Price-Toearnings and Market-to-Book Metrics in the Practical Application of the Discounted Dividend Theory of Equity Valuation

(ProQuest: ... denotes formulae omitted.)INTRODUCTIONRegardless of the selection strategy that an equity investor employs, the adage to buy low and to sell high is intuitively appealing. Consequently, fundamental measures of a candidate security's value or worth are of great general interest. To either the value investor as a primary component of investment selection strategy, or to the technical trader as an assessment gauge for risk, intrinsic value is important.The finance literature is well developed on the question of valuing securities. Williams (1938) and Gordon (1962) developed and refined the Dividend Discount Model (DDM) which serves as a generally accepted theoretical standard for equity valuation. In essence, a security is worth the summation of the cash flows it can be expected to spawn, manifested as future cash dividends, and each discounted to its present value. If this intrinsic value is greater than the issue's current market price, the stock is deemed to be cheap and considered by the value investor to be a candidate for purchase. Conversely, if the intrinsic estimate is less than the market price, the stock is deemed rich and will be numbered among the investor's candidates for sale.Of course, the simplifying assumptions necessary to formulate the DDM are substantial. Major assumptions involve the constancy or stability of future dividend flows and the specification of a discount rate. A sustained pattem of growth in dividends, assumed to reflect the retention and employment of a portion of the firm's earnings, is accommodated by a straight forward extension of the model, but the possibility of fluctuating dividends and the specification of an appropriate discount rate remain daunting impediments. Some would argue that these assumptions seriously impede the theory's practical application. Given the issues with forecasting future dividends and the discount rate, simplified models are likely to be as effective as the DDM model for estimating intrinsic values.The appeal of a simplified DDM as a fundamental screening tool motivates efforts to identify useful heuristics for its application. In this paper we examine two familiar financial ratios, the price-to-eamings or P/E ratio and the market-tobook or M/B ratio, to the DDM framework and underscore their value as accessible vehicles for the practical application of a discounted dividend valuation paradigm.PRESENT VALUE ANALYSIS OR DIVIDEND DISCOUNT MODELWilliams (38) was one of the first economists to argue that equity value should be based on intrinsic value and not on Keynes' view that the equity acts as a casino where participants use a battle of wits to anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over a long term of years... For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs - a pastime in which he is victor who says Snap neither too soon or too late, who passes the Old Maid to his neighbor before the game is over, who secures for himself when the music stops. (Keynes, 1936)Williams work laid the theoretical foundation for Gordon's 1962 dividend discount model. Gordon's model has become one of the dominant paradigms in finance for valuing equity and is found in all finance textbooks that this author is familiar with. Gordon argues that value should be based on future cash flows discounted back at the proper risk adjusted rate of return relevant for these cash flows. He emphasizes that the proper cash flow is the dividend, the cash flow the owner/investor gets every period.The following will be divided into four parts, DDM, Pt/Et & Pt/Et+i Ratios, Pt/BVt Ratio, Pt/Et, Pt/Et+i, Po/BVo, & EPS Ratios, and the Conclusion.DIVIDEND DISCOUNT MODEL (DDM)Gordon's price formula for common stock (Dividend Discount Model or DDM) can be found in most if not all beginning corporate finance books. …