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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
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.
An intrinsic value can be estimated using a variety of models or approaches. The section starts
by presenting the expected holding period return for one year:
3. Dividend Discount Models
PPT 13-7 through PPT 13-12
This equation is not useable because it is an infinite sum of variable cash flows. Therefore one
must make assumptions about the dividends to make the model tractable. If a firm’s earnings and
dividends are not expected to grow in the foreseeable future, the value of the stock can be
=+
=
1t t
t
0)k1(
D
V
Chapter 13 - Equity Valuation
The growth rate that is used in the constant model is a long-term and permanent growth rate.
Students often are not clear on this concept. The approach to estimating growth using return on
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.
The level of reinvestment has a significant impact on growth rates. Higher levels of
reinvestment lead to higher levels of growth. The concept of partitioning the value of stock into
a no growth and a present value of growth opportunities component is presented. The numerical
example fits the valuation examples used earlier for the no growth and constant growth models.
The concept of using the PVGO approach is very useful in assessing how much of the value is
being attributed to growth and growth opportunities. If a substantial portion of the value is
attributed to growth, careful analysis of the growth assumptions is appropriate. The PVGO
model is given by:
Since many firms do not fit the constant growth model, the multistage growth approach can be
used to obtain a better estimate of value in many cases. The multistage growth model allows the
4. Price Earnings Ratios
PPT 13-12 through PPT 13-22
Chapter 13 - Equity Valuation
An alternative approach to using the dividend growth model approach is to use a P/E approach.
The P/E method is used extensively in industry and is helpful in comparing relative values of
firms, particularly with respect to future growth opportunities. The appropriate P/E is a function
Riskier stocks, all else equal, will have lower P/E multiples as riskier firms will have a higher
required rate of return. Some analysts look at the PEG ratio, which is the P/E ratio divided by
the expected growth rate of earnings and dividends. Since the P/E is a proxy for growth, some
investors believe that stocks with a PEG less than one are a good buy.
There are also pitfalls associated with the P/E analysis as earnings can be affected by somewhat
5. Free Cash Flow Valuation Approaches
PPT 13-23 through PPT 13-29
Chapter 13 - Equity Valuation
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
The free cash flow methods discount year to year cash flows plus some estimate of the terminal
value PT where
Equity residual free cash flows (FCFE) can be directly calculated with the following:
Equity value can then be estimated as:
gWACC
FCFF
P1T
T−
=+
Debt Net in Increase)TExpense(1 InterestFCFFFCFE C+−−=
gk
FCFE
P
E
1T
T−
=+
T
E
T
T
1t t
E
t
)k1(
P
)k1(
FCFE
Valuequity E +
+
+
=
=
6. The Aggregate Stock Market
PPT 13-30 through PPT 13-32
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
corporate profits for the coming period for an index such as the S&P500. Derive an estimate for
Excel Applications
This chapter contains an Excel exhibit that allows calculation of a two-stage and multi-stage
