3.3 Equity Valuation Methods
Equity valuation models bridge macroeconomic forecasting and microeconomic balance sheet analysis to determine intrinsic share value.
Key NASAA Exam Takeaways
- Dividend Discount Model (DDM) values a share as the present value of all expected future dividends.
- Gordon Growth Model: Value = D1 / (k - g), where D1 is next year's dividend, k is required return, and g is constant dividend growth rate.
- Price-to-Earnings (P/E) evaluates market expectations: Growth stocks feature high P/E ratios, value stocks low P/E ratios.
- Discounted Cash Flow (DCF) models enterprise value by discounting forecasted free cash flows to the present.
Gordon Growth Model Valuation
A stock just paid an annual dividend of $2.00 (D0). Dividends are projected to grow at a constant 5% per year. If the client's required return is 9%, what is the intrinsic value per share?
- Calculate D1: D0 * (1 + g) = $2.00 * 1.05 = $2.10.
- Subtract growth from required return: k - g = 0.09 - 0.05 = 0.04.
- Divide D1 by (k - g): $2.10 / 0.04 = $52.50.
Result: Intrinsic Value = $52.50 per share.
Interactive Knowledge Checkpoint • Section 3.3
Using the Gordon Growth Model, what happens to the estimated intrinsic value of a stock if the expected dividend growth rate (g) increases while the required return (k) remains constant?