Topic 9 (Ch. 18)
Equity Valuation Models
 Intrinsic value versus market price
 Dividend discount models (DDM)
 The constant-growth DDM
 Stock prices and investment opportunities
 Life cycles and multistage growth models
 Price-earnings (P/E) ratio
 Free cash flow valuation approaches
 Inflation and equity valuation
1
Intrinsic Value versus Market Price
 The expected holding-period return:
Assume a one-year holding period.
Suppose that ABC stock has:
• an expected dividend per share: E(D1) = $4.
• the current price of a share: P0 = $48
• the expected price at the end of a year: E(P1) = $52.
Question:
Is the stock attractively priced today given your
forecast of next year’s price?
2
The expected holding-period return (HPR):
Expected HPR = E ( r ) 
E ( D1 )  [ E ( P1 )  P0 ]
P0
4  [52  48]

 0.167 or 16.7%
48
The stock’s expected HPR is the sum of:
• the expected dividend yield: E(D1)/P0
• the expected capital gains yield (i.e. the expected rate
of price appreciation): [E(P1) - P0]/P0.
3
The required rate of return for ABC stock:
From the CAPM, when stock market prices are at
equilibrium levels, the rate of return that investors
can expect to earn on a security is:
r f   [ E ( rM )  r f ]
This is the return that investors will require of a
security given its risk as measured by beta.
4
Suppose:
rf = 6%
E(rM) – rf = 5%
the beta of ABC: 1.2.
 The required rate of return for ABC stock:
k  6%  1.2  5%  12%
The rate of return the investor expects exceeds the
required rate based on ABC’s risk by a margin of
4.7% (= 16.7% - 12%).
Thus, the investor will want to buy ABC stock.
5
 Another way:
Compare the intrinsic value of a share of stock to its
market price.
The intrinsic value (V0) of a share of stock:
The present value of all expected cash payments to
the investor in the stock (including expected
dividends as well as the proceeds expected from the
ultimate sale of the stock) discounted at the
appropriate risk-adjusted interest rate, k.
6
Whenever the intrinsic value (i.e. the investor’s own
estimate of what the stock is really worth) exceeds the
market price, the stock is considered undervalued and
a good investment.
In case of ABC stock:
E ( D1 )  E ( P1 ) $4  $52
V0 

 $50
1 k
1  12%
Because intrinsic value ($50) exceeds current price
($48), the stock is undervalued in the market.
Thus, investors will want to buy ABC.
7
In market equilibrium:
market price = intrinsic value.
(i.e. P0 = V0)
required return = expected return.
(i.e. k = E(r))
Note: k is the discount rate, the required rate of
return, or the market capitalization rate.
8
Dividend Discount Models (DDM)
 We will use the simpler notation Pt and Dt instead of
E(Pt) and E(Dt) to avoid clutter.
Notations:
Dt: expected dividend to be received at the end of year t.
(D0: most recent dividend, has just been paid.)
Pt: expected stock price at end of year t.
Keep in mind that future prices and dividends are
unknown, and we are dealing with expected values, not
certain values.
9
Suppose the investor holds stock for 1 year,
then sell.
D1
P1
D1
V1
V0 



1 k 1 k 1 k 1 k
 D2  P2 


D1
1 k 



1 k
1 k
D1
D2
P2



1  k (1  k ) 2 (1  k ) 2
10
D1
D2
V2



2
1  k (1  k )
(1  k ) 2
 D3  P3 


D1
D2
1 k 




1  k (1  k ) 2
(1  k ) 2
D1
D2
D3
D4




...
1  k (1  k ) 2 (1  k ) 3 (1  k )4
i.e.

V0  
Dt
t
(
1

k
)
t 1
11
Suppose the investor plans to hold the
stock for H years, then sell.
D1
DH
PH
V0 
 ... 

H
H
1 k
(1  k )
(1  k )
D1
DH
VH

 ... 

H
1 k
(1  k )
(1  k ) H
 DH 1

D

P
2
H
2
H



...

 (1  k )
H 
D1
DH
(
1

k
)



 ... 

H
H
1 k
(1  k )
(1  k )
12
D1
DH
DH 1
D2 H  P2 H

 ... 

 ... 
H
H

1
2H
1 k
(1  k )
(1  k )
(1  k )
D1
DH
DH 1
D2 H  V2 H

 ... 


...

H
H 1
2H
1 k
(1  k )
(1  k )
(1  k )
D1
DH
DH 1
D2 H

 ... 


...


