Equity Valuation

Question 1

Dividend discount model - what is it and what is it used for?

Answer 1

Used to calculate value of a share

Share price = dividend / return on equity

Does not take account of rising dividends

This gives rise to Gordon’s growth model which assumes that future dividends grow at a constant rate

Share price = next year’s dividend* / (return required - dividend growth)

*i.e. if expected to grow by 5% then x 1.05

Question 2

Price earnings (PE) ratio - what is it and what is it used for?

Answer 2

Share price / earnings per share

Used to provide an indication of value of share

Indicates number of years needed at current EPS to repay share price (ignoring time value of money)

Question 3

Shareholder value model - how to calculate and what it is used for?

Answer 3

To calculate:

Adjust operating profit by:

Adding back non-cash items

Subtracting company’s weighted average cost of capital

Multiplied by adjusted net asset figure (invested capital)

Used to establish whether a company can add value for its ordinary shareholders

Economic value added

If result is positive - value is being added

If value is negative - value is being destroyed