CFIN401 Module - 1 CH7 4th

Fundamentals of Corporate Finance
Fourth Canadian Edition
Chapter 7
Valuing Stocks
Copyright © 2023 Pearson Canada Inc. 7-1

Chapter Outline (1 of 2)
7.1 Stock Basics
7.2 The Dividend-Discount Model
7.3 Estimating Dividends in the Dividend-Discount
Model
7.4 Limitations of the Dividend-Discount Model

Chapter Outline (2 of 2)
7.5 Share Repurchases and the Total Payout Model
7.6 The Discounted Free Cash Flow Model
7.7 Valuation Based on Comparable Firms
7.8 Information, Competition, and Stock Prices
7.9 Individual Biases and Trading

Learning Objectives (1 of 2)
• Describe the basics of common stock, preferred stock,
and stock quotes
• Value a stock as the present value of its expected
future dividends
• Understand the tradeoff between dividends and
growth in stock valuation
• Appreciate the limitations of valuing a stock based on
expected dividends

Learning Objectives (2 of 2)
• Value a stock as the present value of either the
company’s total payout or its free cash flows
• Value a stock by applying common multiples based on
the values of comparable firms
• Understand how information is incorporated into stock
prices through competition in efficient markets
• Describe some behavioural biases that influence the
way individual investors trade

7.1 Stock Basics (1 of 3)
• Stock Market Reporting: Stock Quotes
– Common Stock: A share of ownership in the
corporation, which confers rights to any common
dividends as well as rights to vote on election of
directors, mergers, or other major events.
– Ticker Symbol: A unique abbreviation assigned to
each publicly traded company.

• Common Stock
– Shareholder Voting
 Straight Voting
 Cumulative Voting
 Classes of Stock
– Shareholder Rights
 Annual Meeting
 Proxy
– Proxy Contest

• Preferred Stock
– Cumulative versus Non-Cumulative Preferred Stock
– Preferred Stock: Equity or Debt

Key Terms and Definitions (1 of 3)
• Straight voting: Voting for directors during which
shareholders must vote for each director separately,
with each shareholder having as many votes as
shares held.
• Cumulative voting: Voting for directors during which
each shareholder is allocated votes equal to the
number of open spots multiplied by his or her number
of shares.

• Annual meeting: Meeting held once per year at
which shareholders vote on directors and other
proposals, as well as ask managers questions.
• Proxy: A written authorization for someone else to
vote your shares.
• Proxy contest: A contest between two or more
groups competing to collect proxies to prevail in the
matter up for shareholder vote (such as election of
directors).
Copyright © 2023 Pearson Canada Inc. 7 - 10

• Preferred stock: Stock with preference over common
shares in payment of dividends and in liquidation.
• Cumulative preferred stock: Preferred stock for
which all missed preferred dividends must be paid
before any common dividends may be paid.
• Non-cumulative preferred stock: Preferred stock for
which missed preferred dividends do not accumulate.
Only the current dividend is owed before common
dividends may be paid.

7.2 The Dividend-Discount Model (1 of 9)
• A One-Year Investor
– Two potential sources of cash flows from owning a
stock:
 Dividends
 Selling Shares

• A One-Year Investor
– Since the cash flows are not risk-less, they must be
discounted at the equity cost of capital
𝐷𝑖 𝑣 1 + 𝑃 1
𝑃0=
1+𝑟 𝐸

• Dividend Yields, Capital Gains, and Total Returns

– Dividend Yield: The expected annual dividend of a
stock divided by its current price; the percentage return
an investor expects to earn from the dividend paid by
the stock.
– Capital Gain: The amount by which the selling price of
an asset exceeds its initial purchase price.
 Capital Gains Rate: An expression of capital gain as a
percentage of the initial price of the asset.


– Total Return: The sum of a stock’s dividend yield and
its capital gain rate.
Total Return


– The expected total return of the stock should equal the
expected return of other investments available in the
market with equivalent risk.

Example 7.1: Stock Prices and Returns
• Suppose you expect Loblaw Companies Ltd. to pay
an annual dividend of $0.56 per share in the coming
year and to trade $45.50 per share at the end of the
year.
• If investments with equivalent risk to Loblaw’s stock
have an expected return of 6.80%, what is the most
you would pay today for Loblaw’s stock?
• What dividend yield and capital gain rate would you
expect at this price?

Example 7.1: Stock Prices and Returns:
Plan
• To solve for the beginning price we would pay now
(P0) given our expectations about dividends (Div1 =
$0.56) and future price (P1 = $45.50) and the return
we need to expect to earn to be willing to invest (rE =
6.8%).
• We can then calculate the dividend yield and capital
gain rate
𝐷𝑖 𝑣 1 + 𝑃 1
𝑃0=
1+𝑟 𝐸

Execute
𝐷 𝑖𝑣 𝑖 + 𝑃1 $ 0.56 +$ 45.50
𝑃0= = =$ 43.13
1+ 𝑟 𝐸 1.0680
• We see that at this price, Loblaw’s dividend yield is

Div1/P0 = 0.56/43.13 = 1.30%. The expected capital
gain is $45.50 − $43.13 = $2.37 per share, for a
capital gain rate of 2.37/43.13 = 5.50%.

Evaluate
• At a price of $43.13, Loblaw’s expected total return is
1.30% + 5.50% = 6.80%, which is equal to its equity
cost of capital (the return being paid by investments
with equivalent risk to Loblaw’s).
• This amount is the most we would be willing to pay for
Loblaw’s stock.
• If we paid more, our expected return would be less
than 6.8% and we would rather invest elsewhere.