...
1 k
(1  k ) H (1  k ) H 1
(1  k ) 2 H

i.e.
V0  
Dt
t
(
1

k
)
t 1
13
Suppose the investor plans to hold the
stock forever.

D1
D2
D3
Dt
V0 



...


2
3
t
1  k (1  k )
(1  k )
(
1

k
)
t 1
The dividend discount model (DDM):
The current value of a share of common stock
is the sum of all future expected dividend
payments discounted to the present, no
matter what the investor’s holding horizon is.
14
 Note:
It is incorrect to conclude that the DDM focuses
exclusively on dividends and ignores capital gains as
a motive for investing in stock.
Indeed, capital gains (as reflected in the expected
sales price) are part of the stock’s value.
The price at which you can sell a stock in the future
depends on dividend forecasts at that time.
15
The constant-growth DDM
 Assume that dividends are trending upward at a
stable growth rate (g).
For ABC stock:
If g = 0.05, and the most recently paid dividend was
D0 = 3.81, then expected future dividends are:
D1  D0 (1  g )  3.81  1.05  4.00
D2  D0 (1  g ) 2  3.81  (1.05) 2  4.20
D3  D0 (1  g ) 3  3.81  (1.05) 3  4.41 etc.
3
D
(
1

g
)
 V0  D0 (1  g )  D0 (1  g )  0
 ...
2
3
1 k
(1  k )
(1  k )
2
16

D0 (1  g )
D1
V0 

kg
kg
(the constant-growth DDM)
 V 
0
$4
 $57.14
12%  5%
Notes:
D1
 If g = 0, then V0 
.
k
 The model requires:
k > g (otherwise, the value of the stock would be
infinite).
17
Implications:
 A stock’s value will be greater:
 The larger its expected dividend per share.
 The lower the market capitalization rate, k.
 The higher the expected growth rate of dividends.
The stock price is expected to grow at the same rate
(g) as dividends.
Suppose a stock is selling at its intrinsic value, i.e.
P0  V0
 P0  D1
kg
18
D
D
(
1

g
)
2
1
 P1 

 P0 (1  g )
kg
kg
D
D
(
1

g
)
3
2
 P2 

 P1 (1  g )  P0 (1  g ) 2
kg
kg
.
.
.
 P  P (1  g ) t
t
0
i.e. in the case of constant growth of dividends, the rate
of price appreciation in any year will equal that
constant-growth rate, g.
19
 For a stock whose market price equals its intrinsic
value (P0 = V0), the expected holding-period return
will be:
E(r) = k = dividend yield + capital gains yield
D1

g
P0
 The discounted cash flow (DCF) formula:
D1
k
g
P0
i.e. by observing the dividend yield (D1/P0) and
estimating the growth rate of dividends (g), we can
compute k.
20
Stock prices and investment opportunities
 Consider a company, X, with expected earnings in the
coming year of $5 per share.
X pays out all of its earnings as dividends, maintaining
a perpetual dividend flow of $5 per share.
If k = 12.5%, X would then be valued at:
D1/k = $5/12.5% = $40 per share.
X would not grow in value, because with all earnings
paid out as dividends, and no earnings reinvested in
the firm, capital stock and earnings capacity would
remain unchanged over time; earnings and dividends
would not grow.
21
 Now suppose X engages in projects that generate a
return on investment of 15%, which is greater than
the required rate of return, k = 12.5%.
It would be foolish for such a company to pay out all
of its earnings as dividends.
If X retains or plows back some of its earnings into
its highly profitable projects, it can earn a 15% rate
of return for its shareholders, whereas if it pays out
all earnings as dividends, it forgoes the projects,
leaving shareholders to invest the dividends in other
opportunities at a fair market rate of only 12.5%.
22
Suppose that X chooses a lower dividend payout
ratio (the fraction of earnings paid out as dividends),
reducing payout from 100% to 40%, maintaining a
plowback ratio (the fraction of earnings reinvested
in the firm) at 60%. The plowback ratio is also
referred to as the earnings retention ratio.
The dividend of the company will be $2 (= 40%  $5
earnings) instead of $5.
Although dividends initially fall under the earnings
reinvestment policy, subsequent growth in the assets
of the firm because of reinvested profits will generate
growth in future dividends, which will be reflected in
today’s share price.
23
24
 How much growth will be generated?
Suppose X starts with plant and equipment of $100
million and is all equity financed.
With a return on investment or equity (ROE) of 15%:
total earnings = ROE  $100 million
= 15%  $100 million = $15 million.
There are 3 million shares of stock outstanding, so
earnings per share are $5 (= $15 million/3 million).
If 60% of the $15 million in this year’s earnings is
reinvested, then the value of the firm’s capital stock
will increase by:
0.60  $15 million = $9 million, or by 9%.
25
i.e. The percentage increase in the capital stock:
= ROE  the plowback rate (b)
= 15%  60% = 9%.
Now endowed with 9% more capital, the company
earns 9% more income, and pays out 9% higher
dividends.
 The growth rate of the dividends is:
g = ROE  b = 15%  60% = 9%.
If the stock price equals its intrinsic value, it should
sell at:
D1
$2
P0 

