Equity #34 - Discounted Dividend Valuation

Question 1

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

Answer 1

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

Question 2

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

Answer 2

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

Question 3

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

Answer 3

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

Question 4

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

Answer 4

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

Question 5

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

Answer 5

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

Question 6

Advantages and disadvantages in using residual income for DCF models

Answer 6

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

Question 7

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

Answer 7

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

Question 8

What is the formula for multi-period DDM?

Answer 8

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

Question 9

Return on Equity (formulas)

Answer 9

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

Question 10

List the different dividend discount models (DDM)

Answer 10

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)

Question 11

present value of growth opportunities

Answer 11

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

Question 12

justified P/E

Answer 12

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)

Question 13

strengths & weaknesses of GGM

Answer 13

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

Question 14

terminal value estimation

Answer 14

LOS 34.k

Two methods:

GGM

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

Question 15

sustainable growth rate (SGR)

Answer 15

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

Question 16

sustainable growth rate (SGR) using DuPont formula

Answer 16

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

Question 17

determine if stock is over/under/fairly valued

Answer 17

LOS 34.p

P₀ > V₀ ⇒ “overvalued”

P₀ = V₀ ⇒ “fairly valued”

P₀ < V₀ ⇒ “undervalued”