TFIN 601
Business Finance
UNIT 5 - Valuing Shares
What does "valuing shares" mean?
What is a share?
A share (or stock) is a small ownership piece of a company. If you buy one share of a company, you become a part -owner,
even if it’s a very small part.
What does it mean to value a share?
To value a share means to estimate how much it's truly worth based on how well the company is doing now and how well
it’s expected to do in the future.
Just because the market price (the price you see on the stock market) says $50, it doesn’t always mean the share is really
worth $50. The market price can go up and down due to hype, fear, news, etc.
Valuing shares means estimating the intrinsic value of a company’s stock — in other words, determining how much a share
should be worth based on the company’s financial performance and future prospects.
This process is important because the market price of a share can be different from its true value. Investors aim to buy
shares that are undervalued (priced lower than their real worth) and avoid or sell those that are overvalued.
To value a share, analysts usually look at:
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Future cash flows the company is expected to generate - Earnings
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Profits (earnings) and how fast they are growing – Growth (Are earnings increase over time?)
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Dividends, if the company pays them. does the company pay some profit back to shareholders?
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Risk factors, like how stable or risky the company is
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External factors, such as interest rates, inflation, or economic conditions. (do we expect more growth, or
problems?)
Why is this important?
Investors want to:
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Buy cheap (undervalued) shares → where the real value is higher than the market price
Avoid expensive (overvalued) shares → where the market price is too high compared to the real value
Common Methods to Value Shares:
1. Dividend Discount Model (DDM): Used when the company pays regular dividends.
It says the value of a share = the present value of all future dividends.
Where:
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D1: next year’s dividend
r: required return
g: dividend growth rate
2. Price/Earnings (P/E) Ratio: Used to compare how expensive a stock is based on its earnings.
You multiply the company’s earnings per share (EPS) by an appropriate P/E ratio (like the industry average).
3. Discounted Cash Flow (DCF): Used for companies that don’t pay dividends.
It calculates the present value of all the company’s future free cash flows (money the company can use after
paying expenses and investments).
Each method requires estimating future performance and discounting it back to today using a required rate of return,
which reflects the risk of investing in that company.
Understanding share valuation is crucial for making informed investment decisions and for corporate financial
management.
Key topics covered in this chapter include:
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Dividend Discount Models (DDM): These models estimate the value of a share based on the present value of
expected future dividends. The chapter discusses different forms of DDM, including the Gordon Growth Model,
which assumes constant dividend growth.
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Price/Earnings (P/E) Ratios: The chapter explains how P/E ratios can be used to value shares by comparing a
company's current share price to its per-share earnings. This method is particularly useful for companies that do
not pay dividends.
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Free Cash Flow Models: For companies that do not pay dividends or have unpredictable dividend patterns, the
chapter introduces valuation based on free cash flows, emphasizing the importance of forecasting and discounting
future cash flows.
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Market Efficiency and Valuation: The authors discuss how market efficiency impacts share valuation and the
implications for investors and corporate managers.
Throughout the chapter, the authors provide practical examples and exercises to illustrate the application of these
valuation methods in real-world scenarios.
The Essential Features of Preferred and Ordinary Shares
Ordinary (Common) Shares:
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Ownership and Voting Rights: Ordinary shareholders are the primary owners of a company and typically have
voting rights, allowing them to influence corporate decisions such as electing the board of directors.
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Dividends: Dividends for ordinary shares are not guaranteed and are paid at the discretion of the company's board,
depending on profitability and other factors.
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Residual Claim: In the event of liquidation, ordinary shareholders have a residual claim on assets, meaning they are
paid after all debts and obligations have been settled.
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Ordinary shareholders are residual claimants.
No claim to earnings or assets until all senior claims are paid in full.
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High risk but historically also high return.
Shareholders have voting rights on important company decisions.
