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Unformatted text preview: nds on the assumptions made and the techniques used. Professional
securities analysts typically use a variety of models and techniques to value
stocks. For example, an analyst might use the constant-growth model, liquidation
value, and price/earnings (P/E) multiples to estimate the worth of a given stock. If
the analyst feels comfortable with his or her estimates, the stock would be valued
at no more than the largest estimate. Of course, should the firm’s estimated liquidation value per share exceed its “going concern” value per share, estimated by
using one of the valuation models (zero-, constant-, or variable-growth or free
cash flow) or the P/E multiple approach, the firm would be viewed as being
“worth more dead than alive.” In such an event, the firm would lack sufficient
earning power to justify its existence and should probably be liquidated. 11. Generally, when the P/E ratio is used to value privately owned or closely owned corporations, a premium is
added to adjust for the issue of control. This adjustment is necessary because the P/E ratio implicitly reflects minority interests of noncontrolling investors in publicly owned companies—a condition that does not exist in privately or
closely owned corporations.
12. The price/earnings multiple approach to valuation does have a theoretical explanation. If we view 1 divided by
the price/earnings ratio, or the earnings/price ratio, as the rate at which investors discount the firm’s earnings, and if
we assume that the projected earnings per share will be earned indefinitely (i.e., no growth in earnings per share), the
price/earnings multiple approach can be looked on as a method of finding the present value of a perpetuity of projected earnings per share at a rate equal to the earnings/price ratio. This method is in effect a form of the zerogrowth model presented in Equation 7.3 on page 325. CHAPTER 7 Stock Valuation 335 Review Questions
7–13 Describe the events that occur in an efficient market in response to new
information that causes the expected return to exceed the required return.
What happens to the market value?
7–14 What does the efficient-market hypothesis say about (a) securities prices,
(b) their reaction to new information, and (c) investor opportunities to
7–15 Describe, compare, and contrast the following common stock dividend
valuation models: (a) zero-growth, (b) constant-growth, and (c) variablegrowth.
7–16 Describe the free cash flow valuation model and explain how it differs
from the dividend valuation models. What is the appeal of this model?
7–17 Explain each of the three other approaches to common stock valuation:
(a) book value, (b) liquidation value, and (c) price/earnings (P/E) multiples. Which of these is considered the best? LG6 7.4 Decision Making and Common Stock Value
Valuation equations measure the stock value at a point in time based on expected
return and risk. Any decisions of the financial manager that affect these variables
can cause the value of t...
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