• A Multi-Year Investor
– Suppose we planned to hold the stock for two years
 Then we would receive dividends in both year 1 and year
2 before selling the stock, as shown in the following
timeline:

• A Multi-Year Investor
– As a two-year investor, we care about the dividend and
stock price in year 2.
𝐷𝑖 𝑣1 𝐷𝑖 𝑣 2 + 𝑃 2
𝑃0= +
1+𝑟 𝐸 ( 1+𝑟 𝐸 ) 2

• Dividend-Discount Model Equation
𝐷𝑖 𝑣1 𝐷𝑖 𝑣 2 𝐷𝑖𝑣 𝑛 𝑃𝑛
𝑃0= + 2
+⋯+ 𝑛
+ 𝑛
1+𝑟 𝐸 ( 1+𝑟 𝐸 ) ( 1+𝑟 𝐸 ) ( 1+𝑟 𝐸 )
– The price of the stock is equal to the present value of

all of the expected future dividends it will pay, along
with the cash flow from the sale in year N.

• Dividend-Discount Model Equation

– The price of a stock is equal to the present value of all
of the expected future dividends it will pay.
𝐷𝑖 𝑣 1 𝐷𝑖 𝑣 2
𝑃0= +
1 + 𝑟𝐸 ¿¿

7.3 Estimating Dividends in the
Dividend-Discount Model (1 of 9)
• Constant Dividend Growth Model: A model for
valuing a stock by viewing its dividends as a constant
growth perpetuity.
– Assumes that dividends will grow at a constant rate, g,
forever
– The value of the firm depends on the dividend level of
next year, divided by the equity cost of capital adjusted
by the growth rate
𝐷𝑖𝑣 1
𝑃0=
𝑟𝐸−𝑔

Example 7.2: Valuing a Firm with
Constant Dividend Growth: Problem
• Hydro One is a regulated utility company that services
Ontario.
• Suppose Hydro plans to pay $2.30 per share in
dividends in the coming year.
• If its equity cost of capital is 7% and dividends are
expected to grow by 2% per year in the future,
estimate the value of Hydro’s stock.

Constant Dividend Growth: Plan
• The dividends are expected to grow perpetually at a
constant rate.
• The next dividend (Div1) is expected to be $2.30, the
growth rate (g) is 2% and the equity cost of capital (rE)
is 7%.

Constant Dividend Growth: Execute
• The price would be:
¿1 $ 2.30
𝑃0= = =$ 46.00
𝑟 𝐸 − 𝑔 0.07 − 0.02

Constant Dividend Growth: Evaluate
• You would be willing to pay 20 times this year’s
dividend of $2.30 to own Hydro One stock because
you are buying claim to this year’s dividend and to an
infinite growing series of future dividends.

• Dividends Versus Investment and Growth
– A Simple Model of Growth
 The dividend each year is equal to the firm’s earnings per
share (EPS) multiplied by its dividend payout rate
(fraction of a firm’s earnings that the firm pays out as
dividends each year).
Earnings𝑡
¿𝑡= × Dividend Payout Rate 𝑡
⏟
Shares Outstanding 𝑡
𝐸𝑃 𝑆 𝑡

 The firm can increase its dividend in three ways:
– It can increase its earnings
– It can increase its dividend payout rate
– It can decrease its number of shares outstanding

 If all increases in future earnings result exclusively from
new investment made with retained earnings, then:
Change in Earnings = New Investment × Return on New Investment

 New investment equals the firm’s earnings multiplied by its
retention rate (fraction of current earnings that the firm
retains):
New Investment = Earnings × Retention Rate

 The growth rate of earnings:

 If the firm chooses to keep its dividend payout rate
constant, then the growth in its dividends will equal the
growth in its earnings:
g = Retention Rate × Return on New Investment

Example 7.3: Cutting Dividends for
Profitable Growth (1 of 8)
• The Canadian Tire Corporation Ltd expects to have
earnings per share of $6 in the coming year.
• Rather than reinvest these earnings and grow, the firm
plans to pay out all of its earnings as a dividend.
• With these expectations of no growth, Canadian Tire’s
current share price is $60.

• Suppose Canadian Tire could cut its dividend payout
rate to 75% for the foreseeable future and use the
retained earnings to open new stores.
• The return on investment in this group is expected to
be 12%. If we assume that the risk of these new
investments is the same as the risk of its existing
investments, then the firm’s equity cost of capital is
unchanged.
• What effect would this new policy have on Canadian
Tire’s stock price?

Profitable Growth: Plan (3 of 8)
• To figure out the effect of this policy on Canadian
Tire’s stock price, we need to know several things.
First, we need to compute its equity cost of capital.
Next we must determine Canadian Tire’s dividend and
growth rate under the new policy.
• Because we know that Canadian Tire currently has a
growth rate of 0 (g = 0), a dividend of $6 and a price of
$60, we can estimate rE.

Profitable Growth: Plan (4 of 8)
• Next, the new dividend will simply be 75% of the old
dividend of $6. Given a retention rate of 25% and a
return on new investment of 12%, we can compute
the new growth rate (g).
• Finally, armed with the new dividend, Canadian Tire’s
equity cost of capital, and its new growth rate, we can
compute the price of Canadian Tire’s shares if it
institutes the new policy.

Profitable Growth: Execute (5 of 8)
• To estimate rE we have
𝐷𝑖𝑣 1 $6
𝑟 𝐸= + 𝑔= + 0 %=0.10+0=10 %
𝑃0 $ 60
• In other words, to justify Canadian Tire’s stock price

under its current policy, the expected return of other
stocks in the market with equivalent risk must be 10%.

