Business
Valuing Common Stock
Valuing common stock involves determining the intrinsic worth of a company's shares based on various factors such as earnings, growth potential, and market conditions. This process often utilizes financial models like discounted cash flow analysis and comparable company analysis to estimate the stock's fair value. Investors use these valuations to make informed decisions about buying, selling, or holding common stock.
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11 Key excerpts on "Valuing Common Stock"
eBook - PDF- R. Charles Moyer, James McGuigan, Ramesh Rao, , R. Charles Moyer, James McGuigan, Ramesh Rao(Authors)
- 2017(Publication Date)
- Cengage Learning EMEA(Publisher)
There are significant economies of scale associated with security offerings. The valuation of common stock is considerably more complicated than the valuation of either bonds or preferred stock for the following reasons: 1. The cash flows can take two forms, cash dividend payments and price appreciation. 2. Common stock dividends are normally expected to grow and not remain constant. 3. The cash flows from common stocks are generally more uncertain than the cash flows from other types of securities. In the general dividend valuation model, the value of a common stock is equal to the present value of all the expected future dividends discounted at the investor’s required rate of return. Simpler common stock valuation models can be derived from assumptions concerning the expected growth of future div- idend payments. One of the most commonly encountered simplified dividend valuation models is the constant growth dividend valuation model. In this model, the value of a common stock is equal to next year’s dividend divided by the difference between the required rate of return and the expected growth rate. The valuation of stock in small corporations poses special challenges because of its limited mar- ketability, lack of liquidity, and the difference between minority interest and controlling interest shares. Important Equations Book value per share ¼ Total common stockholders 0 equity Number of shares outstanding Number of shares ¼ Number of directors desired Number of shares outstanding Number of directors being elected þ 1 þ 1 Underwriting spread ¼ Selling price to public Proceeds to company Chapter 7: Common Stock: Characteristics, Valuation, and Issuance 251 Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-300 7-7 Questions and Topics for Discussion 1. Define the following terms associated with common stock: a. Nonvoting stock b. Stock split c. Reverse stock split d.
No longer available |Learn moreInvestments
An Introduction
- Herbert Mayo(Author)
- 2016(Publication Date)
- Cengage Learning EMEA(Publisher)
But in any event, you must have some notion as to the value of the stock in order to justify the purchase. Conceptually, the valuation of a stock is the same as the valuation of a bond or any asset. In each case, future cash flows are discounted back to their present value. For debt instruments this process is relatively easy because debt instruments pay a fixed amount of interest and mature at a specified date. Common stock, however, does not pay a fixed dividend, nor does it mature. These two facts considerably increase the difficulty of Valuing Common Stock. Two approaches, often referred to as “fundamental analysis,” are used to value a stock: discounted cash flow and analysis of financial statements. Discounted cash flow models require estimating future sales, expenses, earnings, and dividends and express -ing these values in the present (i.e., discounting future cash flows). This present value is compared to the current price of the stock to make a buy or sell decision. Analy -sis ofuni00A0financial statements employs a variety of ratios such as price-to-earnings (P/E), price-to-book value (P/B), price-to-sales (P/S), return on equity (ROE), and debt-to-equity (D/E). These ratios may be compared to industry averages or to a predetermined critical value to determine if the stock should be bought or sold. Initially this chapter lays out the basic, logical framework associated with fun -damental analysis. Next the chapter covers an investor’s expected return: the sum of anticipated dividends and capital gains. This return is then used as a required return in a model that discounts future dividends to value the stock. After this initial presenta -tion, the dividend-growth model is expanded to include the capital asset pricing model, which adjusts the required return for the systematic risk associated with the stock. Many companies do not pay cash dividends, so a discounted dividend model can -not be applied.
