4. Discounted Dividend Valuation Flashcards
In which conditions dividends are appropriate as a measure of cash flow?
1) The company has a history of dividend payments
2) The dividend policy is clear and related to the earnings of the firm
3) The perspective is that of a minority shareholder
Firms in the mature stage of the industry life cycle are most likely to meet the first two criteria.
In which conditions free cash flow models are most appropriate?
1) For firms that do not have a dividend payment history or have a dividend payment history that is not clearly and appropriately related to earnings
2) For firms with free cash flow that corresponds with their profitability
3) When the valuation perspectives is that of a controlling shareholder
In which conditions the residual incoe approach is most appropriate?
1) Firms that do not have dividend histories
2) Firms that have negative free cash flow for the foreseeable future (usually due to capital demands)
3) Firms with transparent financial reporting and high quality earnings
Explain multi-period dividend discount model (DDM).
The DDM can easily be adapted to any number of holding periods by adjusting the discount factor to match the time to receipt of each expected return. With this, the present value becomes the sum of the properly discounted values of all expected cah flows (dividend and terminal value):
V0 = D1/(1+r)^1+D2/(1+r)^2+…+(Dn+Pn)/(1+r)^n
Explain the Gordon Growth Model.
The Gordon Growth Model (GGM) assumes that dividends increase at a constant rate indefinitely. The moldel Assumes that:
1) The firm expects to pay a dividend, D1, in one year
2) Dividends grow indefinitely at a constant rate, g (which may be less than zero)
3) The growth rate, g, is less than the required return, r
V0 = D0*(1+g)/(r-g)
Explain the Present Value of Growth Opportunities (PVGO).
A firm that has additional opportunities to earn returns in excess of the required rate of return would benefit from retaining earnings and investing in those growth opportunities rather than paying out dividends. The fundamental value then represents not only the present value of the future dividends (on a non-growth basis) but also the present value of the growh opportunities (PVGO):
V0 = E1/r + PVGO
This means the value of a firm’s equity has two components:
1) The value of its assets in place (E1/r), which is the present value of a perpetual cash flow of E1
2) The present value of its future investment opportunities (PVGO)
Explain ‘justified leading P/E’ and ‘justified trailing P/E’.
The price-to-earnings ratio is the most commonly used relative valuation indicator. An analyst derives a justified P/E based on the firm’s fundamentals.
The leading P/E is based on the earnings forecast for the next period and the trailing P/E is based on the earnings for the previous period.
Justified Leading P/E = P0/E1 = D1/E1/(r-g) = (1-b)/(r-g)
Justified Trailing P/E=P0/E0=D0(1+g)/Eo/(r-g)=(1-b)(1+g)/(r-g)
b = retention rate (1-b) = dividend payout ratio
- The notation is trickly here. Because these are justified P/E ratios, the ‘price’ in the numerator is actually the fundamental value of the stock derived from the Gordon growth model. It would be more accurate to label these ratios V0/E0 and V0/E1, but the common convention is to call themm ‘justified P/Es’.
Which are the most appropriate valuation model to apply in each phase of growth (initial growth, transition and maturity)?
Initial growth: three-stage
Transition: two-stage
Maturity: gordon growth
This pattern is not predestined because many firms are sucessful in constantly adapting and entering into new growth opportunities. Mature firms may develop technology that forms the basis for a whole new product and market. The point is that a multistage model is required in order to value many firms. Fortunately, the GGM is easily adaptable to multistage growth.
Explain valuation using the H-Model.
The earnings growth of most firms does not abruptly change from a high rate to a low rate as in the two-stage model but tends to decline over time as competitive forces come into play.
The H-model approximates the value of a firm assuming that an initially high rate of growth declines linearly over a specified period.
The formula for this approximation is:
V0 = D0(1+gL)/(r-gL) + D0H*(gS-gL)/(r-gL)
H = (t/2) = half-life (in years) of high-growth period
Note that the first term is what the shares would be worth if there were no high-growth period and the perpetual growth rate was gL. The second term is an approximation of the additional value that results from the high-growth period.
Explain the ‘sustainable growth rate (SGR or g).
How to calculate ‘g’ from ROE and dividend payout rate?
The sustainable growth rate is the rate at which earnings (and dividends) can continue to grow indefinitely, assuming that the firm’s debt-to-equity ratio is unchanged and it doesn’t issue new equity.
g = (1 - dividend payout rate) * ROE
Which is the best valuation method if the firm dows not pay dividends, has a negative free cash and has transparent financial reporting and high earnings quality? (FCFE, FCFF, Residual Income Model?)
Residual income models are the best valuation method if the firm dows not pay dividends, has a negative free cash and has transparent financial reporting and high earnings quality.