Profitable Growth: Execute (6 of 8)
• Next, we consider the consequences of the new policy.
If Canadian Tire reduces its dividend payout rate to
75%, then its dividend this coming year will fall to Div1
= EPS1 × 75% = $6 × 75% = $4.50.
• At the same time, because the firm will now retain 25%
of its earnings to invest in new stores, from Eq. 7.12 its
growth rate will increase to:
g = Retention Rate × Return on New Investment = 25% × 12% = 3%

• Assuming Canadian Tire can continue to grow at this
rate, we can compute its share price under the new
policy using the constant dividend growth model:
𝐷𝑖𝑣 1 $ 4.50
𝑃0= = =$ 64.29
𝑟 𝐸 − 𝑔 0.10 − 0.03

Profitable Growth: Evaluate (8 of 8)
• Canadian Tire’s share price should rise from $60 to
$64.29 if the company cuts its dividend in order to
increase its investment and growth, implying that the
investment has positive NPV.
• By using its earnings to invest in projects that offer a
rate of return (12%) greater than its equity cost of
capital (10%), Canadian Tire has created value for its
shareholders.

Example 7.4: Unprofitable Growth
• Suppose Canadian Tire decides to cut its dividend
payout rate to 75% to invest in new stores, as in
Example 7.3.
• But now suppose that the return on these new
investments is 8%, rather than 12%.
• Give its expected earnings per share this year of $6
and its equity cost of capital of 10% (we again assume
that the risk of the new investments is the same as its
existing investments), what will happen to Canadian
Tire’s current share price in this case?

Example 7.4: Unprofitable Growth: Plan
• We will follow the steps in Example 7.3, except that in
this case, we assume a return on new investments of
8% when computing the new growth rate (g), instead
of 12% as in Example 7.3.

Example 7.4: Unprofitable Growth:
Execute
• Just as in Example 7.3, Canadian Tire’s dividend will
fall to $6 × 75% = $4.50. Its growth rate under the new
policy, given the lower return on new investment, will
now be g = 25% × 8% = 2%. The new share price is
therefore
𝐷𝑖𝑣 1 $ 4.50
𝑃0= = =$ 56.25
𝑟 𝐸 − 𝑔 .10 −.02

Example 7.4: Unprofitable Growth:
Evaluate
• Even though Canadian Tire will grow under the new
policy, the new investments have a negative NPV.
• The company’s share price will fall if it cuts its
dividend to make new investments with a return of
only 8%.
• By reinvesting its earnings at a rate (8%) that is lower
than its equity cost of capital (10%), Canadian Tire
has reduced shareholder value.

• Changing Growth Rates
– If the firm is expected to grow at a long-term rate g
after year n + 1, then from the constant dividend growth
model:
𝐷𝑖 𝑣 𝑛 +1
𝑃 𝑛=
𝑟𝐸 − 𝑔

Example 7.5: Valuing a Firm with Two
Different Growth Rates (1 of 8)
• Small Fry, Inc. has just invented a potato chip that
looks and tastes like a french fry.
• Given the phenomenal market response to this
product, Small Fry is reinvesting all of its earnings to
expand its operations.
• Earnings were $2 per share this past year and are
expected to grow at a rate of 20% per year until the
end of year four. At that point, other companies are
likely to bring out competing products.

Different Growth Rates (2 of 8)
• Analysts project that at the end of year four, Small Fry
will cut its investment and begin paying 60% of its
earnings as dividends.
• Its growth will also slow to a long-run rate of 4%. If
Small Fry’s equity cost of capital is 8%, what is the
value of a share today?

Different Growth Rates: Plan (3 of 8)
• We can use Small Fry’s projected earnings growth
rate and payout rate to forecast its future earnings and
dividends.
• After year four, Small Fry’s dividends will grow at a
constant 4%, so we can use the constant dividend
growth model (Equation 7.13) to value all dividends
after that point.
• Finally, we can pull everything together with the
dividend-discount model.

Different Growth Rates: Execute (4 of 8)
• The following spreadsheet projects Small Fry’s
earnings and dividends:
1 Year 0 1 2 3 4 5 6
2 Earnings Blank Blank Blank Blank Blank Blank Blank
3 EPS Growth Rate (versus prior year) Blank 20% 20% 20% 20% 4% 4%
4 EPS $2.00 $2.40 $2.88 $3.46 $4.15 $4.31 $4.49
5 Dividends Blank Blank Blank Blank Blank Blank Blank
6 Dividend Payout Rate Blank 0% 0% 0% 60% 60% 60%
7 Div Blank $— $— $— $2.49 $2.59 $2.69

• Starting from $2.00 in year zero, EPS grows by 20%
per year until year four, after which growth slows to
4%.
• Small Fry’s dividend payout rate is zero until year four,
when competition reduces its investment opportunities
and its payout rate rises to 60%.
• Multiplying EPS by the dividend payout ratio, we
project Small Fry’s future dividends in line 4.

• After year four, Small Fry’s dividends will grow at the
expected long-run rate of 4% per year.
• Thus, we can use the year four dividend as the first
dividend in a constant dividend growth model (g = 4%)
to project Small Fry’s share price at the end of year
three. Given its equity cost of capital of 8%,
𝐷𝑖 𝑣 4 $ 2.49
𝑃3= = =$ 62.25
𝑟 𝐸 − 𝑔 0.08 − 0.04

• We then apply the dividend-discount model with this
terminal value:
𝐷𝑖 𝑣1 𝐷𝑖 𝑣 2 𝐷𝑖𝑣 3 𝑃3 $ 62.25
𝑃0= + 2
+ 3
+ 3
= 3
=$ 49.42
1+𝑟 𝐸 ( 1+𝑟 𝐸 ) ( 1+𝑟 𝐸 ) ( 1+𝑟 𝐸 ) ( 1.08 )

Different Growth Rates: Evaluate (8 of 8)
• The dividend-discount model is flexible enough to
handle any forecasted pattern of dividends.
• Here the dividends were zero for three years and then
settled into a constant growth rate, allowing us to use
the constant growth rate model as a shortcut.

