QF5213 Chap.8 Common Stock Valuation Methods
Common Stock Valuation Methods
Three ways to put a number on a share
Valuing common stock is harder than valuing a bond because nothing is promised. Shareholders hold the residual claim on the company, vote for directors and usually enjoy a preemptive right to buy new shares first, but the amount and timing of every future payment has to be inferred from expected earnings and the board's payout policy.
The class organises the toolkit into three families. Assets in place are measured with book value or net tangible assets. Future performance is estimated by discounting either dividends or free cash flows. Relative performance is read from market multiples of comparable listed firms.
Each family answers a slightly different question.
Book value tells you what the accounts say has been invested, at historical cost, and ignores what those assets can earn, so a share can sit well above or below it. Discounting tells you what a stream of expected cash is worth to an investor who demands a particular return.
Multiples tell you what investors are currently paying for similar businesses, whether or not that price is justified.
The dividend discount model and its growth patterns
The central idea is that a share is worth the present value of all dividends it will ever pay, discounted at the return shareholders require.
That required return comes from the capital asset pricing model: the risk-free rate plus beta times the market risk premium. Since forecasting dividends forever is impossible, three simplifications carry most exam questions. A zero growth stock is a perpetuity, priced as next dividend over required return.
A constant growth stock uses next dividend over the gap between required return and growth, and the model breaks down unless growth is lower than the required return.
A non-constant stock is valued in two stages: discount each dividend of the unusual period individually, then add the discounted value of a terminal price set with the constant growth formula once growth stabilises.
The model also explains why quoted prices move.
A rise in risk aversion, in the stock's beta or in inflation lifts the required return and pushes the price down, while news about the economy or the company changes expected dividends and growth.
Multiples, cash flow and takeover offers
Relative valuation multiplies a peer group's mean or median ratio by the target's own figure.
Price to earnings is the most quoted but fails with losses or tiny earnings; price to sales suits young unprofitable sectors; price to book compares market value with net assets; enterprise value to EBITDA values the whole firm, so excess cash must be added and debt subtracted before dividing by shares.
Free cash flow discounting at the weighted average cost of capital follows the same bridge and is preferred when a company pays no dividend.
The two buyout cases from the Week 5 class apply all of this to a live decision.
In each, a controlling shareholder offered minority holders a premium of roughly a third or more over the last traded price, yet the offer sat well below a long-run benchmark: the price long-term holders had paid in one case, the insurer's embedded value in the other.
Judging such an offer means comparing it with an independent valuation, not just with yesterday's quote, and then weighing the practical risk of being left in a delisted company.
What this chapter covers
- 01
Rights issues: ex-rights price and the value of a right
- 02
Book value and net tangible assets per share
- 03
Dividend discount model: zero and constant growth
- 04
Required return from the CAPM and why prices change
- 05
Two-stage valuation with a terminal price
- 06
Market multiples: P/E, P/B, P/S and EV/EBITDA
- 07
Judging a buyout premium against intrinsic value
Worked example · free
Pricing a share with two years of fast dividend growth
- 1Project the dividends for years 1 to 3.
- 2Set the terminal price at the end of year 2 with the constant growth formula.
- 2Discount every component to today and add them.
- 1Compare with a constant growth valuation and interpret the gap.
Key terms
- Required Return
- The rate shareholders demand for bearing a stock's risk, estimated as the risk-free rate plus beta times the market risk premium.
- Constant Growth Model
- A valuation formula that prices a share as next year's dividend divided by the required return minus a permanent growth rate.
- Terminal Price
- The value placed on a share at the date growth becomes constant, computed with the constant growth formula and then discounted to today.
- Net Tangible Assets
- A book value measure equal to shareholder equity less intangible assets and the par value of preferred shares, often stated per share.
- Price Earnings Ratio
- A market multiple that divides share price by earnings per share and signals how strongly investors expect future profit growth.
- Enterprise Value
- The value of the whole firm to all capital providers, equal to equity plus debt minus excess cash, used in EV to EBITDA multiples.
- Takeover Premium
- The percentage by which an offer price exceeds the target's last traded share price before the offer was announced.
- Embedded Value
- An insurer valuation measure that adds adjusted net assets to the present value of future profits from policies already in force.
Common Stock Valuation Methods FAQ
Why can the constant growth formula not be used when growth exceeds the required return?
The denominator, required return minus growth, would be zero or negative, producing an infinite or negative price that has no economic meaning. Very high growth can only last a few years because competitors enter and markets saturate, so value those years separately and switch to the formula once growth falls below the discount rate.
Should I use D0 or D1 in the dividend growth model?
The formula always needs the dividend expected one period from now. If a question says a dividend was just paid, grow it once by multiplying by one plus g before dividing by the gap between the discount rate and growth. Using the paid dividend directly understates the price by exactly the growth factor.
How do I value a stock that pays no dividends?
Discount the firm's expected free cash flows at the weighted average cost of capital to get enterprise value, add excess cash, subtract debt and divide by shares outstanding. A peer multiple such as price to sales or EV to EBITDA offers a cross check when profits are still negative.
Which valuation multiple is best for loss-making companies?
Price to sales usually works best because revenue cannot be negative and is less affected by accounting choices than earnings or book value. Price to earnings becomes meaningless with losses and unstable when earnings are tiny, so it should be dropped or replaced for young firms in growing sectors.
Is a large takeover premium proof that a buyout offer is fair?
No. The premium only compares the bid with the recent market price, which may be depressed by thin trading, a dominant shareholder or past losses. Fairness requires an independent estimate from discounted cash flows, dividends or comparable transactions, plus a view on whether sellers deserve part of any synergy.
Exam move
Build one small spreadsheet with inputs for D0, two growth rates, the length of the fast-growth period and the required return. Have it print each discounted dividend, the discounted terminal price and their share of total value. Rework the class examples and the two practice cards in it, then change one input at a time to see which assumption moves the price most.
Finish by valuing a stock with peer multiples and comparing the two answers.
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