STOCK VALUATION

Differences Between Debt & Equity

 Common Stock Valuation

 Stockholders expect to be compensated for their

investment in a firm’s shares through periodic
dividends and capital gains.

 Investors purchase shares when they feel they are

undervalued and sell them when they believe they are
overvalued.
 Common Stock Valuation
Market Efficiency
 Investors base their investment decisions on their
perceptions of an asset’s risk.

 In competitive markets, the interaction of many buyers

and sellers result’s in an equilibrium price – the market
value – for each security.

 This price is reflective of all information available to

market participants in making buy or sell investment
decisions.
 Common Stock Valuation
Market Adjustment to New Information
 The process of market adjustment to new information
can be viewed in terms of rates of return.
 Whenever investors find that the expected return is
not equal to the required return, price adjustment will
occur.
 If expected return is greater than required return,
investors will buy and bid up price until new
equilibrium price is reached.
 The opposite would occur if required return is greater
than expected return.
 Common Stock Valuation
The Efficient Market Hypothesis
 The efficient market hypothesis, which is the basic
theory describing the behavior of a “perfect” market
specifically states:
 Securities are typically in equilibrium, meaning they are
fairly priced and their expected returns equal their
required returns.
 At any point in time, security prices full reflect all public
information available about a firm and its securities and
these prices react quickly to new information.
 Because stocks are fairly priced, investors need not
waste time trying to find and capitalize on mis-priced
securities.
 individual investors form expectations rationally, markets
aggregate information efficiently, and equilibrium prices
incorporate all available information.
 EMH paradigm can be summarized in the “three P’s of Total
Investment Management” (see Lo, 1999): prices, probabilities,
and preferences
ADAPTIVE MARKET HYPOTHESIS

 Lo argues that an evolutionary perspective provides the missing

ingredient in Simon’s framework. The proper response to the
question of how individuals determine the point at which their
optimizing behavior is satisfactory is this: Such points are
determined not analytically, but through trial and error and, of
course, natural selection.
 The primary components of the AMH consist of the following
ideas: (A1) Individuals act in their own self-interest. (A2)
Individuals make mistakes. (A3) Individuals learn and adapt. (A4)
Competition drives adaptation and innovation. (A5) Natural
selection shapes market ecology. (A6) Evolution determines
market dynamics.
 SINGLE-PERIOD VALUATION MODEL

 Suppose you are thinking of purchasing the stock of Moore Oil, Inc. and you
expect it to pay a $2 dividend in one year and you believe that you can sell the
stock for $14 at that time. If you require a return of 20% on investments of
this risk, what is the maximum you would be willing to pay?

 Remember, the cash flows to the stockholder is simply the dividends received
+ the future sales price

D1 P1
Vc  
(1  k c ) (1  k c )
 SINGLE HOLDING PERIOD

You expect XYZ stock to pay a $5.50 dividend at the end of

the year. The stock price is expected to be $120 at that time.
If you require a 15% rate of return, what would you pay for
the stock now?

? 5.50 + 120

0 1
Ans: $ 109.13
 WHAT HAPPENS IF ?

The price of common stock is expected to grow at

the rate of g % annually ?
The current price P0 becomes Po(1+g) a year hence.

D1 Po (1  g ) D1
Po   
(1  k c ) (1  k c ) (k c  g )
 EXAMPLE

The expected dividend per share on the equity share of Roadking

Limited is Rs 2.00. The dividend per share of Roadking Limited has
grown over the past five years at the rate of 5 % per year. This
growth rate will continue in future. Further, the market price of the
equity share of Roadking Limited, too, is expected to grow at the
same rate. What is a fair istimate of the intrinsic value of the equity
share of Roadking Limited if the required rate is 15% ?

D1 2
Po    Rs 20.00
(k c  g) (0.15  0.05)
 EXPECTED RATE OF RETURN

What rate of return can the investor expect, given the current
market price and forecasted values of dividend and share price ?

Kc = (D1 / Po)+ g
 MULTI-PERIOD VALUATION
MODEL
 The value of a stock today (its current price) is in theory equal to
the present value of all future dividends plus that of the selling
price.

