Financial Management

Valuation of Common Stocks

Common (Equity) Stocks
• Common stock never matures, today’s value is the
present value of an infinite stream of cash flows (i.e.,
dividend).
• But dividends are not fixed.
• Not knowing the amount of the dividends
– or even if there will be future dividends
– makes it difficult to determine the value of common stock.
• So what should we do?

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Valuation Models
• Dividend Valuation Model (DVM):
– Let D be the constant dividend paid:
Div 1 Div 2 Div 3
P0    
(1  R )1
(1  R ) 2
(1  R ) 3

Div
P0 
R
• The required rate of return (R) is the return
shareholders demand
– to compensate them for the time value of money tied up in
their investment and
– the uncertainty of the future cash flows from these
investments.

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Valuation Models…Cont’d
• Gordon Model (Constant Growth Rate)
Assume that dividends will grow at a constant rate, g,
forever, i.e.,
Div 1  Div 0 (1  g )
Div 2  Div 1 (1  g )  Div 0 (1  g ) 2

Div 3  Div 2 (1  g )  Div 0 (1  g ) 3

.
Since future cash flows grow at a constant rate forever,
..
the value of a constant growth stock is the present value
of a growing perpetuity:
Div 1
P0 
Rg 4
Constant Growth Rate
• Suppose Big D, Inc., just paid a dividend of Rs 0.50.
• It is expected to increase its dividend by 2% per year.
• If the market requires a return of 15% on assets of
this risk level,
• how much should the stock be selling for?

• P0 = 0.50(1+.02) / (.15 - .02) = Rs.3.92

•

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Valuation Model Estimating “g”
• Sometimes when firms finds more opportunities for
the investments, instead of paying all earning as
dividends firms invest a part or full of the earnings in
the firm.
– Payout Ratio: Fraction of earnings paid out as dividends
– Plowback Ratio: Fraction of earnings retained (reinvested
in the business, also called retention ratio) by the firm
• In this case, growth g = ROI * Plowback ratio
• This is the steady (or sustainable) rate at which firm
can grow

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Exercise: Valuing Common Stocks
• Our company forecasts to pay a $8.33 dividend next
year, which represents 100% of its earnings.
• This will provide investors with a 15% expected
return.
• Instead, we decide to plow back 40% of the earnings
at the firm’s current return on equity of 25%.
• What is the value of the stock before and after the
plowback decision?

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Exercise: Valuing Common Stocks
• Our company forecasts to pay a $8.33 dividend next year,
which represents 100% of its earnings. This will provide
investors with a 15% expected return. Instead, we decide to
plow back 40% of the earnings at the firm’s current return on
equity of 25%. What is the value of the stock before and after
the plowback decision?

No Growth With Growth

8.33 g  .25  .40  .10

P0   $55.56
.15
5.00
P0   $100.00
.15  .10

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Valuing Common Stocks…Estimating R
• The discount rate can be broken into two parts.
– The dividend yield
– The growth rate (in dividends)
• In practice, there is a great deal of estimation error
involved in estimating R.
D 0 (1  g) D1
P0  
R -g R -g

D 0 (1  g) D1
R   g   g
P0 P0

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 Implementing the Continuing Value Concept
• Present value is the sum of discounted present
values of explicit and continuing value cash flows:

– PV: present value of the venture

– Ct: the annual cash flow for each explicit period, t
– CVT is the continuing value at the end of the explicit
period, time T
– rt is the discount rate for period t cash flows.
Implementing the Continuing Value Concept
• Estimating the multiple
– The relation between value in one period and all
future cash flows

– The implied cash flow multiple

Where DCF May Not Be Ideal
• Startups and Early-Stage Companies:
– Startups often have highly unpredictable cash flows, limited financial history, and
uncertain futures.

• Cyclical Industries:
– Industries with significant business cycle fluctuations can have cash flows that are
difficult to predict.
– Example: The automotive or construction industries experience periods of high and low
demand, making long-term cash flow projections challenging and potentially inaccurate.

• Highly Volatile Companies:

– Companies with highly volatile cash flows due to market conditions, regulatory changes,
or other factors can produce unreliable DCF valuations.
– Example: A commodity-based company, such as an oil exploration firm, may face
volatile prices and regulatory uncertainties that affect cash flow predictions.

