C Explain the rationale for using present‐value of cash flow models to value equity and describe the dividend discount and free‐cash‐flow‐to‐equity models

Question 1

The dividend discount model (DDM) is based on the rationale that a corporation has an indefinite life and a stock’s value is the present value of its future cash dividends

Estimate intrinsic value based on present value of future benefits.

Example approaches

– 1. Cash to be received (dividends expected)

– 2. Cash flows available to be distributed to shareholders (but may

not be paid out

• (Note movement of stock prices immediately before

and after dividend record date)

Answer 1

The dividend discount model is based on the rationale that a corporation has an indefinite life, and a stock’s value is the present value of its future cash dividends. The most general form of the model is:

The rationale for using dividend discount models to value equity is that the: the fundamental or intrinsic value of a stock is the present value of all its future dividends. Dividend discount models can be applied to either a finite or infinite stream of dividends. There are many ways to calculate the inputs and the estimated stock values may vary significantly with small changes in the inputs.

Question 2

Free cash flow to equity (FCFE) can be used instead of dividends. FCFE is the cash remaining after all debt obligations and necessary capital expenditures. FCFE reflects capacity for dividends and is useful for firms that do not pay a dividend

A valuation model based on the cash flows that a firm will have available to pay dividends in the future isbest characterized as a(n): Free cash flow to equity represents a firm’s capacity to pay future dividends. A free cash flow to equity model estimates the firm’s FCFE for future periods and values the stock as the present value of the firm’s future FCFE per share.

Answer 2

Free cash flow to equity (FCFE) can be used instead of dividends. FCFE is the cash remaining after a firm meets all of its debt obligations and provides for necessary capital expenditures. FCFE reflects the firm’s capacity for dividends and is useful for firms that currently do not pay a dividend. By using FCFE, an analyst does not need to project the amount and timing of future dividends.

FCFE = Cash from Operations (CFO) – Fixed Capital Investments (fixed assets and working capital) + Net Borrowing

Question 3

Witronix is a rapidly growing U.S. company that has increased free cash flow to equity and dividends at an average rate of 25% per year for the last four years. The present value model that is mostappropriate for estimating the value of this company is a: multistage dividend discount model.

Answer 3

A multistage model is the most appropriate model because the company is growing dividends at a higher rate than can be sustained in the long run. Though the company may be able to grow dividends at a higher-than-sustainable 25% annual rate for a finite period, at some point dividend growth will have to slow to a lower, more sustainable rate. The Gordon growth model is appropriate to use for mature companies that have a history of increasing their dividend at a steady and sustainable rate. A single stage free cash flow to equity model is similar to the Gordon growth model, but values future free cash flow to equity rather than dividends.

Question 4

Holding all else equal, if the beta of a stock increases, the stock’s price will: Decrease

Answer 4

When the beta of a stock increases, its required return will increase. This increases the discount rate investors use to estimate the present value of the stock’s future cash flows, which decreases the value of the stock.

Question 5

Price Multiples Models, Multiplier Models

Answer 5

“■ Price-to-earnings ratio (P/E). This measure is the ratio of the stock price to earnings per share. P/E is arguably the price multiple most frequently cited by the media and used by analysts and investors (Block 1999). The seminal works of McWilliams (1966), Miller and Widmann (1966), Nicholson (1968), Dreman (1977), and Basu (1977) presented evidence of a return advantage to low-P/E stocks.
■ Price-to-book ratio (P/B). The ratio of the stock price to book value per share. Considerable evidence suggests that P/B multiples are inversely related to future rates of return (Fama and French 1995).
■ Price-to-sales ratio (P/S). This measure is the ratio of stock price to sales per share. O’Shaughnessy (2005) provided evidence that a low P/S multiple is the most useful multiple for predicting future returns.
■ Price-to-cash-flow ratio (P/CF). This measure is the ratio of stock price to some per-share measure of cash flow. The measures of cash flow include free cash flow (FCF) and operating cash flow (OCF).”

• Forward or trailing basis – Examples: Price / Last Twelve Months (LTM)

earnings or Price / Projected Twelve Months Earnings. It’s very

important that there be consistency in use of the same “forward” or

“trailing” earnings data from the subject company and the market

comparables

• Sources of multiples

– Comparable firms

– Intrinsic multiples : One example (k – g)

Question 6

Asset Based Models

Answer 6

• Adjusts book values of assets and liabilities to reflect their market
values to develop estimate of equity value
• Challenge: Identifying and valuing individual assets and liabilities can
be difficult
• Best for asset intensive companies with readily valued assets or firms
in liquidation