eBook - PDFValuation of Internet and Technology Stocks
Implications for Investment Analysis
- Brian Kettell(Author)
- 2002(Publication Date)
- Butterworth-Heinemann(Publisher)
Valuation techniques for traditional common stocks 45 The required rate of return An investor who is considering the purchase of a common stock must assess its risk and, given its risk, the minimum expected rate of return that will be required to induce the investor to make the purchase. This minimum expected return, or required rate of return, is an opportunity cost. The required rate of return, capitalization rate and discount rate are interchangeable terms in valuation analysis. While in theory we know what this variable is, in practice it is not easy to determine the precise number to use. Because of this complex-ity, we will generally assume that we know the capitalization rate and concentrate here on the other issues involved in the valuation of stocks. The expected cash flows The other component that goes into the present value frame-work is the expected stream of cash flows. The value of common stock is the present value of all the cash flows to be received from the issuer. The questions that then arise are as follows: (1) What are the cash flows to use in valuing a stock? (2) What are the expected amounts of the cash flows? (3) When will the expected cash flows be received? Stockholders may plan to sell their shares at some time in the future, resulting in a cash flow from the sales price. As shown later, however, even if investors think of the total cash flows from common stocks as a combination of dividends and a future price at which the stock can be sold, this is equivalent to using the stream of all dividends to be received on the stock as the key valuation principle. What about earnings? Are they important? Can they be used in valuing a stock? The answer to both questions is a clear Yes. Dividends are paid out of earnings, so earnings are clearly important. The second stock valuation approach, fundamental analysis, to be considered later, uses earnings and a P/E ratio to determine intrinsic value.
eBook - PDF- Robert Parrino, David S. Kidwell, Thomas Bates, Stuart L. Gillan(Authors)
- 2021(Publication Date)
- Wiley(Publisher)
3 Describe how expected future cash flows, discounted at the required rate of return, determine the value of common stock. The value of common stock depends on the expected future cash flows and the rate of return, or discount rate. A share of stock is worth the present value of all of its expected future flows when discounted at the rate of return required by investors for investments with a sim- ilar level of risk. One-period models and perpetuity models are start- ing points for understanding how to value common stock. 4 Describe how the general dividend-valuation model values a share of stock. The general dividend-valuation model values a share of stock as the present value of all future cash dividend payments, where the dividend payments are discounted using the rate of return required by investors for investments with a similar level of risk. 5 Discuss the assumptions that are necessary to make the general dividend-valuation model easier to use, and use the model to compute the value of a firm’s common stock. Summary of Key Equations Equation Description Formula 9.1 General dividend-valuation model P 0 = D 1 _____ 1 + R + D 2 _______ (1 + R ) 2 + D 3 _______ (1 + R ) 3 + D 4 _______ (1 + R ) 4 + D 5 _______ (1 + R ) 5 + . . . + D ∞ ________ (1 + R ) ∞ = ∑ t=1 ∞ D t _______ (1 + R ) t 9.2 Zero-growth dividend model P 0 = D __ R 9.3 Value of a dividend at time t with constant growth D t = D 0 × (1 + g) t Solutions to Self-Study Problems 9-25 Equation Description Formula 9.4 Constant-growth dividend model P 0 = D 1 ___ R − g 9.5 Value of a stock at time t when dividends grow at a constant rate P t = D t+1 ____ R − g 9.6 Mixed (supernormal) growth dividend model P 0 = D 1 _____ 1 + R + D 2 _______ (1 + R ) 2 + . . . + D t _______ (1 + R ) t + P t _______ (1 + R ) t 9.7 Value of preferred stock with a fixed maturity PS 0 = D/m _______ 1 + i/m + D/m _________ (1 + i/m) 2 + D/m _________ (1 + i/m) 3 + .
