Valuing Equity Shares

This Teaching Note Supplements Textbook Chapter 13

LEARNING OBJECTIVES CHAPTER OUTLINE

1. What determines the value of a stock?
2. How are investors repaid and rewarded?
3. What determines the discount rate?
4. How can we forecast dividends accurately?
5. How retained earnings impact stock prices
6. What is a growth stock?
7. Are cash dividends really relevant?
8. Determining the price/earnings ratio
9. Mastering the cash dividend yield
10. Investigating the cash flows
1. Cash Dividend Payments
2. The Present Value of Cash Dividends
3. The Stages of Growth Model
4. The Dividend Discount Model (DDM)
5. Analysis of Internally Financed Growth
6. Dividend Policy Can Be Irrelevant
7. The Relationship Between ROE and k
8. The Price-Earnings Ratio
9. The Cash Dividend Yield
10. Free Cash Flow

Three simple rules govern decisions to buy or sell a share of stock. The buy rule for the ith stock at
time t is:
1. If Pricei,t < Valuei,t  Under-priced. Buy.
The don't trade rule is:
2. If Pricei,t = Valuei,t  Priced correctly. Don’t trade.
The sell rule is:
3. If Pricei,t > Valuei,t  Over-priced. Either liquidate or sell short.
It is easy to look up the current market price of a share of stock in a financial newspaper. It is much
more difficult to estimate the value of a share. This is a chapter about how to find the value of an
equity share. Finding insightful value estimates is the key to making decisions to buy or sell that are
profitable.

Right and Wrong Ways to Value Stocks

Consider several well-known ways to assess the value of a share of stock.

1. Accountants display a common stock’s book value per share in the Net Worth section of
the company’s balance sheet. The book value per share equals the corporation’s total Net
Worth (Equity) divided by the number of shares of common stock outstanding.

Book value per share is not a good estimate of the market price of a corporation’s stock because
accountants’ generally accepted accounting principles (GAAP) are sometimes inappropriate.
Furthermore, the GAAP rules are rigid and mechanical. Consider estimating depreciation using
either straight line or sum-of-the-digits depreciation, estimating the value of inventory value using
LIFO or FIFO, and the several methods to value various accruals. Using mechanical GAAP rules in
a dynamic economy does not always lead to the best possible estimates of a stock’s value.

2. When a corporation nears bankruptcy its liquidation value becomes relevant. A

corporation’s liquidation value equals the auction value of the firm’s assets less the firm’s
total liabilities.

Equity Share Valuation – Professor Jack Clark Francis – Page 1

The liquidation value of a failing firm is unrelated to the firm’s value as a going concern. The market value
of a profitable going corporation far exceeds the liquidation value of an identical collection of idle assets.

3. A corporation’s value can be assessed by adding up the cost of replacing all its assets at
their replacement cost, and then deducting the firm’s total liabilities.

The purchase prices (replacement prices) for a firm’s idle assets typically differs significantly from the
market value of the same assets when they are operating profitably as a going concern.

4. The intrinsic value of a share of stock equals the value that is intrinsic in the security. The
intrinsic value is calculated by summing the discounted present value of the future income
an investor can expect to receive from the asset. The intrinsic value is also called the
fundamental value. Security analysts that compute fundamental values are called
fundamental analysts. The dividend discount model (DDM) presented in this chapter
shows how to estimate of the intrinsic value per share of common and preferred stock. The
intrinsic value of a corporation’s stock is not closely related to or even highly positively
correlated with a common stock’s book value, liquidation value, or its replacement cost.

Before delving into various equity valuation models it is helpful to consider corporations’ cash
dividend payments. Cash dividends are the only cash flows corporations pay their shareholders. Not
every corporation follows the cash dividend payment policies suggested here. More importantly,
most investors believe that Boards of Directors at most corporations think as suggested in Figure 1.
As a result, regardless of what a corporation’s Board of Directors actually thinks or what cash
dividend policies are actually employed, investors usually react to corporations’ announcements of
cash dividend payments as if the corporation’s Board of Directors were following the policies
suggested below.

CASH DIVIDEND PAYMENTS

Figure 1 illustrates a corporation’s earnings per share (EPS) for three consecutive years. These EPS
are highly seasonal with a slight upward trend. The cash dividend payments per share shareholders
receive come from these EPS and are altered infrequently.

Equity Share Valuation – Professor Jack Clark Francis – Page 2

FIGURE 1 – A Corporation with Seasonal Earnings per Share (EPS) Pays Stable Cash Dividends

SUMMARY: The Board of Directors of most U.S. corporations believe regular cash dividend
payments should be stable and sustainable. Regular cash dividend payments may be increased only
if the new higher payments can be sustained. Regular cash dividend payments should never be
reduced because a reduction conveys negative information content about the company’s long-run
earning power.

Corporations can pay more than one kind of cash dividends.

 Regular cash dividends are usually constant quarterly payments, as illustrated in Figure 1.
 Extra dividends and Special dividends are unusual cash dividends. For example, Microsoft
began paying regular cash dividends of 24 cents per share per year in 2003. In 2004 the
corporation raised its regular cash dividend to 32 cents per share. In addition, it paid a one-time
Special Cash Dividend of $3 per share in 2004, to rid the Corporation of $32 billion of excess
cash. Then, in 2005 Microsoft resumed its regular cash dividend of 32 cents per share.1
 Liquidating dividends are cash payouts that only occur when all or part of the business is
liquidated. Liquidating dividends represent a return of principal to the owners.

The Time Value of Money

The following time line depicts an infinite stream of cash dividend payments for one share of stock.

1
Microsoft’s earnings per share and cash dividends per share might be less than 32 cents per share
per year today because Microsoft split its common stock in half (that is, paid a 100 percent stock
dividend) several times since 2005. Stock splits and stock dividends reduce a corporations per
share earnings and cash dividends per share while simultaneously increasing the number of
outstanding shares. The total value of the corporation is unchanged by such changes in the unit of
account.

Equity Share Valuation – Professor Jack Clark Francis – Page 3

Per share cash dividend paid per time period DIV1 DIV2 DIV3 … DIV
Quarterly or annual time period counter t=1 t=2 t=3 … t=

Eqn.(1) suggests a cash dividend per share constant growth model that can be used to forecast
future cash dividends. The present time period is represented by the subscript t = 0. If cash
dividends per share are DIV0 = $1 today and we assume the dividends grow at a constant growth
rate of g (for instance, g = 2% per year) for one year, the future cash dividend forecasted for year t
= 1 is DIVt=1 = $1.02.

(𝐃𝐈𝐕𝟎 )(𝟏 + 𝐠)𝐭 = 𝐃𝐈𝐕𝐭 (1)

$1(1 + 2%)1 = $1.021 (1a)

Eqn.(1) implies a constant single-period growth rate of g.

g = (DIVt+1 - DIVt) / (DIVt) (2)

$1.02 −$1
𝑔 = 2% = (2a)
$1

If a cash dividend stream of $1 per year continues to grow at a constant growth rate of two percent
per year the following equations show how future cashflows unfold.

DIV1 = (DIV0 )(1 + g)1 = $1(1 + 2%)1 = $1.02

DIV2 = (DIV0 )(1 + g)2 = $1(1 + 2%)2 = $1.04

DIV3 = (DIV0 )(1 + g)3 = $1(1 + 2%)3 = $1.06

DIVt = (DIV0 )(1 + g)t = $1(1 + 2%)𝑡

Most preferred stocks have cash dividend growth rates of zero, g = 0. In other words: DIV1 = DIV2
= DIV3 = DIV4 =…. = 𝐷𝐼𝑉∞ . The horizontal line in Figure 2 illustrates a preferred stock’s cash
dividend payments. The common stock with two stages of growth in Figure 2 is discussed below.

Equity Share Valuation – Professor Jack Clark Francis – Page 4

FIGURE 2 - Different Patterns For A Corporation’s Cash Dividend Payments

THE PRESENT VALUE OF CASH DIVIDENDS

Cash dividends provide the only cash flow income that equity investors receive. The present value
of an infinite stream of cash dividends equals the dividend discount model (DDM) defined by
Eqns.(3) and (3a).
𝐷𝐼𝑉1 𝐷𝐼𝑉 𝐷𝐼𝑉 𝐷𝐼𝑉
𝑃0 = (1+𝑘)1
+ (1+𝑘)2 2 + (1+𝑘)3 3 + ⋯ + (1+𝑘)∞∞ (3)

DIV
= ∑∞ t
t=1 (1+k)t (3a)

where k represents a risk-adjusted discount rate, and P0 is the present value of all the future cash
dividends that the owner of an equity share can expect to receive. P0 is also called the intrinsic
value or fundamental value per share.

Assuming that cash dividends grow at a constant perpetual rate permits substituting Eqn.(1) into
Eqn.(3a).

