CFA 2.33 Discounted Dividend Valuation

compare dividends, free cash flow, and residual income as inputs to discounted cash flow models, and identify investment situations for which each measure is suitable;

A discounted dividend approach is most suitable for dividend-paying stocks in which the company has a discernible dividend policy that has an understandable relationship to the company's profitability, and the investor has a noncontrol (minority ownership) perspective. The free cash flow approach (FCFF or FCFE) might be appropriate when the company does not pay dividends, dividends differ substantially from FCFE, free cash flows align with profitability, or the investor takes a control (majority ownership) perspective. The residual income approach can be useful when the company does not pay dividends (as an alternative to a FCF approach) or free cash flow is negative.

calculate and interpret the implied growth rate of dividends using the Gordon growth model and current stock price;

Assuming that price equals value, the Gordon growth model estimate of a stock's expected rate of return is (image)

calculate and interpret the sustainable growth rate of a company, and demonstrate the use of DuPont analysis to estimate a company's sustainable growth rate;

Dividend growth rates can be obtained from analyst forecasts, statistical forecasting models, or company fundamentals. The sustainable growth rate depends on the ROE and the earnings retention rate, b: g = b × ROE. This expression can be expanded further, using the DuPont formula, as (image)

explain the growth phase, transitional phase, and maturity phase of a business;

For many companies, growth falls into phases. In the growth phase, a company enjoys an abnormally high growth rate in earnings per share, called supernormal growth. In the transition phase, earnings growth slows. In the mature phase, the company reaches an equilibrium in which such factors as earnings growth and the return on equity stabilize at levels that can be sustained long term. Analysts often apply multistage DCF models to value the stock of a company with multistage growth prospects.

Calculate the no-growth value per share.

If the company was a no-growth company, that is it paid out all its earnings and did not reinvest any, its earnings would stay the same. The value of such a company would be the value of a perpetuity, which is D/r = E/r

estimate a required return based on any DDM, including the Gordon growth model and the H-model;

In addition to valuing equities, the IRR of a DDM, assuming assets are correctly priced in the marketplace, has been used to estimate required returns. For simpler models (such as the one-period model, the Gordon growth model, and the H-model), well-known formulas may be used to calculate these rates of return. For many dividend streams, however, the rate of return must be found by trial and error, producing a discount rate that equates the present value of the forecasted dividend stream to the current market price.

calculate and interpret the PRAT model

P (Profit margin) R (retention) A (Asset Turnover) T (Leverage) g = P*R*A*T

calculate and interpret the value of a common stock using the dividend discount model (DDM) for single and multiple holding periods;

See image

explain the assumptions and justify the selection of spreadsheet modeling to value a company's common shares;

Spreadsheet models are very flexible, providing the analyst with the ability to value any pattern of expected dividends.

calculate the value of a common stock using the Gordon growth model, and explain the model's underlying assumptions;

The Gordon growth model assumes that dividends grow at a constant rate g forever, so that Dt = Dt-1(1 + g).

describe strengths and limitations of the Gordon growth model, and justify its selection to value a company's common shares;

The Gordon growth model may be useful for valuing broad-based equity indices and the stock of businesses with earnings that are expected to grow at a stable rate comparable to or lower than the nominal growth rate of the economy. Gordon growth model values are very sensitive to the assumed growth rate and required rate of return.

explain the assumptions and justify the selection of the H-model to value a company's common shares;

The H-model assumes that the dividend growth rate declines linearly from a high supernormal rate to the normal growth rate during Stage 1, and then grows at a constant normal growth rate thereafter. H is half-life, and 2H = period of decline. For example 10 year decline period results in H=5.

calculate and interpret the present value of growth opportunities (PVGO) and the component of the leading price-to-earnings ratio (P/E) related to PVGO;

The present value of growth opportunities (PVGO) is the part of a stock's total value, V0, that comes from profitable future growth opportunities in contrast to the value associated with assets already in place. The relationship is V0 = E1/r + PVGO, where E1/r is defined as the no-growth value per share (earnings in period 1 divided by required rate of return)

describe terminal value, and explain alternative approaches to determining the terminal value in a DDM;

The terminal stock value, Vn, is sometimes found with the Gordon growth model or with some other method, such as applying a P/E multiplier to forecasted EPS as of the terminal date.

explain the assumptions and justify the selection of the two-stage DDM to value a company's common shares;

The two-stage dividend discount model assumes different growth rates in Stage 1 and Stage 2. (Image) where gS is the expected dividend growth rate in the first period and gL is the expected growth rate in the second period.

explain the assumptions and justify the selection of the three-stage DDM to value a company's common shares;

There are two basic three-stage models. In one version, the growth rate in the middle stage is constant. In the second version, the growth rate declines linearly in Stage 2 and becomes constant and normal in Stage 3.