eBook - PDFInvestments
Analysis and Management
- Gerald R. Jensen, Charles P. Jones(Authors)
- 2019(Publication Date)
- Wiley(Publisher)
Common Stock Valuation AFTER READING THIS CHAPTER, YOU WILL BE ABLE TO: • Explain the foundation of valuation for common stocks, discounted cash flow techniques, and the con- cept of intrinsic value. • Use the dividend discount model to estimate the intrinsic value of a stock. • Estimate target prices for stocks using price multiples and firm fun- damentals. • Apply the two-stage, three-stage, and H-model in deriving stock values. Overview 257 Overview Major approaches to Valuing Common Stocks using fundamental security analysis include: 1. Discounted cash flow (DCF) techniques 2. Multiplier approach 3. Relative valuation metrics DCF techniques attempt to estimate the value of a stock (its intrinsic value) using a present value analysis. For example, using the Dividend Discount Model, the future stream of dividends to be received from a common stock is discounted back to the present at an appropriate discount rate (i.e., the investor’s required return) and summed. Alternative DCF versions discount such variables as free cash flow. The end result is an estimate of the current “fair value” or intrinsic value of the stock. The multiplier approach attempts to estimate intrinsic value by multiplying an estimated firm characteristic by an estimated multiple. The most prominent mul- tiplier approach relies on estimated earnings per share (EPS) and the earnings multiplier, the P/E ratio. To implement this approach: • Estimate EPS for next period, typically the next 12 months. • Determine an appropriate P/E ratio. Part of this process may involve compar- ing the company being valued with its peers in order to derive the appropriate P/E ratio. • Multiply the estimated EPS by the P/E ratio that has been determined. While the earnings multiplier is the most commonly used approach, we discuss several other multipliers that are used in practice.
eBook - PDFInvestments
Analysis and Management
- Gerald R. Jensen, Charles P. Jones(Authors)
- 2020(Publication Date)
- Wiley(Publisher)
Common Stock Valuation AFTER READING THIS CHAPTER, YOU WILL BE ABLE TO: • Explain the foundation of valuation for common stocks, discounted cash flow techniques, and the con-cept of intrinsic value. • Use the dividend discount model to estimate the intrinsic value of a stock. • Estimate target prices for stocks using price multiples and firm fun-damentals. • Apply the two-stage, three-stage, and H-model in deriving stock values. Overview 257 Overview Major approaches to Valuing Common Stocks using fundamental security analysis include: 1. Discounted cash flow (DCF) techniques 2. Multiplier approach 3. Relative valuation metrics DCF techniques attempt to estimate the value of a stock (its intrinsic value) using a present value analysis. For example, using the Dividend Discount Model, the future stream of dividends to be received from a common stock is discounted back to the present at an appropriate discount rate (i.e., the investor’s required return) and summed. Alternative DCF versions discount such variables as free cash flow. The end result is an estimate of the current “fair value” or intrinsic value of the stock. The multiplier approach attempts to estimate intrinsic value by multiplying an estimated firm characteristic by an estimated multiple. The most prominent mul-tiplier approach relies on estimated earnings per share (EPS) and the earnings multiplier, the P/E ratio. To implement this approach: • Estimate EPS for next period, typically the next 12 months. • Determine an appropriate P/E ratio. Part of this process may involve compar-ing the company being valued with its peers in order to derive the appropriate P/E ratio. • Multiply the estimated EPS by the P/E ratio that has been determined. While the earnings multiplier is the most commonly used approach, we discuss several other multipliers that are used in practice.
