Equity Valuation Models
CONTENTS
• Valuation by Comparables
• Limitations of Book Value
• Intrinsic Value versus
Market Price
• Dividend Discount Models
• The Constant-Growth DDM
• Convergence of Price
• Intrinsic Value
• Stock Prices and Investment
Opportunities
• Life Cycles and Multistage
Growth Models
• Multistage Growth Models
The Price–Earnings Ratio
• The Price–Earnings Ratio
and Growth Opportunities
• P/E Ratios and Stock Risk
• Pitfalls in P/E Analysis
• The Cyclically Adjusted P/E
Ratio
• Combining P/E Analysis and
the DDM
• Other Comparative
Valuation Ratios: Price-to-
Book Ratio, Price-to-Cash-
Flow Ratio, Price-to-Sales
Ratio, Be Creative
• Free Cash Flow Valuation
Approaches
• Comparing the Valuation
Models
• The Problem with DCF
Models
• The Aggregate Stock
Market/Forecasting P/E
ratio.
 Overview
• Fundamental analysts use information concerning the current and
prospective profitability of a company to assess its fair market value.

• Alternative measures of a company’s value

1. Dividend discount models
2. P/E ratios
3. Free cash flow models
 Valuation by Comparables
• Purpose of fundamental analysis is to identify stocks that are mispriced relative
to some measure of “true” or intrinsic value that can be derived from
observable financial data

• Valuation ratios are commonly used to assess the valuation of one firm
compared to others in the same industry
 Valuation by Comparables
• These valuation ratios are Financial highlights for Microsoft and software applications industry
commonly used to assess the
valuation of one firm compared to
others in the same industry.
• The column to the right gives
comparable ratios for other firms in
the software applications industry.
• For example, an analyst might note
that Microsoft’s price/earnings
ratio is below the industry average.
• However, its ratio of market value
to book value, the net worth of
the company as reported on the
balance sheet, as well as its price-
to-sales and PEG ratios, are above
industry norms.
• Clearly, rigorous valuation models
will be necessary to sort through
these conflicting signals of value.
 Limitations of Book Value
• Shareholders are sometimes called “residual claimants”.

• Book values are based on historical cost, while market values measure the
current values of assets and liabilities.

• Market values generally will not match historical values.

• Market prices reflect the value of the firm as a going concern.

• Can book value represent a “floor” for the stock’s price, below which level
the market price can never fall?
 Limitations of Book Value
• Can book value represent a “floor” for the stock’s price, below which level the market price
can never fall?
• While it is not common, there are always some firms selling at a market price below book
value. In 2022, for example, such unfortunate firms included Honda, Mitsubishi, and
Citigroup.
• A better measure of a floor for the stock price is the firm’s liquidation value per share.
• This is the amount of money that could be realized by breaking up the firm, selling its
assets, repaying its debt, and distributing the remainder to the shareholders.
• If market capitalization drops below liquidation value, the firm becomes attractive as a
takeover target. A corporate raider would find it profitable to buy enough shares to gain
control and then liquidate.
• Another measure of firm value is the replacement cost of assets less liabilities.
• Some analysts believe the market value of the firm cannot remain for long too far above its
replacement cost (sometimes called reproduction cost) because if it did, competitors would
enter the market. The resulting competitive pressure would drive down profits and the
market value of all firms until they fell to replacement cost.
 Limitations of Book Value
• Tobin’s q is the ratio of market value of the firm to replacement cost.
• In the long run, according to this view, the ratio of market price to replacement
cost will tend toward 1, but the evidence is that this ratio can differ
significantly from 1 for very long periods.

