Stock Valuation

Mr. Anthony dela Cruz | Financial Markets

Learning Objectives:
1. Differentiate between debt and equity.
2. Discuss the rights, characteristics, and features of both common and preferred stock.
3. Describe the process of issuing common stock, including venture capital, going public
and investment bankers, and interpreting stock quotations.
4. Discuss the concept of market efficiency and basic common stock valuation using zero
growth, constant growth, and variable growth models.
5. Discuss the free cash flow valuation model and the book value, liquidation value, and
price/earnings (P/E) multiple approaches.
6. Explain the relationship among financial decisions, return, risk, and the firm’s value.

Differences between Debt and Equity

Legal Rights and Privileges of Common Stockholders
Common and Preferred Stock

Debt vs. Equity

● Debt involves borrowing money (like loans or bonds) that must be repaid with
interest. It creates an obligation for the company to pay creditors on time. Debt is
prioritized in liquidation proceedings.
○ Legal Rights - Creditors (lenders of debt) have a contractual agreement
that obligates the company (debtor) to make regular interest payments
and repay the principal amount by a specific date. If the company fails to
meet these obligations, creditors can initiate legal action to recover their
funds, potentially forcing the company into bankruptcy or liquidation.
○ Advantages - Interest payments are tax-deductible, reducing the
company's taxable income. Debt holders have priority over shareholders
(both common and preferred) in case of liquidation​.
■ The allowable deduction for interest expense shall be reduced by an
amount equal to 20% of interest income that is subject to final tax, if any.
(Source: https://taxsummaries.pwc.com/philippines/corporate/deductions)
○ Disadvantages - The company must make regular interest payments
regardless of its financial performance, which can strain cash flow.

● Equity refers to ownership in the company, typically through the issuance of

stock.
○ Legal Rights - Equity holders are the owners of the company. They are
entitled to a share of the company’s profits through dividends (if declared)
and potential capital gains from stock price appreciation.
○ Advantages - No fixed obligations to pay dividends or repay equity; it is a
source of permanent capital. Equity financing does not risk the company’s
financial position as debt does. Also, equity holders have the potential for
greater returns through dividends and appreciation of the stock price​.
○ Disadvantages - Equity holders are not guaranteed dividends since the
company has no legal obligation to pay them. It also bears more risk since
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Mr. Anthony dela Cruz | Financial Markets

they are paid after debt holders in case of liquidation, meaning they only
receive value if there are assets left after paying off all creditors and
preferred shareholders​.

Common Stock
● Common stockholders represent the primary owners of a company. They have
voting rights, typically one vote per share. Common stockholders may also
receive dividends, but only after the company has met its obligations to debt
holders and preferred shareholders.
○ Legal Rights - Common stockholders have voting rights, generally one
vote per share, which allows them to participate in major corporate
decisions, including electing the board of directors and approving mergers,
thus, influencing key corporate decisions. They are also entitled to a
portion of the company’s residual profits through dividends.
○ Advantages - Offers potential for capital gains if the company performs
well. Common stockholders have a say in the company's governance.
○ Disadvantages - Common stockholders are paid dividends only after all
other obligations (such as debt interest and preferred dividends) are
fulfilled. If the company faces liquidation, common stockholders may not
receive anything. Thus, they are the least priority in bankruptcy or
liquidation, making it riskier but potentially more rewarding if the company
performs well​.

Preferred Stock
● Preferred stock is a hybrid between debt and equity. It offers investors priority
over common shareholders in terms of dividends and liquidation. Some preferred
stocks can be convertible into common shares, and they can also be callable,
meaning the company can buy back the shares at a predetermined price.
○ Legal Rights - Preferred stockholders have a higher claim on dividends
and assets than common stockholders. They usually receive fixed
dividends before common stockholders can be paid, which makes
preferred shares similar to debt, but after debt holders in case of
liquidation. However, preferred stockholders generally do not have voting
rights, meaning they cannot influence corporate policy or decisions.
○ Advantages - Priority over common stockholders in receiving dividends
and in case of liquidation. Preferred shares typically offer fixed dividends,
making them more predictable than common stock dividends.
○ Disadvantages - Lack of voting rights limits influence on company
decisions. Preferred stock can also be callable, which means the company
can repurchase shares at a set price, potentially capping gains for
investors​.
○ Convertible Preferred Stock - Some preferred shares can be converted
into common stock, offering flexibility and a chance to benefit from the
company’s stock price appreciation​.
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Mr. Anthony dela Cruz | Financial Markets

Key Differences Between Debt, Common Stock, and Preferred Stock

● Priority:
○ Debt holders have the highest claim on assets in liquidation, followed by
preferred shareholders, and finally common shareholders.

