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Chapter 10:
Common Stock Valuation
CHAPTER OVERVIEW
The coverage of
common stocks is divided into two chapters.
Chapter 10 covers the
valuation of stocks, while Chapter 11 focuses on the analysis and management of stocks.
In
addition, the chapter on efficient markets concludes
Part III because the concept is almost
entirely concerned with stocks as far as students in a beginning Investments course are
concerned.
Chapter 10 is one of the most important chapters in the text.
It covers the valuation of
common stocks in detail, including both the discounted cash flow approach and the P/E ratio
approach.
Clearly, students should know how to find the intrinsic value of a stock using the
capitalization of income approachthat is, they should know how to use the Dividend Discount
Modelas well as be familiar with how the P/E ratio is used in common stock valuation.
The chapter opens by explaining the present value approach to valuation.
This
capitalization of income method seeks to determine the value of a security (its intrinsic value) by
discounting all expected future cash flows using a required rate of return.
This discussion also
includes a brief consideration of the required rate of return and the expected cash flows.
The chapter centers around Discounted Cash Flow (DCF) techniques, which underlie a
true understanding of common stock valuation.
The traditional Dividend Discount Model
(DDM)
includes the three growth rate cases: zero growth, constant growth, and multiple growth.
Numerous examples are provided throughout.
The purpose of this analysis is to provide students
with the necessary insight into how stock valuation often relies on discounting expected cash
flows.
Students will be able to apply this knowledge to sove valuation problems, which are
found at the end of the chapter.
NOTE:
While the DDM has its limitations, and may in many cases not be used by practicing
security analysts and investors, it is essential that students understand this model as the basis for
valuation.
It is the classic, timehonored approach, and should be the beginning point when
learning common stock valuation techniques.
Furthermore, major providers of stock information
and recommendations, such as
, regularly calculate an intrinsic value for a
stock and talk about this intrinsic value.
Morningstar
also does this when it talks about “fair
value estimates.”
Therefore, the DDM cannot simply be dismissed as being not very useful in
the real world.
The essential points about the Dividend Discount Model are discussed, including
dividends vs. price in the model and the concept of intrinsic value itself.
A detailed analysis of
the constant growth model is highlighted in the Appendix by an example showing the present
value of the first 60 years of dividends, year by year.
The multiple growth model is fully
described, with examples.
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View Full Document DCFs techniques involving both free cash flow to equity and free cash flow to the firm
are discussed.
Differences between the two are considered.
Relative valuation techniques and target prices are considered as an alternative approach
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This note was uploaded on 02/13/2012 for the course FINA 3480 taught by Professor Moore during the Spring '11 term at Toledo.
 Spring '11
 Moore
 Stock Valuation, Valuation

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