1. Common Stock Valuation:
Fundamental Analysis Using A
Discounted Cash Flow Model
Presented by:
Allen D. Hahn, CFA, ASA, CMT
October 23, 2013
 Introductions
 Are we going to
have more formulas?
No….maybe 1
 Framework for
using a Discounted
Cash Flow approach to
value common stock
 Considerations
beyond formulas when
valuing common stock
 Build Excel
Spreadsheet DCF
model

2. “Only a Fool thinks Price and Value are
the Same”
Value is never a fact but always an opinion of
the worth of an asset
Price is a fact; it is the amount asked, offered
or paid for an asset
2
 Value is the
monetary relationship
between property and
buyer/seller
 The term Value is
always qualified by
either market,
investment or
liquidation
 Financial
capabilities,
motivations or special
interests often
influence price
 The price paid for
an asset may or may
not have any relation
to the Value that
might be ascribed to it
by others

3. What are the Characteristics that Give
Common Stock Value ?
3
 Works well on the
wall in a man-cave
 Provides economic
benefits to its owners
 It may have the
ability to be readily
transformed into cash
 Can be grouped
with similar assets to
transform the
risk/reward profile of
a portfolio
 Its appreciation is
unconstrained but its
loss is limited
 As pro rata owner,
provides a vote on key
policies of the
company
 A legalized form of
gambling

4. Aren’t the Prices of Common Stock
Available On-line?
Dispute Resolution
Gift and Estate Tax Filings
Acquisition
ESOP Annual Reporting
Reorganization in Bankruptcy Proceedings
Semi-liquid common stock
4
 All companies do
not issue common
stock that is publicly-
traded
 Private companies
have valuations
performed on common
stock for many
different purposes
 The purpose of the
valuation defines the
“rules” of the
analysis…no one size
fits all

5. The Valuation Process
5
 Understand the
business
 Forecast company
performance
 Select appropriate
valuation model
 Convert forecasted
company performance
into an estimate of
value
$11,756,338 $11,756,338
$3,532,668
Accounting Balance Sheet Market Value Balance Sheet
Current Liabilities
$1,552,726
Intangible Assets
$50,000
Market Value
Equity
$11,706,338
Fixed Assets
$7,776,685
Other Assets
Interest Bearing
Long Term Debt
$6,670,945
Book Value
Fixed Assets
$46,360
Other Assets
$7,776,685
$11,706,338
$46,360
Interest Bearing
Long Term Debt
$6,670,945
$3,482,668
Current Liabilities
$1,552,726
Current Assets
$3,883,292
Current Assets
$3,883,292

6. The Song Remains the Same or Same
as it always was….
Suppose that a stock will pay three annual dividends of
$200 per year, and the appropriate risk-adjusted
discount rate, k, is 8%.
In this case, what is the value of the stock today?
6
 Represents a
fundamental principle
in theoretical finance
 Dividends are one
characteristic among
many attributes that
contribute to the value
of common stock
 Strict interpretation
of formula can result
in material errors:
decay function
 Courts,
practitioners and
security analysts
recognize this
representation as an
oversimplification of a
complex process
     
     
$515.42
0.081
$200
0.081
$200
0.081
$200
V(0)
k1
D(3)
k1
D(2)
k1
D(1)
V(0)
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7. The Dividend Dilemma
The only cash flow an investor will receive
from holding a share of common stock is a
dividend
Actual dividends may vary greatly from a firm’s
dividend potential
When potential dividends exceed those
actually paid, using a model focused only on
dividends will under-estimate the market value
of the equity in a firm
7
 Dividends can be
from continuing
operations, specially
declared or
liquidating; PIK
shares are not
considered cash flows
 Behavior of firm
managers is
conservative, smooth
dividends and reserve
assets to meet
unforeseen future
contingencies or
investment
opportunities
 Dividend Discount
Models are useful for
firms that pay
dividends close to
potential (REITs)

8. A Company’s Earnings is not a Proxy for
Its Dividend Potential
8
The income statement is
not a substitute for the
statement of cash flows
 Earnings support a
company’s dividend
but do not represent
dividend potential
 Earnings contain
non-cash revenues
and expenses
 Earnings based
valuation models
ignore a firm’s
required capital
investment and
financing activities
 A valuation model
that uses discounted
earnings is likely to
over estimate the
value of common
equity

9. Defining Potential Dividends as Free
Cash Flow to Equity (FCFE)
9
FCFE for a Levered Firm:
Net Income
+/- Non-cash items
+/- Changes in non-cash Working Capital
+/- Capital Investments
+/- Additional Borrowings or Repayment
= FCFE
 FCFE is dividend
potential after
required investment
for future growth and
net debt obligations
 If preferred stock
exists, preferred
dividends should also
be deducted
 Definition implicitly
removes financial
discretion from firm’s
managers
 Model
accommodates excess
cash and other non-
operating assets of the
firm as equity value

10. So Where Are We?…And, Are
We Almost There?
Free Cash Flows to Equity (FCFE) is the
theoretical basis for common equity valuation
FCFE is a more accurate measure of the
market value of a firm’s equity than PV models
based on dividends or earnings
The market price of common stock may be
more or less than the PV of FCFE
10
 Establish the
theoretical basis for
cash flows in DCF
model

11. Questions?
11