DDM Flashcards
What is a DDM
Dividend discount models define cash flow as the dividends to be received by the shareholders
What are the advantages of DDMs
- Theoretically justified, as investor investments are based on the PV of Future Cashflows expected to receive
- Dividends are less volatile than other measures (earnings or free cash flow)
- So DDM models are less volatile and reflect the long-term earnings potential of the company
What are the Disadvantages of DDMs
- Difficult to implement for firms that don’t currently pay dividends.
- Estimating expected future dividends by forecasting the point in the future to begin paying dividends is possible
- But uncertainty is associated with forecasting the fundamental variables that influence stock price
- Takes the perspective of an investor who owns a minority stake in the firm and cannot control the dividend policy
- If the dividend policy is not related to the firm’s ability to create value, then dividends are not an appropriate measure of expected future cash flow to shareholders
When are Dividends appropriate as a measure of cash flow?
- The company has a history of dividend payments.
- The dividend policy is clear and related to the firm’s earnings.
- The perspective is that of a minority shareholder.
What are 2 types of free-cash flow models?
- Free cash flow to the firm (FCFF)
The cash flow generated by the firm’s operations that is in excess of the capital investment required to sustain the firm’s current productive capacity - Free cash flow to equity (FCFE)
Cash available to stockholders after funding capital requirements and expenses associated with debt financing
What are the advantages of Free cash flow models
- Can be applied to many firms, regardless of dividend policies or capital structures
- Ability to influence the distribution and application of a firm’s free cash flow makes them more pertinent to a firm’s controlling shareholder
- Useful to minority shareholders because the firm may be acquired for a market price equal to the value to the controlling party.
What are the disadvantages of Free cash flow models
- Application can be difficult in some cases
- Firms that have significant capital requirements may have negative free cash flow for many years into the future.
- Negative free cash flow complicates the cash flow forecast and makes the estimates less reliable.
When are free cash flow models appropriate as a measure of cash flow
- 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.
- For firms with free cash flow that corresponds with their profitability.
- When the valuation perspective is that of a controlling shareholder.
What is Residual Income models
- Amount of earnings during the period that exceeds the investors’ required return
- Theoretical basis for this approach is that the required return is the opportunity cost to the suppliers of capital, and the residual income is the amount that the firm is able to generate in excess of this return
What are the advantages of residual income?
Can be applied to firms with negative free cash flow and to dividend- and non-dividend-paying firms.
What are the disadvantages of residual income?
- More difficult to apply because they require in-depth analysis of the firm’s accounting accruals
- If the accounting is not transparent or if the quality of the firm’s reporting is poor, the accurate estimation of residual income is likely to be difficult
When are residual income models appropriate as a measure of cash flow
- Firms that do not have dividend histories.
- Firms that have negative free cash flow for the foreseeable future (usually due to capital demands).
- Firms with transparent financial reporting and high-quality earnings.
How to calculate one-period DDM
V0=(D1+P1)/(1+r)
V0 = fundamental value
D1 = dividends expected to be received at end of Year 1
P1 = price expected upon sale at end of Year 1
r = required return on equity
How to calculate two-period DDM
V0=[D1/(1+r)^1] +[(D2+P2)/(1+r)^2 ]
V0 = fundamental value D1 = dividends expected to be received at end of Year 1 D2 = dividends expected to be received at end of Year 2 P2 = price expected upon sale at end of Year 2 r = required return on equity
How to calculate multi-period DDM
V0=[D1/(1+r)^1] +[D2/(1+r)^2 ]+…+[(Dn+Pn)/(1+r)^n ]
V0 = fundamental value
Di = dividends expected to be received at end of year i, i = 1 to n
Pn = price expected upon sale at end of year n
r = required return on equity
n = length of holding period
What is the GGM model formula?
What is the GGM?
Gordon growth model (GGM)
* assumes that dividends increase at a constant rate indefinitely
* simplifying factor: The rate of growth can be expressed per period in the same way that the required return is expressed
What are the assumptions of the GGM?
- The firm expects to pay a dividend, D1, in one year.
- Dividends grow indefinitely at a constant rate, g (which may be less than zero).
- The growth rate, g, is less than the required return, r
What is the CAPM Model
r = Risk Free r + [beta x (Expected Return on Market - Risk Free r)]