• Although focusing on the balance sheet can give some useful information
about a firm’s liquidation value or its replacement cost, the analyst must
usually turn to expected future cash flows for a better estimate of the firm’s
value as a going concern.
• We therefore turn to the quantitative models that analysts use to value
common stock based on forecasts of future earnings and dividends.
 Intrinsic Value vs. Market Price
• The return on a stock is composed of cash dividends and capital gains or losses

E ( D1 ) +  E ( P1 ) − P0 
Expected HPR= E ( r ) =
P0
• The expected HPR may be more or less than the required rate of return
• Variation based on the stock’s risk
We begin by assuming a 1-year holding period and supposing that ABC stock has an expected
dividend per share, E(D1), of $4; the current price of a share, P0 , is $48; and the expected price
at the end of a year, E(P1), is $52.
Whether the stock seems attractively priced today given your forecast of next year’s price.

But what rate of return do

investors require of ABC stock?
 Required Return
• CAPM gives the required return, k:
k = r f +   E ( rM ) − r f 
• k is the required rate of return
If a stock is priced “correctly,” it will offer investors a “fair” return, that is, its expected return
will equal its required return. The goal of a security analyst is to find stocks that are mispriced.
An under-priced stock will provide an expected return greater than the required return.

k = 6% + 1.2 × 5% = 12%
The expected holding-period return on ABC, 16.7%, therefore exceeds the required rate of return by a margin of
4.7%. Naturally, the investor will want to include more of ABC stock in the portfolio than a passive strategy would
indicate.
Another way to see this is to compare the intrinsic value of a share to its market price.
 Intrinsic Value and Market Price
The intrinsic value, denoted V0 , is defined as the present value of all the cash flows the
investor will receive (on a per-share basis), including dividends as well as the proceeds from
the ultimate sale of the stock, discounted at the appropriate risk-adjusted interest rate, k.
• The intrinsic value (V0) is the “true” value, according to a model
• If intrinsic value > market value, the stock is considered undervalued and a good
investment
• Trading signal
• IV > MV → Buy
• IV < MV → Sell
• IV = MV → Hold
 Dividend Discount Models (DDM)

D1 D2 D3
V0 = + + + ...
1 + k (1 + k ) (1 + k )
2 3

• V0 = current value
• Dt = dividend at time t
• k = required rate of return
• DDM says V0 = the present value of all expected future dividends into perpetuity
 Dividend Discount Models (DDM)

If we assume the stock will be selling for its intrinsic value next year, then V1 = P1 , and we can
substitute this value for P1 in V0

For a holding period of H years, we can write the stock value as the present value of
dividends over the H years, plus the ultimate sale price, PH

One can continue to substitute for price indefinitely, to conclude

 Constant Growth DDM

D0 (1 + g ) D1
V0 = =
k−g k−g
• V0 = current value
• Dt = dividend at time t
• k = appropriate risk-adjusted interest rate
• g = dividend growth rate
 Constant Growth DDM
For example, if g = .05, and the most recently paid dividend was D0 = 3.81, expected future
dividends are

Assuming constant growth in DDM, we can write intrinsic value as

This equation can be simplified to

 Constant Growth DDM
• A stock just paid an annual dividend of $3/share
• Dividend is expected to grow at 8% indefinitely
• Market capitalization rate is 14%
D1 $3.24
V0 = = = $54
k − g .14 − .08

Given Equation is called the constant-growth DDM, or the Gordon model, after Myron
Gordon, who popularized it.
It should remind you of the formula for the present value of a perpetuity. If dividends were
expected not to grow, then the dividend stream would be a simple perpetuity, and the
valuation formula would be 3 V0 = D1/k.
Given Equation generalizes the perpetuity formula for the case of a growing perpetuity. For
any given value of D1 , as g increases, the stock price also rises.
DDM Implications
• The constant-growth rate DDM implies that a stock’s value will be
greater:
1. The larger its expected dividend per share
2. The lower the market capitalization rate, k
3. The higher the expected growth rate of dividends

• The stock price is expected to grow at the same rate as dividends

 Discounted Cash Flow (DCF) Formula
For a stock whose market price equals its intrinsic value (V0 = P0), the expected
holding-period return will be

when dividends grow at a constant rate, the rate

of price appreciation in any year will equal that
growth rate.
This formula allows us to infer the market capitalization rate, 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 (assumed steady) growth rate of
dividends, we can compute k. This equation is also known as the discounted cash flow (DCF)
formula.

