CHAPTER 7 Stock Valuation 339below, respectively, the required return for the
period. The efficient-market hypothesis suggests
that securities are fairly priced, that they reflect
fully all publicly available information, and that
investors should therefore not waste time trying to
find and capitalize on mispriced securities. The
value of a share of common stock is the present
value of all future dividends it is expected to pro-
vide over an infinite time horizon. Three dividend
growth models—zero-growth, constant-growth,
and variable-growth—can be considered in com-
mon stock valuation. The basic stock valuation
equation and these models are summarized in
Table 7.6. The most widely cited model is the con-
stant-growth model.
Discuss the free cash flow valuation model and
the use of book value, liquidation value, and
price/earnings (P/E) multiples to estimate common
stock values.The free cash flow valuation model is
appealing when one is valuing firms that have no
dividend history, startups, or operating units or di-
visions of a larger public company. The model finds
the value of the entire company by discounting the
firm’s expected free cash flow at its weighted aver-
age cost of capital. The common stock value is
found by subtracting the market values of the firm’s
debt and preferred stock from the value of the entire
company. The two equations involved in this model
are summarized in Table 7.6.
LG5Book value per share is the amount per share of
common stock that would be received if all of the
firm’s assets weresold for their book (accounting)
valueand the proceeds remaining after paying all
liabilities (including preferred stock) were divided
among the common stockholders. Liquidation value
per share is theactual amountper share of common
stock that would be received if all of the firm’s
assets weresold for their market value,liabilities
(including preferred stock) were paid, and the
remaining money were divided among the common
stockholders. The price/earnings (P/E) multiples
approach estimates stock value by multiplying the
firm’s expected earnings per share (EPS) by the
average price/earnings (P/E) ratio for the industry.Explain the relationships among financial deci-
sions, return, risk, and the firm’s value.In a sta-
ble economy, any action of the financial manager
that increases the level of expected return without
changing risk should increase share value, and any
action that reduces the level of expected return with-
out changing risk should reduce share value. Simi-
larly, any action that increases risk (required return)
will reduce share value, and any action that reduces
risk will increase share value. Because most financial
decisions affect both return and risk, an assessment
of their combined effect on stock value must be part
of the financial decision-making process.LG6LG4LG5SELF-TEST PROBLEMS (Solutions in Appendix B)
ST 7–1 Common stock valuation Perry Motors’ common stock currently pays an
annual dividend of $1.80 per share. The required return on the common stock is
12%. Estimate the value of the common stock under each of the following
assumptions about the dividend.
a. Dividends are expected to grow at an annual rate of 0% to infinity.
b. Dividends are expected to grow at a constant annual rate of 5% to infinity.
c. Dividends are expected to grow at an annual rate of 5% for each of the next 3
years, followed by a constant annual growth rate of 4% in years 4 to infinity.ST 7–2 Free cash flow valuation Erwin Footwear wishes to assess the value of its
Active Shoe Division. This division has debt with a market value of $12,500,000
and no preferred stock. Its weighted average cost of capital is 10%. The Active