D1 D2 D3 D4 Dn Pn
P0      ...........  
1  k c (1  k c ) (1  k c ) (1  k c )
2 3 4
(1  k c ) n
(1  k c ) n
n
Dt Pn
 
t 1 (1  k c ) (1  k c ) n
t
 MULTI-PERIOD VALUATION MODEL

But common shares have no maturity period – they

may be expected to bring a dividend stream of infinite
duration

D1 D2 D3 D4 D
P0      ........... 
1  k c (1  k c ) 2 (1  k c )3 (1  k c ) 4 (1  k c ) 

Dt

t 1 (1  k c ) t
MULTI-PERIOD VALUATION
MODEL
 That was the generalized multi-period valuation
formula – which is general enough to permit any
dividend pattern – constant, rising, declining or
randomly fluctuating.

 For practical applications, it is helpful to make

simplifying assumptions about the pattern of
dividend growth.
 COMMONLY USED ASSUMPTIONS
TYPES:
1. The dividend per share remains constant forever, implying that the
growth rate is nil (THE ZERO GROWTH MODEL)
2. The dividend per share grows at a constant rate per year forever (THE
CONSTANT GROWTH MODEL)
3. The dividend per share grows at a constant rate for a finite period,
followed by a constant normal rate of growth forever thereafter (THE
TWO STAGE MODEL)
4. The dividend per share, currently growing at an above-normal rate,
experiences a gradually declining rate of growth for a while.
Thereafter it grows at a constant normal rate (THE “H” MODEL)
ZERO GROWTH MODEL

Assuming that the dividend per share remains

constant year after year, at a value of D, the valuation
model becomes as that of the perpetual preference
stock;
D D D D D
P0      ........... 
1  k c (1  k c ) (1  k c ) (1  k c )
2 3 4
(1  k c ) 
 D D
 
t 1 (1  k c )
t
kc
EXAMPLE

Suppose stock is expected to pay a $0.50

dividend every quarter and the required return is
10% with quarterly compounding. What is the
price?

D 0.5
P0    $ 20.00
k c 0.025
 CONSTANT GROWTH MODEL
Assumes that the dividend per share grows at a
constant rate (g)
D1 D1 (1  g) D1 (1  g) 2 D1 (1  g)3 D1 (1  g) n
P0      ...........  n 1
 .......
1  k c (1  k c ) 2
(1  k c ) 3
(1  k c ) 4
(1  k c )

With a little algebra, this reduces to:

D 0 (1  g) D1
P0  
kc - g kc - g
EXAMPLE 1
Suppose Big K, Inc. just paid a dividend of $5. It is
expected to increase its dividend by 2% per year.
If the market requires a return of 15% on assets of
this risk, how much should the stock be selling
for?

5(1  0.02) 5.10

P0    $ 39.23
0.15 - 0.02 0.13
EXAMPLE 2

Suppose Comolli, Inc. is expected to pay a $2

dividend in one year. If the dividend is expected to
grow at 5% per year and the required return is
20%, what is the price?

Ans: $ 13.33
EXAMPLE 3

Griggs Inc. last dividend (D0) was $2. The dividend growth rate
(g) is a constant 5%. If the required return (kc) = 10%, what is P0?

2(1.05)
P0   $42
(.10  .05)
 EXAMPLE 4

Overton Corp. just paid a $2 dividend. If the

dividends will grow at a constant rate of 5% in
the future, what is the stock price in 4 years (at t
= 4) assuming a required rate of return = 10%?

2.1 2.1(1  0.05) 2.1(1  0.05) 2 2.1(1  0.05)3

P0    
1  0.10 (1  0.10) 2
(1  0.10) 3
(1  0.10) 4
 => P4 = D5 / (r-g), where D5 = D0(1+g)5
 => D5 = $2(1.05)5 = $2.55
 => P4 = $2.55 / (.10-.05) = $51
 WHAT DRIVES GROWTH ?

 Most stock valuation models are based on the assumption that

dividends grow over time.
 What drives this growth ?
 The two major drivers of growth are :
a) Plough-back or Retention Ratio
b) Return on Equity (ROE)
 Growth = Retention Ratio x Return on Equity
 Illustration:
Omega limited has an equity (net worth) base of 100 at the
beginning of year 1. It earns a ROE of 20 %. It pays out 40 % of its
equity earnings and ploughs back 60 % of its equity earnings
 FINANCIALS OF OMEGA LIMITED

Year 1 Year 2 Year 3

Beginning Equity
ROE
Equity Earnings
Dividend Payout Ratio

Dividends
Retention Ratio
Retained earnings

What is the growth Rate of Dividend ?

