Chapter 10: Common Stock Valuation

Download as docx, pdf, or txt
Download as docx, pdf, or txt
You are on page 1of 7

CHAPTER 10: COMMON STOCK VALUATION

The moment you have been waiting for is almost at hand. Having prepared yourself to manage
your inheritance by learning about topics such as mutual funds, short selling, portfolio theory,
and the capital asset pricing model (CAPM), you are now anxious to get out there and buy some
stocks. After all, you know someone who bought Amazon in 2009 at $80 and it went to over
$300 , and you know for sure this person is not the brightest bulb in the chandelier. On the other
hand, you have read horror stories about the folks who bought technology stocks which
subsequently collapsed and some of these people were really smart. So there must be more to
equity investing than meets the eye.
To better understand what differentiates poor performing from strong performing stocks, you
need to bite the bullet and learn about the principles of stock valuation. The bad news, as you are
about to learn, is that valuation is an art and not a science—it requires judgment as well as skill.
The good news is that learning the basic principles of valuation will give you an advantage over
many investors who simply act on tips or jump in without doing adequate analysis.
How do investors typically go about analyzing stocks to buy and sell? This chapter concentrates
on the valuation of common stocks, while Chapter 11 concentrates on how investors should
analyze and manage their equity holdings. Here we consider the major approaches used by
investors in the valuation of stocks: discounted cash flow techniques, target prices, and relative
valuation techniques. Every serious investor should be comfortable with the basic principles of
common stock valuation represented by these approaches.

Major approaches to valuing common stocks using fundamental security analysis include:
1. Discounted cash flow (DCF) techniques 2. Earnings multiplier approach 3. Relative valuation
metrics
DCF techniques attempt to estimate the value of a stock (its intrinsic value) using a present value
analysis. For example, using the Dividend Discount Model, the future stream of dividends to be
received from a common stock is discounted back to the present at an appro- priate discount rate
(that is, the investor’s required rate of return) and summed. Alternative DCF versions discount
such variables as free cash flow. The end result is an estimate of the current “fair value” or
intrinsic value of the stock.
The multiplier approach attempts to estimate intrinsic value by multiplying an esti- mated firm
characteristic by an estimated multiple. The most prominent multiplier approach relies on
estimated earnings per share (EPS) and the earnings multiplier, the P/E ratio. To implement this
approach:
◨ Estimate EPS for next period, typically the next 12 months.
◨ Determine an appropriate P/E ratio. Part of this process may involve comparing the
company being valued with its peers in order to derive the appropriate P/E ratio.
◨ Multiply the estimated EPS by the P/E ratio that has been determined.
While the earnings multiplier is the most commonly used approach, we discuss several other
multipliers that are also used in practice. Each approach relies on the same basic pro- cess. The
end result for each approach is an estimate of the intrinsic value of the stock or the estimated
value of the stock today.
Relative valuation metrics typically involve the P/E ratio, the Price/Book Value (P/B) ratio, the
Price/Sales (P/S) ratio, the Price/Cash Flow (P/CF) ratio, and Enterprise Value (EV)/earnings
before interest, taxes, depreciation, and amortization (EBITDA) ratio. With the relative value
approach, the emphasis is on selecting stocks for possible purchase based on a comparison
between comparable firms rather than estimating each stock’s value.
Exhibit 10-1 summarizes the most prominent approaches to common stock valuation. In this
chapter, we discuss these approaches in order. Before doing so, however, let’s briefly consider
why it is important to understand the alternative valuation approaches. It is impor- tant to
understand DCF models for at least two reasons. First, virtually all investment professionals that
work in valuation agree that the DCF approach is conceptually correct. It may have its
limitations (as do all other valuation models), but we can learn from it. Secondly, some of the
most popular investment advisory services, in particular Morningstar and Standard & Poor’s
Outlook, rely on a DCF approach.
The DCF approach, however, is not universally relied upon by investment professionals. A 2006
study found that practitioners and investment advisory services often rely on multipliers and
relative valuation metrics when making investment decisions.

Discounted Cash Flow Models


The classic method of calculating the estimated value of any security is the DCF model, which is
based on a present value analysis.

✓ The DCF model estimates the value of a security by discounting its expected future cash
flows back to the present and adding them together.
The estimated value of a security is equal to the discounted (present) value of the future stream
of cash flows that an investor expects to receive from the security, as shown in Equation 10-1:
RUMUS
Where,
K=the appropriate discount rate, that is, the required return for the security To use such a model,
an investor must:
Estimate the amount and timing of the future cash flows 2. Estimate an appropriate discount rate
3. Use these two components in a present value model to estimate the intrinsic value of the
security, V0, and then compare V0 to the current market price of the security

Intrinsic Value The estimated value of a security.

✓ The intrinsic value for a stock is simply its estimated value—what the investor believes
the stock is worth.
TWO BROAD DCF APPROACHES
There are two fundamentally different approaches to calculate the value of common stock using
firm cash flows and the appropriate discount rate.
1. Value the equity of the firm using the required rate of return to shareholders (the cost of
equity capital). The approach includes two methods based on the different cash flow (CF)
streams that are used: a. Dividend discount model (DDM) A firm’s expected dividends
represent the CF stream that is discounted. b. Free cash flow to equity (FCFE) model A
firm’s expected FCFE represents the CF stream that is discounted.
2. Free cash flow to the firm (FCFF) model Value the entire firm using the weighted
average cost of capital as the discount rate and then subtract the value of debt and
preferred stock. A firm’s expected FCFFs represent the CF stream that is discounted.
Figure 10-1 summarizes the DCF process used in fundamental analysis. It emphasizes the
factors that go into valuing common stocks. The exact nature of the present value pro- cess used
by investors in the marketplace depends upon which cash flows are used to value the asset.
Because we emphasize the stockholder’s required rate of return, this discussion of DCF
techniques concentrates on valuing the equity of the firm.
✓ The DDM is simply a special case of valuing the equity to the firm. It is prominently
featured in virtually all discussions of valuation and indeed can be regarded as the basis for
common stock valuation using DCF techniques.
Following a discussion of the DDM, we will consider other models for valuing the equity
of the firm. The alternative approach, valuing the firm as a whole, is also considered.

