Discounted Dividend Valuation

Question 1

What is discounted cash flows?

Answer 1

• calculates intrinsic value of company’s common stock as present value of expected future cash flows

Question 2

What are the 4 broad steps in DCF analysis are:

Answer 2

• Defining cash flows
• Forecasting cash flows
• Choosing a discount rate methodology
• Estimating a discount rate

Question 3

What is present value of future cash flows formula?

Answer 3

PV = (CFC/ (1+r)^t) + (CF/ (1+r)^t)

Question 4

What are 3 streams of cash flows that the discounted cash flow model can be used?

Answer 4

• dividends
• free cash flows
• residual income

Question 5

What 3 conditions met would make it most appropriate to use dividend discount model?

Answer 5

• company is paying dividends.
• dividend policy is consistent with the company’s profitability.
• investor has a non-control perspective.

Question 6

What are the 3 types of free cash flow methods you can use in discounted cash flow method?

Answer 6

• cash flow from operations (CFO): cash generated from day to day activities
• free cash flow to firm (FCFF): cash flows available to all capital providers
• free cash flow to equity (FCFE): cash flow available to shareholders only

Question 7

What 4 conditions met would make it most appropriate to use free cash flow discount model?

Answer 7

• company is not dividend-paying.
• company pays dividends that are materially different from the FCFE.
• projected free cash flows are aligned with the company’s profitability.
• investor has a control perspective (or views the company as a likely merger target).

Question 8

What 2 conditions met would make it most appropriate to use residual income discount model?

Answer 8

• company is not paying dividends (used as an alternative to the free cash flow model).
• company has negative expected free cash flows.

Question 9

What is the formula for dividend discount model for a single period and multiple periods?

Answer 9

• single period: V0 = (D1 + P1/ (1+r)^1)
• multi period: V0 = (D1 / (1+r)^1) + (D2 / (1+r)^2) + (P2 / (1+r)^2)

V0 = present value
D1 = dividend in one year
P1 & P2 = selling price
r = discount rate
D2 = dividend in two years

Question 10

What is the dividend discount formula if dividends are assumed to be paid indefinitely?

Answer 10

V0 = Dt / (1+r)^t

V0 = present value
Dt = infinite dividend
r = discount rate
t = years or time

Question 11

What does the Gordon growth model assume and what is the formula?

Answer 11

• assumes dividend will grow at constant rate forever

V0 = (D0 (1+g) / r - g) which is also equivalent to D1/ r - g

D0 = dividend at time 0 or now
g = growth rate
r = required rate of return
D1 = dividend in 1 year

Question 12

What is share repurchase?

Answer 12

• when a company buys back its own shares from the market place

Question 13

What is the implied dividend growth rate?

Answer 13

• determining growth rate of dividend if market price is available

Question 14

The value of a stock is the sum of what 2 following? What is the formula?

Answer 14

• value of the company without earnings reinvestment
• the present value of growth opportunities (PVGO)

V0 = E1/r +PVGO

V0 = present value
E1 = earnings per share in 1 year
r = discount rate
PVGO = present value of growth opportunities

Question 15

What is the formula for P/E derived from the value of a stock sum formula (present value of growth opportunities?

Answer 15

P0 /E1 = 1/r + PVGO/E1

P0 = present value price
E1 = earnings in 1 year
r = discount rate
PVGO = present value of growth opportunities

Question 16

What is the formula for leading P/E ratio and trailing P/E ratio?

Answer 16

leading P/E ratio = P0/E1 = ((D1/E1) / (r-g)) = ((1-b) / (r-g))

trailing P/E ratio = P0/E0 = ((D0 (1+g))/ E0) /r-g = ((1+g)*(1-b)) / r-g

P0 = price now or present value
E1 = earnings per share in 1 year
D1 = dividend in 1 year
r = discount rate
g = growth
b = retention rate
1-b = dividend payout ratio
E0 = earnings per share now
D0 = dividend now

Question 17

What is the formula that can be derived from the Gordon growth model to get stocks required rate of return?

Answer 17

r = (D1/P0) +g

r = required rate of return or discount rate
D1 = dividend in 1 year
P0 = price now or present value
g = dividend growth rate

Question 18

What are 3 stages that growth usually falls into?

Answer 18

• growth phase
• transition phase
• mature phase

Question 19

What is the formula for 2 stage Gordon growth model?

Answer 19

V0 = ((D0 (1+gs)^t)/ (1+r)^t) + (Vn / (1+r)^n)

V0 = value now or present value
D0 = dividend now
gs = short term dividend growth rate
t = time
r = discount rate
Vn = terminal value of second stage of Gordon growth model
N = time

Question 20

What is the formula for terminal value derived from 2 stage Gordon growth model?

Answer 20

Vn = ((D0 (1+gs)^n)* (1+gl)) / (r - gl)

Vn = terminal value
D0 = dividend now at time 0
gs = short term dividend growth rate
gl = long term dividend growth rate
r = discount rate
n = time

Question 21

What is the formula for present value of stock for a company that doesn’t pay dividends until a later date?

Answer 21

V0 = D / (((1 + r)^n) * (r-g))

V0 = present value
D = dividend when they start paying dividends in the future
r = discount rate
n = years or time until they pay dividend
g = dividend growth rate

Question 22

What is the difference in assumption from the 2 stages Gordon growth model and the h model?

Answer 22

• Gordon growth model: assumes high growth for a period the normal growth thereafter, which can result in very abrupt change in growth rate
• h model: overcomes abrupt change in growth rate by smoothing transition from short term growth rate to long term growth rate

Question 23

What is the formula for h model?

Answer 23

V0 = (D0 (1+gl)) + ((D0*H) * (gs -gl)) / (r -gl)

V0 = present value
D0 = dividend now
gl = dividend growth rate long term
H = period of high growth divided by half
gs = dividend growth rate short term
r = discount rate

Question 24

What is formula of sustainable growth rate with retention ratio and ROE?

Answer 24

g = b * ROE

g = growth rate
b = retention rate
ROE = return on equity

Question 25

What is the formula for ROE using DuPoint three way analysis?

Answer 25

ROE = net income/sales * sales/total assets * total assets/shareholders equity

net income/sales = retention rate
sales/total assets = asset turnover
total assets/shareholders equity = financial leverage

Question 26

What is formula of sustainable growth rate using the PRAT method?

Answer 26

g = (net income - dividends /net income) * (net income/sales) * (sales/total assets) * (total assets/shareholders equity)

net income - dividends/ net income = profit margin (P)
net income/sales = retention rate (R)
sales/total assets = asset turnover (A)
total assets/shareholders equity = financial leverage (T)