• Value Drivers and the Dividend-Discount Model
– The dividend-discount model includes an implicit
forecast of the firm’s profitability which is discounted
back at the firm’s equity cost of capital.

7.4 Limitations of the Dividend-
Discount Model (1 of 2)
• Uncertain Dividend Forecasts
– The dividend-discount model values a stock based on
a forecast of the future dividends, but a firm’s future
dividends carry a tremendous amount of uncertainty.

7.4 Limitations of the Dividend-
Discount Model (2 of 2)
• Non-Dividend-Paying Stocks
– Many companies do not pay dividends; thus, the
dividend-discount model must be modified.

7.5 Share Repurchases and the Total
Payout Model (1 of 3)
• Share Repurchases (A firm’s use of cash to buy back
its own stock)
– The firm uses excess cash to buy back its own stock.
Consequences:
 The more cash the firm uses to repurchase shares, the
less cash it has available to pay dividends
 By repurchasing shares, the firm decreases its share
count, which increases its earnings and dividends on a
per-share basis.

• Share Repurchases
– In the dividend-discount model, a share is valued from
the perspective of a single shareholder, discounting the
dividends the shareholder will receive:
P0 = PV(Future Dividends per Share)

• Total Payout Model
– Values all of the firm’s equity, rather than a single share
 To use this model, discount the total payouts that the firm
makes to shareholders, which is the total amount spent
on both dividends and share repurchases
𝑃𝑉 (𝐹𝑢𝑡𝑢𝑟𝑒 𝑇𝑜𝑡𝑎𝑙 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑎𝑛𝑑 𝑅𝑒𝑝𝑢𝑟𝑐h𝑎𝑠𝑒𝑠)

𝑃0=
Shares Outstanding 0

Example 7.6: Valuation with Share
Repurchases
• Buhler Industries has 217 million shares outstanding
and expects earnings at the end of this year of $860
million. Buhler plans to pay out 30% of its earnings as
a dividend and 20% of its earnings through share
repurchases.
• If Buhler’s earnings are expected to grow by 7.5% per
year and these payout rates remain constant,
determine Buhler’s share price assuming an equity
cost of capital of 10%.

Repurchases: Plan (1 of 2)
• Based on the equity cost of capital of 10% and an
expected earnings growth rate of 7.5%, we can
compute the present value of Buhler’s future payouts
as a constant growth perpetuity.
• The only input missing here is Buhler’s total payouts
this year, which we can calculate as 50% of its
earnings (30% by dividends plus 20% by
repurchases).

Repurchases: Plan (2 of 2)
• The present value of all of Buhler’s future payouts is
the value of its total equity.
• To obtain the price of a share, we divide the
total value by the number of shares outstanding (217
million).

Repurchases: Execute (1 of 2)
• Buhler will have total payouts this year of
50%  $860 million = $430 million. Using the constant
growth perpetuity formula, we have
billion

Repurchases: Execute (2 of 2)
• This present value represents the total value of
Buhler’s equity (i.e., its market capitalization). To
compute the share price, we divide by the current
number of shares outstanding:
per share

Repurchases: Evaluate (1 of 2)
• Using the total payout method, we did not need to
know the firm’s split between dividends and share
repurchases.
• To compare this method with the dividend-discount
model, note that Buhler will pay a dividend of 30% 
$860 million/(217 million shares) = $1.19 per share,
for a dividend yield of 1.19/79.26 = 1.50%.

Repurchases: Evaluate (2 of 2)
• Buhler’s expected EPS, dividend, and share price
growth rate is g = rE − Div1/P0 = 8.50%.
• This growth rate exceeds the 9.50% growth rate of
earnings because Buhler’s share count will decline
over time owing to its share repurchases.

7.6 The Discounted Free Cash Flow
Model (1 of 7)
• The discounted free cash flow model determines
the total value of the firm’s productive assets to all of
its investors—both equity holders and debt holders.
Enterprise Value = Market Value of Equity + Debt − Cash

Model (2 of 7)
• Valuing the Enterprise
– To estimate a firm’s enterprise value, we compute the
present value of the firm’s free cash flow (FCF)
available to pay all investors.
Free Cash Flow = EBIT × (1 − Tax Rate) + Depreciation

− Capital Expenditures − Increases in Net Working Capital

Model (3 of 7)
• Discounted Free Cash Flow Model
V0 = PV(Future Free Cash Flow of Firm)
– Given the enterprise value, to solve for the value of

equity and divide by the total number of shares
outstanding.
𝑉 0 + Cash0 − Debt 0
𝑃0=
Shares Outstanding

Model (4 of 7)
• Implementing the Model
– Since we are discounting the cash flows to all
investors, we use the weighted average cost of
capital (WACC), denoted by rwacc
– Forecast free cash flow up to some horizon, together
with a terminal value of the enterprise:
𝐹𝐶 𝐹 1 𝐹𝐶 𝐹 2 𝐹𝐶 𝐹 n Vn
V 0= + +…+ +
1+ 𝑟 wacc ( 1+𝑟 wacc )2 n
( 1+ 𝑟 wacc ) ( 1+ 𝑟 wacc )
n

Key Term and Definition
• Weighted average cost of capital (WACC): The cost
of capital that reflects the risk of the overall business,
which is the combined risk of the firm’s equity and
debt.