𝐷𝐼𝑉0 (1+𝑔)𝑡
𝑃0 = ∑∞
𝑡=1 since (𝐷𝐼𝑉0 )(1 + 𝑔)𝑡 = 𝐷𝐼𝑉𝑡 (4)
(1+𝑘)𝑡

Equity Share Valuation – Professor Jack Clark Francis – Page 5

Rearranging Eqn.(4) as shown below results in the elegantly concise but mathematically equal
Eqn.(6). 2

DIV0 (1+g)t
P0 = ∑∞
t=1 (4)
(1+k)t

DIV0 (1+g)
= (5)
(k-g)

DIV
= (k-g)1 (6)

A valuation model is a simplified version of reality.3 The derivation of Eqn.(6) is based on five
simplifying assumptions that are made to facilitate building a valuation model that is simple and
transparent. First, both k and g are assumed to have constant long-run values. Second, assume k >
g, because growing faster involves more risk. Stated differently, a rising value of g causes the risk-
adjusted discount to rise to a level that exceeds g. Third, income taxes are ignored to keep the
formulas simple, without omitting any substantial financial insights. Fourth, to keep the DDM
simple, external financing for the issuing firm is not considered. This means that corporate growth
can only be financed from retained earnings. And, fifth, assume the corporation’s earnings per
share, cash dividends per share, and value per share are never diluted by the use of executive stock
options.

-------------------------------------- Top of Example 1 -------------------------------------------

EXAMPLE 1: Valuing A Share of Preferred Stock

If a preferred stock promises to pay annual cash dividends of $3 per share forever the dividend’s
growth rate is zero, g = 0. The horizontal line in Figure 2 illustrates this promised stream of cash
dividend payments. Assume the stock’s risk-adjusted discount rate is k = 10 percent. Valuation
Eqn.(6) shows that a share of this preferred share is worth $30.

𝐷𝐼𝑉
1 $3
𝑃0 = (𝑘−𝑔) = = $30 (6a)
(.1−0)
-------------------------------------- Bottom of Example 1 -------------------------------------------
Analyzing common stocks is more complex than analyzing preferreds.
----------------------------------------- Top of Example 2 ----------------------------------------------

2
To derive Eqn.(6) from Eqn.(4) let b = DIV1/(1+k) and z = (1+g)/(1+k). Rewrite Eqn.(4) as P0 =
b(1+z1+z2+z3+…) . Multiplying by z creates: P0z = b(z1+z2+z3+…) Subtracting the second
equation from the first gives: P0{1-z} = b, which implies: P0 = b/{1-z}. Substituting for b and z
yields: P0 = b/{1-z}= {DIV1/(1+k)}/{1 - (1+g)/(1+k)}, which equals Eqn.(6), P0 = DIV1/(k-g).
3
Airplane manufacturers like Boeing employ aeronautical engineers that build and test small
models of the Boeing 717, 727, 737, 747, 757, 767, 777 and other planes in wind tunnels to see how
the model planes perform at 400, 800, and 1,200 miles per hour. These tests yield valuable
aerodynamic information from studying the lift coefficients, drag coefficients, and other statistics
from the model airplanes. Financial economists use models too.
Equity Share Valuation – Professor Jack Clark Francis – Page 6
EXAMPLE 2: Analyzing A Common Stock As Significant Changes Occur

Consider four consecutive annual models of how the price per share of a common stock issued by
the Battel Corporation changes.

Year 1, The Initial Share Price for Battel’s Common Stock

At time t=0 Battel Corporation announces an annual cash dividends of 𝐷1 = $2 per share will be
paid to its common stock investors of record at time t = 1; its risk-adjusted discount rate is 10% per
annum, k = 10%; and, its cash dividend payments are expected to grow at a constant rate of g =
2% per year. Under these initial circumstances Eqn.(5a) indicates Battel’s common stock has an
intrinsic value of $25 per share at the end of the first year.

𝐷𝐼𝑉1 ($2) 𝐷1 =$2

𝑃0 = = = = $25 (5a)
(𝑘−𝑔) 0.10−0.02 0.08

Year 2, Modeling New Competition

During year 2 a large blue-chip corporation introduces a new subsidiary corporation that will
compete with Battel. The resulting increase in the riskiness of Battel's business environment causes
Battel's risk adjusted discount rate (cost of equity capital) to rise from k = 10% to k = 11%. This
increased risk causes the present value of Battel's stock to fall about 9% to $22.666 during year
two.

𝐷2 =𝐷𝐼𝑉1 (1+𝑔) $2(1.02) 𝐷2 =$2.04

𝑃1 = = 0.11−0.02 = = $22.666 (5b)
(𝑘−𝑔) 0.09

Year 3, Modeling A Sales Increase for Battel

Battel competes aggressively with its new competitor by hiring an advertising agency. The
resulting increase in sales raises Battel's growth from g = 2% per annum to g = 3% while k
remains at 11%. As a result, Battel’s per share stock price rises about 16% to $26.265.

𝐷3 =𝐷𝐼𝑉2 (1+𝑔) ($2.04)(1.03) 𝐷3 =$2.1012

𝑃2 = = = = $26.265 (5c)
(𝑘−𝑔) 0.11−0.03 0.08

Year 4, Modeling Battel’s International Expansion

Battel executives decide to distribute their products in Europe and, as a result, the firm’s growth
rate rises from g = 3% to g = 4%. Increased risk exposure from the more rapid growth rate and
risks accompanying the new foreign operations raises the Battel’s risk-adjusted cost of equity
capital from k = 11% to k = 12%. As a result of these changes, Battel’s value per share increases
to a new high of $27.316.

𝐷𝐼𝑉4 =𝐷3 (1+𝑔) ($2.1012)(1.04) 𝐷4 =$2.185

𝑃3 = = = = $27.316 (5d)
(𝑘−𝑔) 0.12−0.04 0.08

The purpose of four year example above is to demonstrate the realistic manner in which the
constant growth dividend discount model (DDM) can be used to model various business
developments that might affect a company. Note that in the fourth year the DDM models
incorporates two simultaneous changes: (i) an increase in the growth rate, and, (ii) an increase in the
risk-adjusted discount rate. The constant growth DDM permits investors to analyze “What if…”
questions about the future implications of current decisions.
Equity Share Valuation – Professor Jack Clark Francis – Page 7
------------------------------------- Bottom of Example 2 ----------------------------------------------

The Risk-Adjusted Discount Rate, k

When estimating the value of a share of a stock, the investment analyst must select an appropriate
value for the risk-adjusted discount rate. Selecting an appropriate value for k plays a large role in
determining the asset’s value. Figure 3 illustrates the way a corporation’s default (credit,
bankruptcy) risk interacts with alternating bull and bear market conditions as these factors interact
in the capital market to determine a realistic value for k.

FIGURE 3 – The Appropriate Risk-Adjusted Discount Rate for a Stock Varies with the Issuing
Corporation’s Credit Risk and with Market Conditions

Figure 3 explains how market forces determine appropriate values for the four financial concepts
listed below. The four definitions below provide different ways for one person to interpret the
variable k.

1) The risk-adjusted discount rate, k, is used by common stock analysts to estimate the present
value of a potential investment.
2) The cost of equity capital, k, must be paid by the issuing corporation to its shareholders to
induce them to invest in the corporation.
3) The expected return, E(r) = k, is the probabilistic expectation an investor has about an actual or
potential investment.
Equity Share Valuation – Professor Jack Clark Francis – Page 8
4) The capitalization rate, k, is usually used when estimating the present value of a stream of
expected cashflows from a merger or acquisition candidate.

If a financial analyst estimated identical values for the expected return, cost of capital, required rate
of return, and capitalization rate for a single stock, that happy outcome would eliminate all
uncertainty about that stock’s value. But, typically, a financial analyst obtains a different value
estimate for each of the four definitions of k. This more typical outcome requires the security
analyst to reconsider his work and refine his estimates in an effort to align the four value estimates.

Stock Valuation Over A Two Year Holding Period

Consider the present value of a share of stock that is purchased for P0 dollars, held for two years,
and then sold for P2 dollars.

𝐷𝐼𝑉1 𝐷𝐼𝑉2 𝑃2
𝑃0 = + + (8)
(1 + 𝑘)1 (1 + 𝑘)2 (1 + 𝑘)2

As shown below, P2 equals the present value of all cash dividends (cashflows) from year three to
infinity.

𝐷𝐼𝑉3 𝐷𝐼𝑉4 𝐷𝐼𝑉5 𝑃∞

𝑃2 = 1
+ 2
+ 3
+⋯+ (9)
(1 + 𝑘) (1 + 𝑘) (1 + 𝑘) (1 + 𝑘)∞

Discounting the 𝑃2 by 1⁄(1+k)2 reduces P2 to the present value of P0 shown in Eqns.(10) and
(10a).

