An Introduction to International Capital Markets: Products, Strategies, Participants, Second Edition

10

Cash Flow Models in Equity Valuation

10.1 CHAPTER OVERVIEW

Multiples such as the price/earnings ratio are widely used to value shares. This is a relative valuation method. In an initial public offer the shares are often valued using the average p/e ratio for similar firms. This assumes that the sample is comparable and that the share prices in the sample are fairly valued. Discounted cash flow methods offer an alternative approach. This chapter explores models in which the expected dividend stream from a share is discounted to establish its fair value. It considers a version in which dividends continue to grow at a constant rate in perpetuity, and practical issues with applying such models. The links between dividend discount models and the p/e ratio and dividend yield are also explored. The chapter briefly considers the equity risk premium and the implications for stock market value. It then looks at how to estimate a fair or theoretical value for a firm by forecasting and discounting free cash flows. Firm or enterprise value is the total value of a company, debt plus equity. Cash flow models require a discount rate, which is the required return on the cash flows given the degree of risk. The chapter explores an industry standard model for establishing the discount rate and links between this model, portfolio theory, and the optimal levels of debt and equity in a firm.

10.2 THE BASIC DIVIDEND DISCOUNT MODEL

The return to a shareholder from owning a share consists in ...