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peer to Gracie, then Hudson‟s total value of common equity through the relative value method is
Hudson‟s 2008 net income times this same price-to-earnings ratio:
This relative value method can be used with many possible ratios, including price to cash flow and
market price to book value, among others. The strength of the relative value method is its simplicity of
use. Once you have identified a comparable firm you apply the price to performance ratio, and you
have the value of equity for the target firm. This is also the weakness of the relative value method,
because it applies the price ratio naively. If your target firm differs even a little from the comparable
firm, and there are very few truly comparable firms in the world, then it‟s hard to have much
confidence in the result. Alternatively, you could apply your personal judgment to the price to
performance ratio, adjusting it up if you believe the target is a superior firm, and adjusting it down if
you believe the target is an inferior firm, but this is highly subjective.
A good way to conclude this discussion of the relative value method is to be careful and thoughtful
when using it, and be sure to also use the discounted cash flow valuation method and compare your
results from both methods. Discounted cash flow valuation is the preferred method, but the relative
value method can help a financial analyst better understand the company and support the result
obtained by DCF valuation.
We conclude our work on equity valuation by calculating the value of preferred stock. Preferred
stock is a perpetuity because it pays the same fixed cash dividend forever, so the formula for the value
of a perpetuity can be used to determine the price of a share of preferred stock:
The term in the denominator, K preferred stock , is the current required rate of return for the preferred stock,
so if a company‟s preferred stock pays a dividend of $4 per year and the required return of the
preferred stock is 9%, then the value of the preferred stock is $4 divided by 0.09 or $44.44 per share.
Since preferred dividends do not change over time and go on forever, the value of a share of preferred
stock is calculated as this fixed dividend per share divided by the current required rate of return on the
stock.
Conclusion
The topics discussed in this chapter, risk and return, cost of capital, capital structure, and valuation,
are the bases of the tasks performed by financial managers. Businesses identify, analyze, and approve
investment opportunities, and financial managers raise the capital necessary to fund these investment
opportunities. Investors are willing to invest in companies and their projects, but only if the expected
return from the investment is sufficient given its risk. Financial managers must understand this
relationship between risk and return, so they can determine the cost of the capital provided to the
business by investors.
Financial managers must also understand how capital structure decisions change cost of capital,
because financing the firm in an efficient manner reduces the cost of capital and allows the firm to