Reading 35 - Discounted Dividend Valuation

Question 1

What are the 2 primary advantanges and 2 disadvantages of using dividends as the definition of cash in a valuation model?

Answer 1

Advantages

1. It is theoretically justified. The shareholder’s investment today is worth the PV of the future cash flows he expects to receive
2. Dividends are less volatile than other measures (earnings or free cash flow)

Disadvantage

1. Difficult to implement for firms that don’t current pay dividends
2. It takes the perspective of an investor who owns a minority stake in the firm and cannot control dividend policy.

Question 2

When are dividends an approriate measure of cash flow in a valuation model??

Answer 2

1. The company has a history of dividend payments
2. The dividend policy is clear and related to the earnings of the firm
3. The perspective is that of a minority shareholder

Question 3

Define free cash flow to the firm (FCFF)….

Answer 3

The cash flow generated by the firm’s operations that is in excess of the capital investment required to sustain the firm’s current productive capacity

Question 4

Define free cash flow to equity…..

Answer 4

The cash available to stockholders after funding capital requirements and expenses associated with debt financing

Question 5

What is an advantage and disadvantage of using free cash flow models……

Answer 5

_Advantage : _

Can be applied to many firms, regardless of dividend policies or capital structures

_Disadvantage : _

Firms that have significant capital requirements may have negative free cash flow for many years into the future which complicates the cash flow forecast and makes the estimates less reliable.

Question 6

When are free cash models most appropriate?

Answer 6

• For firms that do not have a dividend payment history or have a dividend payment history that is not clearly and appropriately related to earnings
• For firms with free cash flow that corresponds to their profitablity
• When the valuation perspective is that of a controlling shareholder

Question 7

What is Residual Income?

Answer 7

The amount of earnings during the period that exceeds the investor’s required return

Question 8

The Residual Income approach is most appropriate for firms which….

Answer 8

• that do not have dividend histories
• that have negative free cash flow for the foreseeable future (usually due to capital demands)
• for firms with tranparent financial reporting and high quality earnings

Question 9

How do you calculate a Two-Period DDM?

Answer 9

Question 10

What do you calculate a Multi-Period DDM?

Answer 10

Question 11

What is the assumption that has to be made when using the Gordon Growth Model?

Answer 11

That dividends increase at a constant rate indefinitely

Question 12

How do you calculate the Gordon Growth Model?

Answer 12

Question 13

What are the 3 things that the Gordon Growth model assumes?

Answer 13

1. The firm expects to pay a dividend, D1, in one year
2. Dividends grow indefinitely at a constant rate, g (which may be less than 0)
3. The growth rate, g , is less than the required rate of return, r.

Question 14

A high dividend growth rate is unrealistic. Above what rate should the growth rate be questioned?

Answer 14

> 5%

Question 15

How do you calculate the implied growth rate?

Answer 15

Use the Gordon Growth Model and re-arrange the formula to solve for g

Question 16

What is the equation for fundamental value on a non-growth basis that has additional opportunities for growth?

Answer 16

Question 17

Company XYZ has a price of $60 with expected earnings of $5 per share and a required return on 10%. Calculate the PVGO and the portion of the leading P/E related to PVGO

Answer 17

1. Determine the non-PVGO by dividing the earnings by required return (5/.1) = $50
2. Substract the $50 from $60 to get a PVGO of $10
3. The P/E of the firm is 60/5 = 12
4. The P/E of PVGO = 10/5 = 2
5. The percentage of the firms leading P/E ratio is 2/12 or 16.7%

Question 18

Define the Leading P/E and Trailing P/E….

Answer 18

Leading P/E is based on earnings forecast for the next period

Trailing P/E is based on the earnings for the previous period

Question 19

What is the formula to calculate the Justified Leading P/E?

Answer 19

Question 20

What is the formula to calculate the Justified Trailing P/E?

Answer 20

Question 21

How do you calculate the value of noncallable fixed-rate perpetual perferred stock?

Answer 21

Question 22

What are the characteristics that make the Gordon growth model (GGM) useful and approriate for many applications?

Answer 22

• Is applicable to stable, mature dividend-paying firms
• is appropriate for valuing market indices
• Is easily communicated and explained because of its straightforward approach
• Can be used to determine price-implied growth rates, required rates of return and value of growth opportunities
• Can be used to supplement other, more complex valuation models

Question 23

What are some charactersitics that limit the applications of the GGM?

