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

FUNDAMENTAL ANALYSIS

In addition to screening the universe of stocks into a more manageable set, traditional valuation methods can be used to look for insights into how a company is priced in the market relative to its factual, historical record and relative to any predictions about its future economic performance. This process is typically called fundamental analysis, and the DDM is an often-used application in this context.

Growth and Discount Rates

A two-stage DDM can be used to isolate the valuation impact of growth and discount rates. For simplicity, assume that the first stage runs for 10 years and that the company has growth in excess of the mature growth rate for that 10-year period. The second stage is the mature stage; assume that the company will grow at the average long-term historical earnings growth rate of the S&P 500 from Year 11 through eternity. This framework allows an analyst to pose some interesting questions regarding the growth and discount rates that are embedded in an observed stock price.

Suppose, for instance, that the two-stage DDM is applied to the stock of Microsoft Corporation and International Paper (IP). On September 30, 1997, as shown in Table 7.6, Microsoft’s stock price was $132.31 and IP’s stock price was $55.00. With second-stage growth constant at 6.50 percent annually (which is the S&P 400 Industrials long-term growth rate) for both companies and first-stage annual growth estimates generated by Wall Street of 23.80 percent for Microsoft and ...