𝑫𝑰𝑽𝟑 𝑫𝑰𝑽𝟒 𝑫𝑰𝑽𝟓 𝑷∞

+ + + ⋯+
𝑷𝟐 (𝟏 + 𝒌)𝟏 (𝟏 + 𝒌)𝟐 (𝟏 + 𝒌)𝟑 (𝟏 + 𝒌)∞
𝑷𝟎 = = (𝟏𝟎)
(𝟏 + 𝒌)𝟐 (𝟏 + 𝒌)𝟐

𝐷𝐼𝑉3 𝐷𝐼𝑉4 𝐷𝐼𝑉5 𝑃∞

= 3
+ 4
+ 5
+⋯+ (10a)
(1 + 𝑘) (1 + 𝑘) (1 + 𝑘) (1 + 𝑘)∞

Substituting Eqn.(10a) into of Eqn.(8) to replace 𝑃0 creates the dividend discount model. In other
words, Eqns.(8) and (10) can be combined to form the DDM originally displayed as Eqn.(3).

𝐷𝐼𝑉1 𝐷𝐼𝑉2 𝐷𝐼𝑉3 𝐷𝐼𝑉4 𝐷𝐼𝑉5 𝑃∞

𝑃0 = 1
+ 2
+ 3
+ 4
+ 5
+⋯+ (3)
(1 + 𝑘) (1 + 𝑘) (1 + 𝑘) (1 + 𝑘) (1 + 𝑘) (1 + 𝑘)∞

At first glance, Eqn.(3) seems to be appropriate only if the security is held to infinity. But,
considering how Eqns.(8) and (10a) combine to form Eqn.(3) shows that the DDM includes the
possibility of selling the share of stock after owning it for two time periods. In other words, P0
includes P2, and P2 includes all cash dividends, capital gains, and capital losses that occur after the
first two years.

Equity Share Valuation – Professor Jack Clark Francis – Page 9

 The Stages Of Growth Model

The constant growth DDM is based on the simplifying assumption that a corporation grows or
shrinks at one constant rate. This simplifying assumption can be modified to create a flexible
valuation model that works with different stages of growth. Consider the Spurtz Corporation, which
expects to go through the three successive 2-year spurts of cash dividend growth listed in Table 1.

TABLE 1 - The Spurtz Corporation’s Three Stages of Growth

Three Stages of Growth Years Cash dividend growth rate
S1 - Modest growth 1-2 g1 = 2% for 2 years
S2 - Rapid growth 3-4 g2 = 4% for 2 years
S3 – Accelerated rapid growth 5-6 g3 = 6% for 2 years

Assume that after analyzing the Spurtz Corporation, its stockholders require a rate of return of ten
percent, k = 10%, to induce them to invest in the riskiness associated with Spurtz. Assuming Spurtz
starts with cash dividends per share of $2 at time t = 0 results in the forecasted cash dividends and
discounted cash flows in Table 2. In the first year, for instance, the discount factor (DF) is
1⁄(1 + 10%)𝑌𝑒𝑎𝑟 = 1⁄(1.1)1 = 0.90909 when k=10 percent. This DF is multiplied by the first
year’s cash dividend of $2.04 to get the dividend’s PV of $1.8545 for the first year.

TABLE 2 – One Share of Spurtz Stock’s Cash Dividends and Discounted Cash Flows
Growth PV of $1 DF*DIV=
Stage Year rate Forecasted cash dividends per year, using Eqn.(1) at 10%=DF PV of DIV
Stage 1 1 2%=0.02 ($2)(1.02)=$2.04=DIV1 0.9091 $1.8545
Stage 1 2 2%=0.02 ($2)(1.02)(1.02)=($2)(1.0404)=$2.0808=DIV2 0.8265 $1.7197
Stage 2 3 4%=0.04 ($2)(1.02)(1.02)(1.04)=($2)(1.082016)=$2.164032=DIV3 0.7513 $1.6259
Stage 2 4 4%=0.04 ($2)(1.02)(1.02)(1.04)(1.04)=($2)(1.12529664)=$2.25059328=DIV4 0.6830 $1.5372
Stage 3 5 6%=0.06 ($2)(1.02)(1.02)(1.04)(1.04)(1.06)=($2)(1.192814438)=$2.385628877=DIV5 0.6209 $1.4813
Stage 3 6 6%=0.06 ($2)(1.02)(1.02)(1.04)(1.04)(1.06)(1.06)=($2)(1.2643833)=$2.5287666=DIV6 0.5645 $1.4274
6 Total of six years' cash dividends discounted at k=10% Sum: $9.6459
6 PV of stock's price of 𝑃6 = 𝐷𝐼𝑉7 ⁄(𝑘 − 𝑔) = $2.680492⁄(. 10 − .06) = $67.0123 0.5645 $37.8284
6 PV of six years' cash dividends plus P6 stock price discounted at k=10% Sum: $47.4743
The dividend discount model (DDM) is used to value Spurtz stock if it is sold at the end of the year
six. The computations in Table 2 assume that in year six Spurtz’s earnings will grow at the constant
rate of g3 = 6% into perpetuity, as shown below.
𝑃6 = 𝐷𝐼𝑉7 ⁄(𝑘 − 𝑔) = $2.680492⁄(. 10 − .06) = $67.0123 (6b)
At time t = 0 the present value of P6 equals year six’s discount factor (DF) of 0.5645 multiplied
times P6 [or (0.5645) times ($67.0123)], which equals $37.8284. Adding the sum of the present
values of six years cash dividends, $9.6459, to the stock’s present value of the stock, $37.8284,
yields a total present value of $47.4743 for investing in Spurtz stock at time t = 0.4 Table 2 shows
that using fluctuating growth rates requires more computations than the DDM formulas that are
based on one constant growth rate.

4
The stages of growth model can be restated to accommodate any number of growth stages. For
instance, for the two stages of growth illustrated at the top of Figure 2, the corporation’s dividends
grow at an initial growth rate of g1 for T years and, then, grow at a different growth rate of g2 from
year T+1 to infinity. This corporation’s present value is
𝐷𝐼𝑉0 (1+𝑔1 )𝑡 𝐷𝐼𝑉0 (1+𝑔2 )𝑡 𝐷𝐼𝑉0 (1+𝑔1 )𝑡 𝑃 𝐷𝐼𝑉𝑇+1 (1+𝑔2 )
𝑃0 = ∑𝑇𝑡=1 + ∑∞
𝑡=𝑇+1 = ∑𝑇𝑡=1 𝑇
+ (1+𝑘)𝑇 since 𝑃𝑇 =
.
(1+𝑘)𝑡 (1+𝑘)𝑡 (1+𝑘)𝑡 (𝑘−𝑔2 )

Equity Share Valuation – Professor Jack Clark Francis – Page 10

Estimating A Corporation’s Present Value of Growth Opportunities (PVGO)
Suppose a large, old technology company like International Business Machines (IBM) asked its
stockholders to vote on a new idea from the firm’s top management. The Chief Executive Officer
(CEO) could propose creating a new networking subsidiary to compete with Facebook, Linkedin,
Snap (previously SnapChat), MySpace, WhatsApp, and similar social networking corporations.
Suppose IBM’s CEO sent all stockholders a letter explaining that, after a costly start-up period,
IBM’s proposed new networking subsidiary should provide highly profitable new growth
opportunities. The letter could say the forthcoming networking subsidiary’s start-up costs could be
financed internally by freezing the existing corporation’s cash dividend payouts at their current
level, cancelling substantial share buybacks (which have been averaging half of annual earnings in
recent years), and increasing retained earnings substantially. Many investors would support this idea
if they realized their corporation was merely a cash cow that generated stock price increases only by
buying back its own stock, and, if unaltered, would probably not generate any growth opportunities
that would add value to IBM’s shares.

If IBM’s risk-adjusted discount rate is k = 12 percent and it operated as a no-growth company, it

could pay out 100 percent of each year’s earnings per share of $15 as annual cash dividends, DIVt =
EPSt. These high cash dividend payments would require IBM to discontinue retaining earnings to
finance growth internally, and, to cease buying back its outstanding shares. In this no-growth state,
IBM’s common stock would be worth $125 per share, as shown below.

𝑫𝑰𝑽𝟏 𝑬𝑷𝑺𝟏 (𝟏−𝑹𝑹) 𝑬𝑷𝑺𝟏

(𝑷𝟎 ) = = =( ) with a zero retention rate (RR) and g = 0 (11)
𝒌−𝒈 𝒌−𝒈 𝒌

𝐸𝑃𝑆1 $15
𝑃0 = $125 = ( )= (11a)
𝑘 .12

Eqn.(11a) shows IBM’s common stock would be worth $125 per share if no earnings were retained
to finance new growth. Eqn.(12) extends Eqn.(11) by adding the present value of growth
opportunities (PVGO) that IBM’s CEO proposes.5 We complete Eqn.(12a) by looking up IBM’s
current stock market price to find it is $150 per share.