The Dividend Discount Model


Required Rate of Return The minimum expected rate of return necessary to induce an investor to
purchase a security
FIGURE 10-2
The Process Involved with the Dividend Discount Model
To understand the basis of the DDM, ask yourself the following question: If I buy a common
stock and place it in a special trust fund for the perpetual benefit of my family, what benefits will
my family receive? The answer is a stream of cash dividends because this is the only cash
distribution that a corporation actually makes to its stockholders. Although a firm’s EPS in any
year belongs to the stockholders, corporations generally do not pay out all their earnings to their
stockholders; furthermore, EPS is an accounting concept, whereas divi- dends represent cash
payments. Investors cannot spend EPS, but they can spend dividends received.
Stockholders may plan to sell their shares sometime in the future, resulting in a cash flow from
the sale price. As shown later, however, the value of the cash flow from the sale is equivalent to
evaluating the stream of all subsequent dividends to be received from the stock. Therefore, we
can concentrate on a company’s estimated future dividends and an appropriate required rate of
return.
APPLYING THE DDM
Adapting Equation 10-1 specifically to value common stocks, the cash flows are the dividends
expected to be paid in each future period. An investor or analyst using this approach carefully
studies the future prospects for a company and estimates the likely dividends to be paid. In
addition, the analyst estimates an appropriate required rate of return or discount rate based on the
risk foreseen in the dividends. Finally, he or she discounts the entire stream of estimated future
dividends and adds them together. The derived present value is the intrinsic value of the stock.
This process is illustrated in Figure 10-2.

Required Rate of Return: The minimum expected rate of return necessary to induce an investor
to purchase a security
The required rate of return is the minimum expected rate of return necessary to induce an
investor to buy a stock, given its risk. Note that it is an expected rate of return, and that it is the
minimum rate necessary to induce purchase.

✓ The required rate of return, capitalization rate, and discount rate are interchangeable
terms in valuation analysis. Regardless of the terminology, it is challenging to determine the
precise numerical value to use for a particular stock.
Because in practice it is not easy to determine a precise discount rate, we will assume for
purposes of this discussion that we know the discount rate and concentrate on the other issues
involved in valuation, which are difficult enough. The CAPM model discussed in Chapter 9
serves as a basis for thinking about, and calculating, a required rate of return.

THE DDM EQUATION


The DDM states that the estimated value (per share) of a stock today is the discounted value of
all future dividends:

where
D1,D2,the dividends expected to be received in each future period the required rate of return for
the stock, which is the discount rate applicable
k
for an investment with this degree of riskiness (the opportunity cost of a comparable risk
alternative)
IMPLEMENTING THE DDM
Two immediate issues with Equation 10-2 are the following:
1. Equation 10-2 indicates that investors are dealing with infinity. They must value a stream of
dividends that may be paid forever, since common stock has no maturity date.
2. The dividend stream is uncertain:
(a) Thereisnospecifiednumberofdividendsifinfactanyarepaidatall.Dividends
are declared periodically by the firm’s board of directors. (Technically, they are typically paid
quarterly, but conventional valuation analysis uses annual dividends.)
(b) The dividends for most firms are expected to grow over time; therefore, investors usually
cannot simplify Equation 10-2 to a perpetuity as is done with preferred stock.
Who’s Afraid of Infinity?
From a practical standpoint, the infinity problem is not as troublesome as it first appears. At
reasonably high discount rates, such as 10 percent or more, dividends received 40 or 50 years in
the future are worth very little today so that investors need not worry about them. For example,
the present value of $1 to be received 50 years from now, if the discount rate is 10 percent, is
only $0.0085, which is zero for practical purposes.
ESTIMATING FUTURE DIVIDENDS
The conventional solution to the second issue, that the dividend is expected to grow over time, is
to make a simplifying assumption about the expected dividend growth rate. That is, the investor
classifies each stock to be valued into one of three categories based on the expected growth rate
in dividends.

✓ The DDM is operationalized by estimating the expected growth rate(s) in the dividend
stream.

Zero‐Growth Rate Case One of three growth rate cases of the DDM, when the dollar dividend
being paid is not expected to change

Constant (Normal)‐ Growth Rate Case A well‐known scenario in valuation in which dividends
are expected to grow at a constant‐growth rate over time
Multiple‐Growth Rate Case One of three possible forms of the THE ZERO-GROWTH
RATE MODEL DDM, involves two or more expected growth rates for dividends

A Present Value Process The discounting process is not apparent when the perpetu- ity
formula is applied in the zero‐growth rate case. Nevertheless, the formula accounts for all
dividends from now to infinity in this case, as with the other DDM cases. It is simply a math-
ematical fact—not to mention a great calculation convenience—that dividing a constant dol- lar
amount by the discount rate, k, produces a result equivalent to discounting each dividend from
now to infinity separately and summing all of the present values.

✓ In using a DDM to value a stock, an investor discounts the future stream of dividends
from now to infinity. This fact tends to be overlooked.

You might also like