• DCF formula often used in rate hearings for regulated public utilities
• Focus on “fair” profit
 Stock Prices and Investment Opportunities
Consider two companies, Cash Cow, Inc., and Growth Prospects, each with expected earnings
in the coming year of $5 per share. Both companies could, in principle, pay out all of these
earnings as dividends, maintaining a perpetual dividend flow of $5 per share. If the market
capitalization rate were k = 12.5%, both companies would then be valued at D1/k = $5/.125 =
$40 per share.
Neither firm would grow because, with all earnings paid out as dividends, and none
reinvested in the firm, both companies’ capital stock and earnings capacity would remain
unchanged over time; neither earnings nor dividends would increase.

How much growth will be generated if Growth Prospects retains $3 per share?
Suppose Growth Prospects starts with plant and equipment of $100 million and is all equity
financed. With a return on investment or equity (ROE) of 15%, total earnings are ROE × $100
million = .15 × $100 million = $15 million.
There are 3 million shares of stock outstanding, so earnings per share are $5, as posited
above.
 Stock Prices and Investment Opportunities
If 60% of the $15 million in this year’s earnings
is reinvested, then the value of the firm’s assets
will increase by .60 × $15 million = $9 million,
or by 9%.
Now endowed with 9% more assets, the
company earns 9% more income and pays out
9% higher dividends. The growth rate of the
dividends, therefore, is
g = ROE × b = .15 × .60 = .09
For a given ROE and plowback ratio, the firm can grow
at this rate indefinitely, so g is called the sustainable
growth rate.
If the stock price equals its intrinsic value, and the ROE and payout ratios are consistent with the long-run
capabilities of the firm, the stock should sell at
 Present Value of Growth Opportunities
When Growth Prospects decided to reduce current dividends and reinvest some of its earnings
in new investments, its stock price increased. The increase in the stock price reflects the fact that
the planned investments provide an expected rate of return greater than the required rate. In
other words, the investment opportunities have positive net present value, and the value of the
firm rises by that NPV. This net present value is also called the present value of growth
opportunities, or PVGO

Sum of the value of assets already in place,

Value of the + NPV of future investments
or
firm = the firm will make i.e. PVGO.
the no-growth value of the firm
For Growth Prospects, PVGO = $17.14 per share:
 Life Cycles and Multistage Growth Models
Firms typically pass through life cycles with different dividend profiles.

Early Years Later Years

• Ample opportunities for profitable • Attractive opportunities for reinvestment

reinvestment in the company may become harder to find

• Payout ratios are low • Production capacity is enough to meet

market demand
• Growth is correspondingly rapid
• Competitors enter the market

• Firms may choose to pay out a higher

fraction of earnings as dividends
 Life Cycles and Multistage Growth Models
To value companies with temporarily
high growth, analysts use a multistage
version of the dividend discount model.
For example, a two-stage dividend
discount model allows for an initial
high-growth period before the firm
settles down to a sustainable growth
trajectory.
 Life Cycles and Multistage Growth Models
Dividend inputs Dividends increasing at about 7.6% per
2022 $4.45 2024 $5.18 year, from $4.45 in 2022 to $5.55 in 2025.
2023 $4.81 2025 $5.55

Forecasted dividend payout ratio of 34% and an ROE of 9%, implying long-term growth will
be: g = ROE × b = 9% × (1 - .34) = 5.94%
P2025 price, according to the constant-
growth DDM, should be

Risk-free rate + Market risk premium = 2% + 8% = 10% Therefore, we can solve for the market
capitalization rate as k = rf + β[ E(rM) − rf] = 2% + .8 × (10% − 2%) = 8.4%
Today’s estimate of intrinsic value is
 The Price–Earnings Ratio
Price-Earnings Ratio and Growth Opportunities

• The ratio of PVGO to E/k is equivalent to the component of firm value due to
growth opportunities to the value reflecting assets already in place