• Companies with Negative Cash Flows:

– Firms with consistent negative cash flows or expected prolonged periods of negative
cash flows may not be suitable for DCF valuation.
– Example: A biotech firm in the research and development phase might have significant
expenses and no revenue for many years, complicating DCF analysis.

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Where DCF May Not Be Ideal
• Industries with High Uncertainty:
– High uncertainty in revenue streams, cost structures, or market conditions can make cash
flow projections too speculative.
– Example: The cryptocurrency industry is highly uncertain and speculative, making
traditional DCF models less applicable.

• Mature Companies with Stable Dividends:

– For companies where the value is better reflected by dividends than by uncertain future
growth, the Dividend Discount Model (DDM) might be more appropriate.
– Example: A mature utility company with stable, predictable dividend payments might be
better valued using the DDM.

• Real Estate and Real Assets:

– Real estate and certain real assets might be better valued using asset-based approaches or
comparables rather than DCF.
– Example: A commercial real estate property might be more accurately valued using
comparables from recent transactions or an income capitalization approach rather than
projecting cash flows.

• Financial Institutions:
– Financial institutions like banks and insurance companies have unique regulatory
environments and capital structures that make DCF less suitable.
– Example: A bank's valuation often requires focusing on its book value, regulatory capital,
and specific financial ratios rather than just cash flow projections.

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Alternatives to DCF
• Comparables Analysis:
– Uses valuation multiples from similar companies (P/E ratio, EV/EBITDA, P/B
ratio) to estimate value.
– Useful in industries with readily available peer data.
• Precedent Transactions:
– Values a company based on prices paid for similar companies in past
transactions.
– Common in M&A contexts.
• Net Asset Value (NAV):
– Values a company based on the market value of its assets minus its liabilities.
– Appropriate for asset-heavy industries like real estate or natural resources.
• Dividend Discount Model (DDM):
– Values a company based on the present value of expected future dividends.
– Suitable for companies with stable and predictable dividend payouts.
• Option Pricing Models:
– Uses financial options theory (like Black-Scholes) to value companies with
significant strategic flexibility or contingent assets/liabilities.
– Applicable to high-risk ventures or companies with valuable patents.

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Valuation multiples
• Valuation multiples are straightforward to calculate and
understand, making them accessible to a broad range of
investors and analysts.

• They allow for quick comparisons between companies,

especially within the same industry, facilitating relative
valuation.

• Multiples reflect current market sentiment and

valuation trends, providing a snapshot of how the
market values companies.

• Commonly used in investment analysis, M&A etc.

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Valuation multiples, Limitations
• Multiples provide a relative rather than an intrinsic valuation, which
may not capture the unique aspects of a company's financial health
and future prospects.

• Market volatility can significantly impact multiples, potentially

leading to misleading valuations during periods of market
exuberance or pessimism.

• Differences in accounting practices, capital structures, and business

models can make direct comparisons between companies
challenging.

• Multiples are typically based on historical or current data and do not

explicitly account for future growth prospects or risk factors.

• P/E, P/B, EV/EBITDA, P/S

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Comparable: P/E ratio
• PE = stock price/ earnings per share

• Why stocks in the same industry trade at different PE

ratios?
• PE ratio is related to the growth opportunities
• The firm with growth opportunities should sell at a higher
price, because an investor is buying both current income
and growth opportunities.
• Low risk stocks and companies following conservative
accounting practices have high PE ratios.
• Stocks in some tech companies traded at higher PE ratios
even they have never earned any profit.

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Comparable: EV/EBITDA
• Investors use the EV/EBITDA ratio to compare companies within the same
industry. It's particularly useful in capital-intensive industries where
depreciation can vary significantly among peers.

• Because it accounts for debt, the EV/EBITDA ratio is commonly used by

private equity firms and investment bankers to value potential acquisition
targets.

• Investors often screen for companies with lower EV/EBITDA ratios

compared to their peers, as this might indicate undervaluation.

• Ignores Capital Expenditures

• Overlooks Working Capital
• Banks and insurance companies have unique financial structures and
regulatory environments. Metrics like EV/EBITDA are not useful because
these institutions don't use EBITDA as a measure of performance.

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P/E Ratio Nifty 50

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P/E Ratio Nifty 50

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P/B Ratio Nifty 50

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Dividend Yield Nifty 50

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P/E Ratio Nifty 50

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