This document discusses various methods for valuing common stock, including: 1. The discounted cash flow model, which values a stock based on the present value of its expected future cash flows. 2. The dividend discount model (DDM), which values a stock based on the present value of its expected future dividends. Constant and variable growth DDM are discussed. 3. Other valuation methods like the free cash flow model, P/E ratio approach, and price-to-sales ratio are also presented. The document concludes that the best estimate of a stock's value is usually the present value of its estimated future dividends.

2. MC11-253
Muhammad NAWAZ
HAILEY COLLEGE OF COMMERCE PUNJAB UNIVERSITY LAHORE PAKISTAN

3. Common Stock Valuation

4. Common Stock
A security that represents ownership in a company.
Holders of common stock exercise control by electing
a board of directors.
In the event of liquidation, common shareholders
have rights to a company's assets only after
bondholders, preferred shareholders and other debt
holders have been paid in full.

5. What is Value
 In general, the value of an asset is the
price that a willing and able buyer pays to
a willing and able seller.
 Note that if either the buyer or seller is not
both willing and able, then an offer does
not establish the value of the asset.

6. Valuation of Financial Assets
Process of determining the fair market value
of a financial asset on the basis of present
value of the expected cash flows
Three step process:
1. Estimate the expected cash flows.
2. Determine the appropriate interest rate to
discount the cash flows.
3. Compute the present value of the expected cash
flows by discounted them with interest rate
determine in step 2.

7. Intrinsic Value
Maximum price which an investor is
ready to pay for purchase of a security.
Intrinsic value is present value and is
also called estimated value or economic
value.

8. Intrinsic Value
Intrinsic value is compared with market
value of security and is based on these
factors:
 Future cash inflows
 Timing of return
 Required rate of return i.e. ’’k’’
k=risk free rate of return + risk premium.

9. Discounted Cash Flow Model
This technique estimates the value of a
security by discounting its expected future
cash flows back to the present value and
adding them together.
The estimated value of a security = present
value of future cash flows
t=n expected cash flow
Value = V0 = ∑ -----------------------------
t=1 (1+k)t

10. Discounted Cash Flow Model
To use this model, an investor must:
 Estimate the amount of future cash flows
 Estimate the timing of future cash flows
 Estimate an appropriate discount rate
 Using above components value of a security
is calculated which is then compared to the
current market price of the security
 This calculated value is denoted by V0 and is
called intrinsic value

11. Discounted Cash Flow Model

12. Dividend Discount Model(DDM)
Value of a common stock is the present value
of all future dividends.
D1 D2 Dn
Value of stock= ------- + ------- + --- + --------
(1+k)1
(1+k)2
(1+k)n
n Dn
Value of stock = ∑ ----------
t=1 (1+k)n

13. Dividend Discount Model(DDM)
Types of dividend discount model:
1.Zero dividend growth
2.Constant growth
3.Variable growth

14. Zero Growth Model
Dividend every year will be the same
Investor anticipates to receive the same
amount dividend per year forever
D1
Vcs = ------------- where D1 =D0 (1+g)
Kcs
Dividend Discount Model(DDM)

15. Dividend Discount Model(DDM)
Constant Growth Model
Assume that firm grows at a stable
growth rate of g per year forever
D1
Vcs = ---------
Kcs - g

16. Variable growth rate
Assume that firm’s growth rate is variable
D0(1+g1 )t
Dn +1 1
Vcs = ∑ ------------ + ---------- ---------
( 1+Kcs )t
Kcs – g2 (1+Kcs )n
g1 = growth in 1st
phase
Dividend Discount Model(DDM)

17. 10-17
Intrinsic Value & Market Value
When market value is less than or equal to
intrinsic value then common stock must be
retained or purchased.
When market value is greater than intrinsic value
then common stock must be sold or avoid.

18. Other Valuation Methods
Some companies do not pay dividends,
or the dividends are unpredictable.
In these cases we have several other
possible valuation models:
Free Cash Flow Model
P/E approach
Price to Sales (P/S)

19. The Free Cash Flow Model
Free cash flow is the cash flow that’s left
over after making all required investments in
operating assets:
Where NOPAT is net operating profit after
tax
Note that the total value of the firm equals
the value of its debt plus preferred plus
common:
CapOpNOPATFCF ∆−=
CSPD VVVV ++=

20. The Free Cash Flow Model
We can find the total value of the firm’s
operations (not including non-operating
assets), by calculating the present value of
its future free cash flows:
Now, add in the value of its non-operating
assets to get the total value of the firm:
( )
gk
gFCF
VOps
−
+
=
10
( )
NonOpsNonOpsOps V
gk
gFCF
VVV +
−
+
=+=
10

21. The Free Cash Flow Model
Now, to calculate the value of its equity, we
subtract the value of the firm’s debt and the
value of its preferred stock:
Since this is the total value of its equity, we
divide by the number of shares outstanding
to get the per share value of the stock.
( )
PDNonOpsCS VVV
gk
gFCF
V −−+
−
+
=
10

22. 10-22
Price/Earnings Ratio
Alternative approach often used by
security analysts
P/E ratio is the strength with which
investors value earnings as expressed in
stock price
Divide the current market price of the stock by
the latest 12-month earnings

23. 10-23
To estimate share value
P/E ratio can be derived from
Indicates the factors that affect the estimated
P/E ratio
11 /EPEoP/E ratijustified
earningsestimatedP
o
o
×=×
=
k - g
/ED
/Eor P
k - g
D
P oo
11
1
1 ==
P/E Ratio Approach

24. 10-24
P/E Ratio Approach
The higher the payout ratio, the higher the
justified P/E
Payout ratio is the proportion of earnings that
are paid out as dividends
The higher the expected growth rate, g,
the higher the justified P/E
The higher the required rate of return, k,
the lower the justified P/E

25. 10-25
P/E Ratios and Interest Rates
A P/E ratio reflects investor optimism and
pessimism
Related to the required rate of return
As interest rates increase, required rates
of return on all securities generally
increase
P/E ratios and interest rates are indirectly
related

26. 10-26
Other Valuation Methods
Price-to-book value ratio
Ratio of share price to stockholder equity as
measured on the balance sheet
Price-to-sales ratio
Ratio of a company’s total market value (price
times number of shares) divided by sales
Market valuation of a firm’s revenues

27. 10-27
Which Approach Is Best?
Best estimate is probably the present
value of the (estimated) dividends
P/E multiplier remains popular for its ease
in use and the objections to the dividend
discount model