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

CHAPTER 8

A SIMPLE VALUATION MODEL AND GROWTH EXPECTATIONSa

Morris G. Danielson

A simple valuation model is presented in which a firm can invest in projects with positive net present values for a limited number of years. Although prior models have made this assumption, this model can be simplified to a concise, easy-to-use form. The model can facilitate a broad understanding of the expectations implied by a firm’s stock price—for example, growth patterns consistent with a firm’s P/E—which can guide in-depth analysis of prices.

The valuation model presented here provides a simple, concise method for analyzing stock prices. The model is similar to the finite-horizon model described by Gordon and Gordon (1997), in that both models assume a firm can invest in projects with positive net present values (NPVs) for a limited number of years.1 The two models differ, however, in their treatment of earnings in excess of the amount invested in positive-NPV projects. In the Gordon and Gordon model, the firm pays these amounts as dividends. In the new model, the firm invests these amounts in projects with NPVs equal to zero. Although the two models predict similar stock prices, the new model can be simplified to a more tractable form. The resulting model combines the computational ease of the perpetual-growth model with the more realistic finite-growth assumption.

Gordon and Gordon used the finite-growth model to estimate expected stock returns in a test of the capital asset pricing model (CAPM). ...