 $57.14
k  g 12.5%  9%
26
 When X reduces current dividends and reinvest
some of its earnings in new investments, its stock
price increases.
The increase in the stock price reflects the fact that
the planned investments provide an expected rate of
return greater than the required rate.
That is, the investment opportunities have positive
net present value (NPV). The value of the firm rises
by the NPV of these investment opportunities.
This NPV is called the present value of growth
opportunities (PVGO).
27
 the value of the firm
= the value of assets already in place (i.e. the nogrowth value of the firm)
+ the NPV of the future investments the firm will
make (i.e. the PVGO)
i.e. Price = No-growth value per share + PVGO
E1
P0 
 PVGO
k
57.14 = 40 + 17.14
28
 Note:
Growth enhances company value only if it is
achieved by investment in projects with attractive
profit opportunities (i.e., with ROE > k).
Now suppose that ROE is only 12.5%, just equal to
the required rate of return, k.
 The growth rate of the dividends is:
g = ROE  b = 12.5%  60% = 7.5%.
D1
$2
 P0 

 $40
k  g 12.5%  7.5%
29
Price = No-growth value per share + PVGO
E1
P0 
 PVGO
k
$40 = $40 + PVGO

PVGO = 0.
If the firm’s projects yield only what investors can
earn on their own, shareholders cannot be made
better off by a high reinvestment rate policy.
To justify reinvestment, the firm must engage in
projects with better prospective returns than those
shareholders can find elsewhere.
30
Life cycles and multistage growth models
 Firms typically pass through life cycles with very
different dividend profiles in different phases.
In early years, there are ample opportunities for
profitable reinvestment in the company. Payout ratios
are low, and growth is correspondingly rapid.
In later years, the firm matures, attractive
opportunities for reinvestment may become harder to
find. In this mature phase, the firm may choose to
increase the dividend payout ratio, rather than retain
earnings. The dividend level increases, but thereafter
it grows at a slower rate because the company has
fewer growth opportunities.
31
 To compute the intrinsic value, follow the following
3 steps:
 Find the present value of the dividends during
the nonconstant growth period.
 Find the price of the stock at the end of the
nonconstant growth period (i.e. at which point it
enters its constant-growth phase), and discount this
price back to the present.
 Add these 2 components.
32
Example:
D2013 = $0.78
D2014 = $0.85
D2015 = $0.92
D2016 = $1.00
Dividends enter their constant-growth phase at the
end of 2016.
Suppose: dividend payout ratio = 25%.
ROE = 10%.
 The long-term constant steady-state growth rate:
g = ROE  b = 10%  (1 – 25%) = 7.5%.
33
Find k:
beta = 0.95
risk-free rate = rf = 2%
expected market return = E(rM) = 10%
 k  r f   [ E rM   r f ]
 2  0.9510  2  9.6%
34
Find V2012:
D2013
D2014
D2015
D2016  P2016
V2012 



2
3
(1  k ) (1  k )
(1  k )
(1  k ) 4
0.78
0.85
0.92
1.00  P2016




2
3
4
1.096 (1.096 )
(1.096 )
(1.096 )


D2017 D2016(1  g )
1.00  1.075
P2016 


 $51 .19
kg
kg
0.096  0.075
V2012  $38.29
35
Price-Earnings (P/E) Ratio
Price-earnings multiple:
the ratio of price per share to earnings per share,
commonly called the P/E ratio.
The P/E ratio and growth opportunities

Price = No-growth value per share + PVGO
E1
P0 
 PVGO
k
P0 1 PVGO 1
PVGO

 
 [1 
]
E1 k
E1
k
E1 / k
36
Implications:
 When PVGO = 0:
P0 = E1/k and P/E ratio = 1/k.
PVGO  P/E ratio.
 The P/E ratio might serve as a useful indicator of
expectations of growth opportunities.
A high P/E multiple indicates that a firm enjoys
ample growth opportunities.
37
 Recall:
D1
The constant growth DDM: P0 
.
kg
D1 = E1(1 – b).
g = ROE  b. ( ROE and b  g)
E1 (1  b )
 P0 
k  ROE  b