 FINANCIALS OF OMEGA LIMITED

Year 1 Year 2 Year 3

Beginning Equity 100 112 125.44
ROE 20% 20% 20%
Equity Earnings 20 22.4 25.1
Dividend Payout Ratio 0.40 0.40 0.40
Dividends 8 8.96 10.04
Retention Ratio 0.60 0.60 0.60
Retained earnings 12 13.44 15.06
Growth Rate = RE x ROE = 0.60 x 20 %= 12 %
WHAT IS THIS GROWTH ACTUALLY ?

Sustainable growth rate =ROE  Retention ratio

Return on equity (ROE) = Net income / Equity

Retention ratio = 1 – Payout ratio
 ESTIMATION OF GROWTH

 The growth rate in dividends (g) can be

estimated in a number of ways.

Using the company’s historical

average growth rate.
Using an industry median or
average growth rate.
Using the sustainable growth
rate.
 TWO STAGE GROWTH MODEL
The simplest extension of the constant growth model assumes that
the extraordinary growth will continue for a finite number of years and
thereafter the normal growth rate will prevail indefinitely.

 D1 D1 (1  g1 ) D1 (1  g1 ) 2 D1 (1  g1 ) n 1  Pn
P0      ......   
1  k c (1  k c ) 2
(1  k c ) 3
(1  k c ) n
 (1  k c ) n

where, P0  current price of the equity share

D1  dividend expected a year hence
g1  extraordin ary growth rate applicable for n years
Pn  price of the equity share at the end of the year n
TWO STAGE GROWTH MODEL
(CONTD….)

The first term on the right hand side of above

equation is the PV of a growing annuity, and its
value is equal to:
REMINDER: PRESENT VALUE OF A GROWING
ANNUITY

If ,
D0(1  g)  cash flow at the end of 1st year
D0(1  g) 2  cash flow at the end of 2nd year
D0(1  g) n  cash flow at the end of nth year

 (1  r) n  (1  g ) n 
PV of growing annuity  D0(1  g)  n 
 (r  g )(1  r) 
This is true for g  r and g  r but not for g  r
TWO STAGE GROWTH MODEL
(CONTD….)

The first term on the right hand side of above equation is the
PV of a growing annuity, and its value is equal to:

  1  g n 
1   1
 
 1 kc  
D1 
k c  g1 
 
 
TWO STAGE GROWTH MODEL
(CONTD….)
Hence,

  1 g  n

1   1
 
 1 kc   Pn
P0  D1  
 (1  k ) n
k c  g1
  c

 
 TWO STAGE GROWTH MODEL
(CONTD….)

Since the two-stage growth model assumes that the growth rate
after n years remains constant at g2, Pn will be equal to:

D n 1
Pn 
kc  g2

where , D n 1  dividend for year (n  1)  D1 (1  g1 ) n 1 (1  g 2 )

g 2  growth rate in the second period
TWO STAGE GROWTH MODEL
(CONTD….)

Substituting the above expressions, we have:

  1  g n 
1   1
 
  1  k c    D1 (1  g1 ) (1  g 2 )  
n 1
1
P0  D1      
n 

k c  g1
 
k c  g1   (1  k c ) 
 
EXAMPLE:

The current dividend on an equity share of Vertigo Limited is Rs

2.00. Vertigo is expected to enjoy an above-normal growth rate
of 20% for a period of 6 years. Thereafter, the growth rate will
fall and stabilize at 10%. Equity investors require a return of 15
%. What is the intrinsic value of the equity share of Vertigo ?

g1 = 20 %, g2 = 10 %, n = 6 years, kc = 15%, D0 = Rs 2.00

Ans: Rs 79.597
EXAMPLE: GENERAL TWO-STAGE
DDM
 EXAMPLE: GENERAL TWO-STAGE
DDM
Step 1: Calculate the first three dividends:
• D1 = $2.00 x (1.15) = $2.30
• D2 = $2.30 x (1.15) = $2.6450
• D3 = $2.6450 x (1.15) = $3.0418
Step 2: Calculate the Year 4 dividend:
• D4 = $3.0418 x (1.04) = $3.1634
Step 3: Calculate the value of the constant growth
dividends:
• V3 = $3.1634 / (0.10 – 0.04) = $52.7237
EXAMPLE: GENERAL TWO-STAGE
DDM
$2.30 $2.6450 $3.0418 $52.7237
V0    
1.10 1.102 1.103 1.103
V0  $46.17
H MODEL