eBook - PDFInvestments
Analysis and Management
- (Author)
- 2016(Publication Date)
- Wiley(Publisher)
Common Stock Valuation chapter 10 AFTER READING THIS CHAPTER, YOU WILL BE ABLE TO: ▶ Understand the foundation of valuation for com-mon stocks, discounted cash flow techniques, and the concept of intrinsic value. ▶ Use the dividend discount model to estimate the intrinsic value of a stock. ▶ Estimate target prices for stocks using the P/E ratio and EPS. ▶ Recognize the role of relative valuation metrics in the valuation process. Overview 255 Overview Major approaches to Valuing Common Stocks using fundamental security analysis include: 1. Discounted cash flow (DCF) techniques 2. Earnings multiplier approach 3. Relative valuation metrics DCF techniques attempt to estimate the value of a stock (its intrinsic value) using a present value analysis. For example, using the Dividend Discount Model, the future stream of dividends to be received from a common stock is discounted back to the present at an appro-priate discount rate (that is, the investor’s required rate of return) and summed. Alternative DCF versions discount such variables as free cash flow. The end result is an estimate of the current “fair value” or intrinsic value of the stock. The multiplier approach attempts to estimate intrinsic value by multiplying an esti-mated firm characteristic by an estimated multiple. The most prominent multiplier approach relies on estimated earnings per share (EPS) and the earnings multiplier, the P/E ratio. To implement this approach: ◨ Estimate EPS for next period, typically the next 12 months. ◨ Determine an appropriate P/E ratio. Part of this process may involve comparing the company being valued with its peers in order to derive the appropriate P/E ratio. ◨ Multiply the estimated EPS by the P/E ratio that has been determined. While the earnings multiplier is the most commonly used approach, we discuss several other multipliers that are also used in practice.
eBook - PDF- Timothy Mayes(Author)
- 2020(Publication Date)
- Cengage Learning EMEA(Publisher)
Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 9 Common Stock Valuation 284 Alternative Discounted Cash Flow Models As noted previously, the value of a stock is given by the present value of its expected future cash flows—that is, the dividends that it will pay. However, we can restructure these models in a way that provides some additional insight into the valuation pro- cess. The two models presented in this section do just that. The Earnings Model Imagine a company that pays out 100% of its earnings as dividends. In this case, the dividend is equal to earnings per share (EPS), and the growth rate must be 0% because it is investing only enough (through the depreciation charge) to maintain the assets it currently owns. Using the constant-growth DDM with g 5 0%, equation (9-3), the value of the common stock would be: V CS 5 EPS 1 k This is the value of the stock if the firm doesn’t reinvest and therefore doesn’t grow. Most firms do reinvest at least some of their earnings, so the value of the stock must be equal to the value if it doesn’t grow plus the present value of its future growth opportunities (PVGO): V CS 5 EPS 1 k 1 PVGO (9-9) The future earnings growth rate will be driven by the rate of return that is generated by the reinvested earnings (the ROE). If we let b 5 the retention ratio and r 5 the return on equity, then the growth rate (g) will be: 8 g 5 br (9-10) Incidentally, recall the extended DuPont method of calculating the ROE from Chapter 3 on page 93. From this, we know that the growth rate depends on the operating profit margin, the interest rate on debt, the tax rate, the efficiency with which the firm uses its assets, and the amount of debt that it has in addition to its dividend payout ratio. Thus, the value of the stock always depends on how well-run the firm is.
eBook - PDFUnderstanding Financial Management
A Practical Guide
- H. Kent Baker, Gary Powell(Authors)
- 2009(Publication Date)
- Wiley-Blackwell(Publisher)
In addition, dividends may increase, remain stable, or decrease over time. Future stock prices are also uncertain. Because com-mon stock is generally riskier than bonds or preferred stock, investors require a higher rate of return ( k s ) to compensate for this risk. Before discussing various valuation models, we want to stress that no one “best” model exists. The appropriate model to use in a specific situation depends on the characteristics of the asset being valued. These characteristics include such factors as the level of earnings, current growth rate in earnings, and the source of growth. Discounted Cash Flow Models Although numerous DCF valuation models are available for Valuing Common Stock, these approaches generally differ based upon three factors: VALUATION 143 • measure of cash flow – dividends and free cash flows to equity; • expected holding period – finite (limited) and infinite; and • pattern of expected dividends – zero (no) growth, stable (constant) growth, and supernormal growth. We begin by narrowly defining the measure of cash flow as dividends and consider different expected holding periods and dividend patterns. Each of these models is a type of dividend discount model (DDM). Later, we use a broader measure of cash flow, namely, free cash flow to equity (FCFE) to estimate the value of common stock. FCFE valuation models are simply variants of the DDM, but use FCFE instead of dividends. Dividend Discount Models The most basic models for valuing equity are the dividend discount models. These models require two key inputs: expected dividends and the required rate of return on equity. The attractiveness of these models stems from their simplicity and intuitive logic. Finite-period valuation model A finite-period valuation model is a model that assumes an investor plans to buy a com-mon stock and hold it for a limited period.
