Publications
The value crisis facing low-return UK companies
Over half of the 500 largest firms in the UK earn below the cost of equity. These companies are threatened with a significant drop in their stock price
The Capital Asset Pricing Model (CAPM), based on discounted cash flow valuation, is the best indicator of the way the market will set the stock price of a company. A simplified version of the model measures stock price as a multiple of book value, where the three drivers are return on equity, the market's required return and the company's rate of growth. Other papers in this series have discussed how CAPM has been shown, in general, to be in tune with the prices that are seen in stock markets.
However, the simplistic one-stage Dividend Discount Model has flaws. The most important of these is where a company's expected cash flow rate of return on equity (after tax) is no more than its growth rate. In this case, all the company's cash will be swallowed up in increasing its equity base to support the growing balance sheet. If cash generated only equals, or is less than cash needed for growth, there can be nothing left for shareholders. Were this to continue indefinitely, the discounted free cash flow value of the business would by definition be zero – which is therefore the level at which the market should set the stock price.
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