The H-model assumes an initially high rate of growth that

declines linearly over a specified period (2H) until it reaches
a normal rate that exists in perpetuity. An example would be
a firm facing competition that is expected to increase.
Growth declines as competitors enter the market and then
stabilizes as the industry matures.
H - MODEL
 TWO-STAGE H-MODEL

 D0  1  g L     D0  H  g S  g L  
V0 
r  gL

In the formula shown:

H = half-life (in years) of high-growth period

gS = short-term growth rate
gL = long-term growth rate
r = required equity return
H MODEL

 The formula assumes that the high-growth period lasts 2 x H years.

Stocks with longer high-growth periods and greater high-growth rates
will have higher values. Note that the H-model provides the
approximate stock value. It is less accurate when there are very long
growth periods (high H) and large differences between gS and gL. In
this case, a spreadsheet can be helpful for valuing the stock.
EXAMPLE: TWO-STAGE H-MODEL

Current dividend $3.00

gs 20%
gL 6%
H 5
Required return on stock 10%
Current stock price $120
EXAMPLE: TWO-STAGE H-MODEL
 D0  1  g L     D0  H  g S  g L  
V0 
r  gL

$3  1  0.06    $3  5  0.20  0.06  

V0 
0.10  0.06
V0  $79.50  $52.50  $132.00
NON-CONSTANT GROWTH

 Suppose a firm is expected to increase dividends

by 20% in one year and by 15% in two years. After
that dividends will increase at a rate of 5% per year
indefinitely. If the last dividend was $1 and the
required return is 20%, what is the price of the
stock?

 Remember that we have to find the PV of all

expected future dividends.
NON-CONSTANT GROWTH –
SOLUTION
 Compute the dividends until growth levels off
 D1 = 1(1.2) = $1.20
 D2 = 1.20(1.15) = $1.38
 D3 = 1.38(1.05) = $1.449
 Find the expected future price (by using the final dividend
calculation)
 P2 = D3 / (k – g) = 1.449 / (.2 - .05) = 9.66
 Find the present value of the expected future cash flows
 P0 = 1.20 / (1.2) + (1.38 + 9.66) / (1.2)2 = 8.67
NON-CONSTANT GROWTH

 The Green Shoe Company’s last dividend paid (D0)

was $1.00. Dividends are projected to grow at a
rate of 7% per year for the next 2 years, 5% per
year for the 3rd year, and starting with year 4 they
will grow at a constant rate of 4%, forever. If the
required return on the stock is 12%, what is the
price of the stock today?
 Calculations:
 D1 = 1(1.07) = 1.07
 D2 = 1.07(1.07) = 1.14
 D3 = 1.14(1.05) = 1.20
 D4 = 1.20(1.04) = 1.25
 P3 = 1.25 / (.12-.04) = $15.63

 1.07 / (1.12) +
 1.14 / (1.12)2 +
 (15.63 + 1.20) / (1.12)3
 = 13.85
NON-CONSTANT GROWTH

 At times, a new company may pay no dividends early in its life

but start paying dividends that grow at a constant rate some
time in the future.
 At other times, a new company may pay small dividends initially
and, at some point in the future, start paying dividends that
grow at a constant rate.
 However, as always, the value of the stock is the present value of
all future dividends.
 Many cash flow scenarios are possible in this situation.
COMPONENTS OF REQUIRED
RETURN
 Thus far, the discount rate or required rate of return has been
given to us.
 Later chapters have more to say about this, but for now, using
the dividend growth model, lets analysis the required rate of
return:

Rearranging:
kc = r = D1/P0 + g

where, D1/P0 = the dividend yield

g = the capital gains yield
 COMPONENTS OF REQUIRED RETURN

 Hence, Total Return on Common Stock has two components:

 Dividend Yield
 Capital Gains Yield.

Return = Dividend Yield + Capital Gains Yield

D t Pt  Pt 1
r 
Pt 1 Pt 1
 ILLUSTRATION:

We observe a stock selling for $ 20 per share. The next dividend will be
$ 1 per share. You think that the dividend will grow by 10 % per year
more or less indefinitely. What return does this stock offer you if this is
correct ?
Return = DividendYield + Capital GainsYield
r = D1/P0 + g
= 1 / 20 + 0.10
= 0.05 + 0.10
= 0.15
i.e. 15 %
 VERIFICATION

We can verify this answer by calculating the price in one year P1 , using 15 % as the
required return.