● Risk and Reward:

○ Debt is less risky but offers limited upside (fixed interest payments).
Common stock is the riskiest but offers the highest potential return if the
company succeeds. Preferred stock sits in between, offering fixed
dividends with less risk than common stock but fewer growth
opportunities.

● Tax Implications:
○ Interest on debt is tax-deductible for the company, reducing its tax liability.
Dividends paid to equity holders (both common and preferred) are not
tax-deductible​.

Common Stock Valuation

● Common stockholders expect to be rewarded through periodic cash dividends

and an increasing share value.
● Some of these investors decide which stocks to buy and sell based on a plan to
maintain a broadly diversified portfolio.
● Other investors have a more speculative motive for trading.

- They try to spot companies whose shares are undervalued meaning that
the true value of the shares is greater than the current market price.
- These investors buy shares that they believe to be undervalued and sell
shares that they think are overvalued (i.e., the market price is greater than
the true value).

Market Efficiency
● An efficient market is one where all information is transmitted perfectly,
completely, instantly, and for no cost.
● Market efficiency is a key concept in stock valuation, describing the degree to
which stock prices reflect all available information. In an efficient market, prices
adjust immediately to new information, making it difficult for investors to
consistently achieve returns above the market average without assuming
additional risk.
● Buyers and sellers digest new information quickly as it becomes available and,
through their purchase and sale activities, create a new market equilibrium price.
Because the flow of new information is almost constant, stock prices fluctuate,
continuously moving toward a new equilibrium that reflects the most recent
information available.
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Mr. Anthony dela Cruz | Financial Markets

Stock Valuation

● The process of determining the intrinsic, theoretical, or 'fair' value of a company's

common stock is termed Common Stock Valuation. This process is absolutely
fundamental to building an investment strategy or portfolio. Having an
understanding of this valuation helps you, as an investor, determine whether a
company's share price accurately reflects its real value based on its financial
performance and growth prospects.
● Relevance of Stock Valuation
- It helps them assess the worth of the stock relative to its current price and
the company’s financial fundamentals. Proper valuation allows investors to
identify potential opportunities in undervalued stocks or to avoid
overvalued stocks, leading to better portfolio performance.

1. Zero Growth Model

- The zero-growth model assumes that dividends will remain constant

forever, meaning the company will pay the same dividend each year
indefinitely. This model is suitable for firms that have reached a mature
stage where earnings and dividends are stable, or for firms that do not
expect any significant growth in the future. The formula to calculate the
value of the stock in a zero-growth scenario is:

EXAMPLE:

ABC Corp pays a fixed annual dividend of $5 per share, and investors require a
return of 10% on their investment in the company’s stock. Since dividends are
expected to remain the same indefinitely, the zero growth model applies.
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Mr. Anthony dela Cruz | Financial Markets

2. Variable Growth Model

- The zero- and constant-growth common stock models do not allow for any shift in
expected growth rates.
- A dividend valuation approach that allows for a change in the dividend growth
rate.
- The variable growth model is used for companies that experience different
growth phases—high growth initially, followed by a transition to lower, stable
growth.
- This model is more realistic for firms that start with rapid growth, which slows
down over time as they mature. The formula for a variable growth model breaks
down the valuation into distinct phases, typically a high-growth period followed by
a stable growth period.

Example

DEF Corp, which is experiencing rapid growth. It expects dividends to grow at 20% per
year for the next three years and then slow down to a constant growth rate of 5%
thereafter. The company just paid a dividend of $1 per share, and investors require a
return of 15%.
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Mr. Anthony dela Cruz | Financial Markets

Changes in Expected Dividend and Dividend

● The concept of changes in expected dividends refers to the adjustments
investors make in their estimates of the dividends a company will pay in the
future.
● These changes can have a direct impact on the valuation of a company's stock
and reflect broader expectations about the company's financial health,
profitability, and growth potential.
● Assuming that economic conditions remain stable, any management action that
would cause current and prospective stockholders to raise their dividend
expectations should increase the firm’s value.
● Any action of the financial manager that will increase the level of expected
dividends without changing risk (the required return) should be undertaken,
because it will positively affect owners’ wealth.
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Mr. Anthony dela Cruz | Financial Markets

Constant Growth Stocks

Expected Rate of Return on a constant
The Constant Growth Model, also known as the Gordon Growth Model, is a valuation
method used to determine the intrinsic value of a stock. It is based on the assumption
that a company’s dividends will grow at a constant rate indefinitely.