Model (5 of 7)
• Estimate the terminal value by assuming a constant
long-run growth rate gFCF for free cash flows beyond
year N.
V N=
FCF N +1
𝑟 wacc −𝑔 𝐹𝐶𝐹
=
(
1+𝑔 𝐹𝐶𝐹
𝑟 wacc − 𝑔 𝐹𝐶𝐹
× 𝐹𝐶 𝐹 𝑁
)
– The long-run growth rate gFCF is typically based on
expected long-run growth rate of revenues

Example 7.7: Valuing Nike Stock Using
Free Cash Flow
• Nike had sales of $36.397 billion in 2018. Suppose
you expect its sales to grow at a rate of 15% in 2019,
but then slow by 2% per year to the long-run growth
rate that is characteristic of the apparel industry—5%
—by 2024.
• Based on Nike’s past profitability and investment
needs, you expect EBIT to be 13% of sales, increases
in net working capital requirements to be 5% of any
increase in sales, and capital expenditures to equal
depreciation expenses.

Example 7.7: Valuing Nike, Inc., Stock
Using Free Cash Flow
• If Nike has $5.25 billion in cash, $3.8 billion in debt,
1,626 million shares outstanding, a tax rate of 25%,
and a weighted average cost of capital of 9%, what is
your estimate of the value of Nike stock in early 2019?

Free Cash Flow: Plan (1 of 2)
• We can estimate Nike’s future free cash flow by
constructing a pro forma statement. Furthermore, we
need to calculate a terminal (or continuation) value for
Nike at the end of our explicit projections.
• Because we expect Nike’s free cash flow to grow at a
constant rate after 2024, we can compute a terminal
enterprise value.

Free Cash Flow: Plan (2 of 2)
• The present value of the free cash flows during the
years 2019–2024 and the terminal value will be the
total enterprise value for Nike.
• From that value, we can subtract the debt, add the
cash, and divide by the number of shares outstanding
to compute the price per share.

Free Cash Flow: Execute (1 of 3)
The spreadsheet below presents a simplified pro forma
for Nike based on the information we have:
1 Year 2018 2019 2020 2021 2022 2023 2024
2 FCF Forecast ($ million) Blank Blank Blank Blank Blank Blank Blank
3 Sales 36,397.0 41,856.6 47,297.9 52,500.7 57,225.7 61,231.5 64,293.1

4 Growth Versus Prior Year Blank 15.0% 13.0% 11.0% 9.0% 7.0% 5.0%
5 EBIT (13% of sales) Blank 5,441.4 6,148.7 6,825.1 7,439.3 7,960.1 8,358.1
6 Less: Income Tax (25%) Blank 1,360.3 1,537.2 1,706.3 1,859.8 1,990.0 2,089.5
7 Plus: Depreciation Blank — — — — — —
8 Less: Capital Expenditures Blank — — — — — —
9 Less: Increase in NWC (5% ΔSales) Blank 273.0 272.1 260.1 236.3 200.3 153.1
10 Free Cash Flow Blank 3,808.0 4,339.5 4,858.7 5,343.3 5,769.8 6,115.5

• Because capital expenditures are expected to equal
depreciation, lines 7 and 8 in the spreadsheet cancel
out. We can set them both to zero rather than
explicitly forecast them.
• Given our assumption of constant 5% growth in free
cash flows after 2024 and a weighted average cost of
capital of 9%, we can use Eq. 7.21 to compute a
terminal enterprise value:
million

• Nike’s current enterprise value is the present value of
its free cash flows plus the firm’s terminal value:
• We can now estimate the value of a share of Nike’s

stock:
$ 117,779.5+ $ 5,250 − $ 3,800
𝑃0= =$ 73.34
1,626

Free Cash Flow: Evaluate (1 of 2)
• The total value of all of the claims, both debt and
equity, on the firm must equal the total present value
of all cash flows generated by the firm, in addition to
any cash it currently has.
• The total present value of all cash flows to be
generated by Nike is $117,799.5 million and it has
$5,250 million in cash.

Free Cash Flow: Evaluate (2 of 2)
• Subtracting off the value of the debt claims ($3,800
million), leaves us with the total value of the equity
claims and dividing by the number of shares produces
the value per share.
Two important things about valuation models:
(1) They are only good at the time they are made; as time
goes by, the data and assumptions used in the valuation
model will change and, thus, so will the value;
(2) They use projections of what will happen, but these
projections are subject to a lot of error.

Model (6 of 7)
• Connection to Capital Budgeting
– The firm’s future free cash flow in any particular year is
equal to the sum of that year’s free cash flows from the
firm’s current and future investment projects.
 Firm’s enterprise value = the total value that the firm will
generate from continuing its existing projects and
initiating new ones.
 NPV of any new project = its contribution to the firm’s
enterprise value.
 To maximize the firm’s share price, we should accept
those projects that have a positive NPV.

Model (7 of 7)
• Many forecasts (e.g. future sales, operating expenses,
taxes, capital requirements) are necessary to estimate
the free cash flows of a project and, consequently, the
free cash flows of the firm.
– Advantage: Estimating free cash flow gives us flexibility
to incorporate many specific details about the future
prospects of the firm.
– Disadvantage: Some uncertainty inevitably surrounds
each assumption. A sensitivity analysis shows how our
final calculated value changes with respect to changes
in one of the input variables in our model.

Example 7.8: Sensitivity Analysis for
Stock Valuation
• In Example 7.7, Nike’s EBIT was assumed to be 13%
of sales.
• If Nike can reduce its operating expenses and raise its
EBIT to 14% of sales, how would the estimate of the
stock’s value change?