P1 = D1 (1+g) / (r – g)
= $ 1 x 1.10 / (0.15 -0.10)
= $ 22

 $ 22 is 10 % more than $ 20, so the stock price has grown by 10 %

 If you buy the stock today in $ 20, it’ll pay $ 1 dividend at the end of the year, and
you’ll gain $ 2 by selling it.
 Dividend yield is thus $ 1 / 20 = 0.05 i.e. 5%
 Capital gains yield is thus $ 2 /20 = 0.10 i.e. 10 %
 So your Total return would be 5 % + 10 % = 15 %
ISSUES USING THE GORDON GROWTH
MODEL

Strengths Limitations
Simple and applicable to stable, Not applicable to non-dividend-
mature firms paying firms

Can be applied to entire markets g must be constant

g can be estimated using macro Stock value is very sensitive to r

data –g

Can be applied to firms that Most firms have nonconstant

repurchase stock growth in dividends
VALUATION OF COMMON
STOCK USING MULTIPLES
PRICE RATIO ANALYSIS

 Price-earnings ratio (P/E ratio)

 Current stock price divided by annual earnings per share
(EPS).
 Earnings yield
 Inverse of the P/E ratio: earnings divided by price (E/P).
 High-P/E stocks are often referred to as growth stocks, while
low-P/E stocks are often referred to as value stocks.
PRICE RATIO ANALYSIS

 Price-cash flow ratio (P/CF ratio)

 Current stock price divided by current cash flow per
share.
 In this context, cash flow is usually taken to be net
income plus depreciation.
 Most analysts agree that in examining a company’s financial
performance, cash flow can be more informative than net
income.
 Earnings and cash flows that are far from each other may be a
signal of poor quality earnings.
PRICE RATIO ANALYSIS

 Price-sales ratio (P/S ratio)

 Current stock price divided by annual sales per share.
 A high P/S ratio suggests high sales growth, while a low
P/S ratio suggests sluggish sales growth.
 Price-book ratio (P/B ratio)
 Market value of a company’s common stock divided by
its book (accounting) value of equity.
 A ratio bigger than 1.0 indicates that the firm is creating
value for its stockholders.
PRICE RATIO ANALYSIS

Intel Corp (INTC) - Earnings (P/E) Analysis

Current EPS $1.35
5-year average P/E ratio 30.4
EPS growth rate 16.5%
expected = historical  projected EPS
stock price P/E ratio
= 30.4  ($1.351.165)
= $47.81
PRICE RATIO ANALYSIS

Intel Corp (INTC) - Cash Flow (P/CF) Analysis

Current CFPS $1.97
5-year average P/CF ratio 21.6
CFPS growth rate 15.3%
expected = historical  projected CFPS
stock price P/CF ratio
= 21.6  ($1.971.153)
= $49.06
PRICE RATIO ANALYSIS

Intel Corp (INTC) - Sales (P/S) Analysis

Current SPS $4.56
5-year average P/S ratio 6.7
SPS growth rate 13.3%
expected = historical  projected SPS
stock price P/S ratio
= 6.7  ($4.561.133)
= $34.62
P/E RATIO APPROACH

P0
P0  E1 
E1
where, P0  Estimated Price
E1  Estimated EPS
P0
 Justified P/E Ratio
E1
 DETERMINANTS OF P/E RATIO
According to Constant Growth Dividend Discount Model

D1 E1 (1  b)
P0  
r - g r  ROE  b
P0 (1  b)

E1 r  ROE  b

where , b  ploughback or retention ratio

DETERMINANTS OF P/E RATIO

Factors that determine the P/E ratio are:

1. The dividend payout ratio, (1-b)

2. The required rate or return, r
a) Interest Rate
b) Risk
3. The expected growth rate, g = ROE x b
PRESENT VALUE OF GROWTH
OPPORTUNITIES

