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Chapter 2 Securities Markets and Transactions 15
Chapter 8
Stock Valuation
Outline
Learning Goals
I. Valuation: Obtaining a Standard of Performance
A. Valuing a Company Based on Its Future
1. Forecasted Sales and Profits
2. Forecasted Dividends and Prices
a. Getting a Handle on the P/E Ratio
b. A Relative Price-to-Earnings Multiple
c. Estimating Earnings per Share
d. Pulling It All Together
B. Developing a Forecast of Universal’s Financial Performance
C. The Valuation Process
1. Required Rate of Return
Concepts in Review
II. Stock Valuation Models
A. The Dividend Valuation Model
1. Zero Growth
2. Constant Growth
a. Estimating the Dividend Growth Rate
b. Stock Price Behavior over Time
3. Variable Growth
a. Applying the Variable-Growth DVM
4. Defining the Expected Growth Rate
B. Other Approaches to Stock Valuation
1. Free Cash Flow to Equity
a. Zero Growth in Free Cash Flow
b. Constant Growth in Free Cash Flow
c. Variable Growth in Free Cash Flow
d. Using IRR to Solve for the Expected Return
2. The Price-to-Earnings (P/E) Approach
©2017 Pearson Education, Inc.
16 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
C. Other Price-Relative Procedures
1. A Price-to-Cash-Flow (P/CF) Procedure
2. Price-to-Sales (P/S) and Price-to-Book-Value (P/BV) Ratios
Concepts in Review
Summary
Key Terms
Discussion Questions
Problems
Case Problems
8.1 Chris Looks for a Way to Invest His Newfound Wealth
8.2 An Analysis of a High-Flying Stock
Excel@Investing
Chapter-Opening Problem
Key Concepts
1. The role a company’s future prospects plays in the stock valuation process and a framework for
developing such forecasts
2. Developing a forecast of a stock’s expected cash flow, starting with corporate sales and earnings
and then moving to expected dividends and share prices
3. The concept of intrinsic value as a standard of performance and its use in judging the investment
suitability of a share of common stock
4. Valuation of a stock using zero growth, constant growth, and variable growth dividend valuation
models
5. Other stock valuation models: free cash flow to equity.
6. Understanding that different valuation models work in different instances depending on the
payment of dividends and earnings persistence
Overview
The topics of stock valuation and security analysis are further considered in this chapter. It is basically a
continuation of the discussion in the preceding chapter. Also addressed are some major changes taking
place in the market, as they affect the valuation process.
1. After analyzing a company’s performance to date, the investor projects the company’s future
performance. Basic performance projections are related to the sales and profits of the company,
subject to various economic and industry projections. Next, estimates of future dividends and stock
prices are obtained. Using the example in the text, the instructor should stress the usefulness and
limitations of historical growth rates in obtaining estimates of the future.
2. The P/E ratio is then extensively discussed, including the relationship between a company’s P/E
ratios and the market’s P/E. This ratio is shown to be a function of the growth of the firm, the risk
associated with that growth, and P/E ratios in the marketplace.
©2017 Pearson Education, Inc.
Chapter 2 Securities Markets and Transactions 17
3. Next comes the discussion of various types of stock valuation models. First presented is the
dividend valuation model as a theoretically sound approach to apply to common stocks. The model
requires an estimate of the next dividend, the growth rate, and the required rate of return, which is a
function of risk and alternative returns. In this regard, the CAPM is reintroduced at this point to show
how CAPM can be used to establish the required rate of return. Three types of dividend valuation
models are introduced: zero growth, constant growth, and variable growth models.
4. The free cash flow to equity approach and the P/E approach are then shown as alternatives to the
dividend valuation approach. The free-cash-flow-to-equity model is based on the present value of the
stock’s future free cash flows going to equity.; it corrects some of the practical shortcomings of the
dividend valuation model. The instructor should work out several valuation examples, including the
dividend valuation approach, HPR, the present value of a stock, and yield.
5. In addition, the investment decision process is thoroughly discussed. A stock should be considered
a viable investment candidate when intrinsic value results in a rate of return that meets or exceeds the
investor’s (risk-adjusted) desired rate of return.
Answers to Concepts in Review
8.1 The purpose of stock valuation is to obtain a standard of performance that can be used to judge the
8.2 Expected earnings are indeed important in determining a stock’s investment suitability. In making an
investment decision, the investor must decide if a stock is undervalued or overvalued by comparing
8.3 Both the growth prospects of a company and the amount of debt it uses can affect the P/E ratio. As
the growth rate increases, a higher P/E ratio can be expected. Likewise, as the debt level decreases,
8.4 The market multiple is the average P/E ratio of stocks in the marketplace. It provides insight into the
general state of the market, and it gives the investor information on how aggressively the market is
pricing stocks. Over the past 20 years, average market P/E ratios have ranged from 12.2 in 1988, to
©2017 Pearson Education, Inc.
18 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
8.5 Investors should be willing to purchase a stock if the computed rate of return equals or exceeds the
return the investor feels is warranted, based on the stock’s risk, or if the justified price is equal to or
greater than the current market price. The required rate of return provides a standard so that an
8.6 In general, the value of any asset is the present value of all future cash flow. For common stock, the
cash flow is dividends received each year plus the future sale price of the stock. If any future price
The constant growth dividend valuation model reduces the need to estimate all future dividends
individually by saying that the value of a share of stock is a function of dividends that are growing at
The DVM can be used to value a stock that pays a constant dividend, a stock that pays a dividend
The CAPM fits into the DVM through its effect on r, the required rate of return. The greater the
8.7 The difference between the variable growth dividend valuation model and free cash flow to equity
approach is in the determination of the future selling price of the stock. The variable growth dividend
8.8 Expected return on a stock can be found by using the (present-value-based) internal rate of return
(IRR). The expected rate of return on a stock would be the discount rate that equates the future stream
©2017 Pearson Education, Inc.
Chapter 2 Securities Markets and Transactions 19
8.9 The P/E approach is a simpler, more intuitive approach to valuing a stock. Given an estimated EPS
figure, decide on a P/E ratio that is appropriate for the stock, multiply the EPS by the P/E to
The price-to-cash-flow (P/CF) measure has been popular with investors because cash flow is felt
8.10 Price-to-sales (P/S) and price-to-book-value (P/BV) ratios are alternative price relative measures.
They are useful for valuing firms that are new or have volatile earnings streams, where the P/E
multiple approach has little value. Unprofitable firms still have sales. Both are used in a similar
Suggested Answers to Famous Failures in Finance Questions
Why do you think sell ratings tend to cause stock prices to fall, while buy ratings do not lead to stock price
increases?
Answer:
When economists attempt to explain anomalous behavior, they usually begin by looking at incentives.
Most stock analysts work for investment banking firms that are eager to retain their existing clients and
attract new ones. Although the SEC has taken steps to assure that the public has the same access to
corporate disclosures that analysts have, and some steps have been taken to assure the independence of
Taken together, the combination of incentives and probabilities leads to a sort of “grade inflation” that
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