Principles of Corporate Finance_ 12th Edition

Chapter 4 The Value of Common Stocks 93

bre44380_ch04_076-104.indd 93 09/30/15 12:46 PM

Everything is the same in year 2 except that Fledgling will invest $3.67, 10% more than in
year 1 (remember g = .10). Therefore at t = 2 an investment is made with a net present value of

NPV 2 = −3.67 + _________.83 × 1.10

.15

= $2.44

Thus the payoff to the owners of Fledgling Electronics stock can be represented as the sum
of (1) a level stream of earnings, which could be paid out as cash dividends if the firm did not
grow, and (2) a set of tickets, one for each future year, representing the opportunity to make
investments having positive NPVs. We know that the first component of the value of the share is

Present value of level stream of earnings =

EPS 1

_____

r

= 8.33____

.15

= $55.56

The first ticket is worth $2.22 in t = 1, the second is worth $2.22 × 1.10 = $2.44 in t = 2, the
third is worth $2.44 × 1.10 = $2.69 in t = 3. These are the forecasted cash values of the tickets.
We know how to value a stream of future cash values that grows at 10% per year: Use the con-
stant-growth DCF formula, replacing the forecasted dividends with forecasted ticket values:

Present value of growth opportunities = PVGO =

NPV 1

_____

r − g

= ________2.22

.15 − .10

= $44.44

Now everything checks:

Share price = Present value of level stream of earnings

• Present value of growth opportunities

=

EPS 1

_____r + PVGO

= $55.56 + $44.44

= $10 0

Why is Fledgling Electronics a growth stock? Not because it is expanding at 10% per year.
It is a growth stock because the net present value of its future investments accounts for a sig-
nificant fraction (about 44%) of the stock’s price.
Today’s stock price reflects investor expectations about the earning power of the firm’s
current and future assets. Take Google, for example. Google has never paid a dividend. It
plows back all its earnings into its business. In December 2014, its stock sold for $495 per
share at a forward P/E of about 19. EPS forecasted for 2014 were $26.05.
Suppose that Google did not grow, and that future EPS were expected to stay constant at
$26.05. In this case Google could pay a constant dividend of $26.05 per share. If the cost of
equity is, say, 10%, market value would be PV = 26.05/.10 = $260.50 per share, $235 less
than the actual stock price of $495. So it appears that investors were valuing Google’s future
investment opportunities at $235 per share, almost half of the stock price. Google is a growth
stock because that large fraction of its market value comes from the expected NPV of its
future investments.

BEYOND THE PAGE

mhhe.com/brealey12e

Valuing Google

4-5 Valuing a Business by Discounted Cash Flow

Investors buy or sell shares of common stock. Companies often buy or sell entire businesses
or major stakes in businesses. For example, we have noted Hess’s plans to sell its Asian oil
and gas business. Both Hess and potential bidders were doing their best to value that business
by discounted cash flow.