Fundamentals of Valuations

Ch 13 – Part 1
▪ Equity Valuation
▪ Intrinsic Value vs Market Price
▪ Dividends Discount Models

Dr. Hesham
2024/2025

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▪ Introduction:
- The purpose of fundamental analysis is to identify stocks that are mispriced relative to some
measure of “true” value that can be derived from observable financial data.

- Stock analysts use models to estimate the fundamental value of a corporation’s stock from
observable market data and from the financial statements of the firm and its competitors.

- These valuation models differ in the specific data they use and in the level of their theoretical
sophistication.

- But, most of them use the notion of valuation by comparables:

They look at the relationship between price and various determinants of value for similar
firms and then extrapolate that relationship to the firm in question.

The table below shows some financial highlights for Microsoft as well as some comparable data for
other firms in the software applications industry.

▪ Market Value or Capitalization:

(Market Cap for short), is the Price per share multiplied by the number of outstanding shares.

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▪ Book Value:
The net worth of common equity according to a firm’s balance sheet.
- Shareholders in a firm are sometimes called "residual claimants" which means that the value
of their stake is what is left over when the liabilities of the firm are subtracted from its assets.

Book Value of Equity = Book Value of Assets – Book Value of Liabilities

• Limitations of Book Value

- The values of both assets and liabilities recognized in financial statements are based on
historical—not current—values.
- Whereas book values are based on original cost, market values measure current values of
assets and liabilities.
- The market value of the shareholders’ equity investment equals the difference between the
current values of all assets and liabilities.

Market Value of Equity = Market Value of Assets – Market Value of Liabilities

▪ Liquidation Value:
Net amount can be realized by selling the assets of a firm and paying off the debt.
- A better measure of a floor for the stock price is the firm’s liquidation value per share.
- This represents the amount of money that could be realized by breaking up the firm, selling its
assets, repaying its debt, and distributing the remainder to the shareholders.
- If the market price of equity drops below the liquidation value of the firm, the firm becomes
attractive as a takeover target.
- A corporate raider would find it profitable to buy enough shares to gain control and then actually
liquidate because the liquidation value exceeds the value of the business as a going concern.

▪ Replacement Cost:
Cost to replace a firm’s assets.
- Some analysts believe the market value of the firm cannot get too far above its replacement
cost for long because, if it did, competitors would enter the market.
- The resulting competitive pressure would drive down the market value of all firms until they
fell to replacement cost.

▪ Tobin’s Q:
Ratio of market value of the firm to replacement cost.
𝑴𝒂𝒓𝒌𝒆𝒕 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝒂 𝑭𝒊𝒓𝒎
Tobin’s Q =
𝑹𝒆𝒑𝒍𝒂𝒄𝒆𝒎𝒆𝒏𝒕 𝑪𝒐𝒔𝒕 𝒐𝒇 𝒂 𝑭𝒊𝒓𝒎

- According to this view, In the long run, the ratio of market price to replacement cost will
tend toward 1, but the evidence is that this ratio can differ significantly from 1 for very long
periods of time.
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▪ Intrinsic Value versus Market Price:
- Although focusing on the balance sheet can give some useful information about a firm’s
liquidation value or its replacement cost, the analyst usually must turn to expected future cash
flows for a better estimate of the firm’s value as a going concern.

- The most popular model for assessing the value of a firm as a going concern starts from the
observation that the return on a stock investment comprises cash dividends and capital gains
or losses

• The expected Holding Period Return:

Is the expected dividends, E(D1), plus the expected price appreciation, E(P1) − P0, all divided by
the current price P0.

𝑬(𝑫𝟏 ) + [ 𝑬(𝑷𝟏 ) − 𝑷𝟎 ]
Expected HPR = E (r) =
𝑷𝟎

Where:
- E (r) = is referred to as the stock’s expected holding period return.
- 𝑬 (𝑫𝟏 ) = expected dividend per share
- 𝑷𝟎 = current share price
- 𝑬(𝑷𝟏 ) = expected end-of-year price

Example A:
Suppose you purchased a share of ABC Inc. for $50 in January.
You expect to sell it for $55 in December and expect to receive a dividend of $3 during that year.
What is your expected HPR?