𝐍𝐨 − 𝐠𝐫𝐨𝐰𝐭𝐡
𝐏𝐫𝐢𝐜𝐞 𝐏𝐕𝐆𝐎 𝐩𝐞𝐫
( ) = ( 𝐯𝐚𝐥𝐮𝐞 𝐩𝐞𝐫 ) + ( ) (12)
𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞 𝐬𝐡𝐚𝐫𝐞
𝐬𝐡𝐚𝐫𝐞

𝐸𝑃𝑆1
(𝑃0 ) = ( ) + 𝑃𝑉𝐺𝑂 (12a)
𝑘

$15
$150 = + PVGO (12b)
.12

$150 = $125 + $25 (12c)

5
The present value of growth opportunities (PVGO) theory was created by Nobel laureates M. H.
Miller and F. Modigliani, “Dividend Policy, Growth and the Valuation of Shares, Journal of
Business, 34 (October 1961), 411-433.

Equity Share Valuation – Professor Jack Clark Francis – Page 11

PVGO = $25 = $150 - $125 (12d)

Eqn.(12c) indicates that the net present value (NPV equals Present Value minus Cost Of The
Investment) of the new networking subsidiary would equal IBM’s present value of growth
opportunities (PVGO) of $25 per share. In other words, if IBM’s outstanding common stock was
selling for $150 per share, the present value of the new growth opportunities in the new networking
subsidiary would be worth $25 per share of that market price.

Some IBM stockholders would oppose the financing the new networking subsidiary by (i) freezing
cash dividends at their current level and (ii) ceasing to use most of the corporation’s annual earnings
to buy back its own outstanding stock. These actions could upset many of the corporation’s
investors because they feared a collapse in the corporation’s stock price. In fact, stock market prices
are highly anticipatory. Thus, fears of the hypothesized stock price collapse might be avoided
completely if the IBM CEO’s proposal is accompanied by an adequate explanation of the prospects
for highly profitable growth opportunities in the new networking subsidiary. Compare Eqns.(11a)
and (12c) of the present value of growth opportunities model and see if you would vote for IBM to
create or acquire a new social networking subsidiary.

Forecasting Problems - A Common Criticism Of The DDM

Some critics of the DDM say it is not practical because it is too difficult to forecast the future cash
dividends. Actually, forecasting cash dividend payments is not a big problem, especially for large
blue-chip corporations (like Wal-Mart, Coca-Cola, and Microsoft) for two reasons. First, most blue-
chip corporations change their cash dividend payments infrequently, and they usually only increase
them in small steps that are easy to forecast. Second, the discounted present value of distant cash
dividends have sufficiently reduced the present value so that, if they are forecasted inaccurately, the
forecasting errors are of little consequence.

TABLE 3 - The Discount Rates for Blue-Chip Stocks Is About 10%

Number of years in the future Present value (PV) of $1 discounted at a rate of 10%
when $1 is received
t = 10 PV = $1/(1.1)10 = $0.3855  39¢
t = 25 PV = $1/(1.1)25 = $0.0923  9.2¢
t = 50 PV = $1/(1.1)50 = $0.0085 < 1¢
t = 100 PV = $1/(1.1)100 = $0.00007 < 1/100 of 1¢

Table 3 shows that forecasts of 10 or more years into the future need not be highly accurate because
the small present values (PV) that characterize long range cashflows diminishes their importance in
determining the present value.

Small corporations, new corporations, distressed stocks, value stocks, and other risky corporations
have the present values of their cash dividends discounted with large risk-adjusted discount rates, as
illustrated earlier in Figure 3. Forecasting accurately becomes even less important when the risk-
adjusted discount rate is high, as shown Table 4.

TABLE 4 - Discount Rates for Risky Stocks Can Be 16%, Or More

Number of years in the future Present value (PV) of $1 discounted at a rate of 16%
when $1 is received
Equity Share Valuation – Professor Jack Clark Francis – Page 12
 t = 10 PV = $1/(1.16)10 = $0.2266  23¢
t = 25 PV = $1/(1.16)25 = $0.0245  2.5¢
t = 50 PV = $1/(1.16)50 = $0.0006  6/100 of 1¢
t = 100 PV = $1/(1.16)100 = $0.0000003 < 3/100,000 of 1¢

The present value of cash flows received many years in the future is so small for risky firms that
long-range forecasting accuracy is even less important. As a result, the DDM is also useful for
valuing small, risky, and distressed firms that are more difficult to predict.

Corporate Earnings Influence Stock Prices

The Board of Directors of most corporations meets quarterly to determine how to allocate the
quarter’s after-tax earnings (net income) between the three alternatives listed in Table 5.

TABLE 5 – The Three Possible Uses Of A Corporation’s Earnings per Share

Portions of Total Corporate Earnings
1. Cash dividends per share (DIV)
2. Plus: Retained earnings, per
share
3. Plus: Share buybacks, per share
Total: Earnings per share (EPS)
Explanation
Per share cash dividend payments, if any are paid, pass
some earnings on to the corporation’s owners
Some of the earnings per share can be reinvested
internally to finance the firm’s growth
Some of the earnings might be used to repurchase shares
of the corporation’s outstanding stock
EPS = (Corporation’s total net income)/(Total number of
shares of outstanding common stock)

A corporation’s dividend policy can be represented quantitatively by the percentage of the

corporation’s earnings the Board of Directors allocates to cash dividend payments.

𝑨𝒈𝒈𝒓𝒆𝒈𝒂𝒓𝒆 𝒄𝒐𝒓𝒑𝒐𝒓𝒂𝒕𝒆
𝑷𝒂𝒚𝒐𝒖𝒕 𝑪𝒂𝒔𝒉 𝒅𝒊𝒗𝒊𝒅𝒆𝒏𝒅𝒔 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆 (𝑫𝑰𝑽) ( )
𝒄𝒂𝒔𝒉 𝒅𝒊𝒗𝒊𝒅𝒆𝒏𝒅𝒔
[ ] = 𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆 (𝑬𝑷𝑺) = ′
𝑪𝒐𝒓𝒑𝒐𝒓𝒂𝒕𝒊𝒐𝒏 𝒔
= (𝟏 − 𝑹𝑹) (13)
𝒓𝒂𝒕𝒊𝒐 ( )
𝒂𝒈𝒈𝒓𝒆𝒈𝒂𝒕𝒆 𝒏𝒆𝒕 𝒊𝒏𝒄𝒐𝒎𝒆

The retention ratio (RR) measures the proportion of the corporation’s earnings the Board retains
within the firm. Unless the Board elects to spend some of the corporate earnings on share
buybacks, the retention ratio is the reciprocal of the firm’s payout ratio. If a corporation’s Board of
Directors elects to spend a portion of the firm’s earnings to repurchase some of its outstanding
common stock, then the payout ratio and the retention ratio will sum to less than one during that
particular accounting period, (Payout ratiot) + (RR t) < 1.

Some shareholders would rather receive cash dividends than have his or her share of the
corporation’s earnings spent to repurchase some of its own outstanding shares. These shareholders
should realize they can create “home-made cash dividends” by liquidating some of their stock.

Most corporation’s that repurchase their own shares make public announcements of their planned
share repurchases. Corporations undertake a share repurchase programs for various reasons.
Equity Share Valuation – Professor Jack Clark Francis – Page 13
Sometimes a corporation makes a once-and-for-all buyback its own shares because the corporation
finds itself holding excess cash. Or, outstanding shares can be repurchased because the Board of
Directors thinks the shares are currently underpriced. With the passage of time Boards of Directors
often change their expectations and alter their share repurchase plans before they are fully executed.

Analysis Of Internally Financed Corporate Growth

Retained earnings are the portion of a corporation’s total earnings that remain after cash dividends
and share buybacks are deducted from earnings. Since the dividend discount model (DDM) assumes
the firm does no borrowing, retained earnings are the only source of funds available to pay for the
purchases necessary for the firm’s growth. Whatever earnings are reinvested in the firm earn the
corporation’s return on equity (ROE).

Net income
Return on equity, ROE = (14)
Net worth (𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦)

In the dividend discount model (DDM) the firm’s growth rate equals its retention ratio, RR,
multiplied by the firm’s return on equity, ROE, as shown below.

𝑔 = (𝑅𝑅)𝑥(𝑅𝑂𝐸) (15)

𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑇𝑜𝑡𝑎𝑙 𝑖𝑛𝑐𝑜𝑚𝑒

= 𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 = 𝑥 𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 (15a)
𝑇𝑜𝑡𝑎𝑙 𝑖𝑛𝑐𝑜𝑚𝑒

Growth rate Eqn.(15) can be substituted into extend Eqn.(1) to derive a more complex and
insightful Eqn.(16) which can forecast a corporation’s future dividends per share.

