Dividend Discount Models (DDMs)

• Common stock valuation is complicated by fluctuating dividend payments, the absence of a maturity date or value, and difficulty in estimating the required rate of return.
• Investors buy common stock expecting returns through dividends and/or stock price appreciation.
• An investor holding stock for t years values it based on current price (present value), expected dividends, future selling price (future value), and the required rate of return (discount rate)

Dividend Discount Models (DDMs)

• DDMs discount expected shareholder dividends to their present value.
• Shareholder investments are worth the present value of expected future dividends.
• Dividends as cash flows are theoretically sound measure because even if sold early, the sale price reflects the present value of future dividends.
• Dividends are also less volatile than earnings.
• DDMs are unsuitable for firms not currently paying dividends.
• These models are also less relevant when valuing a minority stake in situations where dividend policy isn't aligned with profitability (i.e. controlling shareholders dictate dividend policy).
• Simplifying assumptions are made regarding future dividend payment patterns due to the difficulty of estimating them.

Zero Growth or Constant Dividend

• Constant dividends are treated as perpetuity, the stock pays the same dividend amount indefinitely.

Constant Growth Dividend

• Dividends grow at a steady rate, denoted as g.
• Stock price grows at the same rate as the dividend (g).
• It's assumed that the stock price grows at the same constant rate as the dividend.
• The value of an investment will grow at the same rate as its cash flows (if those cash flows grow at a constant rate through time).
• Capital gain yield refers to the rate at which the value of an investment grows.
• Capital gain yield is equal to the dividend growth rate.
• Required return is made up of two components: dividend yield and growth rate.
• Dividend yield is the expected cash dividend divided by current price.
• Growth rate is the capital gains yield (rate at which investment value grows).

Non-constant Growth

• A constant growth rate, g, cannot be greater than the required rate of return, R, because it will result in a negative price.
• Non-constant growth model allows for growth rate to be greater than required rate of return for some years.
• Dividends change at different rates until settling at a constant rate in the future
• The model calculates present value as the sum of discounted values of all expected cash flows.

Strengths of DDM

• These models offer flexibility to estimate value under an infinite number of scenarios.
• Analyst can easily identify the impact of different assumptions on value.

Limitations of DDM

• Models depend on the accuracy of input assumptions and projections.
• Stock value estimates are sensitive to growth rate and required return assumptions.

Free Cash Flows Valuation Models

• Free cash flow to the firm (FCFF) represents the cash flow from operations available to investors (shareholders and bondholders) after covering operating expenses, working capital needs, and long-term investments.
• FCFF is used to pay bondholders and the remaining amount is the free cash flow to equity (FCFE), which belongs to shareholders.
• Free cash flow to equity (FCFE) represents the cash flow available to shareholders after funding capital requirements, debt financing, and working capital needs.

Advantages of Free Cash Flow Valuation Models

• Applicable to almost any firm, irrespective of dividend policy or capital structure.
• Most suitable for firms without a clearly defined dividend policy.
• Works from the perspective of controlling shareholders.
• More appropriate from the perspective of controlling shareholders, who can influence the firm's free cash flows.

Limitations Free Cash Flow Valuation Models

• Significant capital investments due to technological changes can result in negative free cash flow for years.
• These models use discounted cash flow techniques; future cash flows are forecasted and discounted at the required return.
• FCFF is discounted at the weighted average cost of capital (WACC).
• FCFE is discounted at the firm’s required rate of return.

Residual Income or Economic Profit

• Residual income or economic profit, is the amount of earnings exceeding shareholder's required return.
• A firm can report positive net income without meeting the return required by its shareholders.

Strengths of Residual Income Models

• Can be applied to dividend and non-dividend paying firms and firms with negative free cash flows.

• These models are also appropriate when the cash flows are volatile.

• Models use accounting data, which is usually easily accessible.

• Valuation is less sensitive to terminal value estimates, reducing forecast errors.

• Models focus on economic profitability rather than just accounting profitability.

Weaknesses of Residual Income Models

• There's reliance on potentially manipulated accounting data.
• The models can be more difficult to apply, needing significant adjustments.
• In-depth analysis of accounting accruals is needed.
• They are more appropriate for firms with high quality earnings and transparent financial reporting.
• Free cash flow valuation model, the residual income valuation model and the price multiples, can be applied to companies that don’t pay dividends.

P/E Ratio

• Earnings power, as measured by earnings per share (EPS), is a primary determiner of investment value.
• The P/E ratio is popular in the investment community.
• P/E differences correlate with long-run average stock returns.

Shortcomings of the P/E Ratio

• Volatile, transitory earnings make P/E interpretation difficult.
• Negative earnings result in a meaningless P/E ratio.
• Management discretion in accounting practices can distort reported earnings.

Trailing vs. Leading P/E

• Trailing P/E uses earnings over the most recent 12 months.
• Leading P/E (forward or prospective) uses next year’s expected earnings.
• Trailing P/E is not useful for forecasting and valuation if the firm’s business has changed.
• Leading P/E may not be relevant if earnings are sufficiently volatile so that next year’s earnings are not easy to forecast with accuracy.

Advantage of Using Price-to-Sales Ratio

• P/S is meaningful even for distressed firms with negative earnings.
• Sales revenue is not easily manipulated.
• P/S is not as volatile as P/E multiples.
• P/S ratios are appropriate for mature, cyclical industries and start-ups.
• P/S differences correlate with long-run average stock returns.

Disadvantages of Using Price-to-Sales Ratios

• High sales growth does not guarantee high operating profits.
• P/S ratios do not capture differences in cost structures across companies.
• Revenue recognition practices can distort sales forecasts.