Stock Valuation: Plan
• In this scenario, EBIT will increase by 1% of sales
compared to Example 7.7.
• From there, we can use the tax rate (25%) to compute
the effect on the free cash flow for each year.
• Once we have the new free cash flows, we repeat the
approach in Example 7.7 to arrive at a new stock
price.

Stock Valuation: Execute (1 of 2)
• In year 1, EBIT will be 1% * $41,857 million = $418.6
million higher. After taxes, this increase will raise the
firm’s free cash flow in year 1 by
(1 − 0.252) * $418.6 = $314 million, to
$4,122.0 million. Doing the same calculation for each
year, we get the following revised FCF estimates:
Year 2019 2020 2021 2022 2023 2024
FCF 4,122.0 4,694.2 5,252.4 5,772.4 6,229.0 6,597.7

Stock Valuation: Execute (2 of 2)
• We can now reestimate the stock price as in Example
7.7. The terminal value is
million, so
million
• The new estimate for the value of the stock is

P0 = (127,128 + 5,250 – 3,800) / 1,626 = $79.08 per
share, a difference of about 8% compared to the
result found in Example 7.7.

Stock Valuation: Evaluate
• Nike’s stock price is fairly sensitive to changes in the
assumptions about its profitability.
• A 1% permanent change in its margins affects the
firm’s stock price by 8%.

7.7 Valuation Based on Comparable
Firms (1 of 14)
• Another application of the valuation principle is the
method of comparables.
• Method of comparables: An estimate of the value of
a firm based on the value of other, comparable firms
or other investments that are expected to generate
very similar cash flows in the future.

Firms (2 of 14)
• Consider the case of a new firm that is identical to an
existing publicly traded firm.
– The Valuation Principle implies that two securities with
identical cash flows must have the same price.
– If these firms will generate identical cash flows, we can
use the market value of the existing company to
determine the value of the new firm.
– We can adjust for scale differences using valuation
multiples.

Firms (3 of 14)
Valuation Multiples
• A ratio of a firm’s value to some measure of the firm’s
scale or cash flow.
– Price-Earnings ratio
– Enterprise Value Multiples
– Other multiples
 Multiples of sales
 Price-to-book value of equity
 Industry-specific ratios

Firms (4 of 14)
• Price-Earnings Ratio
– Most common valuation multiple
 Usually included in basic statistics computed for a stock
– Share price divided by earnings per share

Firms (5 of 14)
• We can compute a firm’s P/E ratio using:
– Trailing earnings: A firm’s earnings over the prior 12 months.
– Forward earnings: A firm’s anticipated earnings over the
coming 12 months.
• The resulting ratio is either:
– Trailing P/E: A firm’s P/E ratio calculated using its trailing
earnings.
– Forward P/E: A firm’s P/E ratio calculated using its forward
earnings.
• For valuation purposes, the forward P/E is generally
preferred, as we are most concerned about future earnings.

Firms (6 of 14)
• P/E ratios are related to other valuation techniques.
– In the case of constant dividend growth, we had
𝐷𝑖 𝑣 1
𝑃0=
𝑟E−𝑔
– Dividing through by EPS1:
𝑃0 ¿ 1 ⁡/ 𝐸𝑃 𝑆1 Dividend Payout Rate

Forward P/ E= = =
𝐸𝑃 𝑆1 𝑟E−𝑔 𝑟E−𝑔

Example 7.9: Growth Prospects and the
Price-Earnings Ratio
• Amazon.com and Macy’s are both retailers in the US.
In 2019, Amazon stock had a price of $1,837.28 and a
forward earnings per share of $39.97. Macy’s had a
price of $25.49 and forward earnings per share of
$2.95.
• Calculate their forward P/E ratios and explain the
difference.

Price-Earnings Ratio: Plan
• We can calculate their P/E ratios by dividing each
company’s price per share by its forward earnings per
share. The difference is most likely due to different
growth expectations.

Price-Earnings Ratio: Execute
• The forward P/E for Amazon: $1,837.28/$39.97 =
45.97. The forward P/E for Macy’s: $25.49/$2.95 =
8.64. Amazon’s P/E ratio is higher because investors
expect its earnings to grow more than those of
Macy’s.

Price-Earnings Ratio: Evaluate
• Although both companies are retailers, they have very
different growth prospects, as reflected in their P/E
ratios.
• Investors in Amazon.com are willing to pay 45.97
times that year’s expected earnings because they are
also buying the present value of high future earnings
created by expected growth.

Firms (7 of 14)
• Enterprise Value Multiples
– P/E ratio relates exclusively to equity, ignoring the
effect of debt.
– Enterprise value multiples use a measure of earnings
before interest payments are made
 EBIT
 EBITDA
 Free cash flow
– Because capital expenditures can vary between years,
most common is to use enterprise value to EBITDA
multiples

Firms (8 of 14)
• When expected free cash flow growth is constant, we
can write EV to EBITDA as:
𝐹𝐶 𝐹 1
𝑉0 𝑟 wacc − 𝑔 𝐹𝐶𝐹 𝐹𝐶 𝐹 1 / 𝐸𝐵𝐼𝑇𝐷 𝐴1
= =
𝐸𝐵𝐼𝑇𝐷 𝐴1 𝐸𝐵𝐼𝑇𝐷 𝐴1 𝑟 wacc −𝑔 𝐹𝐶𝐹

Example 7.10: Valuation Using the
Enterprise Value Multiple
• Westcoast Port, Inc. is an ocean transport company
with EBITDA of $50 million, cash of $20 million, debt of
$100 million, and 10 million shares outstanding.
• The ocean transport industry as a whole has an
average enterprise-value-to-EBITDA (EV/EBITDA)
ratio of 8.5.
• What is one estimate of Westcoast’s enterprise value?
What is a corresponding estimate of its stock price?

