Financial Valuation Methods: DDM, P/E, and DCF Analysis

Posted on Mar 9, 2026 in Finance

Two-Stage Dividend Discount Model (DDM)

PQW will pay an annual dividend of 0.65 one year from now. Analysts expect this dividend to grow at 12% per year until the fifth year. After the fifth year, the growth rate will be 2% per year forever. If the firm’s equity cost of capital is 8%, what is the value of a share of PQW stock using the dividend discount model?

Given Data

  • D1 = 0.65
  • g1 (Years 1–5) = 12%
  • g2 (after Year 5) = 2%
  • r = 8%

Step 1: Calculate Dividends for Years 1–5

  • D1 = 0.65
  • D2 = 0.65(1.12) = 0.728
  • D3 = 0.728(1.12) = 0.81536
  • D4 = 0.81536(1.12) = 0.91320
  • D5 = 0.91320(1.12) = 1.02278

Step 2: Present Value of Dividends (Discounted at 8%)

PV(Dt) = Dt / (1.08)^t

  • PV1 = 0.65 / 1.08 = 0.6019
  • PV2 = 0.728 / (1.08)^2 = 0.6241
  • PV3 = 0.81536 / (1.08)^3 = 0.6475
  • PV4 = 0.91320 / (1.08)^4 = 0.6712
  • PV5 = 1.02278 / (1.08)^5 = 0.6960

Sum of PV (Years 1–5) = 3.2407

Step 3: Terminal Value at Year 5

D6 = D5(1.02) = 1.02278(1.02) = 1.04323
P5 = D6 / (r − g2) = 1.04323 / (0.08 − 0.02) = 17.387

Step 4: Present Value of Terminal Value

PV(P5) = 17.387 / (1.08)^5 = 11.834

Step 5: Stock Price Today

P0 = 3.2407 + 11.834 = 15.07

Relative Valuation using P/E Ratio

PepsiCo has a stock price of 72.62 and earnings per share (EPS) of 3.80. Its competitor, Coca-Cola, has EPS of 1.89. Estimate the value of a share of Coca-Cola stock using this data.

Calculation

  • PepsiCo P/E = 72.62 / 3.80 = 19.11
  • Estimated Price = 19.11 × 1.89 = 36.12

Discounted Free Cash Flow (DCF) Analysis

Heavy Metal Corporation is expected to generate the following free cash flows (in $ millions): Year 1: 53, Year 2: 68, Year 3: 78, Year 4: 75, Year 5: 82. After Year 5, growth is 4% per year. WACC is 14%.

Step 1: Present Value of FCF (Years 1–5)

Total PV (Years 1–5) = 238.48

Step 2: Terminal Value and Enterprise Value

  • Terminal Value (TV5) = 852.8
  • PV(TV5) = 442.91
  • Enterprise Value (EV) = 238.48 + 442.91 = 681.39 million

Step 3: Equity Value and Share Price

  • Equity Value = 681.39 − 300 (Debt) = 381.39 million
  • Price per share = 381.39 / 40 million shares = 9.53

Capital Budgeting: NPV Analysis

Given: Cost = 125,000, Life = 3 yrs, Salvage = 5,000, Sale price = 15,000, Revenue = 120,000/yr, Costs = 60,000/yr, Tax = 35%, r = 10%

  • Depreciation = 40,000/yr
  • Operating Cash Flow (OCF) = 53,000/yr
  • After-tax salvage = 11,500
  • NPV = −125,000 + 53,000/1.10 + 53,000/(1.10)^2 + 64,500/(1.10)^3 = 15,436

Decision: Accept (NPV > 0)