[pic] Michael G. Foster School of Business

Using a Valuation Model to Estimate a Firm’s Stock Price*

In the ongoing search for bargains in the stock market, analysts and investors rely on models to estimate the intrinsic value of a firm’s equity. By comparing the valuation suggested by their model to the actual value in the marketplace, they form opinions as to whether a given stock is under or over valued. Valuation models are also used by investment bankers as an aid to pricing initial public offerings, and to inform parties involved in assorted private transactions such as selling a business or division, dividing property among owners, and settling estates. In this note, we introduce a relatively simple but powerful model of equity (stock) valuation.[1]

1. The basic idea behind valuation Valuation models in finance are typically based on discounted future cash flows or discounted future dividends. Keep in mind that, holding underlying assumptions constant, all valuation models should yield the same result. A model for valuing equity based on accounting data may be preferable in some cases, in that:

o Benchmarks for performance are almost always given in earnings per share (EPS) – not cash flows or dividends. o Since real world dividend payout policies tend to be stable for long periods, valuation models based on dividends are less useful for modeling changes in value. o Earnings generally receive far more attention from the business press, investors and analysts. In fact, analysts typically forecast earnings (rather than cash flows or dividends).[2]

Thus, in the absence of a clearly superior approach, we will emphasize a valuation model based on discounted future accounting earnings in this handout.

1.1 A simple perpetuity valuation model

We start with a highly simplified model that assumes earnings, cash flows