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					                                                               CHAPTER EIGHTEEN
                                                        EQUITY VALUATION MODELS

This chapter discusses the process of valuation of common stock. The relationships between intrinsic
value and market and book values are presented. Various valuation techniques, and the strengths and
weaknesses of these techniques are presented and discussed.

After studying this chapter, the student should be able to value a firm using the appropriate dividend
discount model and the dividend discount-derived price/earnings ratio. The student should understand
the limitations of each of these models.

1. Valuation by Comparables
Three major types of approaches are used in equity valuation. One approach is to tie value to an
accounting value. An example of this approach would be to use Book Value to Market Value
Relationships. A second major approach is the dividend discount model approach. The third method is
to use price/earnings ratios. The most difficult component of valuation is the assessment of the firm’s
growth rates and opportunities. Students should also become familiar with other valuation approaches
such as free cash flow models and the approach used by researcher in forecasting aggregate levels of the
stock market.

        PPT 18-2 Models of Equity Valuation
        PPT 18-3 Table 18.1 Financial Highlights for Microsoft Corporation, March 8, 2006
        PPT 18-4 Limitations of Book Value

2. Intrinsic Value versus Market Price
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.

        PPT 18-5 Intrinsic Value and Market Price

3. Dividend Discount Models
Dividend discount models are developed in PPT 18-6 through PPT 18-12.               The general model is
presented in PPT 18-6.

        PPT 18-6 Dividend Discount Models: General Model

If a firm’s earnings and dividends are not expected to grow in the foreseeable future, the value of the
stock can be estimated using the no growth model. Preferred stock exactly fits this model.

        PPT 18-7 No Growth Model
        PPT 18-8 No Growth Model: Example

If a firm’s earnings and dividends are expected to grow at a constant rate in the foreseeable future, the
general model simplifies to the constant growth model. 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.

        PPT 18-9 Constant Growth Model
        PPT 18-10 Constant Growth Model: Example
        PPT 18-11 Estimating Dividend Growth Rates

The final dividend growth model that is presented in the chapter is the specified holding period model.
The model actually combines the dividend discount model with the P/E approach. The investor estimates
dividends over the holding period, finds the value of those dividends and find the present value of the
expected sales price. The expected sales price is estimated by estimating the earnings level when the
stock is sold and estimating the multiplier that will apply to the earnings.

        PPT 18-12 Specified Holding Period Model

The relationship between dividend payout and growth is depicted in Figure 18.1 of the text.

        PPT 18-13 Figure 18.1 Dividend Growth for Two Earnings Reinvestment Policies

The concept of partitioning the value of stock into a no growth and a present value of growth
opportunities component is presented in PPT 18-14 and PPT 18-15. 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.

        PPT 18-12 Partitioning Value: Example
        PPT 18-13 Partitioning Value: Example

The contribution of growth to the total value is different for different industries and for firms.

        PPT 18-16 Table 18.2 Financial Ratios in Two Industries
        PPT 18-17 Figure 18.2 Value Line Investment Survey Report on Hewlett Packard

4. Price Earnings Ratios
An alternative approach to use of the dividend growth model approach is to use the P/E approach. The
P/E is used extensively in industry and is helpful in comparing relative values of firms. The appropriate
P/E is a function of two factors; the required rate of return and expected growth in earnings. While the
P/E appears easier to use, the same estimates that apply to the dividend discount approach apply to the
P/E approach. The appropriate P/E multiple depends on growth.

        PPT 18-18 Price Earnings Ratios

Formulas used to estimate the P/E ratios with and without growth are presented in PPT 18-15 through
PPT 18-18. The price earnings ratios that are presented in the chapter are based on next year’s expected
earnings. The P/E ratios that are reported in the financial press are often based on historical earnings.
Both measures of Price/Earnings ratios are used in industry.

        PPT 18-19 P/ E Ratio: No expected Growth
        PPT 18-20 P/ E Ratio: With Constant Growth
        PPT 18-21 Numerical Example with No Growth
        PPT 18-22 Numerical Example with Growth

The impact that plowback has on growth is shown in Table 18.3.

        PPT 18-23 Table 18.3 Effect of ROE and Plowback on Growth and the P/E Ratio

Price/Earnings ratios use accounting values in their calculation. Accounting conventions use historical
costs and because of this accounting earnings may not reflect economic earnings. Earnings also fluctuate
significantly around the business cycle. The limitations in using P/E ratios are highlighted in PPTs 18-25
through 18-28.

        PPT 18-19 Pitfalls in P/E Analysis
        PPT 18-25 Figure 18.3 P/E Ratios and Inflation
        PPT 18-26 Figure 18.4 Earnings Growth for Two Companies
        PPT 18-27 Figure 18.5 Price-Earnings Ratios
        PPT 18-28 Figure 18.6 P/E Ratios for Different Industries, 2006

Three additional ratios that are used in valuation are displayed in PPT 18-29. In recent years the price-to-
sales ratio has been used extensively.
        PPT 18-29 Other Valuation Ratios
        PPT 18-30 Figure 18.7 Market Valuation Statistics

5. Free Cash Flow Valuation Approaches
Another popular approach in valuing firms is the free cash flow model. Once free cash flow is estimated,
the cash flow is discounted at the firm’s cost of capital.

        PPT 18-31 Free Cash Flow Approach

6. The Aggregate Stock Market
The most popular approach used in forecasting the aggregate market is the earnings multiplier approach.
Examples of using this approach are shown in PPTs 18-33 and 18-34.

        PPT 18-32 Steps to Forecasting the Aggregate Market
        PPT 18-33 Figure 18.8 Earnings Yield of S&P 500 versus 10-Year Treasury-Bond Yield
        PPT 18-34 Table 18.4 S&P 500 Forecasts Under Various Scenarios

Excel Model

An excel model that can be used to estimate intrinsic values for companies with shifting growth rates can
be found at the Online Learning Center ( The model has capabilities of modeling
a single shift or two shifts in the growth rate in earnings and dividends. The analysis also includes a
sensitivity analysis to growth rates and duration of growth. The model is useful in helping students
understand the impact that estimates of growth have on stock prices and PE ratios.