The formula for calculating the value of a stock using this model is:

Dividends in the Constant Growth Model

In the Constant Growth Model, dividends play a crucial role. Dividends refer to the
portion of a company’s earnings that are distributed to its shareholders. The growth rate
of dividends is a key factor in determining the value of a stock using this model. The
model assumes that the dividends grow at a constant rate ‘g’ indefinitely.

To calculate the value of a stock using the Constant Growth Model

Formula:

Stock Value = Dividend per Share / (Required Rate of Return – Growth Rate)

Gordon Growth Model Formula

The Gordon growth model formula is based on the mathematical properties of an infinite
series of numbers growing at a constant rate. The three key inputs in the model are
dividends per share (DPS), the growth rate in dividends per share, and the required rate
of return (ROR).

where:

P = Current stock price

g = Constant growth rate expected for dividends, in perpetuity

r = Constant cost of equity capital for the company (or rate of return)

D1​= Value of next year’s dividends​

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Mr. Anthony dela Cruz | Financial Markets

Example of the Gordon Growth Model

As a hypothetical example, consider a company whose stock is trading at $110 per

share. This company requires an 8% minimum rate of return (r) and will pay a $3
dividend per share next year (D1), which is expected to increase by 5% annually (g).

The intrinsic value (P) of the stock is calculated as follows:

According to the Gordon growth model, the shares are currently $10 overvalued in the
market.

Importance of the Gordon Growth Model

The Gordon Growth Model can be used to determine the relationship between growth
rates, discount rates, and valuation. Despite the sensitivity of valuation to the shifts in
the discount rate, the model still demonstrates a clear relation between valuation and
return.

Assumptions of the Gordon Growth Model

The Gordon Growth Model assumes the following conditions:

The company’s business model is stable; i.e. there are no significant changes in its
operations

● The company grows at a constant, unchanging rate

● The company has stable financial leverage
● The company’s free cash flow is paid as dividends

Limitations of the Gordon Growth Model

The main limitation of the Gordon growth model lies in its assumption of constant
growth in dividends per share. It is very rare for companies to show constant growth in
their dividends due to business cycles and unexpected financial difficulties or
successes. The model is thus limited to firms showing stable growth rates.
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Mr. Anthony dela Cruz | Financial Markets

Advantages and Disadvantages of the Gordon Growth Model

Advantages

● The GGM is commonly used to establish intrinsic value and is considered the
easiest formula to understand.
● The model establishes the value of a company's stock without accounting for
market conditions, which simplifies the calculation.
● This straightforward approach also provides a way to compare companies of
different sizes and in different industries.

Disadvantages

● The Gordon growth model ignores non-dividend factors (such as brand loyalty,
customer retention, and intangible assets) that can add to a company's value.
● It assumes that a company's dividend growth rate is stable.
● It can only be used to value stocks that issue dividends, which excludes, for
example, most growth stocks.

Valuing the entire corporation

Valuation, as defined by Merriam-Webster, refers to (1) the act or process of
valuing, specifically the appraisal of property, (2) the estimated or determined market
value of an asset, and (3) the judgment or appreciation of worth or character. In a
business context, valuation involves determining the economic value of a company or
its individual units. This process, also referred to as business or company valuation,
entails a comprehensive analysis of the organization’s assets, liabilities, cash flows, and
earnings to assess its overall worth.

Business valuation plays a crucial role, especially during mergers and

acquisitions, where accurate assessment of a company’s value is key to negotiating
favorable deals. However, its importance extends beyond that; valuation is also used for
strategic planning, investment decisions, tax reporting, and even legal proceedings. By
understanding the value of their business, owners gain insights into how to improve
performance, attract investors, or set the right sale price. Expert evaluators often
conduct these assessments to ensure accuracy and reliability, helping businesses make
informed decisions regarding their future direction.

