7: Valuation of Financial Assets—Stocks
- Page ID
- 150117
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Figure 7.0 Chapter concept map illustrating the major equity valuation frameworks, payout policies, market-based comparisons, and market-context considerations developed in this chapter.
Equity valuation focuses on estimating the intrinsic value of a company’s common stock—the value implied by its expected future cash flows, risk, and growth prospects. By comparing intrinsic value to the stock’s observed market price, investors and financial managers can assess whether a stock appears undervalued, fairly valued, or overvalued in the marketplace.
This chapter extends the time value of money framework developed in earlier chapters to the valuation of equity securities. Unlike bonds, which promise fixed contractual payments over a defined life, common stock represents an ownership claim on a firm’s residual cash flows. These cash flows are uncertain, potentially perpetual, and influenced by firm performance, growth opportunities, and payout decisions.
Because equity cash flows are neither fixed nor finite, valuing common stock requires a combination of disciplined quantitative analysis and informed judgment. Analysts must form expectations about future cash flows, assess the risk associated with those cash flows, and evaluate how growth and reinvestment opportunities affect long-term value. As a result, equity valuation is inherently more assumption-driven than bond valuation, yet it follows a structured analytical logic.
Throughout this chapter, you will examine the primary valuation approaches used by professional analysts, portfolio managers, and corporate finance decision-makers, including:
- Dividend-based valuation models, which view equity value as the present value of expected future dividends.
- Growth-based extensions of dividend models that reflect different stages of a firm’s life cycle.
- Relative (price-multiple) valuation, which infers value from comparable firms using ratios such as price-to-earnings, price-to-book, and price-to-sales.
- The relationship between intrinsic value and market price under varying assumptions about market efficiency and investor behavior.
All valuation approaches in this chapter are grounded in the same present value logic introduced earlier in the text. What differs across models is how expected cash flows are defined, how growth is incorporated, and how risk is reflected in required returns. Later sections will introduce these models formally and apply them using numerical examples, timelines, and calculator-based techniques.
By the end of the chapter, you will be equipped to evaluate equity investments using both fundamental valuation models and relative market comparisons, and to interpret why market prices may deviate from intrinsic value in practice.
Learning Outcomes
- Describe the fundamental characteristics of common stock and equity ownership.
- Apply dividend-based valuation models under different growth assumptions.
- Use price-multiple approaches to estimate equity value through relative valuation.
- Interpret differences between intrinsic value and observed market price.