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CHAPTER 10
Approaches to
Common Stock Valuation
Pamela P. Drake, Ph.D., CFA
J. Gray Ferguson Professor Finance
College of Business
James Madison University
271
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to Common Stock ValuationEQUITY ANALYSIS AND PORTFOLIO MANAGEMENT
Dividend Measures
Dividends are measured using three different metrics: dividends per share,
dividend yield, and dividend payout ratio. The value of a share of stock to-
day is the market’s assessment of today’s worth of future cash flows for each
share. Because future cash flows to shareholders are dividends, we need a
measure of dividends for each share of stock to estimate future cash flows
per share.
The dividends per share is the dollar amount of dividends paid out dur-
ing the period per share of common stock:
The complement to the dividend payout ratio is the plowback ratio, which
is the percentage of earnings retained by the company during the period.
The proportion of earnings paid out in dividends varies by company
and industry. If the board of directors of companies focuses on maintaining
a constant dividends per share or a constant growth in dividends per share
in establishing their dividend policy, the dividend payout ratio will fluctu-
ate along with earnings. Typically corporate boards set the dividend policy
such that dividends per share grow at a relatively constant rate, resulting in
dividend payouts that fluctuate from year to year.
or
1
Historically, the dividend yield for U.S. stocks has been a little less than 5% accord-
ing to a study by John Y. Campbell and Robert J. Shiller, “Valuation Ratios and the
Long-Run Stock Market Outlook,” Journal of Portfolio Management 24 (1998):
11–26.
2
This model was first suggested by John Burr Williams, The Theory of Investment
Value (Boston, Mass.: Harvard University Press, 1938).
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∞
D
P0 = ∑ t t
(10.1)
t =1 (1 + rt )
where
or
⎡ N
D ⎤ P
0 ∑ t N
t N
P =⎢ ⎥+
⎣ t =1 (1 + rt ) ⎦ (1 + rN )
Assuming a Constant Discount Rate A special case of the finite-life general DDM
that is more commonly used in practice assumes that the discount rate is
constant. That is, we assume each rt is the same for all t. Denoting this con-
stant discount rate by r, the value of a share of stock today becomes
D1 D2 PN
P
0 = + + +
(1 + r)1 (1 + r)2 (1 + r)N
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Approaches 275
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or
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N
⎡ D ⎤ P
0 ⎢∑ t
r)
⎥ ( r)N
(
t N
P = + (10.2)
⎣ t =1 1 + ⎦ 1+
Equation (10.2) is the constant discount rate version of the finite-life general
DDM, and is the more general form of the model.
Required Inputs The finite-life general DDM requires three sets of forecasts
as inputs to calculate the fair value of a stock:
Q Expected terminal price, PN.
Thus, the relevant issue is how accurately these inputs can be forecasted.
The terminal price is the most difficult of the three forecasts. Accord-
ing to theory, P N is the present value of all future dividends after N; that is,
N+2 '
D N+1 , D , . . . , D . Also, we must estimate the discount rate, r. I
price-earnings ratio, or capitalization rate. Note that the present value of the
expected terminal price PN ÷ (1 + r)N becomes very small if N is very large.
The use of the DDM tells the analyst the relative value but does not
indicate when the price of the stock should be expected to move to its fair
price. That is, the model says that based on the inputs generated by the
analyst, the stock may be cheap, expensive, or fair. However, it does not tell
the analyst, if the stock is mispriced, how long it will take before the market
recognizes the mispricing and corrects it. As a result, an investor may hold
onto a stock perceived to be cheap for an extended period of time and may
underperform during that period.
While a stock may be mispriced, an analyst must also consider how
mispriced it is in order to take the appropriate action (that is, buy a cheap
stock and expect to sell it when the price rises, or sell short an expensive
stock expecting its price to decline). This will depend on (1) how much the
stock is trading from its fair value, and (2) transactions costs. An analyst
should also consider that a stock may look as if it is mispriced (based on the
estimates and the model), but this may be the result of estimates that may
introduce error in the valuation.
4
Myron Gordon and Eli Shapiro, “Capital Equipment Analysis: The Required Rate
of Profit,” Management Science 3 (1956): 102–110.
5
This formula is equivalent to calculating the geometric mean of 1 plus the percent-
age change over the number of years.
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⎛ NumberLast year’sdividend ⎞
g= (10.4)
⎜ of years ⎟ −1
⎝ First year’s dividend ⎠
Another problem that arises in using the constant growth rate model is that
the estimated growth rate of dividends may exceed the discount rate, r.
Therefore, there are some cases in which it is inappropriate to use the con-
stant rate DDM.
6
For a pioneering work that modified the DDM to accommodate different growth
rates, see Nicholas Molodovsky, CatherineMay, and Sherman Chattiner, “Common-
Stock Valuation—Principles, Tables, and Applications,” Financial Analysts Journal
21 (1965): 104–123.
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D0 (1 + g) D1
r= +g = +g (10.5)
P0 P0
In other words, the expected return is the discount rate that equates
the present value of the expected future cash flows with the present value
of the stock. The higher the expected return—for a given set of future cash
flows—the lower the current value.
This rearrangement of the dividend discount model provides a perspec-
tive on the expected return: the expected return is the sum of the dividend
yield (that is, D 1/P 0) and the expected rate of growth of dividends. The latter
represents the appreciation (or depreciation, if negative) anticipated for the
stock. Therefore, this is the expected capital gain or loss (or, simply, capital
yield) on the stock.
