BE331 The Pricing of Securities in

Financial Markets

Dr Stefano Filomeni
stefano.filomeni@essex.ac.uk

Lecture 3
 Share Valuation Models
The Earnings Model

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 The Earnings Model
Setting assumptions:
Companies are financed only through shares
A company earns earnings in each period
Some earnings are distributed to shareholders as
dividends
Companies invest undistributed earnings
Each investment has a fixed yield into perpetuity

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 The Earnings Model
 Define:
• = earnings of the company in period t
• = dividends in period t
• = undistributed profit invested for future return
• = fixed rate of return on investment
• = company’s risk-adjusted discount rate

 Where:
• = “dividend ratio” =
• = “plowback ratio” = =

• Constant investment return =

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 The Earnings Model
The earnings’ growth rate (assumed to be constant) is defined
as:

 Earnings are a result of investments made by the company,

yielding a rate of return RI
• Therefore we expect to receive an incremental infinite inflow of
earnings

 We define the NPV of the expected growth in earnings as:

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 The Earnings Model
The earnings model is therefore:

 If there is no investment opportunity, that is, , then all

earnings will be distributed as dividends

 Thus we get and the equation becomes:

Where the earnings yield is:

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 The Earnings Model
Capital markets prefer to use the inverse of this last
expression, referred to as earnings multiplier (EM) and
defined as:

 Intuitively equivalent to the period in years required for

investors to get a return on their investment through
earnings

 Remember that it implies an assumption of zero growth

in the company’s earnings
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 The Earnings Model
Assume that a fixed % of the earnings PB is
invested in each period
• Equivalent to distributing a fixed % of
the earnings DR as dividends

We go back and calculate the share price

using the following model:

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 The Earnings Model

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 The Earnings Model

When we assume investing a fixed % of a company’s

earnings, the earnings model tells us that the firm’s value
is determined by the dividend distributed to shareholders

 Why focusing on future earnings?

– Core business determinants of value
• Dividend policy is not such a core determinant
» Dividends may not be representative of the firm's financial
status
» Takeover investors are not concerned with the pattern of
future dividends because they can choose any pattern they
wish
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 Share Valuation Models
The Dividend Model

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 The Dividend Model
Setting assumptions:
 No connection between dividend size and company’s
performance
 The model focuses on valuing companies from an
investor’s standpoint

Future yield is reflected in a company’s future

dividend distributions plus future price obtainable
when selling the shares
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 The Dividend Model
Mathematically:

= periods in which we hold the share (t = 1,2,…,T)

= shareholders’ required risk-adjusted discount rate

 If is very large, the second term becomes small

and negligible, therefore the equation can be
approximated by:
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 The Dividend Model
Assume the company distributes a fixed dividend and
is infinitely large, then:

Where the “dividend yield” is:

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 The Dividend Model
When a company distributes fixed dividends its
share price is identical in all periods
The only return is the dividend distributed yearly

However, for fixed-growth companies, the

share price increases in each period

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 The Dividend Model
Assume the dividend increases each year at a fixed rate,

Assume T is infinite and has a propensity of zero

 Then this is the sum of a geometric series growing at a constant rate

 This formula is known as the Gordon Growth Model

 This result is identical to the one derived from the earnings model
• Even if these two models are based on different approaches
(management’s standpoint vs. shareholder’s/owner’s standpoint)

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 The Dividend Model
We have seen that the share price at the beginning of the 1st
period is:

The share price at the beginning of the 2nd period is:

As

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 The Dividend Model
A shareholder who decides to sell his share at
the end of the 1st period will receive a twofold
return:
A return from the dividend payment
A return from the increase in the share’s value

These two components make up the

shareholder’s return
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 The Dividend Model
 The 1st component is the “dividend yield”:

 The 2nd component is the “capital gain”:

This represents the increase in the share’s

value

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 The Dividend Model
The overall return achieved by a shareholder
over one period is given by:

Note: if we took the original share price equation and factor

out , we would end up with the same result

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 Numerical Example
Company A
 Earnings per share = £15
 No growth
 No investment
 Assuming k = 15%

The share price is calculated by:

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 Numerical Example
Company B
 Earnings per share= £15 and k = 15%
 It reinvests 60% of its earnings each year into new investments that
yield a rate of return of 20% per year
 Thus, dividends are £15 x 40% = £6 per share (the other £9 are
reinvested in the company to earn 20% per year)

The formula for the growth rate of dividends and earnings per share is:

The share price is:

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 Share Valuation Models
Modigliani & Miller’s Cash Flow Model

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 Modigliani and Miller’s Cash Flow Model

A share’s value (or a company’s value) is equal to the present

value of the future cash flows generated by the company

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 Modigliani and Miller’s Cash Flow Model

To our interest, Modigliani and Miller hypothesized that:

 the market value of a firm is determined by its cash flow-

generating power and by the risk of its underlying assets

• Its value is independent of the way it chooses to distribute

dividends

• Its value is not based on “earnings” (which is an

accounting term that can be manipulated to some extent)
but on free cash flows the firm can generate though its
investment decisions
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 Concluding Remarks
The earnings model and the dividend model should be used carefully in calculating share
prices through an understanding of their limitations:

 Dividends represent arbitrary distribution decisions

 Earnings are influenced by the broad leeway of accounting board guidelines

However, these models still hold an important place in business practice and in the
economic press today while the cash flow model is used only by financial professionals

 Why ?
1. To present historical developments in financial theory thought
2. For practical purposes as they are still valuable indicators of share market
trends

Free cash flow is subject to less manipulation and it is more relevant in calculating a
company’s value
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Thank you for your attention!