If the analyst feels comfortable with his or her


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Unformatted text preview: nds on the assumptions made and the techniques used. Professional securities analysts typically use a variety of models and techniques to value stocks. For example, an analyst might use the constant-growth model, liquidation value, and price/earnings (P/E) multiples to estimate the worth of a given stock. If the analyst feels comfortable with his or her estimates, the stock would be valued at no more than the largest estimate. Of course, should the firm’s estimated liquidation value per share exceed its “going concern” value per share, estimated by using one of the valuation models (zero-, constant-, or variable-growth or free cash flow) or the P/E multiple approach, the firm would be viewed as being “worth more dead than alive.” In such an event, the firm would lack sufficient earning power to justify its existence and should probably be liquidated. 11. Generally, when the P/E ratio is used to value privately owned or closely owned corporations, a premium is added to adjust for the issue of control. This adjustment is necessary because the P/E ratio implicitly reflects minority interests of noncontrolling investors in publicly owned companies—a condition that does not exist in privately or closely owned corporations. 12. The price/earnings multiple approach to valuation does have a theoretical explanation. If we view 1 divided by the price/earnings ratio, or the earnings/price ratio, as the rate at which investors discount the firm’s earnings, and if we assume that the projected earnings per share will be earned indefinitely (i.e., no growth in earnings per share), the price/earnings multiple approach can be looked on as a method of finding the present value of a perpetuity of projected earnings per share at a rate equal to the earnings/price ratio. This method is in effect a form of the zerogrowth model presented in Equation 7.3 on page 325. CHAPTER 7 Stock Valuation 335 Review Questions 7–13 Describe the events that occur in an efficient market in response to new information that causes the expected return to exceed the required return. What happens to the market value? 7–14 What does the efficient-market hypothesis say about (a) securities prices, (b) their reaction to new information, and (c) investor opportunities to profit? 7–15 Describe, compare, and contrast the following common stock dividend valuation models: (a) zero-growth, (b) constant-growth, and (c) variablegrowth. 7–16 Describe the free cash flow valuation model and explain how it differs from the dividend valuation models. What is the appeal of this model? 7–17 Explain each of the three other approaches to common stock valuation: (a) book value, (b) liquidation value, and (c) price/earnings (P/E) multiples. Which of these is considered the best? LG6 7.4 Decision Making and Common Stock Value Valuation equations measure the stock value at a point in time based on expected return and risk. Any decisions of the financial manager that affect these variables can cause the value of t...
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