Questions and Answers
What is the primary assumption of the Gordon Growth Model?
What is the formula to calculate the present value of growth opportunities (PVGO)?
Which of the following methods is used to determine the discount rate for the FCFF model?
What is the relationship between the discount rate (r) and the growth rate (g) in the Gordon Growth Model?
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What is the purpose of the build-up method?
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How do you calculate the next year's dividend (D1) if you are given the current dividend (D0) and the growth rate (g)?
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What is the fundamental idea behind discounted cash flow (DCF) valuation?
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Which of the following is a characteristic of a firm suitable for dividend discount model (DDM) valuation?
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What is the main use of the present value of growth opportunities (PVGO) concept?
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How many versions of the multiperiod DDM are discussed in the content?
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What is free cash flow to equity (FCFE)?
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When is the residual income (RI) method most appropriate?
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What is residual income?
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Which of the following is a characteristic of a firm suitable for free cash flow (FCF) valuation?
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What is the value of a firm's equity in the residual income (RI) framework?
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When is the dividend discount model (DDM) not suitable?
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Study Notes
Discounted Dividend Valuation
- Discounted cash flow (DCF) valuation is based on the idea that the value today of any security is the discounted value of all future cash flows.
Dividend Discount Models (DDMs)
- DDMs define cash flow as dividends to be received in the future.
- Assumptions of DDMs:
- Earnings and dividends will converge over time.
- Suitable for mature and profitable firms, or large, diversified portfolios like the S&P 500.
- Characteristics of firms suitable for DDM:
- Dividend history exists.
- Dividend policy is consistent and related to earnings.
- Perspective is that of a minority shareholder.
Free Cash Flow (FCF) Models
- Cash flow from a security can also be defined as free cash flow.
- Two versions of FCF models exist:
- FCF to the firm (FCFF): cash flow generated by the firm above that required to be reinvested to maintain current operations.
- FCF to equity (FCFE): FCFF minus debt service and preferred dividends.
- FCF models are suitable when:
- Firm does not have a stable dividend policy.
- Dividend policy is not related to earnings.
- Firm's FCF is related to profitability.
- Perspective is that of a controlling shareholder.
Residual Income (RI) Method
- Residual income refers to the amount of earnings during the period that exceed the investor's required earnings.
- RI is equivalent to economic profit.
- Value of the firm's equity = book value + present value of all future residual income.
- RI method is suitable when:
- Firm does not have a dividend history.
- Firm's FCF is negative.
- Firm has transparent and high-quality accounting.
Discount Rate
- Appropriate discount rate for DDM, FCFE, and RI methods is the cost of equity.
- Three methods to determine the cost of equity:
- Capital Asset Pricing Model (CAPM).
- Multifactor models (e.g. Arbitrage Pricing Theory, Fama-French model).
- Build-up method (e.g. adding a risk premium to the firm's bond yield).
- Appropriate discount rate for FCFF model is the weighted average cost of capital (WACC).
Multiperiod DDMs
- Four versions of multiperiod DDMs: Gordon growth model, 2-stage growth model, H-model, and 3-stage growth model.
- Gordon growth model:
- Assumes dividends will grow at a constant rate forever.
- Formula: V0 = D1 / (r - g).
- Requires r > g.
- Can be solved for r or g to determine the required return or growth rate implicit in the current market price.
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Description
Learn about the discounted cash flow (DCF) valuation method, including dividend discount models (DDMs) and how they're used to estimate a security's value.