• When PVGO = 0, P0 = E1/k

• The stock is valued like a nongrowing perpetuity
• As PVGO becomes an increasingly dominant contributor to price, the P/E ratio
can rise dramatically
• P/E ratio reflects the market’s optimism concerning a firm’s growth prospects
 The Price–Earnings Ratio
Price-Earnings Ratio and Growth Opportunities

P0 1− b
implying the P/E ratio is =
E1 k − ROE x b
When a firm has good investment opportunities,
• P/E increases: the market will reward it with a higher P/E
• As ROE increases multiple if it exploits those opportunities more
• As plowback, b, increases, if ROE > k aggressively by plowing back more earnings into
• As plowback decreases, if ROE < k those opportunities.
• As k decreases
Effect of ROE and Plowback on Growth and the P/E Ratio
 Effect of ROE and Plowback on Growth and the P/E Ratio
Higher the plowback ratio, the higher the growth
rate, but a higher plowback ratio does not
necessarily mean a higher P/E ratio. Higher
plowback increases P/E only if investments
undertaken by the firm offer an expected rate of
return greater than the market capitalization
rate. Otherwise, increasing plowback hurts investors
because more money is sunk into projects with
inadequate rates of return.
P/E and Growth Rate
• Wall Street rule of thumb suggests the growth rate ought to be
roughly equal to the P/E ratio

• “If the P/E ratio of Coca Cola is 15, you’d expect the company to be
growing at about 15% per year, etc. But if the P/E ratio is less than the
growth rate, you may have found yourself a bargain.”
Peter Lynch in One Up on Wall Street
P/E Ratios and Stock Risk
• Holding all else equal, riskier stocks will have lower P/E multiples

• Riskier firms will have higher required rates of return, that is, higher
values of k, which means the P/E multiple will be lower

P 1− b
=
E k−g
 Pitfalls in P/E Analysis
• Denominator in the P/E ratio is
accounting earnings, which are
influenced somewhat by arbitrary
accounting rules
• Earnings management
• Choices on GAAP

• Inflation

• Reported earnings fluctuate around

the business cycle P/E ratio of the S&P 500 versus inflation rate, 1955-2020.
Because the market values the entire stream
of future dividends, when earnings are
temporarily depressed, the P/E ratio should
tend to be high—that is, the denominator of
the ratio responds more sensitively to the
business cycle than the numerator.
Conversely, when earnings are temporarily
high, the P/E ratio will be depressed, as price
increases less dramatically than earnings.

For example, when Con Ed’s earnings fell in

2001–2003, its P/E ratio rose. Similarly, when
Pepsi’s earnings per share increased at an
above-trend rate of 17% between 2008 and
2009, its P/E fell.
Forward P/E Ratios for Different
Industries
• Some of the industries with the highest
multiples—such as online retail or biotech —
have attractive investment opportunities
and relatively high growth rates, whereas
the industries with the lowest ratios—for
example, steel, chemicals, or tobacco—are
in more mature or less profitable industries
with limited growth opportunities.
• The relationship between P/E and growth is
not perfect, which is not surprising in light of
the pitfalls discussed in this section, but as a
general rule, the P/E multiple does appear
to track growth opportunities.
CAPE models
• Cyclically adjusted P/E ratio
• Shiller suggests a “cyclically adjusted” P/E ratio (CAPE) to avoid the problems associated
with using P/E ratios over different phases of the business cycle
• Idea is to divide the stock price by an estimate of sustainable long-term earnings rather
than current earnings
• Proposed using average inflation-adjusted earnings over an extended period, such as 10 years

In the past, the CAPE ratio has proved its importance in identifying
potential bubbles and market crashes. The historical average of the
ratio for the S&P 500 Index is between 15-16, while the highest levels
of the ratio have exceeded 30. The record-high levels occurred three
times in the history of the U.S. financial markets. The first was in
1929 before the Wall Street crash that signaled the start of the Great
Depression. The second was in the late 1990s before the Dotcom
Crash, and the third came in 2007 before the 2007-2008 Financial
Crisis.

