Topic 3 Flashcards
What do DCF models view
intrinsic value of a common stock as the present value of its expected future CF
Name 3 different DCF models
- DDM
- FCF model
- Residual Income model
What is the rationale of DDM
During an investors holding period, he generally receives cash returns only in the form of dividends
What is the argument against DDM
Value should be driven by earnings but not dividends
what is the relationship b/w earnings and dividends
- Reinvested earnings provide a basis for increased future dividends
- Dividend displacement of earnings; a higher payout ratio now may imply a slower growth rate in the future
what the the formula for dividend payout ratio
1-b
what is the formula for growth rate
g = b * ROE
What should you consider when choosing a DDM
- History of dividend payment
- Do the dividends have a consistent relationship to the company’s profitability
- Does the investor take a non-control perspective
What model do you use if there is constant growth forever
gordon growth model
what dividend model do you use if theres 2 stages of growth
- Two-stage growth model
2. H-model involving a linearly declining growth rate
what dividend model do you use if there is three stages of growth
- Three-stage growth model with three distinct growth
2. three-stage growth model involving H model
what is the formula for GGM
D1/ r-g
What are the limitations of GGM
- Stock value is sensitive to r and g
- not applicable to non-dividend paying companies
- g must be constant
- underlying assumption r > g
What does it mean when
Expected g ><= implied g
- Undervalued
- Overvalued
- Fairly valued
How do you value a preferred stock
D0/r
as g = 0
What is trailing and leading P/E ratio
P0/E0
P0/E1
an alternative perspective on the valuation of the stock is
Justified P/E >=< actual P/E
Undervalued
Fairly Valued
Over Valued
What is the formula when using GGM to derive justified leading P/E
(1-b)/r-g
What is the formula when using GGM to derive trailing leading P/E
(1-b)(1+g)/r-g
Stock price $50.00 Trailing earnings per share $4 .00 Current dividends per share $1.60 Dividend growth rate 5% Required return on stock 9%
Use GGM to calculate justified leading P/E
(1.6/4)/0.09-0.05 = 10
Stock price $50.00 Trailing earnings per share $4 .00 Current dividends per share $1.60 Dividend growth rate 5% Required return on stock 9%
Use GGM to calculate justified trailing P/E
10*1.05 = 10.5
Stock price $50.00 Trailing earnings per share $4 .00 Current dividends per share $1.60 Dividend growth rate 5% Required return on stock 9%
evaluate the stock ? overvalued, undervalued or fairly valued
Calculate actual trailing P/E = 50/4 = 12.5 > 10.5 therefore its overvalued
or
Calculate GGm 1.6*(1.05)/0.09-0.05 = 42 < 50 therefore its overvalued
What are the strengths of GGM
- Simple to understand
- Applicable to stable, mature firms that have constant dividend growth
- Can be applied to entire markets
- g can be estimates using macro data ie nominal GDP growth
- Can be applied to firms that repurchase stock
What is the formula for g
g = (1 - modified payout ratio) * ROE
Modified Payout ratio = Dividends+ stock buybacks/ net income
What are the assumptions of the fast growth stage
Rapidly increasing earnings
Heavy reinvestment
Small or no dividends
what are the assumptions of the transition stage
Growth slows
capital reinvestment slows
FCFE and dividends Increase
What are the assumptions of the maturity stage
ROE = r
Earnings and dividends growth matures
GGM useful
what stages are needed for the general two stage model
Fast growth stage and maturity stage
What are two ways to determine the terminal value Pt
Apply GGM to estimat Pt = Dt+1/r-gl
Or
Apply a multiple to Pt
Pt = forecasted earnings*P/E
Forecasted earnings = D/1-b
how do you estimate growth rate at mature stage
g = b*ROE ROE = required return = industry average
g = (NI-Div/NI)* Ni/Sales * Sales/TA * TA/Equity
