Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

APPENDIX 6E: SELECTED VALUATION METHODS

This appendix reviews six widely used methods: the single-stage constant-growth discounted cash flow (DCF) model, the multistage DCF model, the so-called H-model, the price-to-earnings ratio (P/E) approach, the price-to-sales ratio (P/S) approach, and the price-to-book-value (P/B) approach.

Single-Stage Constant-Growth DCF Model

The single-stage constant-growth DCF model values a stock by taking the present value of the cash flows the investment is expected to generate. In practice, this approach implies that an investor or analyst must estimate the company’s future earnings per share, project the proportion of earnings that will be paid out as dividends in the future, and calculate the present value of the expected stream of cash flows at the appropriate risk-adjusted discount rate. The single-stage approach assumes that the expected rate of growth will persist indefinitely and that the appropriate discount rate exceeds that growth rate (i.e., growth is “normal”). The basic form of the model is:

where P0 is the current appropriate or intrinsic value of the stock, dt is the dividend expected in period t, k is the appropriate risk-adjusted discount rate, d0 is the initial dividend, and g is the expected constant rate of dividend growth.

An equivalent form of the model, restated to facilitate making the necessary calculations, is:

This form ...