Chapter 7

Corporate Valuation and Stock Prices
Corporate Valuation and Stock Valuation
What led to wild swings in stock price?

How good are analysts’ predictions and hence their ability to
forecast stock prices?
The analysts’ primary objective is to predict corporate earnings,
dividends, and free cash flow—and thus stock prices.
two widely used valuation models: the free cash flow
valuation model and the dividend growth model.
Legal rights and Privileges of Common
Stockholders
• Control of the Firm;

• The Preemptive Right; purchase any additional shares sold by
the firm.
• enables current stockholders to maintain control
• Classified Stock and Tracking Stock; dual class shares
• Stock Market Reporting
Valuing Common Stocks—Introducing the Free
Cash Flow (FCF) Valuation Model
• The FCF valuation model defines the value of a company’s

operations as the present value of its expected free cash flows
when discounted at the weighted average cost of capital
(WACC)
• Sources of Value and Claims on Value
• Companies have two primary sources of value, the value of
operations and the value of nonoperating assets. There are
three major types of claims on this value: debt, preferred
stock, and common stock.
• SOURCES OF VALUE
Sources of Value and Claims on Value
• we can calculate the value of this infinite sum in three situations: (1)
The free cash flows are constant forever. (2) The FCF grows at a
constant rate forever. (3) The FCF eventually grows at a constant
rate.
• The primary source of value for most companies is the value of

operations. A secondary source of value comes from nonoperating
assets, which are also called financial assets. There are two major
types of nonoperating assets: (1) short-term investments, which are
very marketable short-term securities (like T-bills) that are
temporarily held for future needs rather than to support current
operations, and (2) other nonoperating assets, which often are
investments in other businesses.
• When using the FCF valuation model, a company’s total intrinsic
value is the value of operations plus the value of short-term
investments
• This is called the intrinsic value (or fundamental value) to
distinguish it from the market value. The market value is whatever
price the market is willing to pay, but the intrinsic value is estimated
from the expected cash flows:
• CLAIMS ON VALUE
• For a company that is a going concern, debtholders have the first
claim on value in the sense that interest and scheduled principal
payments must be paid before any preferred or common dividends
can be paid.
The estimated intrinsic value of equity is the remaining value after
subtracting the claims of debtholders and preferred stockholders from
the total intrinsic value
The Intrinsic Value per Share of Common Stock
The estimated intrinsic stock price is equal to the intrinsic value of
equity divided by the number of shares:
The Constant Growth Model: Valuation When
Expected Free Cash Flow Grows at a Constant
Rate
as markets mature, competition and market saturation will tend to limit
FCF growth to a constant long-term rate that is approximately equal to
the sum of population growth and inflation
• Estimating the Value of Operations When Expected Growth Is
Constant
don’t use Equation 7-8 if gL ≥ WACC!

The Constant Growth Model: Valuation When
Expected Free Cash Flow Grows at a Constant
Rate
• APPLICATION OF THE CONSTANT GROWTH MODEL WHEN
CONSTANT GROWTH BEGINS AT t = 0
don’t use Equation 7-8 if gL ≥ WACC!

How to Avoid Common Mistakes When Applying
the Constant Growth Model
• the model only applies if the expected growth rate is constant and is
less than the weighted average cost of capital.
• Second, the constant growth models are calculating the present value
of all future cash flows from t 5 1 to infinity, not from t 5 0 to infinity
• Third, don’t use Equation 7-9 if constant growth doesn’t begin
immediately.
The Multistage Model: Valuation When Expected
Short-Term Free Cash Flow Grows at a Nonconstant
Rate
• Forecast expected free cash flows and calculate the annual growth
rates for each year in the forecast. Continue forecasting additional
years until the growth rate in FCF is expected to become constant.
The last year in the forecast is called the forecast horizon. It is also
called the horizon date
• Because expected growth is constant after the horizon date, you can
apply the constant growth model from the previous section to
estimate the value of operations at the horizon year. This is called the
horizon value, and it is the value of all free cash flows beyond the
horizon discounted back to the horizon
Short-Term Free Cash Flow Grows at a
Nonconstant Rate
• Create a time line with the free cash flows for each year up to the
horizon date. The time line should also include the horizon value at
the horizon date. This means there will be two cash flows on the
horizon date, the free cash flow for that year and the previously
calculated horizon value.
• Discount the cash flows in the time line using the weighted average
cost of capital. The result is the estimated value of operations as of t
=0.
Nonconstant Rate
Nonconstant Rate
The Current Value of Operations

