Chapter 4 The Value of Common Stocks 81
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Of course investors did not need valuation by comparables to value Devon Energy or the
other companies in Table 4.1. They are all public companies with actively traded shares. But
you may find valuation by comparables useful when you don’t have a stock price. For exam-
ple, Hess announced in June 2013 that it was taking offers for its Asian oil and gas assets. The
business was not a public company. Preliminary estimates put its value at $2 billion. It’s a safe
bet that Hess and its advisers were burning the midnight oil, doing their best to identify the
best comparables for the Asian business and checking what it would be worth if it traded at
the comparables’ P/E and P/B ratios.
But Hess would have to be cautious. As Table 4.1 shows, these ratios can vary widely even
within the same industry. To understand why this is so, we need to look more carefully at
what determines a stock’s market value. We start by connecting stock prices to the cash flows
that stockholders receive from the company in the form of cash dividends. This will lead us to
a discounted cash flow (DCF) model of stock prices.
Stock Prices and Dividends
Not all companies pay dividends. Rapidly growing companies typically reinvest earnings
instead of paying out cash. But most mature, profitable companies do pay regular cash
dividends.
Think back to Chapter 3, where we explained how bonds are valued. The market value
of a bond equals the discounted present value (PV) of the cash flows (interest and principal
payments) that the bond will pay out over its lifetime. Let’s import and apply this idea to com-
mon stocks. The future cash flows to the owner of a share of common stock are the future
dividends per share that the company will pay out. Thus the logic of discounted cash flow
suggests
PV(share of stock) = PV(expected future dividends per share)At first glance this statement may seem surprising. Investors hope for capital gains as well
as dividends. That is, they hope to sell stocks for more than they paid for them. Why doesn’t
the PV of a stock depend on capital gains? As we now explain, there is no inconsistency.
Today’s Price If you own a share of common stock, your cash payoff comes in two forms:
(1) cash dividends and (2) capital gains or losses. Suppose that the current price of a share is
P 0 , that the expected price at the end of a year is P 1 , and that the expected dividend per share
is DIV 1. The rate of return that investors expect from this share over the next year is defined as
the expected dividend per share DIV 1 plus the expected price appreciation per share P 1 – P 0 ,
all divided by the price at the start of the year P 0 :
Expected return = r =DIV 1 + P 1 − P 0
P 0
Suppose Fledgling Electronics stock is selling for $100 a share (P 0 = 100). Investors expect
a $5 cash dividend over the next year (DIV 1 = 5). They also expect the stock to sell for $110 a
year hence (P 1 = 110). Then the expected return to the stockholders is 15%:
r =
5 + 110 − 100
____________
10 0
= .15, or 15%On the other hand, if you are given investors’ forecasts of dividend and price and the
expected return offered by other equally risky stocks, you can predict today’s price:
Price = P 0 =DIV 1 + P 1
_________
1 + r