Enterprise Value Multiple: Execute
• Westcoast’s enterprise value is $50 million × 8.5 =
$425 million
• Next, subtract the debt from its enterprise value and
add in its cash:
• $425 million − $100 million + $20 million =
$345 million, which is the equity value.
• Its stock price is equal to its equity value divided by
the number of shares outstanding:
• $345 million ÷ 10 million = $34.50

Enterprise Value Multiple: Evaluate
• If we assume that Westcoast should be valued
similarly to the rest of the industry, then $425 million is
a reasonable estimate of its enterprise value and
$34.50 is a reasonable estimate of its stock price.
• However, we are relying on the assumption that
Westcoast’s expected free cash flow growth is similar
to the industry average.
• If that assumption is wrong, so is our valuation.

Firms (9 of 14)
• Other multiples
– Multiples of sales can be useful if it is reasonable to
assume margins are similar in the future.
– Price-to-book value of equity can be used for firms with
substantial tangible assets.
– Some multiples are specific to an industry
 e.g. Cable TV – Enterprise value per subscriber

Firms (10 of 14)
• Limitations of Multiples
– Firms are not identical
 Usefulness of a valuation multiple will depend on the
nature of the differences and the sensitivity of the
multiples to the differences.
 Differences in multiples can be related to differences in
– Expected future growth rate
– Risk (cost of capital)
– Differences in accounting conventions between countries

Firms (11 of 14)
• Limitations of Multiples
– Comparables provide only information regarding the
value of the firm relative to other firms in the
comparison set
 Cannot help determine whether an entire industry is
overvalued.
– Example: Internet boom

Firms (12 of 14)
• Comparison with Discounted Cash Flow Methods
– Valuation multiple does not take into account material
differences between firms.
 Talented managers
 More efficient manufacturing processes
 Patents on new technology

Firms (13 of 14)
• Comparison with Discounted Cash Flow Methods
– Discounted cash flow methods allow us to incorporate
specific information about cost of capital or future
growth
 Potential to be more accurate

Firms (14 of 14)
• Stock Valuation Techniques: The Final Word
– No single technique provides a final answer regarding
a stock’s true value
– Practitioners use a combination of these approaches
– Confidence comes from consistent results from a
variety of these methods

7.8 Information, Competition, and Stock
Prices (1 of 11)
• Information in Stock Prices
– For a publicly traded firm, market price should already
provide very accurate information regarding the true
value of its shares.

Prices (2 of 11)
• A valuation model is best applied to tell us something
about future cash flows or cost of capital, based on
current stock price.
– Only in the relatively rare case in which we have some
superior information that other investors lack would it
make sense to second-guess the stock price.

Example 7.11: Using the Information in
Market Prices
• Suppose Tecnorth Industries will have free cash flows
next year of $40 million.
• Its weighted average cost of capital is 11%, and you
expect its free cash flows to grow at a rate of
approximately 4% per year, though you are somewhat
unsure of the precise growth rate. Tecnorth has 10
million shares outstanding, no debt, and $20 million in
cash.
• If Tecnorth’s stock is currently trading at $55.33 per
share, how would you update your beliefs about its
dividend growth rate?
Market Prices: Plan
• If we apply the growing perpetuity formula for the
growing FCF based on a 4% growth rate, we can
estimate a stock price.
• If the market price is higher than our estimate, it
implies that the market expects higher growth in FCF
than 4%.
• Conversely, if the market price is lower than our
estimate, the market expects FCF growth to be less
than 4%.

Market Prices: Execute
• Applying the growing perpetuity formula, we have
PV(FCF) = 40 ÷ (0.11 − 0.04)= $571.43 million.
• The price per share would be ($571.43 million −
0 + $20 million ) ÷ 10 million shares = $59.14 per
share.
• The market price of $55.33, however, implies that
most investors expect FCF to grow at a somewhat
slower rate.

Market Prices: Evaluate
• Given the $55.33 market price for the stock, we
should lower our expectations for the FCF growth rate
from 4% unless we have very strong reasons to trust
our own estimate.

Prices (3 of 11)
• Competition and Efficient Markets
– Efficient markets hypothesis: Implies that securities
will be fairly priced, based on their future cash flows,
given all information that is available to investors.

Prices (4 of 11)
• Public, Easily Available Information:
– Information available to all investors includes
information in news reports, financial statements,
corporate press releases, or other public data sources.
• Private or Difficult-to-Interpret Information

Example 7.12: Stock Price Reactions to
Public Information
• Suppose Pfizer announced it is pulling one of its
leading drugs from the market. As a result, its future
expected free cash flow will decline by $850 million
per year for the next ten years.
• Assume Pfizer has 500 million shares outstanding, no
debt, and an equity cost of capital of 8%.
• If this news came as a complete surprise to investors,
what should happen to Pfizer’s stock price upon the
announcement?

Public Information: Plan
• In this case, we can use the discounted free cash flow
method. With no debt, rwacc = rE = 8%.
• The effect on the Pfizer’s enterprise value will be the
loss of a ten-year annuity of $850 million.
• We can compute the effect today as the present value
of that annuity.

Public Information: Execute
• Using the annuity formula, the decline in expected
free cash flow will reduce Pfizer’s enterprise value by
billion
• Thus the share price should fall by $5.704 billion/500

million shares = $11.41 per share.

Public Information: Evaluate
• Because this news is public and its effect on the firm’s
expected free cash flow is clear, we would expect the
stock price to drop by $11.41 per share nearly
instantaneously.