DIVt = 𝐷𝐼𝑉0 (1 + g)t (1)

= DIV0 [1 + (RR)(ROE)]t since g = (RR)(ROE) (16)

If the payout ratio remains constant through time, we can divide the payout ratio into the dividend
per share term in Eqn.(16) to convert DIV0 into EPS0, since EPSo = DIV0 / (Payout ratio). This
algebraic manipulation creates Eqn.(17), which is useful for analyzing the determinants of a
corporation’s future earnings per share.

𝐄𝐏𝐒𝐭 = 𝐄𝐏𝐒𝟎 (𝟏 + 𝐠)𝐭 = 𝐄𝐏𝐒𝟎 [𝟏 + (𝐑𝐑)(𝐑𝐎𝐄)]𝐭 (17)

Eqns. (1), (16) and (17) are not only useful for forecasting; they are also used to reformulate the
DDM.

Reformulating DDM To Answer “What If ...?” Questions

We begin with the familiar constant growth DDM below.

𝐷𝐼𝑉0 (1+𝑔)𝑡
𝑃0 = ∑∞
𝑡=1 (4)
(1+𝑘)𝑡

Equity Share Valuation – Professor Jack Clark Francis – Page 14

The fact that 𝐷𝐼𝑉0 = EPS0 (1 − Payout ratio) can be used with the earnings forecasting model,
Eqn.(17), to restate the intrinsic value per share of the stock in Eqn.(4) in terms of its forecasted
earnings per share.

𝑬𝑷𝑺𝟎 (𝑷𝒂𝒚𝒐𝒖𝒕 𝒓𝒂𝒕𝒊𝒐+𝑺𝒉𝒂𝒓𝒆 𝒃𝒖𝒚𝒃𝒂𝒄𝒌 𝒑𝒆𝒓𝒄𝒆𝒏𝒕){𝟏+𝒈}𝒕

𝑷 𝟎 = ∑∞
𝒕=𝟏 (𝟏+𝒌)𝒕
(18)

𝑬𝑷𝑺𝟎 (𝑷𝒂𝒚𝒐𝒖𝒕 𝒓𝒂𝒕𝒊𝒐+𝑺𝒉𝒂𝒓𝒆 𝒃𝒖𝒚𝒃𝒂𝒄𝒌 𝒑𝒆𝒓𝒄𝒆𝒏𝒕){𝟏+𝒈}𝒕

𝑷 𝟎 = ∑∞
𝒕=𝟏 (𝟏+𝒌)𝒕
(18)
𝐸𝑃𝑆0 (𝑷𝒂𝒚𝒐𝒖𝒕 𝒓𝒂𝒕𝒊𝒐+𝑺𝒉𝒂𝒓𝒆 𝒃𝒖𝒚𝒃𝒂𝒄𝒌 𝒑𝒆𝒓𝒄𝒆𝒏𝒕){(1+(𝑅𝑅)(𝑅𝑂𝐸)}𝑡
= ∑∞
𝑡=1 since 𝑔 = 𝑅𝑅 𝑥 𝑅𝑂𝐸 (18a)
(1+𝑘)𝑡

Eqns.(18) and (18a) are useful for answering investment analysts’ questions about what would
happen if the value of the 𝐸𝑃𝑆0 , payout ratio, ROE, and/or, the risk-adjusted discount rate changed.
It is reassuring to recall that all the various valuation models reviewed here are so logical and
internally consistent that they can be mathematically derived from each other.

A Wealth Maximizing Dividend Policy Depends On The Relationship between ROE and k

U.S. corporations can be divided into one of three categories based on each firm’s relationship
between ROE and k.

1) Normal Firms are in Limbo: Casual observations suggests that roughly eighty percent of all
firms in the U.S. are normal firms that have ROE = k. A corporation’s cash dividend policy is
irrelevant if it is a normal firm. Supermarket chains like A&P, food chains like Dairy Queen, food
manufacturers like Kraft, public utilities like New York City’s Consolidated Edison, and auto
companies like Ford are examples of normal corporations. As the discussion of Eqn.(21) will show,
a corporation’s cash dividend policy does not affect the market value of the common stock of these
corporations.

2) Sustainable Firms: Corporations that have ROE > k are sustainable and their common stock is
truly a growth stock. Growth corporations should pay no cash dividends in order to maximize the
value per share of the stock. Amazon.com, Apple, Google, and Facebook are examples of growth
firms that have maximized their owners’ wealth by not paying cash dividends. Casual empiricism
suggests that roughly ten percent of all corporations in the U.S. are true growth firms.

3) Unsustainable Firms: Corporations that have ROE < k are unsustainable because the value of
their common stock is destined to decline. To maximize the value per share of the shareholders’
stock, a declining firm should liquidate the corporation and pay the proceeds out as one big
liquidating cash dividend. A declining firm may be burdened with an obsolete product, embedded
management that is counter-productive, or local business conditions that are stifling, for example.
Casual empiricism suggests that approximately ten percent of all U.S. corporations are declining
firms. The country’s population would be wealthier if these firms were liquidated. Such liquidations
occur rarely, however, because top management does not want to become unemployed.
Equity Share Valuation – Professor Jack Clark Francis – Page 15
 Proof That Dividend Policy is Irrelevant for Normal Firms

Substituting the accounting identity (EPS1)(1-RR) = DIV1 into the valuation model P0 = (DIV1)/(k-
g) yields Eqn.(19).
(𝑬𝑷𝑺𝟏 )(𝟏−𝑹𝑹)
𝑷𝟎 = (19)
(𝒌−𝒈)

(𝑬𝑷𝑺 )(𝟏−𝑹𝑹)
𝟏
𝑷𝟎 = 𝒌−[(𝑹𝑹)(𝑹𝑶𝑬)] since g = (RR)(ROE) (19a)

Since most corporations have ROE = k, these companies are called the normal firms. Equating k
and ROE for a normal corporation permits the derivation of Eqn.(20) from Eqn.(19a).

(𝑬𝑷𝑺𝟏 )(𝟏−𝑹𝑹)
𝑷𝟎 = since ROE=k for normal firms (20)
𝒌−[(𝑹𝑹)(𝒌)]

(𝑬𝑷𝑺𝟏 )(𝟏−𝑹𝑹)
= (20a)
𝒌[𝟏−(𝑹𝑹)]

Eqn.(20a) simplifies to the insightful Eqn.(21).

𝑬𝑷𝑺𝟏
𝑷𝟎 = (21)
𝒌

Eqn.(21) is insightful because it shows mathematical proof that the firm’s cash dividend policy,
represented by either RR or (1 - RR), cancels out of the valuation model. Thus, regardless of the
firm's initial earnings per share, EPS0, or the firm’s riskiness (which determines k), the firm's value
is not affected by its cash dividend policy. When ROE = k, the firm’s cash dividend policy is
irrelevant.

Nobel Laureates Merton H. Miller and Franco Modigliani (MM) were the first to show that, if
income taxes are ignored, a corporation’s cash dividend policy should have no effect on the value of
its common stock.6 MM’s important finding is thrown into doubt because the U.S. taxes cash
dividends as ordinary income (like salary income) while capital gains income is taxed at a lower tax
rate. The lower preferential taxation of income from capital gains means that a normal corporation’s
cash dividend payout policy has a small effect on the value of its shares. Thus, even though this
section’s mathematical proof abstracts from taxes, the valuation insights gained from these
simplified models are worthwhile when a corporation’s Board of Directors is making cash dividend
policies to maximize the firm’s value.

6
See Merton H. Miller and Franco Modigliani, “Dividend Policy, Growth, and the Valuation of
Shares,” Journal of Business, October 1961, Vol. 34, pp. 411-433.

Equity Share Valuation – Professor Jack Clark Francis – Page 16

Microsoft, Facebook, Amazon.com, Apple, and Google are examples of growth stocks that paid no
cash dividends when they were young. The Boards of Directors of these corporations decided to
retain all earnings and reinvest them within the firm rather than use the funds to pay cash dividends
to the corporation’s owners. Omitting cash dividends does not reduce the discounted present value
of a stock if the retained earnings are invested in profitable internal projects that increase the cash
dividends and capital gains investors can expect to receive in the future. In contrast, if a troubled
corporation that might go bankrupt stopped paying cash dividends, investors might conclude the
corporation probably had no profitable internal investments and, as a result, they should sell the
stock. These two vastly different situations demonstrate how investors may correctly interpret cash
dividend payments of zero to be either good news or bad news.

The DDM is not irrelevant for firms that pay no cash dividends. The discussions below shows how
to reformulate the DDM to evaluate earnings per share so that cash dividends need not be
considered.

THE PRICE-EARNINGS RATIO

Fundamental common stock analysts utilize the venerable procedure defined by Eqn.(22) to
estimate the intrinsic value of a share of common stock.