Answer:
$3 + $55 − 50
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐻𝑃𝑅 = 𝐸 (𝑟) = = 0.16 = 16%
50

• The Capital Asset Pricing Model (CAPM):

- The CAPM may be viewed as providing an estimate of the rate of return an investor can
reasonably expect to earn on a security given its risk as measured by beta.
- This is the return that investors will require of any other investment with equivalent risk.
- We will denote this required rate of return as k.
- Capital asset pricing model (CAPM) is given in the following equation:

K = RF + [ B  (RM – RF ) ]
Where:
K = Required return on asset
RF = Risk-free rate of return, commonly measured by the return on Treasury bills
B = Beta coefficient or index of non-diversifiable risk for asset
RM = Market return; return on the market portfolio of assets
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Notes:
- If a stock is priced “correctly,” it will offer investors a “fair” return, that is, its expected return
will equal its required return.
- Of course, the goal of a security analyst is to find stocks that are mispriced.

Current Situation Pricing Decision

Expected Return = Required Return Fairly (Correctly) Priced Hold it
Expected Return > Required Return Underpriced Buy it
Expected Return < Required Return Overpriced Sell it

Example B:
Suppose that RF = 6%, E(RM) = 11%, and the beta of ABC is 1.2.
What is the required rate of return?

Answer:
k = 6% + [ 1.2 x (11% - 6%) ] = 12%

The rate of return the investor expects exceeds the required rate based on ABC’s risk by a margin
of 4%.
Naturally, the investor will want to include more of ABC stock in the portfolio.

▪ Intrinsic Value:
- The present value of a firm’s expected future net cash flows discounted by the required rate
of return, denoted (V0).
- The present value of all cash payments to the investor in the stock, including dividends as
well as the proceeds from the ultimate sale of the stock, discounted at the appropriate risk-
adjusted interest rate, (K).

o Intrinsic value for one period:

𝑫𝟏 + 𝑷𝟏
𝑽𝟎 =
𝟏+𝒌

o Intrinsic value for holding period H:

𝑫𝟏 𝑫𝟐 𝑫𝑯 + 𝑷𝑯
𝑽𝟎 = + 𝟐
+
𝟏 + 𝒌 (𝟏 + 𝑲) (𝟏 + 𝒌)𝑯

Notes:
Current Situation Pricing Decision
Market Price = Intrinsic Value Fairly (Correctly) Priced Hold it
Market Price < Intrinsic Value Underpriced Buy it
Market Price > Intrinsic Value Overpriced Sell it

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Example C:
Using a one-year investment horizon and a forecast that the stock of ABC can be sold at the end of
the year at price P1 = $55, expect to receive a dividend of $3 during that year.

Suppose that RF = 6%, E(RM) - RF = 5%, and the beta of ABC is 1.2.

Answer:
k = 6% + (1.2 x 5%) = 12%

(3+55 )
The Intrinsic Value = 𝑉0 = (1+12%) = $51.79

If the current price today is $50, then it is an underpriced stock and it is a good investment.

Example D:
XYZ Inc. stock can be purchased today for $65.
If it is expecting to pay a $4 dividends in 1 year from now, $5 dividends in 2 years, and $6 in 3
years, and at the end of the 3rd year it can be sold for $70.
It is required return equal 10%.

What is the Intrinsic value of this stock today?

Answer:
𝟒 𝟓 𝟔 +𝟕𝟎
The Intrinsic Value = 𝑽𝟎 = + 𝟐 + = $64.87
𝟏+𝟏𝟎% (𝟏+𝟏𝟎%) (𝟏+𝟏𝟎%)𝟑

With current price today of $65, then it is an overpriced stock and it is not a good investment.

▪ Market Capitalization Rate:

- The market consensus estimate of the appropriate discount rate for a firm’s cash flows.
- In market equilibrium, the current market price will reflect the intrinsic value estimates of all
market participants.

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▪ Dividend Discount Models (DDM):

- A formula for the intrinsic value of a firm equal to the present value of all expected future
dividends.

𝑫𝟏 𝑫𝟐 𝑫𝟑
𝑽𝟎 = + + + …..
𝟏+𝒌 (𝟏+𝒌)𝟐 (𝟏+𝒌)𝟑

• Constant Growth DDM (Gordon Model):

Form of DDM that assumes dividends will grow at constant rate

𝑫𝟏
𝑽𝟎 =
𝒌−𝒈

Example E:
XYZ Company estimated that the dividends for the next year will be $6, with a growth rate of 10%,
and required rate of return of 20%.
a) What is the value of the share now?
b) If the stock is currently selling at $65 would you purchase it? If you own the stock, would
you sell it?
c) If the stock is currently selling at $58 would you purchase it? If you own it, would you sell
it?

