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Chapter 13 - Equity Valuation
CHAPTER THIRTEEN
EQUITY VALUATION
CHAPTER OVERVIEW
This chapter discusses models to calculate the intrinsic value of common stock. Balance sheet
models, dividend discount models (DDMs), Price/Earnings ratios and free cash flow models are
presented. These are models used in fundamental analysis rather than technical analysis. The
strengths and weaknesses of these techniques are presented and discussed.
LEARNING OBJECTIVES
After studying this chapter, the student should be able to value a firm using either a constant
growth or multistage dividend discount model and the price/earnings ratio model. The reader
should be able to assess the relative growth prospects of stocks based on their P/E ratios.
Students should have a basic understanding of free cash flow models. The student should also
understand the limitations of each of these models.
CHAPTER OUTLINE
1. Valuation by Comparables
PPT 13-2 through PPT 13-3
Four major types of approaches are used in equity valuation. The first approach is to relate
market value to an accounting value by calculating ratios such as price/book value,
price/liquidation value or market value/replacement cost. A second major approach is the
dividend discount model approach. The third method is to use price/earnings ratios and the final
method uses free cash flow models. The most difficult component of valuation is always the
assessment of the firm’s growth rates and future opportunities.
Book value is the value of common equity on the balance sheet. It is based on historical values of
assets and liabilities, which may not reflect current values. Some assets such as brand name or
specialized skills are not even on a balance sheet. Using a market value of equity to book ratio is
thought to be a measure of market valuation over the book value, presumably due to future
growth opportunities of the firm. Some believe that if the market to book is less than one it
indicates an undervalued security that should be purchased. There are unlikely to be very many of
these firms and one would have to examine them further to avoid firms that are underperforming
for a good reason. Liquidation value is the net amount realized from sale of assets and paying off
all debt. The firm becomes a takeover target if the market value of stock falls below this amount,
so liquidation value may serve as a floor value. Tobin’s Q = Market Value/Replacement Cost; and
this ratio should tend toward 1 over time. This ratio may put a ceiling on market value in the long
run because values above replacement cost will attract new entrants into the market.
2. Intrinsic Value versus Market Price
PPT 13-4 through PPT 13-6
Underlying the process of fundamental analysis is the concept of intrinsic value. The intrinsic
value is the value that the analyst places on a stock. It establishes the basis for a trading signal.
Chapter 13 - Equity Valuation
The CAPM can be used to calculate the required return (k or ke):
3. Dividend Discount Models
PPT 13-7 through PPT 13-10
The intrinsic value equation can be generalized to multiple periods by realizing that E(P1) (the sale
price in time 1) is the present value of expected future dividends after the time of sale. Because
utilities may approximate this model:
If a firm’s earnings and dividends are expected to grow at a constant rate in the foreseeable future,
equity and retention rates only applies if current measures are reasonable estimates for long term
values and this is a key point that the instructor should stress.
Stocks with high growth cost more. In other words one must pay for expected growth. This
does not necessarily mean these stocks will have better returns to investors. Buying stocks that
have high expected growth is risky, because if the growth does not occur, the stock’s price will
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Chapter 13 - Equity Valuation
Chapter 13 - Equity Valuation
There are also pitfalls associated with the P/E analysis as earnings can be affected by somewhat
arbitrary accounting rules. Earnings management has been pervasive. Thus, one of the issues that
has become more important in the current environment is the choice of what earnings number to
Alternative valuation models and ratios are presented. With the price-to-book a high ratio
indicates a large premium over book value, and a ‘floor’ value that is often far below market
price. The price-to-cash flow ratio may be used instead of P/E because the former is less subject
to accounting manipulation. The price-to-sales ratio is useful for firms with low or negative
earnings such as firms in the early growth stage. Analysts may have to be creative and identify the
5. Free Cash Flow Valuation Approaches
PPT 13-22 through PPT 13-27
An alternative approach to the dividend discount model values the firm using free cash flow. One
approach uses the free cash flow for the firm (FCFF) discounted at the weighted-average
cost of capital. The value of equity is then found by subtracting the existing market value of
Equity value = Firm Value – Market Value
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In theory free cash flow approaches should provide the same estimate of intrinsic value as the
dividend growth model. In practice the various approaches often differ substantially.
Simplifying assumptions are used in all models and the details may vary slightly in the
different approaches. At best the models establish ranges of likely intrinsic value and using
multiple models forces rigorous thinking about the inputs.
6. The Aggregate Stock Market
PPT 13-28 through PPT 13-30
The most popular approach for forecasting the overall market is to use the earnings multiplier
technique applied to aggregate earnings. The earnings multiplier approach takes a forecast of
