principal repayments minus proceeds from issuance of new debt).
FCFE = FCFF – Interest expense x (1-t) + increase in net debt
Example:
Profit after tax 5775
Interest after tax 525.8
Change in net working 15
capital
Depreciation 3575
Capital expenditure 6570
Increase in net debt (1000)
FCFF 3290.8
FCFE 1765

5.3 Earning multiplier approach

As noted, many investors prefer to estimate the value of common stock using an earnings multiplier
model. The reasoning for this approach recalls the basic concept that the value of any investment is the
present value of future returns. In the case of common stocks, the returns that investors are entitled to
receive are the net earnings of the firm. Therefore, one way investors can estimate value is by
determining how many dollars they are willing to pay for a dollar of expected earnings (typically
represented by the estimated earnings during the following 12-month period). For example, if investors
are willing to pay 10 times expected earnings, they would value a stock they expect to earn $2 a share
during the following year at $20. You can compute the prevailing earnings multiplier, also referred to as
the price/earnings (P/E) ratio, as follows:
Earning multiplier = price / earning
= Current market price
Expected 12-Month earnings

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The infinite period dividend discount model can be used to indicate the variables that should determine
the value of the P/E ratio as follows:

If we divide both sides of the equation by E (expected earnings during the next 12 months), the result is
⁄

Thus, the P/E ratio is determined by

1. The expected dividend payout ratio (divided by earnings)
2. The estimated required rate of return on the stock (k)
3. The expected growth rate of dividends for the stock (g)
As an example, if we assume a stock has an expected dividend payout of 50 percent, a required rate of
return of 12 percent, and an expected growth rate for dividends of 8 percent, this would imply the
following:
D/ E = 0.50; k = 0.12; g = 0.08
P/E =
= 12.5
The spread between k and g is the main determinant of the size of the P/E ratio.

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