Prices (5 of 11)
• Private or Difficult-to-Interpret Information
– Example: Snowy Pharmaceuticals had just announced
the development of a new drug for which the company
is seeking approval from Health Canada.

Prices (6 of 11)
• If the drug is approved future profits will increase
Snowy’s market value by $15 per share.
• Suppose the announcement comes as a surprise to
investors, and average likelihood of Health Canada
approval is 10%.
– The announcement should lead to a 10% × $15.00 =
$1.50 per share immediate stock price increase.

Prices (7 of 11)
• Over time, investors will make their own assessments
of the probable efficacy of the drug.
– If they conclude that the drug looks more (less)
promising than average, they will buy (sell) the stock
and the price will drift higher (lower) over time.
– At the time of the announcement, uninformed investors
do not know which way it will go.

Prices (8 of 11)
• Lessons for Investors and Corporate Managers
– Consequences for Investors
 Must have some competitive advantage
– Expertise or access to information known to only a few
people
– Lower trading costs than others
– If stocks are fairly priced according to valuation models,
then investors who buy stocks can expect fair
compensation for the risk they take.

Prices (9 of 11)
• Lessons for Investors and Corporate Managers
– Implications for Corporate Managers
 Cash flows paid to investors determine value
– Focus on NPV and free cash flows
– Avoid accounting illusions
– Use financial transactions to support investment

Prices (10 of 11)
• The Efficient Markets Hypothesis Versus No Arbitrage
– An arbitrage opportunity is a situation in which two
securities (or portfolios) with identical cash flows have
different prices.
– Because anyone can earn a sure profit in this situation
by buying the low-priced security and selling the high-
priced one, we expect investors to immediately exploit
and eliminate these opportunities.

Prices (11 of 11)
• The Efficient Markets Hypothesis Versus No Arbitrage
– Thus, in a normal market, arbitrage opportunities will
not be found.
– There is no reason to expect the efficient markets
hypothesis to hold perfectly; rather, it is best viewed as
an idealized approximation for highly competitive
markets.

7.9 Individual Biases and Trading (1 of 9)
• Excessive Trading and Overconfidence

– Trading is expensive because of commissions and the
difference between the bid and ask
– Given the difficulty of finding over- and under-valued
stocks, you might expect individual investors to trade
conservatively.

• However, a study of the trading behaviour of individual

investors at a discount brokerage found individual
investors trade very actively.
– Average turnover almost 50% above overall rates
during the time of the study.

• Overconfidence hypothesis: Tendency of individual

investors to trade too much based on the mistaken
belief that they can pick winners and losers better
than investment professionals.
– Implication is that investors who trade more will not
earn higher returns.
 Performance will actually be worse because of trading
costs.

• Hanging on to Losers and the Disposition Effect

– Investors tend to hold on to stocks that have lost value
and sell stocks that have risen in value

• Researchers Hersh Shefrin and Meir Statman suggest

that this effect arises due to investors’ increased
willingness to take on risk in the face
of possible losses.
– May also reflect a reluctance to admit a mistake by
taking the loss.

• From a tax perspective, this behavioural tendency is

costly.
– Capital gains are taxed only when an asset is sold, so
delaying the tax payment reduces its present value.
– Capital losses are tax deductible (to a certain extent),
so investors should capture tax losses early.

• Keeping losers and selling winners might make sense

if losing stocks would outperform the winners going
forward.
– This belief does not appear to be justified – if anything,
losing stocks that investors continue to hold
underperform the winners they sell.
– According to one study, losers underperformed winners
by 3.4% over the next year.

• Investor Attention, Mood, and Experience

– Individual investors are not generally full-time traders
 They have limited time and attention
 More likely to buy stocks that have been in the news,
advertised more, had very high trading volume, or
recently had extreme (high or low) returns.
– Investor mood affects investment behavior
 Annualized market returns at the location of the stock
exchange is higher on sunny days than on cloudy days.

• Investor Attention, Mood, and Experience

– Investors appear to put too much weight on their own
experience rather than considering historical evidence
 People who grow up and live during a time of high stock
returns are more likely to invest in stocks.

Chapter Quiz (1 of 3)
1. What are some key differences between preferred
and common stock?
2. What discount rate do you use to discount the future
cash flows of a stock?
3. What are three ways that a firm can increase the
amount of its future dividend per share?
4. What are the main limitations of the dividend-
discount model?

5. How does the total payout model address part of
the dividend-discount model’s limitations?
6. What is the relation between capital budgeting and
the discounted free cash flow model?
7. What implicit assumptions do we make when
valuing a firm using multiples based on comparable
firms?

8. What are the implications of the efficient markets
hypothesis for investors?
9. What are the implications of the efficient markets
hypothesis for corporate managers?
10. What are several systematic behavioural biases that
individual investors fall prey to?
11. Why would excessive trading lead to lower realized
returns?

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Fundamentals of Corporate Finance

Fourth Canadian Edition

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• Dividend Yields, Capital Gains, and Total Returns

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• Dividend Yields, Capital Gains, and Total Returns

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• Dividend Yields, Capital Gains, and Total Returns

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• We see that at this price, Loblaw’s dividend yield is

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• Dividend-Discount Model Equation

– The price of the stock is equal to the present value of

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• Dividend-Discount Model Equation

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Change in Earnings = New Investment × Return on New Investment

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New Investment = Earnings × Retention Rate

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g = Retention Rate × Return on New Investment

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• In other words, to justify Canadian Tire’s stock price

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g = Retention Rate × Return on New Investment = 25% × 12% = 3%

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