There seems to be a strong inverse correlation between the CAPE and market returns over the
following decade, suggesting that a high CAPE may signify an overpriced market.
Other Comparative Valuation Ratios
• Price-to-book ratio
• Ratio of price per share divided by book value per share
• Price-to-cash-flow ratio
• Cash flow is less affected by accounting decisions than are earnings
• Ratio of price to cash flow per share
• Price-to-sales ratio
• Useful for start-up firms that do not have earnings
• Ratio of stock price to the annual sales per share
Market Valuation Statistics

Valuation ratios for the S&P 500

 Free Cash Flow Valuation Approaches
Free Cash Flow for the Firm (FCFF)
1. Discount the FCFF at the weighted-average cost of capital to find the value of
entire firm
• Free cash flow to the firm, FCFF, is the after-tax cash flow generated by the firm’s
operations, net of investments in fixed as well as working capital
2. Subtracting the value of debt results in the value of equity
𝐹𝐶𝐹𝐹 = 𝐸𝐵𝐼𝑇 × 1 − 𝑡 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 − 𝐶𝑎𝑝. 𝐸𝑥𝑝. − 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑁𝑊𝐶
T
FCFFt Vt
FirmValue =  +
t =1 (1 + WACC ) t
(1 + WACC ) T

FCFFT +1
Vt =
WACC − g
 Free Cash Flow Valuation Approaches
Free Cash Flow for the Equity holders (FCFE)

• Alternative approach is to focus on FCFE, discounting those directly at the cost

of equity to obtain the market value of equity
• Free cash flow to equity holders, FCFE
• Differs from FCFF by after-tax 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  (1 − t ) + Debt

Free Cash Flow to Equityholders (FCFE)
• Intrinsic value of equity
T
FCFEt ET
IntrinsicValue of Equity =  +
t =1 (1 + k E ) t
(1 + k E ) T

• Where
FCFET +1
ET =
kE − g
 Comparing the Valuation Models
• In practice
• Values from the FCF and DDM models may differ
• Analysts are always forced to make simplifying assumptions

• Problems with DCF Models

• Calculations are sensitive to small changes in inputs
• Growth opportunities and growth rates are hard to pin down
 The Aggregate Stock Market - Forecasting P/E Ratio
• Most popular approach to valuing the
overall stock market is the earnings
multiplier approach applied at the aggregate
level.
• The first step is to forecast corporate profits
for the coming period.
• Then we derive an estimate of the earnings
multiplier, the aggregate P/E ratio, based on
a forecast of long-term interest rates.
• The product of the two forecasts is the Earnings yield of S&P 500 versus 10-year
estimate of the end-of-period level of the Treasury-bond yield
market.
 The Aggregate Stock Market - Forecasting P/E Ratio
• In 2021, the forecast for 12-month earnings
per share for the S&P 500 portfolio was
about $196.36. The 10-year Treasury bond
yield was about 1.75%.
• As a first approach, we might posit that the
spread between the earnings yield and the
Treasury yield, which had averaged about
2% in the previous three years, will remain
at that level by the end of the year.
• Given a Treasury yield of 1.75%, this would
imply an earnings yield for the S&P of 3.75%, S&P 500 index forecasts under various
and a P/E ratio of 1/.0375 = 26.67. scenarios
• Our forecast for the level of the S&P index
would then be 196.36 × 26.67 = 5,236.
• Given a current value for the S&P 500 of
4,420, this would imply a 1-year capital gain
on the index of 816/4,420 = 18.5%.
 The Aggregate Stock Market
Forecasting P/E Ratio
• Some analysts use an aggregate version of the dividend discount model rather
than an earnings multiplier approach. All of these models, however, rely
heavily on forecasts of such macroeconomic variables as GDP, interest rates,
and the rate of inflation, which are difficult to predict accurately.
• S&P 500 taken as leading economic indicator.

MIT Professor Paul Samuelson’s famous quip, “the stock market has predicted
nine out of the last five recessions.
https://www.lasalle.com/research-and-insights/macro-indicators-january-2019/