E1
V0   PVGO
r
E1
PVGO  P0 
r
PRESENT VALUE OF GROWTH
OPPORTUNITIES
E1
V0   PVGO
r
P0 1 PVGO
 
E1 r E1
EXAMPLE: PRESENT VALUE OF
GROWTH OPPORTUNITIES

Stock price $80 .00

Expected earnings $5 .00

Required return on stock 10%

 EXAMPLE: PRESENT VALUE OF
GROWTH OPPORTUNITIES
E1
PVGO  P0 
r
5
PVGO  $80   $30
0.10
EXAMPLE: PRESENT VALUE OF
GROWTH OPPORTUNITIES
P0 1 PVGO
 
E r E
P0 1 30
 
E 0.10 5
16  10  6
STOCK VALUATION MODELS:
FREE CASH FLOW MODEL

 The free cash flow model is based on the same

premise as the dividend valuation models except
that we value the firm’s free cash flows rather than
dividends.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 74

MOVING ON UP: THE “POTENTIAL
DIVIDENDS” OR FCFE MODEL

75
TO VALUING THE ENTIRE BUSINESS:
THE FCFF MODEL

76
SAME INGREDIENTS, DIFFERENT
APPROACHES…
Input Dividend Discount FCFE (Potential FCFF (firm)
Model dividend) discount valuation model
model
Cash flow Dividend Potential dividends FCFF = Cash flows
= FCFE = Cash before debt
flows after taxes, payments but after
reinvestment reinvestment
needs and debt needs and taxes.
cash flows
Expected growth In equity income In equity income In operating
and dividends and FCFE income and FCFF
Discount rate Cost of equity Cost of equity Cost of capital
Steady state When dividends When FCFE grow When FCFF grow
grow at constant at constant rate at constant rate
rate forever forever forever

77 77
STOCK VALUATION MODELS:
FREE CASH FLOW MODEL (CONT.)

 The free cash flow valuation model estimates the

value of the entire company and uses the cost of
capital as the discount rate.
 As a result, the value of the firm’s debt and
preferred stock must be subtracted from the value
of the company to estimate the value of equity.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 78

 STOCK VALUATION MODELS:
FREE CASH FLOW MODEL (CONT.)
Dew Inc. wishes to value its stock using the free cash flow model.
To apply the model, the firm’s CFO developed the data given in Table

Table Dew, Inc.’s Data for the Free Cash Flow Valuation Model

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 79

STOCK VALUATION MODELS:
FREE CASH FLOW MODEL (CONT.)
Step 1. Calculate the present value of the free cash flow
occurring from the end of 2012 to infinity, measured at
the beginning of 2012.

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 STOCK VALUATION MODELS:
FREE CASH FLOW MODEL (CONT.)

Step 2. Add the PV (in 2011) of the FCF for 2012 found in
Step 1 to the FCF for 2011 to get total FCF for 2011.

Total FCF2011 = $600,000 + $10,300,000 = $10,900,000

Step 3. Find the sum of the present values of the FCFs for
2007 through 2011 to determine, VC, and the market values
of debt, VD, and preferred stock, VP, given in Table 7.5 on the
following slide.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 81

STOCK VALUATION MODELS:
FREE CASH FLOW MODEL (CONT.)

Calculation of the Value of the Entire

Company for Dew, Inc.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 82

STOCK VALUATION MODELS:
FREE CASH FLOW MODEL (CONT.)

Step 4. Calculate the value of the common stock using

equation 7.8. Substituting the value of the entire
company, VC, calculated in Step 3, and the market value
of the debt, VD, and preferred stock, VP, yields the value
of the common stock, VS.

VS = $8,628,620 - $3,100,000 = $4,728,620

P0 = $4,728,628 / 300,000 shares = $15.16 per share

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 83

OTHER APPROACHES TO STOCK
VALUATION: BOOK VALUE

 Book value per share is the amount per share that

would be received if all the firm’s assets were sold
for their exact book value and if the proceeds
remaining after paying all liabilities were divided
among common stockholders.
 This method lacks sophistication and its reliance
on historical balance sheet data ignores the firm’s
earnings potential and lacks any true relationship
to the firm’s value in the marketplace.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 84

OTHER APPROACHES TO STOCK
VALUATION: LIQUIDATION VALUE

 Liquidation value per share is the actual amount

per share of common stock to be received if al of
the firm’s assets were sold for their market values,
liabilities were paid, and any remaining funds were
divided among common stockholders.
 This measure is more realistic than book value
because it is based on current market values of the
firm’s assets.
 However, it still fails to consider the earning power
of those assets.

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 85