"valuation by comparables,"

Analyse the relationship between price and various determinants of value for similar
firms and then extrapolate that relationship to the firm in question.

a fundamental analysis method to estimate a stock's true value based on financial

data.

book value

Net worth of common equity according to a firm’s balance sheet

Shareholders in a firm are sometimes called “residual claimants,” which means that the
value of their stake is what is left over when the liabilities of the firm are subtracted from
its assets.

which uses historical costs rather than current market values.

Market value reflects the current value of assets

The values of both assets and liabilities recognized in financial statements are based on
historical – not current – values.

liquidation value (the amount if assets were sold and liabilities paid)

Net amount realized by selling assets of firm and paying off debt

replacement cost (the cost to replace assets),

Tobin’s q ratio measuring market price to replacement cost.

Ratio of firm’s market value to replacement cost

The intrinsic value

is the present value of all expected future cash flows (dividends and eventual sale
proceeds) discounted by the required rate of return

E(r) = d1 + ( p1 _ p0 ) / p0

CAPM

The capital asset pricing model (CAPM) asserts that when stock market prices are at
equilibrium levels, the rate of return that investors can expect to earn on a security

K = r_f + beta (E(r_M) – r_f)

If a stock is priced “correctly,” it will offer investors a “fair” return, that is, it’s expected
return will equal its required return.

The goal of a security analyst is to find stocks that are mispriced.

K ( capital asset pricing model ) or required rate of return

Dividend yield = dividend / p0

Capital gains yield = p1 - p0 / p0

Intrinsic Value

Present value all cash payments to the investor in the stock, including dividends as well
as the proceeds from the ultimate sale of the stock, discounted at the appropriate risk-
adjusted interest rate.

For a one-year holding period,

V_0 = {(D_1) + P_)} / {1 + k}

Multi-Year Holding Period:

V_0 = £ {D_t} / {(1 + k)^t

V0 = D1 / 1+ k + D2 / ( 1 + k )2 + ...... + Dh + Ph / ( 1 + k ) h

V0 = Fv1 / ( 1 + r ) + Fv2 / ( 1 + r )2 + .......

As the growth rate increases, the stock’s intrinsic value rises.

As k decreases , the stock’s intrinsic value rises.

As dividend increases, the stock’s intrinsic value rises.

K > g to remain valid

If g > k, intrinsic value becomes unrealistic or infinite.

Market Capitalization Rate

In market equilibrium, the current market price will reflect the intrinsic value estimates
of all market participants.

Market-consensus estimate of appropriate discount rate for firm’s cash flows

Constant-Growth Dividend Discount Model (DDM)

Value equals present value of all expected future dividends

Used for valuing companies with stable dividend growth rates. It applies to both
common stocks with predictable growth and preferred stocks with zero growth.

V0 = D1 / k – g

D1 = D0 ( 1 + g ) n
Impact of ROE and Plowback on Price

• Dividend payout ratio

Percentage of earnings paid as dividends

• Plowback ratio/earnings retention ratio

Proportion of firm’s earnings reinvested in business

g = ROE × b

Present Value of Growth Opportunities (PVGO)

P0 = E1 ( 1- b ) / k- g

PVGO = p0 - E1 / k

focusing on multistage growth models

1. Two-Stage Growth Model:

DDM in which dividend growth assumed to level off only at future date

Long-term Treasury bonds are preferred over short-term T-bills for valuation purposes.

2 . Multistage Growth Models:

Allow dividends per share to grow at several different rates as firm matures

Offer greater realism by accommodating flexible growth patterns, including initial,

transitional, and sustainable growth stages.

A three-stage growth model is often used, incorporating:

Short-term dividend forecasts.

A gradual transition period for declining growth rates.

A terminal growth rate for the long-term.

The free cash flow (FCF) valuation approach

is an alternative to the dividend discount model (DDM) that values firms using free cash
flow (available cash after capital expenditures).

This method is helpful for firms that do not pay dividends but is applicable to all firms.
Types of Free Cash Flow Models:

1. Free Cash Flow for Firm (FCFF) :

• Is the cash flow available to the company’s suppliers of capital after all operating
expenses (including taxes) have been paid and necessary investments in working
capital (e.g., inventory) and fixed capital (e.g., equipment) have been made.
• FCFF is the cash flow from operations minus capital expenditures. A company’s
suppliers of capital include common stockholders, bondholders, and sometimes,
preferred stockholders.
• The equations analysts use to calculate FCFF depend on the accounting information
available.