P0
1 b

E1 k  ROE  b
 The impact of ROE on the P/E ratio:
ROE  P/E ratio.
(High-ROE projects give
opportunities for growth).
the
firm
good
38
 The impact of the plowback rate (b) on the P/E ratio:
 ( P0 / E1 )
ROE  k

b
[ k  ROE  b]2
(i) If ROE > k, then b  P/E ratio.
When ROE exceeds k, the firm offers attractive
investment opportunities, so the market will reward
it with a higher P/E multiple if it exploits those
opportunities more aggressively by plowing back
more earnings into those opportunities.
39
(ii) If ROE < k, then b  P/E ratio.
When ROE < k, investors prefer that the firm pay
out earnings as dividends rather than reinvest
earnings in the firm at an inadequate rate of return.
That is, for ROE < k, P/E falls as plowback increases.
(iii) If ROE = k, then b  P/E ratio does not change.
40
 The impact of stock risk on the P/E ratio:
Riskier stocks
 have higher required rates of return (k)
 have lower P/E multiples (P/E).
Note:
This is true even outside the context of the
constant-growth model.
For any expected earnings and dividend stream,
the present value of those cash flows will be lower
when the stream is perceived to be riskier.
Hence the stock price and P/E ratio will be lower.
41
Combining P/E analysis and the DDM
Recall the example:
D2013 = $0.78
D2014 = $0.85
D2015 = $0.92
D2016 = $1.00
Dividends enter their constant-growth phase at the
end of 2016.
k  r f   [ E rM   r f ]
 2  0.9510  2  9.6%
42
D2013
D2014
D2015
D2016  P2016
V2012 



2
3
(1  k ) (1  k )
(1  k )
(1  k ) 4
0.78
0.85
0.92
1.00  P2016




2
3
4
1.096 (1.096 )
(1.096 )
(1.096 )
The forecasted data for year 2016:
P/E ratio: 14.
EPS: $4.
 the estimate of share price for year 2016:
14  $4 = $56.
0.78
0.85
0.92
1.00  56
V2012 



 $41.62
2
3
4
1.096 (1.096 ) (1.096 ) (1.096 )
43
Other comparative valuation ratios
The P/E ratio is an example of a comparative
valuation ratio. Such ratios are used to assess the
valuation of one firm versus another based on a
fundamental indicator such as earnings.
Other such comparative ratios are commonly used:
 Price-to-book ratio:
The ratio of price per share divided by book value
per share.
Book value is the net worth of a company as shown
on the balance sheet.
44
 Price-to-cash-flow ratio:
Earnings as reported on the income statement can
be affected by the company’s choice of accounting
practices, and thus are commonly viewed as subject
to some imprecision and even manipulation.
In contrast, cash flow—which tracks cash actually
flowing into or out of the firm—is less affected by
accounting decisions.
Some analysts use operating cash flow when
calculating this ratio.
Others prefer “free cash flow” (= operating cash
flow - new investment).
45
 Price-to-sales ratio:
Many start-up firms have no earnings. Thus, the
P/E ratio for these firms is meaningless.
The price-to-sales ratio (the ratio of stock price to
the annual sales per share) has recently become a
popular valuation benchmark for these firms.
Of course, price-to-sales ratios can vary markedly
across industries, since profit margins vary widely.
Nevertheless, use of this ratio has increased
substantially in recent years.
46
Market valuation statistics:
While the levels of these ratios differ considerably,
for the most part, they track each other fairly closely,
with upturns and downturns at the same times.
47
Free Cash Flow Valuation Approaches

Free cash flow: cash flow available to the firm or its
equityholders net of capital expenditures.
This approach is particularly useful for firms that
pay no dividends, for which the dividend discount
model would be difficult to implement.
But free cash flow models may be applied to any firm
and can provide useful insights about firm value
beyond the DDM.
48

The first approach:

Discount the free cash flow for the firm (FCFF) at the
weighted average cost of capital (WACC) to obtain
the value of the firm, and subtract the then-existing
value of debt to find the value of equity.