𝐈𝐧𝐭𝐫𝐢𝐧𝐬𝐢𝐜 𝐄𝐬𝐭𝐢𝐦𝐚𝐭𝐞𝐝 𝐄𝐬𝐭𝐢𝐦𝐚𝐭𝐞𝐝

[𝐯𝐚𝐥𝐮𝐞 𝐩𝐞𝐫] = [ 𝐞𝐚𝐫𝐧𝐢𝐧𝐠𝐬 ] [𝐩𝐫𝐢𝐜𝐞 − 𝐞𝐚𝐫𝐧𝐢𝐧𝐠𝐬] (22)
𝐬𝐡𝐚𝐫𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞 𝐫𝐚𝐭𝐢𝐨

Fundamental security analysts analyze the financial statements of companies, attend corporations’
annual meetings, attend trade association meetings, follow the news announcements about
competing companies, interview executives and labor union officers that might divulge valuable
facts, and study many other fundamental facts that determine the intrinsic value per share of the
stock. They gather data in an effort to forecast the EPS and the price-earnings ratios. Fundamental
analysts usually specialize in one industry, and the companies in that selected industry receive the
focus of their attention.

The Theory of Price-Earnings Ratios

The theory of the price-earnings ratio is derived from the DDM defined above in Eqn.(6).

P0 = DIV1/(k-g) (6)

Dividing both sides of the DDM, Eqn.(6), by next year’s earnings per share, EPS1, yields the P/E
theory in Eqn.(23).

𝑃0 𝐷𝐼𝑉1 ⁄𝐸𝑃𝑆1
= (23)
𝐸𝑃𝑆1 𝑘−𝑔

𝑁𝑒𝑥𝑡 𝑦𝑒𝑎𝑟 ′ 𝑠 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜

= (23a)
𝑘−𝑔

Equity Share Valuation – Professor Jack Clark Francis – Page 17

FIGURE 4 – Price/Earnings Ratio and Prices for the S&P 500 Index, 1921-2016
2500 140

2250

S&P 500 P/E Ratio (Dotted Line)

S&P 500 Price Index (Solid Line)

120
2000

1750 100

1500
80
1250
60
1000

750 40
500
20
250

0 0
1942.02

1964.11

1987.08

2010.05
1912.11
1916.02
1919.05
1922.08
1925.11
1929.02
1932.05
1935.08
1938.11

1945.05
1948.08
1951.11
1955.02
1958.05
1961.08

1968.02
1971.05
1974.08
1977.11
1981.02
1984.05

1990.11
1994.02
1997.05
2000.08
2003.11
2007.02

2013.08
Year.Fraction of Year

SUMMARY: Note that the S&P 500 Index’s P/E ratio rose during 2001 (right hand axis), as stock
prices collapsed (after the Dot.com stock market bubble peaked in 2000).

EXAMPLE 6: The Battel Corporation’s P/E Ratio

Earlier in this chapter Eqn.(5a) suggested that if the Battel Corporation’s cash dividends are DIV0
=$2.00, the firm’s growth rate is g = 2%, the corporation’s cost of equity capital is k = 10%, the
stock’s suggested value is $25.50 per share.

𝐷𝐼𝑉0 (1+𝑔) 1𝐷𝐼𝑉 ($2)(1.02) $2.04

𝑃0 = = = (𝑘−𝑔) = = = $25.50 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 (5a)
(𝑘−𝑔) 0.10−0.02 0.08

If we divide the equation above by earnings per share of $3.00 that Battel is expected to earn next
year, Eqn.(23b) suggests a P/E ratio of 8.5 times the stock’s earnings per share is an appropriate
earnings multiplier.

𝑃0 𝐷𝐼𝑉1 /𝐸𝑃𝑆1 $2.04⁄$3.00 0.68

= = = = 8.5 𝑡𝑖𝑚𝑒𝑠 (23b)
𝐸𝑃𝑆1 (𝑘−𝑔) 0.10−0.02 0.08

Analysis of the Price-Earnings Ratio

The impact of the return on equity (ROE), retention ratio (RR) on the price-earnings ratio can also
be analyzed.

𝟏 (𝑬𝑷𝑺 )(𝟏−𝑹𝑹)
𝑷𝟎 = 𝒌−[(𝑹𝑹)(𝑹𝑶𝑬)] since g = [(RR)(ROE)] (19a)

Equity Share Valuation – Professor Jack Clark Francis – Page 18

Dividing Eqn.(19a) by the next year’s earnings per share, 𝐸𝑃𝑆1 , results in another perspective on
the theory underlying the price-earnings ratio.
𝑷𝟎 (𝟏−𝑹𝑹)
= 𝒌 −(𝑹𝑹)(𝑹𝑶𝑬) (24)
𝑬𝑷𝑺𝟏

Table 9.7 shows the growth rates and price-earnings ratios that are appropriate for corporations with
risk-adjusted discount rates of k = 12 percent, and, four different retention ratios (namely, 0, 25%,
50%, 75%). The growth rates are computed with Eqn.(15), and the P/E ratios are calculated with
Eqn.(23). Table 9.7A shows how the growth rates increase with the retention ratio. In contrast,
Table 9.7B shows how the corporations’ price-earnings ratios move inversely with the retention
ratio. Eqn.(24) can be used to compute the values in Table 9.7.

TABLE 9.7 - The ROE and the Retention Ratio Determine

the Appropriate Growth Rate and P/E Ratio

Panel 7A - Growth rates, g = ROE x RR Eqn.(15)

Consider four retention ratios (RRs):
ROE 0% 25% 50% 75%
8.0% 0.0% 2.0% 4.0% 6.0%
10.0% 0.0% 2.5% 5.0% 7.5%
12.0% 0.0% 3.0% 6.0% 9.0%
14.0% 0.0% 3.5% 7.0% 10.5%

Panel 7B - P/E ratios from Eqn.(24); the payout ratio

is (1-RR); and, g computed in Panel 7A.
Consider four retention ratios (RRs):
ROE 0% 25% 50% 75%
8.0% 8.33 7.50 6.25 4.17
10.0% 8.33 7.89 7.14 5.56
12.0% 8.33 8.33 8.33 8.33
14.0% 8.33 8.82 10.00 16.67
Assuming: k = 12%

During the past century the lowest value of the price-earnings ratio of the S&P 500 Index of 500
stocks was 5.2 times earnings in 1920. More recently, the P/E reached a low of 6.9 in 1982. The
S&P 500 Index’s highest P/E value was 43.8 times earnings in 2000. A median P/E ratio is 14 times
earnings. These historical guidelines can be helpful when seeking to ascertain whether individual
stocks or the entire stock market is over- or under-priced.

The Cash Dividend Yield

The cash dividend yield, Eqn.(25), measures how much cash investors receive from a stock for
each dollar of invested funds.

Equity Share Valuation – Professor Jack Clark Francis – Page 19

 𝑨𝒏𝒏𝒖𝒂𝒍 𝒄𝒂𝒔𝒉 𝒅𝒊𝒗𝒊𝒅𝒆𝒏𝒅,$𝟐
𝑪𝒂𝒔𝒉 𝒅𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝒚𝒊𝒆𝒍𝒅, 𝟕. 𝟖% = (25)
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒔𝒕𝒐𝒄𝒌 𝒑𝒓𝒊𝒄𝒆,$𝟐𝟓.𝟓𝟎
For example, if the Battel Corporation’s stock paid annual cash dividends of $2 per share while the
market price of its common stock was $25 per share, as shown above in Eqn.(5a), Battel’s cash
dividend yield would be 7.8%.

During the past century the highest cash dividend yield the S&P 500 Index ever paid was over 10%
in 1932. This high yield occurred because stock market prices crashed as the Depression of the
1930s unfolded. The S&P 500’s lowest cash dividend yield was 1.2% in 2000, at the peak of the
dot.com stock price bubble. Four percent is a median cash dividend yield. Investors can compare a
stock’s cash dividend yield to a market guideline like the S&P 500 Index to determine if an
individual stock or the entire stock market is over-priced or under-priced.7

From month to month, a corporation’s earnings per share and the market price of its common stock
both fluctuate randomly and continuously. Figure 4 illustrates the way the earnings and market
price of the S&P 500 Index portfolio fluctuated during the past century.