(1) Estimate the present value of the free cash flows in the forecast period. (2) Estimate
the present value of the horizon value. (3) Add the present value of the free cash flows
to the present value of the horizon value.
Application of the FCF Valuation Model to MicroDrive
Value-Based Management: Using the Free Cash
Flow Valuation Model to Identify Value Drivers
The key inputs to the free cash flow valuation model are (1) the most
recent level of sales; (2) the most recent level of total net operating
capital; (3) the projected sales growth rates; (4) the projected operating
profitability ratios; (5) the projected capital requirement ratios; and (6)
the weighted average cost of capital.
Value-Based Management: Using the Free Cash
Flow Valuation Model to Identify Value Drivers
l.
Dividend Valuation Models
Rather than finding the total entity value and then determining the residual share that belongs
to common stockholders, we can find the intrinsic price per share more directly for companies
that pay dividends.
Dividend Valuation Models
Expected Dividends as the Basis for Stock Values
What are a shareholder’s expected cash flows?
Valuing a Constant Growth Stock
constant dividend growth model, or the Gordon model,
if gL is not less than rs, then the company is not

in its constant growth phase, and Equation 7-17
should not be used!
Valuing a Constant Growth Stock
EXPECTED RATE OF RETURN ON A CONSTANT GROWTH STOCK
Valuing Nonconstant Growth Stocks
The Market Multiple Method
• The first step is to identify a group of comparable firms.

• The second step is to calculate for each comparable firm the ratio of
its observed market value to a particular metric, which can be net
income, earnings per share, sales, book value, number of subscribers,
or any other metric that applies to the target firm and the comparable
firms.
• This ratio is called a market multiple. To estimate the target firm’s
market value, the analyst would multiply the target’s metric by the
comparable firms’ average market multiple.
Comparing the FCF Valuation Model, the
Dividend Growth Model, and the Market Multiple
Method
• The free cash flow valuation model and the dividend growth model
give the same estimated stock price
• If a company is paying a dividend but is still in the high-growth stage
of its life cycle, you would need to project the future financial
statements before you could make a reason- able estimate of future
dividends. After you have projected future financial statements, it
would be a toss-up as to whether the corporate valuation model or
the dividend growth model would be easier to apply.
• If you were trying to estimate the value of a company that has never
paid a dividend or a private company (including companies nearing
an IPO), then there would be no choice: You would have to estimate
future free cash flows and use the corporate valuation model.
Comparing the FCF Valuation Model, the
Dividend Growth Model, and the Market Multiple
Method
• The market multiple method is easier to apply than the free cash flow
valuation model, but it has two shortcomings. First, it is hard to find
companies that are truly comparable.
• Second, the market multiple method doesn’t help you identify the
important value drivers or provide much insight into why the
estimated intrinsic value is high or low or into how the company’s
managers can increase its value.
• the free cash flow valuation model can be applied to a division or
specific line of business within a company. This is very useful when
considering the sale or purchase of a division. It also is useful when
setting targets in compensation plans for divisional managers.

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Corporate Valuation and Stock Prices

Corporate Valuation and Stock Valuation

What led to wild swings in stock price?

• Control of the Firm;

• The FCF valuation model defines the value of a company’s

• The primary source of value for most companies is the value of

don’t use Equation 7-8 if gL ≥ WACC!

don’t use Equation 7-8 if gL ≥ WACC!

The Current Value of Operations

if gL is not less than rs, then the company is not

• The first step is to identify a group of comparable firms.

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