A company's value can be measured in different ways, with each method giving a
different aspect of its financial health and market position. Commonly used approaches
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Mr. Anthony dela Cruz | Financial Markets

in business valuation include an analysis of financial statements and the application

of discounted cash flow (DCF) models, which project future cash flows to estimate a
company's present value. However, in this context, we will focus on these four valuation
methods: the free cash flow (FCF) valuation model and the book value, liquidation
value, and price-to-earnings (P/E) multiple approach.

Valuation Methods

1. Free Cash Flow Valuation Model (FCF)

The firm’s free cash flow (FCF) represents the cash available to investors—the
providers of debt (creditors) and equity (owners)—after the firm has met all operating
needs and paid for net investments in fixed assets and current assets.

Unlike dividend valuation models, which focus on future dividend payments, the
free cash flow (FCF) valuation model is especially useful for valuing companies without
a dividend history (e.g., startups) or specific business units within larger companies.
This makes it more appealing when dividends are not available or are not a reliable
measure of value. Moreover, both models are based on the same fundamental principle:
a company’s value is the present value of all future cash flows it will generate. However,
instead of using dividends, the free cash flow valuation model uses expected free cash
flows, providing a broader and more flexible approach to valuing firms.

The Free Cash Flow Valuation Model estimates the value of the entire company by
calculating the present value of its expected free cash flows, discounted at the
company's weighted average cost of capital (WACC), which is its expected average
future cost of funds over the long run.

Formula:

(Equation 1)

Where:
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Mr. Anthony dela Cruz | Financial Markets

The total value of a company (VC) represents the market value of all its assets. So,
to determine the value of the common stock (VS), we need to subtract the market value
of the company's debt (VD), and the market value of its preferred stock (VP) from (VC).

(Equation 2)

It is often challenging to predict a company's free cash flow accurately, so forecasts

are usually made for only the first five years. After that, a constant growth rate is
assumed. In this case, we assume that free cash flows are specifically forecast for the
first five years, and then a steady growth rate continues indefinitely from year six
onwards. This approach is similar to the variable-growth model discussed earlier and is
best explained through an example.

Example:

Bebsters, Inc. wishes to determine the value of its stock by using the free cash
flow valuation model. To apply the model, the firm’s CFO developed the data given in
Table 1.1. Application of the model can be performed in four steps.

Step 1: Calculate the present value of the free cash flow occurring from the end
of 2018 to infinity, measured at the beginning of 2018 (that is, at the end of 2017).
Because a constant rate of growth in FCF is forecast beyond 2017, we can use the
constant-growth dividend valuation model (Table 1.1) to calculate the value of the free
cash flows from the end of 2018 to infinity:
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Mr. Anthony dela Cruz | Financial Markets

Note: to calculate the FCF in 2018, we had to increase the 2017 FCF value of $600,000
by the 3% FCF growth rate, gFCF.

Step 2: Add the present value of the FCF from 2018 to infinity, which is
measured at the end of 2017, to the 2017 FCF value to get the total FCF in 2017.

Step 3: Find the sum of the present values of the FCFs for 2013 through 2017 to
determine the value of the entire company, VC. This calculation is shown in Table 1.2
below.

Step 4: Calculate the value of the common stock using Equation 2. Substituting
into Equation 2 the value of the entire company (VC) calculated in Step 3, and the
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Mr. Anthony dela Cruz | Financial Markets

market values of debt (VD), and preferred stock (VP) given in Table 1.2, yields the value
of the common stock (VS):

The value of Bebsters’ common stock is therefore estimated to be $4,726,426. By

dividing this total by the 300,000 shares of common stock that the firm has outstanding,
we get a common stock value of $15.76 per share ($4,726,426/300,000).

It should now be clear that the free cash flow valuation model aligns with the
dividend valuation models discussed earlier. The key advantage of this approach is that
it focuses on estimating free cash flow rather than dividends, which are harder to predict
since they depend on decisions made by the company's board. This broader and more
flexible nature of the free cash flow model has contributed to its growing popularity,
especially among CFOs and financial managers.

