Question
Asked Jul 28, 2019
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Case Study #3: Chapter 6 Business Analysis 

A business can be valued by capitalizing its earnings stream. 

  • What financial figures associated with shares of stock might be used in the calculation. Consider the per share figures and ratios discussed in chapter 3 including EPS, dividends, book value per share etc. 
  • Does one measure make more sense than the others?
  • What factors would make a stock worth more or less than your calculated value?
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Expert Answer

Step 1

A business can be valued by capitalizing its earnings stream. In fact, the valuation of any asset or business is nothing but present value of all the future cash flows it can generate. We therefore capitalize the cash flows streams to get the value of the business.

Step 2

What financial figures associated with shares of stock might be used in the calculation. Consider the per share figures and ratios discussed in chapter 3 including EPS, dividends, book value per share etc.

The financial figures associated with shares of stock that might be used in calculation are:

  • Dividend per share: Capitalization of dividends per share give rise to valuation using Dividend Discount Models
  • Earnings per share adjusted for payout i.e. EPS x Dividend payout ratio. In this case this transalates into Dividend per share or DPS and capitalization of EPS through this route converges with Dividend Discount Models
  • Free Cash flows per share (FCFE or FCFF per share): Capitalization of cash flows per share give rise to Discounted cash flow models.
  • Residual earnings per share = RI = EPS - charge on capital per share. Capitalization of residual earnings per share gives rise to residual income methods of valuation.
Step 3

Does one measure make more sense than the others?

All the methods of valuations have their own merits and demerits. Amongs the parameters discussed in earlier step:

  1. The capitalization of free cash flows per share is most popular and relevant in the industry. And this also makes the most sense because it's in line with the fundamental concept of valuation that: Value of an asset or ...

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