Equity #34 - Discounted Dividend Valuation Flashcards

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1
Q

What are the three predominant definitions of future cash flows used in DCF stock valuation models?

A

LOS 34.a

dividends - dividends to be received by shareholders

free cash flow:

  • to the firm (FCFF) - operating CF generated by company in excess of capital investment required to sustain firm’s current productive capacity
  • to equity (FCFE) - cash available to shareholders after funding capital requirements and expenses associated with debt financing.

residual income - amount of earnings during the period that exceed the investors’ required return, where:

  • required return is the opportunity cost to to suppliers of capital, and
  • residual income is income in excess of the required return
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2
Q

Advantages and disadvantages in using dividends–i.e. dividend discount model (DDM)–for DCF models

A

LOS 34.a

Advantages:

  • (primary) it is theoretically justified
  • dividends less volatile than other measures (i.e. earnings or FCF)

Disadvantages:

  • (primary) difficult to implement for companies that do not currently pay dividends
  • assumes prospective of minority shareholder that cannot control dividend policy
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3
Q

Dividends are an appropriate measure of cash flows in which cases?

A

LOS 34.a

A company having a history of dividend payments

A company with a clear ividend policy that is related to earnings

Minority shareholder perspective is appropriate

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4
Q

Advantages and disadvantages in using free cash flow (FCF) for DCF models

A

LOS 34.a

Advantages:

  • can be applied regardless of dividend policy or capital structure

Disadvantages:

  • companies with heavy capital requirements may generate negative FCF for some time before FCF becomes positive
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5
Q

Free cash flow (FCF) is an appropriate measure of cash flows in which cases?

A

LOS 34.a

A company with history of no dividend payment or one poorly related to earnings

A company with FCF that corresponds with profitability

Controlling shareholder perspective is appropriate

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6
Q

Advantages and disadvantages in using residual income for DCF models

A

LOS 34.a

Advantages:

  • can be applied regardless of dividend policy or capital structure

Disadvantages:

  • companies with heavy capital requirements may generate negative FCF for some time before FCF becomes positive
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7
Q

Residual income is an appropriate measure of cash flows in which cases?

A

LOS 34.a

A company with no dividend history

A company with negative FCF for the foreseeable future

A company with transparent financial reporting and high quality earnings

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8
Q

What is the formula for multi-period DDM?

A

LOS 34.b

Vo = D1 / (1 + r)^1 + D2 / (1 + r)^2 +
… + Dn / (1 + r)^n + Pn / (1 + r)^n

where:

  • Vo = fundamental value
  • Di = expected dividend at end of period i, i = 1 to n
  • Pn = expected sell price at end of period n
  • r = required return on equity
  • n = number of holding periods
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9
Q

Return on Equity (formulas)

A

LOS 34.o

ROE = NI / stockholders’ equity

DuPont:

ROE = profit margin x asset turnover x fin’l leverage

ROE = NI / S * S / TA * TA / Eq

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10
Q

List the different dividend discount models (DDM)

A

LOS 34.b

Gordon constant growth model - “mature” phase firm val.

2-stage growth model - “transition” phase firm val.

3-stage growth model - “initial growth” phase firm val.

H-model
(H = t/2, t=yrs linear growth period)

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11
Q

present value of growth opportunities

A

LOS 34.e

V0 = E1 / r + PVGO

Interpretation: value of a firm’s equity has 2 components:

  • E1 / r - value of assets in place (perpetutiy)
  • PVGO - present value of growth option
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12
Q

justified P/E

A

LOS 34.f

justified P/E - based on company valuation i.e. V0/E0 or V0/E0

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

trailing P/E = (D1/E0) / (r - g) = (1 - b)(1 + g) / (r - g)

b = rentention ratio

NOTE: trailing P/E = leading P/E * (1 + g)

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13
Q

strengths & weaknesses of GGM

A

LOS 34.h

GGM appropriate for:

  • stable, mature dividend-paying firms
  • valuing market indexes
  • deriving price-implied growth rates or required rate of return
  • supplementing more complex valuation models

Limitations:

  • valuation sensitive to “r” and “g”
  • doesn’t work for firms without dividends
  • doesn’t work for firms with unpredictable growth
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14
Q

terminal value estimation

A

LOS 34.k

Two methods:

GGM

market multiple e.g. P/E * est. earnings

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15
Q

sustainable growth rate (SGR)

A

LOS 34.o

SGR - rate at which earnings (and dividends) can continue to grow indefinately; it tells us how quickly a firm can grow with internally generated funds.

SGR = b x ROE

If firm’s forecasted growth > SGR, then it will have to:

  • issue new equity
  • increase retention ratio
  • increase profit margin
  • increase total asset turnover
  • increase leverage

Assumptions:

  • debt/equity ratio doesn’t change
  • firm doesn’t issue new equity
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16
Q

sustainable growth rate (SGR) using DuPont formula

A

LOS 34.o

SGR = b x ROE

SGR = “PRAT”:

retention rate x profit margin x asset turnover x financial leverage

If firm’s forecasted growth > SGR, then it will have to:

  • issue new equity
  • increase profit margin “P”
  • increase retention ratio “R”
  • increase total asset turnover “A”
  • increase leverage “T”

Assumptions:

  • debt/equity ratio doesn’t change
  • firm doesn’t issue new equity
17
Q

determine if stock is over/under/fairly valued

A

LOS 34.p

P0 > V0 ⇒ “overvalued”

P0 = V0 ⇒ “fairly valued”

P0 < V0 ⇒ “undervalued”