FIGURE 5 – Cash Dividend Yield Values and Prices for S&P 500 Index, 1921-2016
2500 16.00%

S&P 500 Cash Dividend Yield (Dotted Line)

2250
14.00%
S&P 500 Price Index (Solid Line)

2000
12.00%
1750
10.00%
1500

1250 8.00%

1000
6.00%
750
4.00%
500
2.00%
250

0 0.00%
1923.05

1944.05
1912.11
1916.05
1919.11

1926.11
1930.05
1933.11
1937.05
1940.11

1947.11
1951.05
1954.11
1958.05
1961.11
1965.05
1968.11
1972.05
1975.11
1979.05
1982.11
1986.05
1989.11
1993.05
1996.11
2000.05
2003.11
2007.05
2010.11
2014.05

Year.Fraction of Year

7
Since cash dividends are an alternative to investing in bonds and earning market interest rates, it
can be useful to compare the two. In a different vein, note that since 1980 more corporations have
begun buying back their own shares. In fact, many corporations now view share buybacks as an
alternative to paying cash dividends. As a result, the meaning of cash dividend yields has changed
somewhat since 1980. See Douglas Skinner, “The Evolving Relationship Between Earnings,
Dividends, and Stock Repurchases,” Journal of Financial Economics, Volume 87, 2008, pages 582-
609.

Equity Share Valuation – Professor Jack Clark Francis – Page 20

SUMMARY: Note that as the Depression started to unfold during 1929-1930 and stock prices were
collapsing, the S&P 500 cash dividend yield (right hand axis) was rising.

FREE CASH FLOW (FCF)

Since the dividend discount models (DDMs) above are inappropriate for firms that pay no cash
dividends, many financial analysts use valuation models based on a corporation’s free cash flow
(FCF) available to the entire firm (FCFF) and to only the firm’s equity investors (FCFE).

FCF For The Entire Corporation. Eqn.(26) defines a corporation’s free cash flow per accounting
period that is available to the firm (FCFF).

𝑪𝒂𝒑𝒕𝒂𝒍 𝑰𝒏𝒄𝒓𝒆𝒂𝒔𝒆
𝑭𝑪𝑭𝑭 = 𝑬𝑩𝑰𝑻(𝟏 − 𝑻𝒂𝒙 𝒓𝒂𝒕𝒆) + 𝑫𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏 − ( )−( ) (26)
𝒆𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆𝒔 𝒊𝒏 𝑵𝑾𝑪
The firm’s earnings before interest and taxes (EBIT), corporate income tax rate, allowance for
depreciation per time period, and any decrease in the firm’s net working capital (NWC) during the
time period contribute to its FCFF. The FCFF is used to pay the claims from debt holders and to
pay cash dividends to the firm’s stock holders. To determine a firm’s total value the firm’s weighted
average cost of capital (WACC) is the appropriate risk-adjusted discount rate to use in Eqn.(27).

𝑭𝒊𝒓𝒎′ 𝒔 𝑭𝑪𝑭𝑭𝒕 𝑷𝑻
( ) = ∑𝑻𝒕=𝟏 (𝟏+𝑾𝑨𝑪𝑪)𝒕 + (𝟏+𝑾𝑨𝑪𝑪)𝑻
(27)
𝒕𝒐𝒕𝒂𝒍 𝒗𝒂𝒍𝒖𝒆

If T = ∞ we can use the simple and elegant model from Eqn.(6), 𝑃𝑜 = 𝐷𝐼𝑉1⁄(𝑘 − 𝑔), to restate
Eqn.(27) as Eqn.(27a).
𝐹𝐶𝐹𝐹𝑇+1
(𝑃𝑇 ) = (27a)
(𝑊𝐴𝐶𝐶−𝑔)

Eqn.(27a) is like the familiar Eqn.(6), 𝑃𝑜 = 𝐷𝐼𝑉1⁄(𝑘 − 𝑔), restated to include the entire firm (that
is, debt plus equity) instead of only the firm’s equity shares.

FCF For Only The Corporation’s Equity Shares. The free cash flow available to the firm’s
equity owners (FCFE) differs from the FCFF by the firm’s after-tax interest expenses and debt
repayments minus the proceeds from new issues of debt.

𝑭𝑪𝑭𝑬 = 𝑭𝑪𝑭𝑭 − (𝑰𝒏𝒕. 𝒆𝒙𝒑𝒆𝒏𝒔𝒆)(𝟏 − 𝑪𝒐𝒓𝒑. 𝒕𝒂𝒙 𝒓𝒂𝒕𝒆) + 𝑰𝒏𝒄𝒓𝒆𝒂𝒔𝒆𝒔 𝒊𝒏 𝒏𝒆𝒕 𝒅𝒆𝒃𝒕 (28)

Eqn.(29) defines the value of the firm’s total equity, it is discounted at the firm’s cost of equity
capital, denoted 𝑘𝑒 .

𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝒕𝒉𝒆 𝑭𝑪𝑭𝑬 𝑷

( ) = ∑𝑻𝒕=𝟏 (𝟏+𝒌 )𝒕𝒕 + (𝟏+𝒌𝑻 )𝑻 (29)
𝒇𝒊𝒓𝒎′ 𝒔 𝒆𝒒𝒖𝒊𝒕𝒚 𝒆 𝒆

If T = ∞ we can use the simple and elegant model from Eqn.(6), 𝑃𝑜 = 𝐷𝐼𝑉1⁄(𝑘 − 𝑔), to restate
Eqn.(29) as Eqn.(29a).
Equity Share Valuation – Professor Jack Clark Francis – Page 21
 𝐹𝐶𝐹𝐸𝑇+1
(𝑃𝑇 ) = (29a)
(𝑘𝑒 −𝑔)

Eqn.(29a) is a reformulated version of to the familiar Eqn.(6), 𝑃𝑜 = 𝐷𝐼𝑉1⁄(𝑘 − 𝑔). The firm’s
aggregate equity value can be divided by the number of common stock shares outstanding to
determine the value of a common stock on a per share basis.

A MARGIN FOR ERROR

The formulas used above and the numbers written with decimal point precision can give the false
impression that stock market analysis is always very precise. In fact, stock market analysis is an
imprecise process that involves subjective estimates and forecasts that cannot always be accurate.

To avoid earning losses by trading on erroneous stock price forecasts, it is wise to include a margin
for error of at least plus or minus twenty percent when making investment decisions. For instance,
if a security analysis report asserts that a stock’s intrinsic value per share is $40, readers of that
report would be wise to act like the stock was priced correctly as long as its market price was
fluctuating between ($40 minus 20 percent equals) $32 and ($40 plus 20 percent equals) $48.
Stated differently, endeavor to avoid over-confidence by not buying the stock unless its price falls
below $32, and not selling the stock short unless its price rises above $48.

Valuing Equity Shares – Outline

CASH DIVIDEND PAYMENTS ........................................................................................... 2

FIGURE 1 – A Corporation with Seasonal Earnings per Share (EPS) Pays Stable Cash Dividends ............................. 3
𝐃𝐈𝐕𝟎𝟏 + 𝐠𝐭 = 𝐃𝐈𝐕𝐭 (1) .............................................................................................................................. 4
g = (DIVt+1 - DIVt) / (DIVt) (2) ................................................................................................................ 4
FIGURE 2 - Different Patterns For A Corporation’s Cash Dividend Payments ............................................................ 5

THE PRESENT VALUE OF CASH DIVIDENDS ................................................................. 5

EXAMPLE 1: Valuing A Share of Preferred Stock ....................................................................................................... 6
EXAMPLE 2: Analyzing A Common Stock As Significant Changes Occur ................................................................. 7
The Risk-Adjusted Discount Rate, k ........................................................................................................................... 8
FIGURE 3 – The Appropriate Risk-Adjusted Discount Rate for a Stock Varies with the Issuing Corporation’s Credit
Risk and with Market Conditions ................................................................................................................................... 8

Stock Valuation Over A Two Year Holding Period ...................................................................................................... 9

𝑷𝟎 = 𝑷𝟐(𝟏 + 𝒌)𝟐 = 𝑫𝑰𝑽𝟑(𝟏 + 𝒌)𝟏 + 𝑫𝑰𝑽𝟒(𝟏 + 𝒌)𝟐 + 𝑫𝑰𝑽𝟓(𝟏 + 𝒌)𝟑 + ⋯ + 𝑷∞𝟏 + 𝒌∞(𝟏 + 𝒌)𝟐 (𝟏𝟎) ... 9

The Stages Of Growth Model .........................................................................................................................................10

TABLE 1 - The Spurtz Corporation’s Three Stages of Growth ....................................................................................10
TABLE 2 – One Share of Spurtz Stock’s Cash Dividends and Discounted Cash Flows ..............................................10

Equity Share Valuation – Professor Jack Clark Francis – Page 22

Estimating A Corporation’s Present Value of Growth Opportunities (PVGO) ........................................................11
𝑷𝟎 = 𝑫𝑰𝑽𝟏𝒌 − 𝒈 = 𝑬𝑷𝑺𝟏(𝟏 − 𝑹𝑹)𝒌 − 𝒈 = 𝑬𝑷𝑺𝟏𝒌 with a zero retention rate (RR) and g = 0 (11) ...........11
𝐏𝐫𝐢𝐜𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞 = 𝐍𝐨 − 𝐠𝐫𝐨𝐰𝐭𝐡𝐯𝐚𝐥𝐮𝐞 𝐩𝐞𝐫𝐬𝐡𝐚𝐫𝐞 + 𝐏𝐕𝐆𝐎 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞 (12) .......................................11

Forecasting Problems - A Common Criticism Of The DDM .......................................................................................12

TABLE 3 - The Discount Rates for Blue-Chip Stocks Is About 10% ...........................................................................12
TABLE 4 - Discount Rates for Risky Stocks Can Be 16%, Or More .....................................................................12
Corporate Earnings Influence Stock Prices ...................................................................................................................13
TABLE 5 – The Three Possible Uses Of A Corporation’s Earnings per Share.............................................................13
𝑷𝒂𝒚𝒐𝒖𝒕 𝒓𝒂𝒕𝒊𝒐 = 𝑪𝒂𝒔𝒉 𝒅𝒊𝒗𝒊𝒅𝒆𝒏𝒅𝒔 𝒑𝒆𝒓 𝑠𝒉𝒂𝒓𝒆 (𝑫𝑰𝑽)𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆 (𝑬𝑷𝑺) =
𝑨𝒈𝒈𝒓𝒆𝒈𝒂𝒓𝒆 𝒄𝒐𝒓𝒑𝒐𝒓𝒂𝒕𝒆 𝒄𝒂𝒔𝒉 𝒅𝒊𝒗𝒊𝒅𝒆𝒏𝒅𝒔𝑪𝒐𝒓𝒑𝒐𝒓𝒂𝒕𝒊𝒐𝒏′𝒔 𝒂𝒈𝒈𝒓𝒆𝒈𝒂𝒕𝒆 𝒏𝒆𝒕 𝒊𝒏𝒄𝒐𝒎𝒆 = (𝟏 − 𝑹𝑹) (13) .....13

Analysis Of Internally Financed Corporate Growth ....................................................................................................14

𝑔 = 𝑅𝑅𝑥𝑅𝑂𝐸 (15) .....................................................................................................................................14
= 𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 =
𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠𝑇𝑜𝑡𝑎𝑙 𝑖𝑛𝑐𝑜𝑚𝑒𝑥𝑇𝑜𝑡𝑎𝑙 𝑖𝑛𝑐𝑜𝑚𝑒𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 (15a) ................................................14
𝐄𝐏𝐒𝐭 = 𝐄𝐏𝐒𝟎(𝟏 + 𝐠)𝐭 = 𝐄𝐏𝐒𝟎[𝟏 + 𝐑𝐑𝐑𝐎𝐄]𝐭 (17) ...................................................................14

Reformulating DDM To Answer “What If ...?” Questions ..........................................................................................14

𝑷𝟎 = 𝒕 = 𝟏∞ 𝑬𝑷𝑺𝟎(𝑷𝒂𝒚𝒐𝒖𝒕 𝒓𝒂𝒕𝒊𝒐 + 𝑺𝒉𝒂𝒓𝒆 𝒃𝒖𝒚𝒃𝒂𝒄𝒌 𝒑𝒆𝒓𝒄𝒆𝒏𝒕){𝟏 + 𝒈}𝒕𝟏 + 𝒌𝒕 (18)...................15
𝑷𝟎 = 𝒕 = 𝟏∞ 𝑬𝑷𝑺𝟎(𝑷𝒂𝒚𝒐𝒖𝒕 𝒓𝒂𝒕𝒊𝒐 + 𝑺𝒉𝒂𝒓𝒆 𝒃𝒖𝒚𝒃𝒂𝒄𝒌 𝒑𝒆𝒓𝒄𝒆𝒏𝒕){𝟏 + 𝒈}𝒕𝟏 + 𝒌𝒕 (18)...................15

Proof That Dividend Policy is Irrelevant for Normal Firms .......................................................................................16

𝑷𝟎 = (𝑬𝑷𝑺𝟏)(𝟏 − 𝑹𝑹)(𝒌 − 𝒈) (19) ..............................................................................................................16
𝑷𝟎 = (𝑬𝑷𝑺𝟏)(𝟏 − 𝑹𝑹)𝒌 − [𝑹𝑹𝑹𝑶𝑬] since g = (RR)(ROE) (19a) ................................................................16
𝑷𝟎 = 𝑬𝑷𝑺𝟏(𝟏 − 𝑹𝑹)𝒌 − [𝑹𝑹𝒌] since ROE=k for normal firms (20) ..........................................................16
= (𝑬𝑷𝑺𝟏)(𝟏 − 𝑹𝑹)𝒌[𝟏 − 𝑹𝑹] (20a) .............................................................................................................16
𝑷𝟎 = 𝑬𝑷𝑺𝟏𝒌 (21) .......................................................................................................................................16

THE PRICE-EARNINGS RATIO .................................................................................................................................17

𝐈𝐧𝐭𝐫𝐢𝐧𝐬𝐢𝐜 𝐯𝐚𝐥𝐮𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞 = 𝐄𝐬𝐭𝐢𝐦𝐚𝐭𝐞𝐝 𝐞𝐚𝐫𝐧𝐢𝐧𝐠𝐬𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞𝐄𝐬𝐭𝐢𝐦𝐚𝐭𝐞𝐝𝐩𝐫𝐢𝐜𝐞 − 𝐞𝐚𝐫𝐧𝐢𝐧𝐠𝐬𝐫𝐚𝐭𝐢𝐨 (22)...17

The Theory of Price-Earnings Ratios ............................................................................................................................17

FIGURE 4 – Price/Earnings Ratio and Prices for the S&P 500 Index, 1921-2016 .......................................................18
EXAMPLE 6: The Battel Corporation’s P/E Ratio .....................................................................................................18

Analysis of the Price-Earnings Ratio .............................................................................................................................18

𝑷𝟎𝑬𝑷𝑺𝟏 = (𝟏 − 𝑹𝑹)𝒌 − (𝑹𝑹)(𝑹𝑶𝑬) (24) ..................................................................................................19
TABLE 9.7 - The ROE and the Retention Ratio Determine .........................................................................................19
the Appropriate Growth Rate and P/E Ratio .................................................................................................................19

.......................................................................................... 19
THE CASH DIVIDEND YIELD
𝑪𝒂𝒔𝒉 𝒅𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝒚𝒊𝒆𝒍𝒅, 𝟕. 𝟖% = 𝑨𝒏𝒏𝒖𝒂𝒍 𝒄𝒂𝒔𝒉 𝒅𝒊𝒗𝒊𝒅𝒆𝒏𝒅, $𝟐𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒔𝒕𝒐𝒄𝒌 𝒑𝒓𝒊𝒄𝒆, $𝟐𝟓. 𝟓𝟎 (25) .......20
FIGURE 5 – Cash Dividend Yield Values and Prices for S&P 500 Index, 1921-2016 ................................................20

FREE CASH FLOW (FCF) ................................................................................................ 21

𝑭𝑪𝑭𝑭 = 𝑬𝑩𝑰𝑻𝟏 − 𝑻𝒂𝒙 𝒓𝒂𝒕𝒆 + 𝑫𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝑖𝒐𝒏 − 𝑪𝒂𝒑𝒕𝒂𝒍 𝒆𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆𝒔 − 𝑰𝒏𝒄𝒓𝒆𝒂𝒔𝒆 𝒊𝒏 𝑵𝑾𝑪 (26) ............21
𝑭𝒊𝒓𝒎′𝒔𝒕𝒐𝒕𝒂𝒍 𝒗𝒂𝒍𝒖𝒆 = 𝒕 = 𝟏𝑻𝑭𝑪𝑭𝑭𝒕(𝟏 + 𝑾𝑨𝑪𝑪)𝒕 + 𝑷𝑻(𝟏 + 𝑾𝑨𝑪𝑪)𝑻 (27) ...........................................21
𝑭𝑪𝑭𝑬 = 𝑭𝑪𝑭𝑭 − 𝑰𝒏𝒕. 𝒆𝒙𝒑𝒆𝒏𝒔𝒆𝟏 − 𝑪𝒐𝒓𝒑. 𝒕𝒂𝒙 𝒓𝒂𝒕𝒆 + 𝑰𝒏𝒄𝒓𝒆𝒂𝒔𝒆𝒔 𝒊𝒏 𝒏𝒆𝒕 𝒅𝒆𝒃𝒕 (28) ....................................21
𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝒕𝒉𝒆𝒇𝒊𝒓𝒎′𝒔 𝒆𝒒𝒖𝒊𝒕𝒚 = 𝒕 = 𝟏𝑻𝑭𝑪𝑭𝑬𝒕(𝟏 + 𝒌𝒆)𝒕 + 𝑷𝑻(𝟏 + 𝒌𝒆)𝑻 (29) .........................................21

A MARGIN FOR ERROR .................................................................................................. 22

Equity Share Valuation – Professor Jack Clark Francis – Page 23