Debt and equity have substantially different marginal benefits and marginal costs
Preferred Shares:
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Fixed Dividends: Preferred shareholders usually receive fixed dividends, which are paid before any dividends are
distributed to ordinary shareholders.
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Priority in Liquidation: In case of company liquidation, preferred shareholders have a higher claim on assets than
ordinary shareholders but are subordinate to debt holders.
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Limited or No Voting Rights: Preferred shares often do not carry voting rights, limiting shareholders' influence on
corporate governance.
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Hybrid Characteristics: Preferred shares exhibit features of both equity and debt, making them a hybrid financial
instrument.
Preferred shares have some features similar to debt and other features similar to equity.
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Claim on assets and cash flow rank senior to ordinary shares.
Dividend payments are not tax-deductible.
Preferred shares are held mostly by corporations.
Promises a fixed annual dividend payment, though this is not legally enforceable.
Preferred shareholders usually do not have voting rights
The section emphasizes how understanding these features is crucial for investors when assessing the risk and return
profiles of different equity instruments. It also discusses how companies use these instruments strategically to raise capita l
while balancing control and financial obligations.
Constant Growth Valuation Model (Gordon Growth Model)
What is it?
This model is used to value a share that is expected to pay dividends forever, and those dividends are expected to grow at a
constant rate every year.
It’s most useful for companies that are stable and mature — for example, large firms that pay regular dividends and grow
slowly but steadily.
The Formula
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P0 = the value (or price) of the share today
D1 = the dividend expected next year
r= the required rate of return (what the investor wants to earn)
g= the constant growth rate of the dividend
What does it mean?: You're calculating the present value of an infinite stream of dividends that grow at a constant rate.
In other words, you’re asking: "If I’m going to receive a growing dividend every year forever, how much should I pay for the
share today?"
Example:
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A company is expected to pay a dividend of $2 next year
The dividend is expected to grow by 5% per year
Your required return is 10%
This means the share is worth $40 today.
Assumptions of the Model: To use this model correctly, certain things must be true:
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Dividends grow at a constant rate forever
The growth rate (g) must be less than the required return (r)
(If not, the formula breaks — you can't divide by a negative or zero!)
The company actually pays dividends
When does this model work best?
Works well for:
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Large, stable companies
Companies with a long history of steady dividend growth (e.g., utilities, banks)
Doesn’t work well for:
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Startups or companies that don’t pay dividends
Companies with unstable or irregular growth
The authors explain this model in the context of valuing ordinary shares. They give examples using Australian companies
and emphasize:
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The model is simple but powerful
It’s a special case of the more general Dividend Discount Model (DDM)
It helps build intuition about how stock value is influenced by:
o Dividend size
o Growth rate
o Required return
They also explain how the model connects with expected returns, and why investors demand a return premium when
growth is low or risk is high.
The Zero Growth Valuation Model, another basic type of dividend-based valuation. It’s even simpler than the Constant
Growth Model.
Zero Growth Valuation Model
What is it?
The Zero Growth Valuation Model assumes that a company pays the same dividend forever, with no growth. So each year,
investors receive a fixed amount.
It’s like valuing a perpetual annuity — a stream of equal payments continuing forever.
The Formula
Where:
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P0= the value (or price) of the share today
D = the fixed dividend paid every year
r = the required rate of return
This is just a special case of the constant growth model where the growth rate g=0
What does it mean? You're calculating how much you should pay today to receive a fixed dividend forever.
Example:
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The company pays a dividend of $3 every year (and will do so forever)
Your required return is 8%
This means the share is worth $37.50 today.
Assumptions
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Dividends are constant forever (no increase or decrease)
The company is stable and mature
You know the required return rrr
When does this model work well?
Best for:
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Preferred shares (which often pay a fixed dividend)
Some utility companies or very mature firms with no growth prospects
Not suitable for:
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Growing companies
Companies that may change dividend policy
In the textbook
In Chapter 5, the authors explain this model as the starting point of share valuation. It helps students understand the logic
of discounting future cash flows. They introduce it before the Gordon Growth Model to show how growth impacts value.