FCFF = EBIT ( 1 – t ) + depreciation- capital expenditures - Δ NWC

2. Free Cash Flow to Equity Holders (FCFE) :

• Is the cash flow available to the company’s holders of common equity after all
operating expenses, interest, and principal payments have been paid and necessary
investments in working and fixed capital have been made.
• FCFE is the cash flow from operations minus capital expenditures minus payments
to (and plus receipts from) debtholders.
• Cash available to all capital providers (debt and equity holders).
• Discounted at the weighted average cost of capital (WACC) to estimate firm value.
Subtracting the debt value yields equity value.
• Cash available to equityholders, obtained by adjusting FCFF for after-tax interest
payments and net debt changes.
• Discounted at the cost of equity to derive equity value

FCFE = FCFF — Interest Expense X (1 — tc) + Δ NetDebt

FCFE = FCFF - after - tax interest + net debt changes

Terminal Value: Pt = FCFt + 1 / discount rate – g

Firm value = ∑ FCFF / ( 1+ WACC ) t + Pt / ( 1 + WACC ) T

Pt = FCFF ( 1+ g ) / WACC – g

FCFF / ( 1+ WACC ) t = FCFF / ( 1 + WACC )1 + FCFF / ( 1 + WACC )2 + .........

Market Value of Equity = ∑ FCFE / ( 1+ Ke ) t + Pt / ( 1 + Ke ) T

Pt = FCFE ( 1+ g ) / Ke – g
• Comparing Valuation Models
▪ Model values differ in practice
▪ Differences stem from simplifying assumptions
▪

• Problems with DCF Models

▪ DCF estimates are always somewhat imprecise

• Investors employ hierarchy of valuation

▪ Real estate, plant, equipment
▪ Economic profit on assets in place
▪ Growth opportunities

Questions:

1. Suppose you purchased a share of DAR Inc. For $40 in January. You expect to sell it for
$42 in December and expect to receive a dividend of $2.42 during that year. What is your
expected HPR?

E(r) = E(Di) + [E(Pi.) — Po] / Po = $2.42 + $420 — 40HPR / 40 = .1105 = 11.05%

2. using a one-year investment horizon and a forecast that the stock can be sold at the
end of the year at price P1 = $42, expect to receive a dividend of $2.42 during that year.
Suppose that rf = 4%, E(rm) – rf = 5%, and the beta of ABC is 1.2.

Vo = (2.42 + 42) / (1 + 10%) = $40.38

3. ABC Co. Has just paid its annual dividend of $3 per share. The dividend is expected to
grow at a constant rate of 8% indefinitely. The beta of ABC Co. Stock is 1, the risk-free
rate is 6%, and the market risk premium is 8%.

What is the intrinsic value of the stock?

What would be your estimate of intrinsic value if you believed that the stock was riskier,
with a beta of 1.25?

D = $3 x 1.08 = $3.24

K = 6% + 1.0 x 8% = 14%

Vo = (3.24) / (14%-8%) = $54

K = 6% + 1.25 x 8% = 16%

Vo = (3.24) / (16%-8%) = $40.5

4. Suppose that ABC Co. Wins a major contract for its revolutionary computer chip. The
very profitable contract will enable it to increase the growth rate of dividends from 5% to
6% without reducing the current dividend from the projected value of $4 per share. If
you know that rf = 6%, E(r,,) = 11%, and the beta of ABC is 1.2.

What will happen to the stock price?

What will happen to future expected rates of return on The stock?

D0 = 4 ( 1 + 5% ) = 4.2 D1 = 4 ( 1 + 6% ) = 4.24

K = 6% + 1.2 ( 11% - 6% ) = 12

V0 = 4.2 / ( 12% - 5% ) = 60 V1 = 4.24 / ( 12% - 6% ) = 70.67

E (r) = (4.2 / 60 ) + 5% = 12% E (r) = (4.24 / 70.67) + 6% = 12%

Because the risk of the stock has not changed, neither should the expected rate of
return.

5. Find the value of a preferred stock that pays a dividend of $2 per share, assuming that
your required rate of return is 8%.

V0 = D1 / K -g = 2 / 8% - 0 = 25
6. XYZ’s stock dividend at the end of this year is expected to be $2.15, and it is expected
to grow at 11.2% per year forever. If the required rate of return on XYZ stock is 15.2% per
year.

1. What is its intrinsic value?

2. If XYZ’s current market price is equal to this intrinsic value, what is next year’s
expected price?

If an investor were to buy XYZ stock now and sell it after receiving the $2.15 dividend
a year from now.

3. What is the expected capital gain in percentage terms?

4. What is the dividend yield, and what would be the holding-period return?

1. V0 = D1 / k – g = 2.15 / 15.2 – 11.2 = 53.75

2. P0 = v0

P1 = p0 ( 1 + g ) = 53.75 ( 1 + 11.25 ) = 59.77

3. Capital gain yield = p1 - p0 / p0 = 59.77 - 53.75 / 53.75 = 11.2 %

4. Dividend yield = D1 / p0 = 2.15 / 53.75 = 4%
Er = Dividend yield + Capital gain yield = 4% + 11.2% = 15.2%

7. A company is going to earn $2 per share next year, and it should be able to pay out
50% of those earnings in the form of a dividend and reinvesting in projects that provide
an ROE of 8%. The company has a cost of equity of 12%. Find out PVGO.