The free cash flow to the firm:
FCFF = EBIT(1 - tc) + Depreciation – Capital expenditures
- Increase in NWC
where
EBIT = earnings before interest and taxes
tc = corporate tax rate
NWC = net working capital
49

WACC is the weighted average of the after-tax cost
of debt and the cost of equity.
To compute the cost of equity, we will use the CAPM,
but accounting for the fact that equity beta increases
with the firm’s financial leverage:
 L   u [1  (1  tc )( D / E )]
where L: leveraged beta
U: unleveraged beta
D/E: debt-equity ratio
(D: market value of debt; E: market value of equity)
50

The free cash flow to the firm approach discounts
year-by-year cash flows plus some estimate of
terminal value, VT .
As in the dividend discount model, free cash flow
models use a terminal value to avoid adding the
present values of an infinite sum of cash flows.
We use the constant-growth model to estimate
terminal value and discount at the WACC.
51
T
Firm value  
FCFF t
t 1 (1  WACC )
t

VT
(1  WACC )T
FCFFT 1
where VT 
WACC  g
(g: the steady growth rate)
 Equity value = value of the firm  market value of debt
52
 Example:
2013
2014
2015
2016
(1)
EBIT(1 - tc)
4,945.9
5,567.5
6,189.2
6,810.8
(2)
Depreciation
2,625.0
2,880.0
3,135.0
3,390.0
(3)
Capital spending
2,800.0
2,783.3
2,766.7
2,750.0
(4)
Change in NWC
1,411.0
663.3
663.3
663.3
(5)
FCFF
3,359.9
【= (1)+(2)-(3)-(4)】
5,000.9
5,894.2
6,787.5
53

Current year 2012:
Current market value of equity: $66,383
Current market value of debt: $3,392
Current beta (leveraged beta): 1.4
Corporate tax rate: 35%
 current unlevered beta :  u   L /[1  (1  tc )( D / E )]
 u  1.4 /[1  (1  0.35)( 3,392 / 66,383 )]  1.355
54
2013
2014
2015
2016
(1)
P/E
15.075
16.050
17.025
18.000
(2)
Profits (after tax)
4,860
5,490
6,120
6,750
(3)
Market value of
equity 【=(1) × (2)】
73,265
88,115
104,193
121,500
(4)
Market value of debt
3,090
2,790
2,490
2,190
(5)
Levered beta
1.392
1.383
1.376
1.371
(6)
Cost of equity
0.140
0.140
0.139
0.139
(7)
WACC
0.136
0.137
0.137
0.137
 levered beta :  L   u [1  (1  t c )( D / E )]
2013 :  L  1.355[1  (1  0.35)( 3,090 / 73,265 )]  1.392
55

Risk-free rate: 5%
Market risk premium: 6.5%
 cost of equity  r f   [ E ( rM )  r f ]
2013: cost of equity  0.05  1.392(0.065)  0.140
56

Before-tax cost of debt: 5.7%
 WACC
 (before  tax cost of debt )(1  tc )[ D /( D  E )]
 (cost of equity )[ E /( D  E )]
2013 : WACC
 (0.057)(1  0.35)[3,090 /(3,090  73,265)]
(0.140)[73,265/(3,090  73,265)]
 0.136
57

The steady growth rate: 5%
FCFFT 1 FCFFT (1  g )
 VT 

WACC  g
WACC  g
FCFF2016(1  0.05) 6,787 .5(1  0.05)
 V2016 

0.137  0.05
0.137  0.05
= 81,918.1
58
The intrinsic value of the firm:

T
 
FCFF t
t 1 (1  WACC )

t

VT
(1  WACC )T
3,359 .9
5,000 .9

(1  0.136 ) (1  0.136 )(1  0.137 )

5,894 .2
6,787 .5
81,918 .1


(1  0.136 )(1  0.137 ) 2 (1  0.136 )(1  0.137 )3 (1  0.136 )(1  0.137 )3
 $63,967
59
 The intrinsic value of equity
= firm value – debt value
= 63,967 –3,392 = $60,575
The number of shares outstanding: 2,850
 The intrinsic value of equity per share
= ($60,575/2,850)
= $21.25
60
 The second approach:

Start on the free cash flow to equity holders (FCFE),
discounting those directly at the cost of equity to obtain
the value of equity.