They also relate it to the valuation of preferred shares, which often match this exact situation: fixed dividend, no growth,
paid indefinitely.
The variable Growth Valuation Model (sometimes called the Multi-Stage Dividend Discount Model). This is a more
advanced and flexible model
Variable Growth Valuation Model (Multi-Stage DDM)
What is it?
This model is used when a company’s dividends are expected to grow at different rates over time — for example:
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High growth in the first few years (e.g., 20% per year for 3 years)
Then a stable, constant growth afterward (e.g., 5% forever)
It combines the flexibility of forecasting different short-term growth rates with the long-term assumptions of the Constant
Growth Model.
When do we use it?
Best for companies that:
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Are new or expanding, with high short-term growth
Will eventually stabilize and grow at a slower, constant rate
Not useful for companies with unpredictable or non-dividend-paying histories
How does it work?
We break the valuation into stages:
Step 1: Estimate dividends during the high-growth period (year by year)
Use standard discounting to calculate the present value (PV) of each of those dividends.
Step 2: Estimate the terminal value
At the point where growth becomes constant, use the Constant Growth Model to find the value of all future dividends
beyond that point.
Then discount this terminal value back to the present.
Step 3: Add everything up
Sum the present values of:
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Each dividend during high growth
The terminal value (representing constant-growth dividends)
Formula Summary:
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Dt: dividends during the high-growth phase
PN: value of the share at the end of high-growth phase, using the constant-growth formula
r: required rate of return
N: number of high-growth years
Example:
Suppose a company will:
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Grow dividends at 20% for 2 years, then
Grow at 5% forever
The first dividend is $1
Required return = 10%
Step 1: Forecast dividends
Step 2: Calculate terminal value at year 2
Step 3: Discount all cash flows back to today
The estimated share value today is $27.25
This model is introduced after the simpler zero and constant growth models. The authors emphasize that real companies
don’t always grow at a single rate forever — especially startups or firms in developing markets (e.g., in Asia-Pacific
economies). The multi-stage model gives a more realistic valuation for such firms.
They encourage students to build spreadsheets for this model to handle multiple growth rates and cash flows efficiently.
Share Valuation
Share valuation is the process of determining the intrinsic (true) value of a company's share — that is, how much a share is
really worth, based on its ability to generate future cash flows for investors.
Why do we value shares?
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To know if a share is underpriced (a good investment) or overpriced
To make decisions about buying, selling, or holding shares
For company decisions like mergers, issuing equity, or stock-based compensation
The value of a share = the present value of future cash flows the investor expects to receive from that share.
These cash flows usually come in the form of:
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Dividends (for ordinary shares)
Fixed payments (for preferred shares)
So, when we value shares, we’re applying the time value of money: A dollar received today is worth more than a dollar
received tomorrow.
Share Valuation Approaches (from the textbook)
1. Dividend Discount Models (DDM): These are the most common models when the company pays dividends.
There are three types, depending on the growth pattern of dividends:
These models are used for ordinary shares.
2. Valuation Using Multiples (P/E Ratio): When a company doesn’t pay dividends, analysts may use valuation
multiples like:
Price/Earnings (P/E) Ratio: This method compares a company’s earnings to others in the same industry. It’s quick, practical,
but less precise.
3. Free Cash Flow Models: When dividends don’t reflect true firm value, use Free Cash Flow to Equity (FCFE):
These models estimate cash available for shareholders after all expenses and reinvestments.
Used for:
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High-growth firms
Firms that don’t pay dividends
More complex or realistic valuations
4. Preferred Share Valuation: Because preferred shares usually pay a fixed dividend, their valuation is similar to a
perpetual bond:
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D = fixed dividend
r = required return for preferred shares
The authors highlight that no one model works best for all companies. Analysts choose models based on:
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Dividend policies
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Growth prospects
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Availability of financial data