Lecture 4 Flashcards
What is the dividend discount model
- Looks at the value of a company’s equity is at the PV of all expected dividends
- Companies can increase value by delaying dividends and investing in positive NPV projects which will lead to bigger dividends in the future
What does the dividend discount model yield
The intrinsic value or the fundamental value of the firm
What is the General DDM model
- Value of stock
- Expected dividend at time t
- Required return or discount rate or cost of equity
When is the DDM suitable
- Company is paying dividends
- Have established a dividend policy that is consistent with companys profitability
- Investor takes a non control perspective
What is the DDM Constant Growth Model (Gordon Model)
- The firms value at time zero
- The dividend at time one
- The cost of equity
- The perpetual dividend growth rate
What does the constant growth model do
- Determines the companys growth rate and estimate of the economy nominal growth rate
- Nominal growth rate is usually measured by the growth in GDP → (SUM: of estimated real growth rate GDP + expected long run inflation rate)
What are the functions of growth rates
- Return on Equity (Return from investing)
- Reinvestment (How much to invest)
What is b
Reinvestment rate
What is d
Dividend payout ratio = 1-b
What is g
Rate of dividend growth
How do you estimate g
- Assume that growth rates are a function of two factors
- ROE (Return from investing)
- Reinvestment (How much you invest)
- b= reinvestment rate, plowback ratio or earnings retention ratio
- D = dividend pay out ratio = 1b
- ROE
- g = growth of dividend
How do you value a firms growth opportunity
- Chosen investment and dividend rates
- Decompose the firms equity into:
- No growth component
- Growth opportunities component (expected value of opportunities today to profitably reinvest future earnings)
How do you partition value
- = Present value of growth opportunities
- = Earnings per share for period 1
What happens in a no growth model
- Same as constant growth with g = 0
- This is when a company doesn’t have positive expected NPV projects
- Earnings are all distributed in dividends
How to partition value
- Look for PV of growth rates
- Earnings per share for period 1
What is the Free Cash Flow valuation
- This is useful for companies that are not paying dividends yet
- This aligns with profitability within a reasonable forecast period
- The investor takes a control perspective
What is Free Cash Flow to the Firm
Valuing the entire firm. The cash flow available to the company’s suppliers of capital after all operating expenses have been paid and necessary investments in working capital and fixed capital have been made
What happens during growth opportunities
- Companies do not pay their entire earnings as dividends
- Current earnings is invested back into the same
- ROE>K, shareholders gain
Why would a firm with negative PVGO represent a good takeover target?
Bc another firm could buy the firm for the market price
What does it mean to have a negative PVGO
Negative present value of growth opportunities means by reinvesting earnings, a company is eroding value rather than creating it. Company should distribute more of its net earnings to shareholders
What happens if you the value from the gordon model is different from mp
- Valuation is right and market is wrong or vice versa
- Do a sensitivity analysis on k and g
- Implied growth ate
- Implied ROE = implied growth rate/retention ration
What is FCFE (Free cash flow to equity)
Cash flow available to the companys suppliers of capital after all operating expenses, interest and principal payment have been paid and necessary investments in working capital and fixed capital have been made
How do you compute free cash flow
- Find cap ex
- Find change NWC
- Find Net debt
What is cap ex
Capital expenditures for long term assets (property, plant and equipment)
What is Change in NWC
Current assets - current liabilities
What is change in Net Debt
New debt borrowing minus debt repayment
What is change of net debt
New debt borrowing minus debt repayment
What are the advantages and disadvantages of Free Cash Flow Valuation
- Financial methods commonly accepted
- May require number of inputs each requiring estimates that require professional judgement
- May adjust financial statements
- Requires significant amount of effort
- Sensitivity Analysis is important
What is the value of the financial asset
Present value of all expected cash flows
What is cashflow that equities produce
Dividends
What happens when a company delays its dividends
Invest in positive NPV projects
When is the Gordon Growth Model best suited
For firms growing at a rate comparable to or lower than the nominal growth of the economy
What is the discount rate for asset pricing
Risk Free rate
What happens if the cashflow or earnings are uncertain
Same earnings, risk will be higher, price of the asset will be lower to induce you to invest, discount rate will be higher
What determines risk premium
Risk aversion and risk characteristics such as volatility
What happens when risk security goes up
Price comes down