eBook - PDFBusiness Valuations
Advanced Topics
- Larry Kasper(Author)
- 1997(Publication Date)
- Praeger(Publisher)
The analysis that follows discusses the determination of the value per share of a common stock. The formulas apply equally well for the entire firm because the value of the total firm is just the number of shares multiplied by the per share value (ignoring possible adjustments for discounts and premiums dis- cussed later). The following terms and conventions are used: E() is the symbol for expected value t is the time period and refers to the end of the period / = 0 refers to the beginning of the period 1 Div is the dividends at the end of period t E is the earnings during period / P is the price per share at the end of period / k is the market capitalization rate. INTRINSIC VALUE We can think of the price that one would be willing to pay for a stock as the current value that equated some future payoff. The trade-off between current value and future payoff has a price. Investors must be paid for delaying con- sumption in the current period to receive value in some later period. That pay- t t 34 THE PARAMETERS OF VALUATION PRACTICE ment is the required return on the investment made today. For any stock, in an efficient market, there exists a consensus rate of return commensurate with the risk associated with holding the stock. The required rate of return that will equate the future payoff of holding the stock with the current value is called the market capitalization rate. Assume that the investor has a one-period investment horizon. The above relationships can be formally expressed as follows. The expected payoff is the sum of the future dividend received at the end of time 1 plus the proceeds from the sale of the stock at the end of time 1, which is equal to the current price in- vested at the required rate of return. P 0 (l + k) = E(Div x ) + E(P X \ ssolving for P 0 E(Di Vl)+ E( 0 (l + k) P 0 is the present value of the expected payoff.
eBook - PDF- Frank Reilly, Keith Brown, Sanford Leeds, Frank Reilly, Keith Brown, Sanford Leeds, (Authors)
- 2018(Publication Date)
- Cengage Learning EMEA(Publisher)
The present value of these three dividends is $2.54. 264 Part 3: Valuation and Management of Common Stocks 2. The value of the dividends in years 4 through perpetuity. Dividend 4 will equal dividend 3 1 growth rate $1 21 1 04 $1 258. Since we know dividend four, we can calculate the value of the stock at the end of Year 3. V 3 $1 258 / 14 04 $12 58. This was simply the constant growth model. This $12.58 must be discounted for three years at 14 percent. The value of this is $12 58 / 1 14 3 $8 49 3. Adding the present value of the dividends plus the present value of the terminal value equals $2 54 $8 49 $11 03. This example can be seen in Exhibit 8.5. Again, the analyst could examine how much of this $11.03 comes from growth. If the company never grew again, it could pay out all of next year’s $1 of earnings. This would make the no-growth value equal to $1 / 14 $7 14. This means that the PVGO $11 03 $7 14 $3 89. 8.3.2 Method #2: Free Cash Flow to Equity—The Improved DDM Many students learn about the dividend discount model and get frustrated. They try to apply it and find that it often predicts values that are far below market prices. Almost all stocks look grossly overvalued. There is one simple issue that you must understand in order to make the dividend discount model useful in all situations. Instead of using actual dividends paid, what you are actually val-uing is the amount of dividends that could be paid. This is the free cash flow to equity (FCFE). To begin, FCFE is defined (measured) as follows: Net Income Depreciation expense Capital expenditures Change in working capital Principal debt repayments New debt issues The goal is to determine the free cash flow that is available to the stockholders after payments to all other capital suppliers and after providing for the continued growth of the firm. This model is a more general version of the dividend discount model. Imagine that you are the sole shareholder in a company.
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