2. Book Value

Book value represents the equity value of a company as shown in its financial
statements. It is often compared to the company's stock value, or market capitalization.
Book value per share is the amount each common stockholder would receive if the
company sold all its assets for their exact book (accounting) value and used the
remaining money to pay off all its debts, including preferred stock. The leftover amount
would then be divided among the common stockholders. To calculate book value, you
take the total value of the company’s assets and subtract its outstanding liabilities
(including preferred stocks).

Formula:

This figure reflects the historical cost of assets, which can be quite different from
their current market values. Thus, to further calculate and assess the market value on a
per-share basis, use this formula:
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Mr. Anthony dela Cruz | Financial Markets

Where:

Outstanding Shares – Companies’ stock currently held by all its

shareholders.

Book value is frequently used as a conservative measure of value, especially for

companies in industries with a lot of tangible assets. But since book value assumes that
assets could be sold for their recorded value, it might not accurately reflect the lowest
price at which shares are valued in the market. While most stocks are sold for more
than their book value, it is common for some stocks to trade below book value. This
usually happens when investors think that the assets are overvalued or that the
company's liabilities are underestimated.

3. Liquidation Value

Liquidation value is the net worth of a company's assets if it were to go out of

business, sell everything off for their market value, pay their liabilities (including
preferred stock), and the remaining money is divided among its common stockholders.

Formula:

To further measure and assess the market value of the company, calculate:

Liquidation value per share is the amount each common stockholder would
receive if the company sold all its assets for their current market value, paid off its debts
(including preferred stock), and then distributed any remaining funds to the common
stockholders. This measure is considered more accurate than book value because it
reflects the market value of the company’s assets. However, it does not consider the
earning potential of those assets.

4. Price/Earnings (P/E) Multiples

The price-to-earnings (P/E) ratio, also referred to as the price/earnings multiple,

indicates how much investors are willing to pay for each dollar a company earns. It is a
widely used metric for assessing the relative value of a stock, providing insights into
whether a company is overvalued or undervalued compared to its earnings potential.
The P/E ratio is valuable for comparing a company's current valuation with its past or
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Mr. Anthony dela Cruz | Financial Markets

historical performance, against other companies in the same industry, or even in the
broader market. So, this helps investors make more informed decisions about the
attractiveness of a stock.

To estimate the firm’s share value, it is calculated by multiplying the firm’s

expected earnings per share (EPS) by the average price/earnings (P/E) ratio for the
industry. Wherein, average P/E ratio is the one that can be used as a guide to a firm’s
value.

To get P/E Ratio:

To get Earnings per Share:

Where:

Market Price per Share - the current trading price of one share of the
company's stock.

Earnings per Share (EPS) - calculated as the company's net income

divided by the number of outstanding shares.

The P/E ratio valuation technique is a simple method of determining a stock’s

value and can be quickly calculated after companies make earnings announcements,
which accounts for its popularity.

Stock market equilibrium

Equilibrium is a state in which supply and demand are perfectly balanced,
leading to stable prices in a market. This balance occurs when the quantity of goods or
services available (supply) matches the quantity consumers want to purchase
(demand). When there is an excess supply of goods, prices typically decrease, making
the product more attractive to buyers and increasing demand. On the other hand, when
there is a shortage or undersupply, prices rise, leading to a reduction in demand as
fewer buyers are willing to pay the higher price. This dynamic interaction between
supply and demand naturally moves toward equilibrium, where market forces balance
out, and prices remain steady.
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Mr. Anthony dela Cruz | Financial Markets

The concept of equilibrium applies not only to traditional markets but also to the
stock market. The stock market determines prices through the constant fluctuations in
supply and demand for stocks. Wherein, supply in stock refers to the total number of
stockholders who would be willing to sell their shares at any price. For example,
imaging we have 10 shareholders, and each one is willing to sell their share at a certain
price:

Each seller has a different value for their shares. The sellers on the left are willing
to accept a much lower price than those on the right. In the overall market, as the price
increases, the total number of shares available for sale also increases.