• G = ROE x b = 8 % x (1- 50%) = 4%

• P0 with growth = (2 * 0.5) + (.12 – 0.04) = $12.5
• P0 with no-growth = 2 + .1 2 = $1 6.67
• PVGO = $12.5 - $16.67 = - 4.17
• PVGO = E1 ( 1- b ) / k- g - E1 / k = 2 ( 1 – 50% ) / (12% - 4% ) - 2 / 12% = 4.17

8. Consider the following information

• The firm’s dividends are expected to grow at g = 20% until t = 3 yrs

• At the start of year four, growth slows to gs= 5%.
• The stock just paid a dividend Div0 = $1.00
• Assume a market capitalization rate of k = 12%
• What is the price, P0, of this stock?

V0 = D1 / 1+ k + D2 / ( 1 + k )2 + ...... + D4+ P4 / ( 1 + k ) 4

D1 = D0 ( 1 + g ) = 1 ( 1 + 20% )1 = 1.2

D2 = D0 ( 1 + g ) 2 = 1 ( 1 + 20% )2 = 1.44

D3 = D0 ( 1 + g ) 3 = 1 ( 1 + 20% )3 = 1.728

D4 = D3 ( 1 + g ) = 1.728 (1 + 5% ) = 1.8144

P3 = D3 ( 1 + g ) / k – g = 1.728 ( 1 + 5% ) / 12% - 5% = 25.92

V0 = 1.2 / ( 1 + 12% ) + 1.44 / ( 1 + 12% ) 2 + 1.728 / ( 1 + 12% )3 + ( 25.92 ) / ( 1 + 12% ) 3=

1.07 + 1.15 + 1.23 + 18.45 = 21.9

9. Suppose FCFF = $1 mil for years 1-4 and then is expected to grow at a rate of 3%.
Assume WACC = 15%

• If 500,000 shares are outstanding, what is the predicted price of this stock if the firm
has $5,000,000 of debt?

Firm value = ∑ FCFF / ( 1+ WACC ) t + Pt / ( 1 + WACC ) T

Pt = FCFF ( 1+ g ) / WACC – g

Pt = 1,000,000 × 1.03 / 0.15 – 0.03 = 8583333.33

FCFF / ( 1+ WACC ) t = 1000000 / ( 1 + 0.15 ) + 1000000 / ( 1 + 0.15 )2 + 1000000 / ( 1 +

0.15 )3 + 1000000 / ( 1 + 0.15 )4 = 2854978.36

Firm value = ∑ 2854978.36 + 8583333.33 / ( 1 + 0.15 ) 4 = 2854978.36 + 4907548.691

= 7762527

P0 = asset value – liabilities / share outstanding = 7762527 – 5000000 / 5000000

= 5.53

10. Suppose FCFE = $900,000 for years 1-4 and then is expected to grow at a rate of 3%.
Assume ke = 18%

• If there are 500,000 shares outstanding, what is the predicted price of this stock? Why
can debt be ignored?
Market Value of Equity = ∑ FCFE / ( 1+ Ke ) t + Pt / ( 1 + Ke ) T

= ∑ 900,000 / ( 1 + 0.18 ) t + [( 900,000 × 1.03 ) /(0.18 – 0.03 )] / (1+0.18 )4

= 5467725

P0 = asset value / share outstanding = 5467725 / 500,00 = 10.94

Debt is ignored in this case because we are using Free Cash Flow to Equity (FCFE),
which already accounts for interest payments and principal repayments. FCFE
represents the cash flows that are directly available to equity holders, so there’s no
need to make adjustments for debt separately.

11. XYZ Corporation is evaluating its cash flows for the year which has Earnings Before
Interest and Taxes $800,000 , Corporate Tax Rate 30% , Depreciation $100,000

Capital Expenditures $200,000 and Change in Net Working Capital $50,000

What is the Free Cash Flow to the Firm (FCFF) for XYZ Corporation?

12. A company has Free Cash Flow to Firm $500,000 , Interest Expense $50,000

Corporate Tax Rate 30% and Change in Net Debt (ΔNetDebt): $20,000

Calculate the FCFE for the company.

Aggregate stock market forecasting using the earnings multiplier approach

This method involves forecasting corporate profits and estimating the price-to-earnings
(P/E) ratio based on long-term interest rates to predict the market level.

While useful for organizing analysis and uncovering investment opportunities, these
models require caution and cannot be applied mechanically due to uncertainties in
economic forecasts.

The Price-Earnings (P/E) ratio

is the ratio of a firm’s stock price to its earnings per share and is often used as a
measure of stock valuation.

It provides insight into a firm’s growth opportunities and market valuation.

Firms with higher growth opportunities have higher P/E ratios.

P/E = (1 – b) / {k – (ROE × b)}

Higher ROE increases the P/E ratio, as it reflects better growth prospects.

Higher plowback raises P/E only if the firm’s ROE exceeds the required return ().

Higher risk leads to lower P/E multiples

1. Price-to-book: Compares stock price to book value per share, useful for
fundamental valuation.

2. Price-to-cash-flow: Preferred for minimizing accounting manipulation impacts.

3. Price-to-sales: Useful for start-ups without earnings, though profit margin variability
complicates comparisons.