1.5 Overview: Valuation

What is a stock really worth?  How do you know if a stock price is “too high”? How do analysts forecast future price targets for stocks, or downgrade and upgrade them? The answers to these questions require some way to determine a value of a stock separately from the market price. This value is known as the intrinsic value.

There are different techniques used to calculate this intrinsic value.  The simplest is called the “dividend model,” covered in Chapter 6.  It takes the view that if you buy a stock, you receive the dividends that will be paid out in the future.  So the intrinsic value must equal the present value of the future dividends.  This requires forecasting future dividends and also the rate(s) at which these will be discounted.  Methods for forecasting future dividends as well as methods for discounting are discussed in Chapter 6.

The dividend model is admittedly simple.  With this model, the value of a firm that does not pay any dividends cannot be computed.  An extension that deals with this difficulty is the free cash flow to equity (FCFE) model, covered in Chapter 7.  It takes the view that what really matters is the cash that could have been paid out to the shareholders as a dividend as opposed to the actual dividend paid.  This is referred to as the “free cash flow to equity.”   The “to equity” means it’s the cash available after interest payments have been made and so this part is purely for shareholders.  This immediately resolves the problem in Chapter 6 because it applies to all firms not just those firms that actually pay a dividend.  For example, Google is capable of paying a dividend because it generates large amounts of FCFE even though its management chooses not to.

This model requires forecasting the future free cash flow to equity and the discount rate.  Forecasts are typically done using a growth rate, i.e., the future FCFE is the current FCFE multiplied by a growth factor.  Current FCFE can be calculated in many different ways; we cover the major variations in this textbook.  For example, you can start with the cash flow statement or start with the income statement.  In theory, these estimates should come out to be the same!  However, an important part of developing your practical skills and professional judgment is by working with the real world statements along with their measurement and aggregation issues to gain insight into why theory and practice often depart from each other.

Another approach is the residual income model, covered in Chapter 8.  This approach focuses more directly on the shareholder equity, defined as total assets minus total liabilities.  One way to think about shareholders’ equity is that if you liquidated the firm today, what would be left to distribute to shareholders is this value.  Over time, as the firm generates profits, the shareholders’ equity grows.  So the value of the stock must reflect the growth in shareholder equity.  So we need to forecast the future growth of shareholders’ equity and then discount all these to the preset to determine the intrinsic value.  The concept of residual income measures the change in shareholder equity.  In Chapter 8, we start with a simple example that explains these important concepts.  As you will see, this model gives you a nice economic understanding of how a firm creates value.

In Chapter 9, we discuss the abnormal earnings growth model.  This model focuses squarely on earnings, and argues that firms create value by producing earnings that are greater than expected, or “abnormal” earnings.  That is, Chapter 9’s valuation technique capitalizes expected earnings, in contrast to Chapter 8’s technique which anchors the valuation on current book value and computes the present value of expected residual earnings.  Both of these methods are sensitive to “dirty surplus” items that fail to be reflected in Comprehensive Income (CI).  CI is a measure of income that is relevant to the valuation models presented in Chapters 8 and 9 because it reflects all changes in shareholder equity that do not result from transactions with shareholders.  However, there are other items such as accounting for human capital where the treatment is incomplete under GAAP.  Furthermore, existing treatments under U.S. GAAP have different implications for the balance sheet and the income statement.  As a result, this incomplete and differential treatment of human capital can create important practical differences when applying the two valuation techniques presented in chapters 8 and 9.  In Chapter 9 we develop how to apply the Abnormal Earnings Growth model and include some discussion of real world imperfections an analyst must work with when implementing the accounting valuation models.

Finally, in Chapter 10, we look at firms that are distressed.  Consider a firm whose assets are smaller than its liabilities, so it is bankrupt.  Can it have a positive value?  The answer is yes, since the assets can grow over time.  The value depends on how fast it can grow and also how likely it is to become solvent.  This is captured by the Merton model.  We show you how to implement the model, and use a case study to value General Motors at the time of its bankruptcy in 2008.