Corporate Finance

Valuing Stocks

Philipp Krüger
Lecture objectives
• How to apply the Dividend – Discount Model?

• Understanding and being able to apply other models for

valuation (e.g. Free Cash Flow Valuation Model)

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Overview
• Dividend-Discount Model
• Free Cash Flow valuation model

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The setting
• You are a partner at Barclays private equity fund, bidding for
the Basel airport
– What is the price of the Basel airport?
– How much should you bid?

• You observe that the stock price of Novartis drops by 6%

because the president, who has been with the company for
15 years, is resigning
– Why would the stock be suddenly worth 6% less on the
announcement of this news?
– What actions can the managers of Novartis take to increase the stock
price?

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Dividend-Discount Model
• The Law of One Price implies that to value any security, we
must determine the expected cash flows an investor will
receive from owning it.
• We first look at a one-year investor.
• Two potential sources of cash flows:
– Dividend
– Sale of stock
• Timeline for a one-year investor:

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Dividend-Discount Model
• Future dividend payment and stock price are not known with
certainty.
• They are based on the investor’s expectations at the time the
stock is purchased.
• Given these expectations, the investor will be willing to buy
the stock at today’s price as long as the NPV of the transaction
is not negative
• Because the cash flows are risky, we must discount them at
the equity cost of capital, rE, for the stock.
• It is the expected return of other investments available in the
market with equivalent risk to the firm’s shares.

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Dividend-Discount Model
• The stock price must satisfy:

 Div1 + P1 
P0 =  
 1 + rE 

• If the current stock price were less than this amount, investors
would rush in and buy it, driving up the stock’s price.
• If the stock price exceeded this amount, selling it would cause
the stock price to quickly fall.

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Dividend-Discount Model
Div1 + P1 Div1 P1 − P0
rE = − 1 = +
P0 P0 P0
Dividend Yield Capital Gain Rate

• Dividend yield
• Capital gain and capital gain rate
• Total return = dividend yield + capital gain rate
• The expected total return of the stock should equal the
expected return of other investments available in the market
with equivalent risk.

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Dividend-Discount Model

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Dividend-Discount Model

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Dividend-Discount Model
• What is the price if we plan on holding the stock for two
years?

Div1 Div2 + P2
P0 = +
1 + rE (1 + rE ) 2

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Dividend-Discount Model
• What is the price if we plan on holding the stock for N years?

Div1 Div2 DivN PN

P0 = + + + +
1 + rE (1 + rE ) 2
(1 + rE ) N (1 + rE ) N

• This is know as the Dividend Discount Model.

• This equation holds for any horizon N.

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Dividend-Discount Model
• Letting N go to infinity yields:

Div1 Div2 Div3 Divn
P0 =
1 + rE
+
(1 + rE )2
+
(1 + rE )3
+ = 
n =1 (1 + rE )n

• The price of any stock is equal to the present value of the

expected future dividends it will pay.

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Dividend-Discount Model
• Estimating dividends – especially for the distant future – is
difficult.

• A common approximation is to assume that in the long run,

dividends will grow at a constant rate.

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Dividend-Discount Model
• In the Constant Dividend Growth Model, the value of the
firm depends on
– The current dividend level
– The cost of equity
– The growth rate

Div1 Div1
P0 = rE = + g
rE − g P0

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Dividend-Discount Model

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Dividend-Discount Model
• Limitations of the Dividend-Discount Model

– There is a tremendous amount of uncertainty associated with

forecasting a firm’s dividend growth rate and future dividends.

– Small changes in the assumed dividend growth rate can lead to large
changes in the estimated stock price.

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Free Cash Flow Valuation
• In the Dividend Discount Model, we directly value the firm’s
equity (stock price).

• The discounted free cash flow model begins by determining

the total value of the firm to all investors – both equity and
debt holders.

Enterprise value = Market value of equity + Debt – Cash

• The enterprise value can be interpreted as the net cost of

acquiring the firm’s equity, taking its cash, paying off all debt,
and owning the unlevered business.

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Free Cash Flow Valuation
• In this model, the enterprise value of the firm is given by

• And the share price satisfies

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Free Cash Flow Valuation
• A key difference between this and the Discounted Dividend
Model is the discount rate.

• In previous calculations, we used the firm’s equity cost of

capital, rE, because we were discounting the cash flows to
equity holders.

• Here we are discounting the free cash flow that will be paid to
both debt and equity holders. Thus we need to use the firm’s
weighted average cost of capital, rWACC.

• If the firm has no debt rE = rWACC

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Free Cash Flow Valuation
• Implemeting the Model

FCF1 FCF2 FCFN VN

V0 = + + + +
1 + rwacc (1 + rwacc ) 2
(1 + rwacc ) N (1 + rwacc ) N

• Often, the terminal value is estimated by assuming a constant

long-run growth rate gFCF for free cash flows beyond year N,
so that:

FCFN + 1  1 + g FCF 
VN = =    FCFN
rwacc − g FCF  (rwacc − g FCF ) 

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Free Cash Flow Valuation

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Free Cash Flow Valuation

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Free Cash Flow Valuation
• Connection to Capital Budgeting:

– The firm’s free cash flow is equal to the sum of the free cash flows
from the firm’s current and future investments, so we can interpret
the firm’s enterprise value as the total NPV that the firm will earn from
continuing its existing projects and initiating new ones.

– The NPV of any individual project represents its contribution to the

firm’s enterprise value. To maximize the firm’s share price, we should
accept projects that have a positive NPV.

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