Cash flow available to equityholders:
This differs from free cash flow to the firm by aftertax interest expenditures, as well as by cash flow
associated with net issuance or repurchase of debt (i.e.,
principal repayments minus proceeds from issuance of
new debt).
 FCFE = FCFF – Interest expense  (1 – tc)
+ Increases in net debt
61

Discount free cash flows to equity (FCFE) at the cost of
equity (kE):
T
Equity value  
FCFE t
VT

t
T
(1  k E )
t 1 (1  k E )
FCFE T 1
where VT 
kE  g
(g: the steady growth rate)
62
Inflation and Equity Valuation
 No-inflation case:
Consider a firm X that pays out all earnings as
dividends.
Earnings and dividends per share are $1, and there is
no growth.
Consider an equilibrium real capitalization rate (k*)
of 10% per year.
$1
 $10
 The price per share of X stock: P0 
10%
63
 Inflation-case:
Inflation (i) is 6% per year, but the values of the other
economic variables adjust so as to leave their real
values unchanged.
The nominal capitalization rate (k):
k = (1 + k*)(l + i) - 1 = 1.10  1.06 - 1 = 16.6%.
The expected nominal growth rate of dividends (g) is
now 6%, which is necessary to maintain a constant
level of real dividends.
Thus, the nominal dividend expected at the end of this
year is $1.06 per share.
64
D1
$1.06
 P0 

 $10
k  g 0.166  0.060
Thus, as long as real values are unaffected, the
stock’s current price is unaffected by inflation.
Notes:
D1
 10.6%
 The expected nominal dividend yield:
P0
The expected nominal capital gains rate = g = 6%.
Almost the entire 6.6% increase in nominal return
comes in the form of expected capital gains.
65
 The effect of inflation on earnings, plowback ratio,
and P/E ratio:
 Firm X produces a product that requires purchase of
inventory at the beginning of each year, and sells the
finished product at the end of the year.
Last year there was no inflation. The inventory cost
$10 million. Labor, rent, and other processing costs
(paid at year-end) were $1 million, and revenue was
$12 million.
Assuming no taxes:
–
–
=
Revenue
Labor and rent
Cost of goods sold
Earnings
$12 million
1 million
10 million
1 million
66
All earnings are distributed as dividends to the 1
million shareholders.
Because the only invested capital is the $10 million in
inventory, the ROE is 10% (= $1 million/$10 million).
 This year, inflation of 6% is expected, and all prices
are expected to rise at that rate.
Because inventory is paid for at the beginning of the
year, it will still cost $10 million.
However, revenue will be $12.72 (= $12  1.06) million,
and other costs will be $1.06 (= $1  1.06) million.
67
Nominal Earnings
Revenue
$12.72 million
– Labor and rent
1.06 million
– Cost of goods sold
10.00 million
Earnings
ROE
$1.66 million
16.6%
68
Note:
The amount required to replace inventory at year’s
end is $10.6 million (rather than the beginning cost of
$10 million), so the amount of cash available to
distribute as dividends is $1.06 million (not the
reported earnings of $1.66 million).
A dividend of $ 1.06 million would be just enough to
keep the real value of dividends unchanged and at the
same time allow for maintenance of the same real
value of inventory.
That is, the reported earnings of $1.66 million
overstate true economic earnings.
69
Thus, we have the following set of relationships:
No Inflation
6% Inflation
Dividends
$1 million
$1.06 million
Reported earnings
$1 million
$1.66 million
10%
16.6%
Plowback ratio
0
0.36145
Price of a share
$10
$10
P/E ratio
10
6.0241
ROE
70
Notes:
• The plowback ratio rises from 0 to 0.36145.
Inventory must rise from a nominal level of $10
million to a level of $10.6 million to maintain its real
value.
This inventory investment requires reinvested
earnings of $0.6 million.
• The P/E ratio drops from 10 in the no-inflation
scenario to 6.0241 in the 6% inflation scenario.
This is entirely a result of the fact that the reported
earnings figure gets distorted by inflation and
overstates true economic earnings.
71
• We have seen that as long as real values are
unaffected, the stock’s price is unaffected by
inflation.
However, inflation may affect stock price because:
 An increase in inflation may be associated with a
decrease in real expected dividend ( D1* ), an increase
in real capitalization rate (k*), a decrease in real
growth rate (g*), or some combination of all three.
 Economic “shocks” such as oil price hikes can cause
a simultaneous increase in the inflation rate and
decline of expected real earnings (and dividends).
72
 Higher inflation is associated with greater
uncertainty about the economy, which tends to
induce a higher required rate of return on equity
and hence a lower level of stock prices.
 Many investors in the stock market suffer from a
form of “money illusion.”
Investors mistake the rise in nominal rate of
interest for a rise in the real rate.
As a result, they undervalue stocks in a period of
higher inflation.
73