Given the expected return and the required return (that is, the value
for r), any mispricing can be identified. If the expected return exceeds the
required return, then the stock is undervalued; if it is less than the required
return then the stock is overvalued. A stock is fairly valued if the expected
return is equal to the required return.
With the same set of inputs, the identification of a stock being mispriced
or fairly valued will be the same regardless of whether the fair value is deter-
mined and compared to the market price or the expected return is calculated
and compared to the required return.
price or value as the numerator and some form of earnings or cash flow
generating performance measure for the denominator and that are observ-
able for other similar or like-kind companies.
These multiples are sometimes called “price/X ratios,” where the denom-
inator “X” is the appropriate cash flow generating performance measure and
the numerator is either a market value per share or a total market value. For
example, the price/earnings (P/E) ratio is a popular multiple used for relative
valuation, where an earnings estimate is the cash flow generating perfor-
mance measure. Keep in mind that the terms relative valuation and valuation
by multiples are used interchangeably here as are the terms price and value.
The essence of valuation by multiples assumes that similar or compa-
rable companies are fairly valued in the market. As a result, the scaled price
or value (the present value of expected future cash flows) of similar compa-
nies should be much the same. That is, comparable companies should have
similar price/X ratios. The key for the analyst is to find the comparable
companies that can be used for valuing a target company using valuation
by multiples.
Valuation by multiples, or simply relative valuation, is quick and con-
venient. The simplicity and convenience of valuation by multiples, how-
ever, constitute both the appeal of this valuation method and the problems
associated with its use. Simplicity, however, means that too many facts are
swept under the carpet and too many questions remain unasked. Multiples
should never be an analyst’s only valuation method and preferably not even
the primary focus because no two companies, or even groups of companies,
are exactly the same. The term “similar” entails just as much uncertainty
as the concept of “expected future cash flows” in DCF valuation methods.
Actually, when an analyst has more than five minutes to value a company,
the DCF method, which forces an analyst to consider the many aspects of an
ongoing concern, is the preferred valuation method and the use of multiples
should be secondary.
Having said this, valuation by multiples can provide a valuable “sanity
check.” If an analyst has completed a thorough valuation, he can compare
his predicted multiples, such as the P/E ratio or market value to book value
(MV/BV) ratio, to representative multiples of similar companies. In the MV/
BV ratio, the book value of assets is the cash flow generating performance
measure. That is, each dollar of book value of assets is assumed to generate
cash flow for the company. If an analyst’s predicted multiples are compa-
rable, he can, perhaps, feel more assured of the validity of his analysis. On
the other hand, if an analyst’s predicted multiples are out of line with the
representative multiples of the market, the analyst should reexamine the
assumptions, the appropriateness of the comparables, and the appropriate-
ness of the multiple to the situation at hand.
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Investors do not want to buy earnings; they only want cash flows (in the
form of either dividends or capital gains). Earnings (or sales) are paid for
only to the extent that they generate cash. In computing average ratios for
various bases, an analyst implicitly assumes that the ability of companies to
convert each basis (e.g., sales, book value, and earnings) to cash is the same.
Keep in mind that this assumption is more tenable in some cases than in
others and for some scaling factors than for others.
Realize that we use the word “average” to mean the appropriate value
that is determined by the average company in the comparable group. It may
not be the strict average. It may be a mean, median, or mode. The analyst is
also free to throw out outliers that do not seem to conform to the majority
of companies in the group. Outliers are most likely so because the market
has determined that they are different for any number of reasons.
KEY POINTS
Q The basis for the dividend discount model is simply the application of
present value analysis, which asserts that the fair price of an asset is the
present value of its expected cash flows.
Q Most dividend discount models use current dividends, some measure of
historical or projected dividend growth, and an estimate of the required
rate of return. The three most common dividend measures are dividends
per share, dividend yield, and dividend payout.
Q Variations of the dividend discount models allow an analyst to vary
assumptions regarding dividend growth to accommodate different pat-
terns of dividends. Popular models include the finite-life general divi-
dend discount model, the constant growth dividend discount model,
and multiphase dividend discount model.
Q A dividend discount model can be recast in terms of expected return. The
expected return is found by calculating the interest rate that will make
the present value of the expected cash flows equal to the market price.
Q An alternative valuation method to the dividend discount model is the
use of multiples that have price or value as the numerator and some form
of earnings or cash flow generating performance measure for the denomi-
nator and that are observable for other similar or like-kind companies.
These multiples are sometimes called “price/X ratios,” where the denom-
inator X is the appropriate cash flow generating performance measure.
Q The essence of valuation by multiples assumes that similar or compa-
rable companies are valued fairly in the market. When using relative
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Approaches to Common Stock ValuationEQUITY ANALYSIS AND PORTFOLIO MANAGEMENT
QUESTIONS
1. Consider three companies, A, B, and C. Suppose that a common stock
analyst estimates that the market risk premium is 5% and the risk-free
rate is 4.63%. The analyst estimated the beta for each company to be as
follows: Company A, 0.9; Company B, 1.0, and; Company C, 1.2. The
analyst uses to CAPM to estimate the discount rate. The CAPM says
that the expected return is equal to the risk-free rate plus the product of
the market risk premium and the company’s beta. What is the estimated
discount rate for each company?
2. Estimate the value of a share of stock for each of the following compa-
nies using the constant growth model and estimating the average annual
growth rate of dividends from 20X1 through 20X6 as given below as
the basis for estimated growth beyond 20X6:
Dividends per Share
Company 20X1 20X6 Discount Rate
1 $1.00 $1.20 8%
2 $2.00 $1.80 9%
3 $0.50 $0.60 7%
4 $0.25 $0.30 12%