Chapter 5 : Discounted Dividend Model

estimate cash flows, discount for time value of money

2 elements of DCF valuation?

growth, transition to maturity, mature

3 stages of growth for most companies

company pays no dividends or they're a lot higher or lower than FCFE, company's FCFs align with company's profitability in the forecast horizon, investor takes a control perspective

3 times when FCFE and FCFF models are most appropriate

company pays dividends, dividend policy bears consistent relationship to company's profitability, investor takes non-control perspective

3 times when it's good to use DDM model

forward dividend yield

A dividend yield based on the anticipated dividend during the next 12 months.

dividends

DDM defines cash flows as

stockholder

DDM defines cash flows at the ___________ level

reinvested earnings

DDM model also accounts for _________ __________ because it takes all future dividends into account

gordon growth model

DDM model that assumes dividends grow indefinitely at a constant rate

long run intrinsic value

DDM values reflect what

a lot higher or a lot lower

FCF model may be preferred when dividends are what compared to FCFE

dividend growth rate

GGM can also be used to infer the _______ _____ _______ of a stock given price, expected D1, and estimated rE

preferred stock

GGM can also be used to value this type of stock

growth rate and required rate of return, sensitivity analysis to see how things change

GGM is very sensitive to what what should you do about it

= or less than economy's nominal growth rate

GGM model is most appropriate for company's whose dividends grow at what

long term expectations

GGM's required return and growth rate should reflect what

less, so they're less sensitive to short run fluctuations in value

are dividends more or less volatile than other return concepts?

equity market indices

can also use GGM to value what

no bc investor buying a small ownership share can't influence the timing or magnitude of distributions of cash to shareholders

can ddm be used from a controlling perspective?

no bc they would grow faster or at same rate at which their discounted, making value of stock infinite

can dividends grow at same rate as Re or faster than Re?

maybe. can use first stage where dividends equal 0

can you use multi-stage dividend discount model to value a non-dividend paying company?

investing cash flow

cash flow from buying and selling assets ex-investing in a new factory

financing cash flow

cash flow from debt and equity ex-buying back stock or issuing bonds

operating cash flows

cash flow from selling goods and services

FCFE

common equity can be as PV all expected future what

repurchases, dividends

companies can distribute FCF to shareholders through _________ or ___________

growth rate assumptions

difference between estimated value of stock from DDM and actual market value may be explained in different ______ _____ _______

European

do more American or European companies pay dividends

flat

earnings for a no growth company are _________ in perpetuity assuming a constant ROE

economic growth rates

equity market indices reflect avg _____ ______

market price per share/earnings per share

formula for PE ratio?

free cash flow to firm - payments to debtholders

formula for free cash flow to equity

cash flow from operations - capital expenditures

formula for free cash flow to firm?

d1/(re-g)

formula for ggm?

(D0*(1+SL))/(r-sL)+(D0*H*(Sg-Sl))/(r-SL)

formula for h-model?

dps/eps

formula for payout ratio?

=E1/r+PVGO

formula in numbers for value of share using pvgo

D/r

formula to value preferred stock?

chose class of DCF model, forecast cash flows, choose discount rate methodology, estimate discount rate

four steps in applying DCF analysis

dividends

future selling price of a stock should reflect expectations about

payout ratio

given a constant _______ ______, dividends and earnings both grow at g under the GGM model

changes in business mix, technology, strategic focus

how can company go from mature to growth stage?

distorting financials with accounting practices

how can management mess up RI valuation?

mature, profitable companies tend to pay dividends bc they make a lot of money but have no investment opportunities young profitable companies don't tend to pay dividends because they spend their money on growth opportunities

how do dividends vary between mature and young companies?

use a formula g=retention ratio in mature phase (b) * ROE in mature phase

how do you estimate a mature growth rate?

stays the same because both dividends and prices grow at same rate

how does dividend yield change in the GGM model?

less dividends, more repurchases

how have cash dividends and repurchases changed in recent years?

market multiples, GGM

how to estimate terminal value in two stage model?

nominal gdp growth, sum of real gdp growth rate and long run inflation rate

how to meausre economy's growth rate? how to measure the it?

pv of expected future cash flows

intrinsic value of common stock = what under DCF models

required rate of return on equity

investor's opportunity cost when they invest in a stock

capital expenditures

needed to maintain the company at a going concern

dividend discount model

oldest and simplest PV approach to valuing stock

abrupt transition from abnormal to sustainable growth

possible limitation of general two stage model?

forecast dividends over finite horizon

practical approach to DDM valuation?

