Analysis of Common Stocks
Investments and Portfolio
Management (MB 72)
Outline
Process of Valuation of a Financial Asset
Process of Valuation of Common Stocks
Determining parameters of models
How to determine the growth rate?
Length of growth period
How to determine the required rate of return
Models for Stock Valuation
Dividend Discount Models
Price-Earnings Models
Free Cash Flow to Equity Valuation Models
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:
Estimate the expected cash flows
Determine the appropriate interest rate or interest
rates to discount the cash flows
Compute the present value of the expected cash
flows in step 1 by discounted them with interest
rate(s) in step 2
Estimating Cash Flows
Holding aside the risk of bankruptcy,
the cash flows of a common stock are:
• Payment of dividend so long as we hold the
stock
• Sale price of common stock when we sell the
stock
Is it difficult to estimate the cash flows
of a common stock?
Value of a Common Stock
Fair Market Value of a common stock
depends on
PV of cash flows from a stock
PV of an infinite dividend stream OR
PV of a finite dividend stream plus PV of
the sale price of the stock
Discounted Cash Flow Valuation
Value of any asset—a function of 3 variables
How it generates its cash flows?
When these cash flows are expected to occur?
Uncertainty of these cash flows
t=n CFt
Value =  ---------t=1 (1+r)t
Dividend Discount Model (DDM)
Value of a share of common stock is the
present value of all future dividends
n DPSt
Value per share of stock=  ---------t=1 (1+r)t
What if the stock is not held for an infinite
period?
One year holding period
Multiple year holding periods
Dividend Discount Model
Two types of cash flows
Dividends during the holding period
Expected price at the end of holding period—this
itself is dependent on future dividends
How to determine the value of a share of
common stock?
Infinite Holding Period
What will be the value of a share of common
stock?
Present value of an infinite stream of anticipated
dividends
Simplified assumptions to simply valuation
model
Zero Growth Model
Constant Growth Model
Two-stage growth model
Three-stage growth model
Zero Growth Model
Dividend every year will be the same
Investor anticipates to receive the same
amount dividend per year forever
DPS
V = ------------rcs
Constant Growth Model
Assume that firm grows at a stable
growth rate of g per year forever
DPS1
V = --------r-g
Two-Stage DDM
In general version of the model, two stages
of growth
An initial period of extraordinary growth
After initial period, a period of stable growth
n DPSt
Pn
P0 =  ---------- + ---------
t=1 (1+r)t
(1 + r)n
DPSn+1
Where Pn = ----------------(r – gn)
Three-stage growth model
Four Basic Inputs
Length of high growth period
Dividends per share each period
Required rate of return by stockholders
each period
Terminal price at the end of high
growth period
High Growth Rate and Stable
Growth Rate
Stable Growth Rate?
Growth rate expected to last forever
Firm’s other measures of performance including
can be expected to grow at the same rate
What growth rate is reasonable as a “stable”
growth rate?
A firm cannot in the long term grow at a rate
significantly greater than the growth rate in the
economy
Length of High Growth Period?
How much is the current growth rate?
Source of high growth?
High Growth Period
The greater the current growth rate in
earnings of a firm, relative to the stable
growth rate, the longer the high-growth
period
The larger the current size of the firm,
the shorter the high-growth period.
Guide to Length of High-Growth
Period
Current Growth
Rate
Length of High
Growth Period
 1% higher than stable No high growth
1 – 10% higher than stable 5 years
> 10% higher than stable
10 years
How do we Estimate Growth
Rate?
g = b[ROA+D/E(ROA-I (1-t))]
Where b refers to the retention ratio
ROA is the return on assets
D/E is the debt to equity ratio in book
value terms
i = interest expense/book value of debt
FCFE Valuation Model
The cash flow that the firm can afford
as dividends and contrasted with actual
dividends—may not payout as dividends
The residual cash flow left over after
meeting interest and principal payments
and providing for capital expenditures
to maintain existing assets and create
new assets for future growth.
FCFE = Net Income + Depreciation –
Capital Spending - Working Capital –
Principal Repayments + New Debt
Issues
If there is a target debt ratio, 
FCFE = Net Income - (1 - )(Capital
Expenditure – Depreciation) - ( 1- )
Working Capital
FCFE Model
n
FCFEt
Pn
P0 =  ---------- + --------t=1 (1+r)t
(1 + r)n
FCFEn+1
Where Pn = ----------------(r – gn)