Answer 23

• Valuations are very sensitive to estimates of growth rates and required rates of return
• The model cannot be easily applied to non-dividend paying stocks
• Unpredictable growth patterns of some firms would make using the model difficult and the resulting valuations unreliable

Question 24

What are the three phases of a business?

Answer 24

1. Initial Growth Phase - where the firm is rapidly increasing earnings, little or no dividends and heavy reinvestment
2. Transition Phase - earnings and dividends are still increasing but at a slowe rate as competitive forces reduce profit opportunities and the need for reinvestment
3. Mature Phase - in which earnings grow at a stable but slower rate, and payout ratios are stabilizing as reinvestment matches depreciation adn asset maintenance requirements

Question 25

Describe Earnings Growth in the Intial Growth Phase, Transitional Phase and Mature Phase….

Answer 25

• Initial Growth - Very High
• Transition - Above average but falling
• Mature- stable at Long Run level

Question 26

Describe Capital Investment in the Intial Growth Phase, Transitional Phase and Mature Phase….

Answer 26

• Initial Growth - Significant requirement
• Transition - Decreasing
• Mature- stable at Long Run level

Question 27

Describe the Profit Margin in the Initial Growth Phase, Transitional Phase and Mature Phase….

Answer 27

• Initial Growth - High
• Transition - Above average but falling
• Mature- stable at Long Run level

Question 28

Describe FCFE in the Initial Growth Phase, Transitional Phase and Mature Phase….

Answer 28

• Initial Growth - Negative
• Transition - May be positive, and growing
• Mature- stable at Long Run level

Question 29

Describe ROE vs. Return in the Initial Growth Phase, Transitional Phase and Mature Phase….

Answer 29

• Initial Growth - ROE > r
• Transition - ROE approaching r
• Mature- ROE = r

Question 30

Describe the Dividend Payout in the Initial Growth Phase, Transitional Phase and Mature Phase….

Answer 30

• Initial Growth - Low to zero
• Transition - Increasing
• Mature- stable at Long Run level

Question 31

Describe the appropriate model to use in the Initial Growth Phase, Transitional Phase and Mature Phase….

Answer 31

• Initial Growth - Three Stage
• Transition - Two Stage
• Mature- Gordon growth

Question 32

How do you calculate the terminal value in Yr 10 given the following?

• Yr 10 dividend = $6.00
• Required return = 11%
• Dividend growth rate = 4%

Answer 32

Question 33

What is the formula to calculate a two-stage growth model?

Answer 33

Question 34

How is an H - model different than other models in valuation?

Answer 34

It approximates the value of a firm assuming that an intially high rate of growth declines linearly over a specified period.

Question 35

What is the formula for a H-model?

Answer 35

Question 36

How can you re-arrange the Gordon growth model to calculate the implied expected return?

Answer 36

Question 37

The H-model can be rewritten in terms of r an used to solve for r given the other model input. What is the formula?

Answer 37

Question 38

How do you calculate the sustainable growth rate of a company using the PRAT model?

Answer 38

Question 39

Davidson determines that over the past three years, Samson has maintained an average net profit margin of 8 percent, a total asset turnover of 1.6, and a leverage ratio (equity multiplier) of 1.39. Assuming Samson continues to distribute 35 percent of its earnings as dividends, Samson’s estimated sustainable growth rate (SGR) is:

Answer 39

Utilizing the PRAT model, where SGR is a function of profit margin (P), the retention rate (R), asset turnover (A) and financial leverage (T):

g = P × R × A × T

g = 0.08 × (1 &£8722; 0.35) × 1.6 × 1.39 = 0.116 = 11.6%.

Question 40

An analyst is considering the purchase of Delphos Machinery, which has a price-to-book value (P/B) ratio of 8.00. Return on equity (ROE) is expected to be 14%, current book value per share is $12.00, and the cost of equity is 11%. What growth rate is implied by the current P/B rate?

Answer 40

The P/B ratio of 8.00 and the current book value per share of $12.00 imply a current market price of $96.00. This implies a growth rate of:

g = r − [B₀(ROE − r)] / (V₀ − B₀) = 0.11 − [12.00(0.14 − 0.11)] / (96.00 − 12.00) = 0.1057 = 10.57%.

Question 41

In the formulas for Justified P/E and Sustainable growth rate, what does the term **B **stand for?

Answer 41

B = earnings retention rate

Question 42

In the formulas for Justified P/E and Sustainable growth rate, what does the term 1-B stand for?

Answer 42

1-B = Dividend Payout Ratio