Answer:
$6
a- 𝑉0 = = $60 per share
20%−10%

b- If the stock is currently selling at $65 it is overvalued, do not buy the stock, if you own you
should sell it.
c- Is the stock currently selling at $58 it is undervalued, buy it, if you own it you should hold the
stock (do not sell).

Note:
Preferred stock that pays a fixed dividend can be valued using the constant-growth dividend
discount model.
The constant growth rate of dividends is simply zero.

Example F:
What is the value of preferred stock paying a fixed dividend of $2 per share when the discount
rate is 8%.

Answer:
$2
𝑉0 = = $25 per share
8% − 0

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Notes:
- The constant growth DDM is valid only when g is less than k.

- 𝑫𝟏 is the dividend in one year from now, to calculate 𝑫𝟏 ,

D1 = D0 × (1 + g)

- The current year dividend, recent year dividend, recently paid dividend, just paid dividend, all
these means it is D0.
- Next year dividend, End of year dividend, Expected Dividends, all these means it is D1.

- Stock's value will increase if:

o Larger dividend per share
o Lower market capitalization rate, k
o Higher expected growth rate of dividends

Example G:
In response to the stock market’s reaction to its dividend policy, the Nico’s Toy Company has
decided to increase its dividend payment at a rate of 4% per year.
The firm’s most recent dividend is $3.25 & the required rate of interest is 9%.
What’s the maximum you would be willing to pay for a share of the stock?

Answer:
$3.25 x (1 + 4%)
𝑉0 = = $67.6 per share
9% − 4%

Example H:
ABC Co. has just paid its annual dividend of $3 per share. The dividend is expected to grow at a
constant rate of 8% indefinitely. The beta of ABC Co. stock is 1, the risk-free rate is 6%, and the
market risk premium is 8%.

Required
1. What is the intrinsic value of the stock?
2. What would be your estimate of intrinsic value if you believed that the stock was riskier, with a
beta of 1.25?

Answer:
- The year-end dividend is $3 x 1.08 = $3.24
- The market capitalization rate (using the CAPM) is = 6% + )1.0 × 8%( = 14%
𝟑. 𝟐𝟒
𝑽𝟎 = = $𝟓𝟒
(𝟏𝟒% − 𝟖%)

- If the stock is perceived to be riskier, its value must be lower. At the higher beta, the
market capitalization rate is = 6% + (1.25 × 8%) = 16%
𝟑. 𝟐𝟒
𝑽𝟎 = = $𝟒𝟎. 𝟓
(𝟏𝟔% − 𝟖%)

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Notes:
- The DDM implies that, in the case of constant expected growth of dividends, the expected
rate of price appreciation in any year will equal that constant growth rate, g.

- For a stock whose market price equals its intrinsic value (V0 = P0), the expected holding-
period return will be:

𝑬(𝒓) = 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝒀𝒊𝒆𝒍𝒅 + 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑮𝒂𝒊𝒏𝒔 𝒀𝒊𝒆𝒍𝒅

𝑫𝟏 𝑷𝟏 − 𝑷𝟎
𝑬 ( 𝒓) = +
𝑷𝟎 𝑷𝟎
𝑷𝟏
𝑬 ( 𝒓) = +𝒈
𝑷𝟎

Example I:
Suppose that ABC Co. wins a major contract for its revolutionary computer chip.
The very profitable contract will enable it to increase the growth rate of dividends from 5% to 6%
without reducing the current dividend from the projected value of $4 per share.
If you know that rf= 6%, E(rm) = 11%, and the beta of ABC is 1.2.

Required:
1. What will happen to the stock price?
2. What will happen to future expected rates of return on the stock?

Answer:
- The stock price ought to increase in response to the good news about the contract, and
indeed it does.
- The market capitalization rate (using the CAPM) is = 6% + [ 1.2 x (11% - 6%) ] = 12%
- The stock price jumps from its original value of
𝟒
𝑽𝟎 = = $𝟓𝟕. 𝟏𝟒
(𝟏𝟐% − 𝟓%)
- To a post announcement price of
$𝟒
𝑽𝟎 = = $𝟔𝟔. 𝟔𝟕
(𝟏𝟐% − 𝟔%)
- Investors who are holding the stock when the good news about the contract is announced
will receive a substantial windfall.
- On the other hand, at the new price the expected rate of return on the stock is 12%, just as
it was before the new contract was announced.
𝟒
𝑬 ( 𝒓) = + 𝟔% = 𝟏𝟐%
𝟔𝟔. 𝟔𝟕
- Once the news about the contract is reflected in the stock price, the expected rate of
return will be consistent with the risk of the stock.
- Because the risk of the stock has not changed, neither should the expected rate of return.