At a market price of $10, only 1 share will be supplied, but at a price of $25, 5
shares would be supplied as shown in the figure below.
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Mr. Anthony dela Cruz | Financial Markets

Demand in stock, on the other hand, refers to the total amount of stock that
potential buyers are willing to purchase at any price. Similar to the example above,
imagine we have 10 people who want to purchase 1 share each, but each of them is
only willing to pay a certain price:

In contrast to supply, this means that as the price increases, fewer people are
willing to purchase a share. For example, if the price per share is $30, only 4 people
(the ones on the right side who are willing to pay $30 or more) would be interested in
buying. So, when we plot total demand on a graph, it slopes downward:
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Mr. Anthony dela Cruz | Financial Markets

Furthermore, the price and quantity at which supply and demand are balanced is
called stock market equilibrium. This happens when the number of stocks that
investors want to buy equals the number that sellers are willing to sell at a certain price.

With the example of buyers and sellers, we can identify the exact point where the
market reaches equilibrium:

At a price of $27 (actually anywhere between $25.50 and $27.50) and a quantity
of 5, the supply equals demand and the market is balanced. From a practical
standpoint, these are the buyers and sellers who made a trade.
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Mr. Anthony dela Cruz | Financial Markets

The most eager buyers and sellers completed their trade, those who really
wanted to buy and those most eager to sell. However, for the remaining buyers, no
seller was willing to drop the price low enough to make a deal. The next seller is asking
for $28, but the highest offer from a buyer is only $25, so no further trades will occur.

At this point, the supply of stocks perfectly matches the demand for them,
creating a stable pricing environment. There is no pressure for the stock price to either
increase or decrease. This balance is maintained through the actions of investors, who
make decisions based on several factors such as a company’s earnings, broader
economic conditions, interest rates, and market sentiment.

In both cases, whether in goods or stock markets, equilibrium reflects a state of

balance where market forces align, ensuring that prices remain stable unless disrupted
by external factors.

Efficient Equilibrium

Efficient equilibrium refers to a state in a market where supply and demand are
balanced, and all available information is fully reflected in the prices of assets. At this
point, no buyer or seller can improve their position without disadvantaging someone
else, meaning that prices accurately reflect the true value of the assets, and resources
are allocated in the most efficient manner possible. The example above seems logical,
but why didn't we see 8 trades instead of just 5? If the highest buyers and lowest sellers
were matched directly, many more trades could happen.
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Mr. Anthony dela Cruz | Financial Markets

Unfortunately, a major issue with this scenario is the availability of information.

Once a seller who sold their shares for around $10 to $12 realizes that another seller
got over $35, they would naturally hold out for the highest bidders. Likewise, buyers
would only seek to purchase from sellers offering the lowest prices. This behavior would
reduce the number of trades, as both sides would be more selective, waiting for the
most favorable deals.
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Mr. Anthony dela Cruz | Financial Markets

References
Valuation of the Entire Company
● Business Valuation: 6 Methods for Valuing a Company (investopedia.com)
● What Is Valuation? How It Works and Methods Used (investopedia.com)
● Chapter 7 | PPT (slideshare.net)
● StockValuation_lecture.pdf (slideshare.net)
● Liquidation Value: Definition, What's Excluded, and Example (investopedia.com)
● Price-to-Earnings (P/E) Ratio: Definition, Formula, and Examples
(investopedia.com)
● 24.Lawrence-J.-Gitman.pdf
Common Stock Valuation
● Market Efficiency
● What is the concept of market efficiency?
● Stock Valuation
● How to Choose the Best Stock Valuation Method
Changes in Expected Dividend
● 24.Lawrence-J.-Gitman.pdf
Stock Market Equilibrium
● Equilibrium Price: Definition, Types, Example, and How to Calculate
(investopedia.com)
● Market Equilibrium: Supply & Demand | Definition & Examples - Lesson |
Study.com
● Market Equilibrium, Economic Lowdown Podcasts | Education | St. Louis Fed
(stlouisfed.org)
● Supply And Demand Examples In The Stock Market (howthemarketworks.com)

CONSTANT GROWTH STOCKS

● Gordon Growth Model (GGM): Definition, Example, and Formula

(investopedia.com)
● Gordon Growth Model - Guide, Formula, Examples and More
(corporatefinanceinstitute.com)

Group member contributions

Researcher:
- Abella, Kimverlie
- Alcoseba, Airah Jeanette
- Ducos, Jemuel
- Laurilla, Sophia Ellaine
- Mirano, Kaye Angel
- Ramirez, Jake Paolo
Presenter:
- Banot, Jona Kristel
- Calaycay, Julianne
- Camaing, Yassie
- Rebusio, Josselle