One approach to firm valuation is to focus on the firm's book value, either as it appears
on the balance sheet or adjusted to reflect the current replacement cost of assets or the
liquidation value. Another approach is to focus on the present value of expected future
dividends.
The dividend discount model holds that the price of a share of stock should equal the present value of all future dividends per share, discounted at an interest rate commensurate
with the risk of the stock.
The constant growth version of the DDM asserts that, if dividends are expected to grow at
a constant rate forever, then the intrinsic value of the stock is determined by the formula
This version of the DDM is simplistic in its assumption of a constant value of g. There
are more sophisticated multistage versions of the model for more complex environments.
When the constant growth assumption is reasonably satisfied, the formula can be inverted
to infer the market capitalization rate for the stock:
Stock market analysts devote considerable attention to a company's price–earnings
ratio. The P/E ratio is a useful measure of the market's assessment of the firm's
growth opportunities. Firms with no growth opportunities should have a P/E ratio that
is just the reciprocal of the capitalization rate, k. As growth opportunities become a
progressively more important component of the total value of the firm, the P/E ratio will
increase.
Many analysts form their estimates of a stock's value by multiplying their forecast of next
year's EPS by a predicted P/E multiple. Some analysts mix the P/E approach with the
dividend discount model. They use an earnings multiplier to forecast the terminal value
of shares at a future date and add the present value of that terminal value with the present
value of all interim dividend payments.
The free cash flow approach is the one used most in corporate finance. The analyst first
estimates the value of the firm as the present value of expected future free cash flows to
the entire firm and then subtracts the value of all claims other than equity. Alternatively,
the free cash flows to equity can be discounted at a discount rate appropriate to the risk
of the stock.
The models presented in this chapter can be used to explain or to forecast the behavior of
the aggregate stock market. The key macroeconomic variables that determine the level of
stock prices in the aggregate are interest rates and corporate profits.