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 Example J:
XYZ's stock dividend at the end of this year is expected to be $2.15, and it is expected to grow at
11.2% per year forever. If the required rate of return on XYZ stock is 15.2% per year.

Required:
a) What is its intrinsic value?
b) If XYZ's current market price is equal to this intrinsic value, what is next year's expected
price?
c) If an investor were to buy XYZ stock now and sell it after receiving the $2.15 dividend a
year from now. What is the expected capital gain in percentage terms?
d) What is the dividend yield?
e) What would be the holding-period return?

Answer:

A-
2.15
𝑉0 = = $53.75
(15.2% − 11.2%)

B- The expected rate of price appreciation in any year will equal that constant growth rate
P1 = P0 x (1 + g) = $53.75 x (1 + 11.2%) = $59.77

$𝟓𝟗.𝟕𝟕 − $𝟓𝟑.𝟕𝟓
C- The expected capital gain equals = = 11.2%.
$𝟓𝟑.𝟕𝟓

$𝟐.𝟏𝟓
D- The dividend yield = = 4%.
$𝟓𝟑.𝟕𝟓

E- Holding-period return = 4% + 11.2% = 15.2%.

Exercise 1 (MCQs):

1. K < Expected HPR when the stock is

A. Correctly Priced Stock
B. Overvalued Stock
C. Undervalued Stock
D. None of the above

2. Market Value is …….

A. Required return B. Correctly priced stock
C. Book value D. Price multiplied by shares outstanding.

3. Liquidation Value is ……..

A. Book value
B. Overvalued Stock
C. Net amount realized by selling assets of firm and paying off debt; provides a floor for the stock
price.
D. Required return

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 4. Intrinsic Value Formula for Constant Growth DDM
A. V0 = D1/(k-g) B. V0 = (1+g) / (k-g). C. V1= D2/ (k-g) D. V0 < P0.

5. The intrinsic value of a stock is given by the

A. Current market price of the stock B. Total assets minus total liabilities
C. Historical average price of the stock D. Present Value of its future cash flows

6. Dividend Discount Model (DDM) is the …….

A. Present value of firm's expected future net cash flows discounted by required return.
B. Book value
C. Form of DDM that assumes dividends will grow at a constant rate g.
D. Intrinsic value of a company's stock should equal the present value of its expected future
dividends.

7. Buy the stock when it is ……..

A. Penny Stock B. Undervalued Stock C. Overvalued Stock D. Correctly Priced Stock

8. Hold the stock when it is ……..

A. undervalued stock B. overvalued stock.
C. stock is undervalued D. correctly priced stock

9. Relative Valuation ………….

A. Compares a company's value to that of its competitors or industry peers to assess if the firm is
undervalued or overvalue
B. Price-to-Sales Ratio
C. T compares a company's market value to its cash flow
D. Compares a company's stock price to its revenues

10. Intrinsic value of a company's stock should equal to

A. the market price of the stock on the exchange
B. the sum of all historical earnings of the company
C. the total assets of the company minus its liabilities
D. present value of its expected future dividends

Exercise 2:
You expect the price of IBX stock to be $59.77 per share a year from now.
Its current market price is $50, and you expect it to pay a dividend one year from now of $2.15 per share.
Required:
a) What are the stock’s expected dividend yield, rate of price appreciation, and expected holding-period
return?
b) If the stock has a beta of 1.15, the risk-free rate is 6% per year, and the expected rate of return on
the market portfolio is 14% per year, what is the required rate of return on IBX stock?
c) What is the intrinsic value of IBX stock, and how does it compare to the current market price?

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 Answers

Exercise 1:
1 2 3 4 5 6 7 8 9 10
C D C A D D B D A D

Exercise 2:
a.
Dividend yield = $2.15/$50 = 4.3%
Capital gains yield = (59.77 − 50)/50 = 19.54%
Total return = 4.3% + 19.54% = 23.84%

b.
k = 6% + 1.15(14% − 6%) = 15.2%

c.
V0 = ($2.15 + $59.77)/1.152 = $53.75,
which exceeds the market price. This would indicate a “buy” opportunity.

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