capitalization rate

r is often called what in ggm perpetuity model

value added in excess of opportunity cost

residual income tries to measure what

decrease

share repurchases ________ the number of shares outstanding

neutral

share repurchases are _______________ in their effect on wealth of remaining shareholders if repurchases are done at market prices

no. use model like FCF or residual income that defines cash flows at company level

should you use DDM with a company that doesn't pay dividend?

dividends investor receives before stock is sold, all future dividends bc they determine stock's price when it's sold

stock value today under DDM model depends directly on _______ and indirectly on _____

pv of all future dividends

stockprice = what under an infinite holding period in DDM

supernormal growth period, supernormal growth rate

the longer these two things in the H-model, the hgiher the value of the stock

FCFF

this type of dcf model may be best when company's leverage is expected to change a lot over time

dividend discount model, free cash flow, residual income

three main discounted cash flow models

true

true/false 3 stage DDM with declining growth is mad popular

false

true/false FCF can't be used from a controlling perspective

true

true/false FCFF or FCFE can be calculated for any company

false

true/false GGM can't have a negative growth rate

false (may be committed to reinvestment or investment in a new asset)

true/false all cash flow from operations is free

false

true/false corporations are committed to share repurchases like they are for dividends

false (can be used for dividend and non-dividend paying stock)

true/false residual income model can only be used for dividend paying stock

true

true/false you can use different discount rates for different growth phases in multi-stage models

assume they grow at a pattern (GGM, two stage/h model, 3 stage), use pro-forma financial statement analysis to forecast finite # of dividends up to a terminal point and then forecast dividends from terminal point forward with growth pattern

two approaches to figuring out value of all future dividends?

calculated justified PE, use PE to decide whether forecasts of earnings growth bult into price are reasonable

two uses of P/E ratio in GGM

normal one has 3 stages of distinct growth, second version (basically h model) has linear decline in growth during second stage to mature rate

two versions of 3 stage growth?

general two stage model, H-model in general, stage 1 is abnormal growth and transition to stage 2 mature growth it abrupt in h-model, stage 1 is abnormal and dividends gradually decline to mature stage over course of stage 1

two versions of two stage dividend discount model? how do they differ

h-model

two-stage DDM model where Growth rate starts out high, declines linearly until it reaches the long run average growth rate

can be used to value last (mature) stage

use of GGM in multi-stage models?

higher

using RI model with companies that have negative cash flows produces higher or lower value estimates than a FCF model would have

sum of value of company without earnings reinvestment and PV of growth opportunities (pv of opportunity to profitably reinvest future earnings)

value of stock can be analyzed as sum of these two things (related to pv of growth opportunities)

value of opportunities to invest, value of real options

what determines company's PVGO?

cash flow that can be redeployed outside company without affecting its capital investments

what does FCFE represent

no growth in dividends, so same dividends as last year

what does it mean if a company has a flat EPS?

expanding market, high margins, high growth rate in EPS, negative FCFE bc of profitable investments, low dividend payout ratio

what happens in growth stage for companies?

company reaches equilibrium where opportunities for invevestment return opportunity cost, ROE approaches required RE and earnings, dividend payout ratio, and ROE stabilize, company can be valued with GGM

what happens in mature phase for companies?

earnings growth slow because competition decreases prices, margins or sales growth slow because of saturation, earnings growth rate declines to growth rate of overall economy, positive FCF and higher dividend payout ratio

what happens in transition to maturity stage for companies?

cash flow from operations that can be withdrawn without hurting the company

what is FCFF?

earnings-required return on shareholder equity

what is residual income?

risk free rate

what rate do you use to discount default risk free cash flows

distribute to shareholders

what should companies without profitable growth opportunities do with their earnings

multi-stage DDM with more plausible final stage growth related to nominal GDP growth

what should you do when a company has an earnings growth rate way above nominal gdp growth?

take account of effect of expected repurchases on per share growth

what should you do with share repurchases in DDM models?

only when earnings growth results from earnings returns that are higher than the opportunity cost of funds

when do earnings growth increase shareholder wealth?

company doesn't pay dividends, FCFs are negative within forecast horizon

when is the RI model good?

company has intense capital demand>negative FCFs into the future

when may a FCF model not be practical?

really long extraordinary growth periods, or big differences in Sg and Sl

when might you not want to use a h-model?

pv of yearly dividends + pv of expected stockprice

with a finite holding period, value of stock equals what under DDM

discount rate

you adjust the ______________ ___________ of equity cash flows to reflect their risk

1

you want to adjust raw, historical betas to overall mean value of