1
Q
What is a DDM
A
Dividend discount models define cash flow as the dividends to be received by the shareholders
2
Q
What are the advantages of DDMs
A
- Theoretically justified, as investor investments are based on the PV of Future Cashflows expected to receive
- Dividends are less volatile than other measures (earnings or free cash flow)
- So DDM models are less volatile and reflect the long-term earnings potential of the company
3
Q
What are the Disadvantages of DDMs
A
- Difficult to implement for firms that don’t currently pay dividends.
- Estimating expected future dividends by forecasting the point in the future to begin paying dividends is possible
- But uncertainty is associated with forecasting the fundamental variables that influence stock price
- Takes the perspective of an investor who owns a minority stake in the firm and cannot control the dividend policy
- If the dividend policy is not related to the firm’s ability to create value, then dividends are not an appropriate measure of expected future cash flow to shareholders
4
Q
When are Dividends appropriate as a measure of cash flow?
A
- The company has a history of dividend payments.
- The dividend policy is clear and related to the firm’s earnings.
- The perspective is that of a minority shareholder.
5
Q
What are 2 types of free-cash flow models?
A
- Free cash flow to the firm (FCFF)
The cash flow generated by the firm’s operations that is in excess of the capital investment required to sustain the firm’s current productive capacity - Free cash flow to equity (FCFE)
Cash available to stockholders after funding capital requirements and expenses associated with debt financing
6
Q
What are the advantages of Free cash flow models
A
- Can be applied to many firms, regardless of dividend policies or capital structures
- Ability to influence the distribution and application of a firm’s free cash flow makes them more pertinent to a firm’s controlling shareholder
- Useful to minority shareholders because the firm may be acquired for a market price equal to the value to the controlling party.
7
Q
What are the disadvantages of Free cash flow models
A
- Application can be difficult in some cases
- Firms that have significant capital requirements may have negative free cash flow for many years into the future.
- Negative free cash flow complicates the cash flow forecast and makes the estimates less reliable.
8
Q
When are free cash flow models appropriate as a measure of cash flow
A
- For firms that do not have a dividend payment history or have a dividend payment history that is not clearly and appropriately related to earnings.
- For firms with free cash flow that corresponds with their profitability.
- When the valuation perspective is that of a controlling shareholder.
9
Q
What is Residual Income models
A
- Amount of earnings during the period that exceeds the investors’ required return
- Theoretical basis for this approach is that the required return is the opportunity cost to the suppliers of capital, and the residual income is the amount that the firm is able to generate in excess of this return
10
Q
What are the advantages of residual income?
A
Can be applied to firms with negative free cash flow and to dividend- and non-dividend-paying firms.
10
Q
What are the disadvantages of residual income?
A
- More difficult to apply because they require in-depth analysis of the firm’s accounting accruals
- If the accounting is not transparent or if the quality of the firm’s reporting is poor, the accurate estimation of residual income is likely to be difficult
11
Q
When are residual income models appropriate as a measure of cash flow
A
- Firms that do not have dividend histories.
- Firms that have negative free cash flow for the foreseeable future (usually due to capital demands).
- Firms with transparent financial reporting and high-quality earnings.
12
Q
How to calculate one-period DDM
A
V0=(D1+P1)/(1+r)
V0 = fundamental value
D1 = dividends expected to be received at end of Year 1
P1 = price expected upon sale at end of Year 1
r = required return on equity
13
Q
How to calculate two-period DDM
A
V0=[D1/(1+r)^1] +[(D2+P2)/(1+r)^2 ]
V0 = fundamental value D1 = dividends expected to be received at end of Year 1 D2 = dividends expected to be received at end of Year 2 P2 = price expected upon sale at end of Year 2 r = required return on equity
14
Q
How to calculate multi-period DDM
A
V0=[D1/(1+r)^1] +[D2/(1+r)^2 ]+…+[(Dn+Pn)/(1+r)^n ]
V0 = fundamental value
Di = dividends expected to be received at end of year i, i = 1 to n
Pn = price expected upon sale at end of year n
r = required return on equity
n = length of holding period
15
Q
What is the GGM model formula?
A
16
Q
What is the GGM?
A
Gordon growth model (GGM)
* assumes that dividends increase at a constant rate indefinitely
* simplifying factor: The rate of growth can be expressed per period in the same way that the required return is expressed
17
Q
What are the assumptions of the GGM?
A
- The firm expects to pay a dividend, D1, in one year.
- Dividends grow indefinitely at a constant rate, g (which may be less than zero).
- The growth rate, g, is less than the required return, r
18
Q
What is the CAPM Model
A
r = Risk Free r + [beta x (Expected Return on Market - Risk Free r)]
19
Q
A
19
Q
How to Calculate the value of non-callable fixed-rate perpetual preferred stock.
A
Value of perpetual preferred shares=DP/rP
Dp = preferred dividend (which is assumed not to grow)
rp = cost of preferred equity
20
Q
What are the assumptions of Value of non-callable fixed-rate perpetual preferred stock
A
- A firm that has no additional opportunities to earn returns in excess of the required rate of return should distribute all of its earnings to shareholders in the form of dividends.
○ The growth rate would be zero
21
Q
What are the Characteristics that make CCM useful and appropriate for many applications
A
- Is applicable to stable, mature, dividend-paying firms.
- Is appropriate for valuing market indices.
- Is easily communicated and explained because of its straightforward approach.
- Can be used to determine price-implied growth rates, required rates of return, and value of growth opportunities.
- Can be used to supplement other, more complex valuation methods
22
Q
What are the characteristics that limit the applications of the GGM
A
- Valuations are very sensitive to estimates of growth rates and required rates of return, both of which are difficult to estimate with precision.
- The model cannot be easily applied to non-dividend-paying stocks.
- Unpredictable growth patterns of some firms would make using the model difficult and the resulting valuations unreliable.
23
What are the present value of growth opportunities (PVGO)
* A firm that has additional opportunities to earn returns in excess of the required rate of return would benefit from retaining earnings and investing in those growth opportunities rather than paying out dividends.
* The fundamental value then represents not only the present value of the future dividends (on a non-growth basis) but also the present value of the growth opportunities (PVGO)
24
How to calculate the value of companies with PVGO
V0=E1/r+PVGO
E1 = earnings at t = 1
r = required return on equity
present value of the growth opportunities (PVGO)
25
What are the 2 components of a firms value under the PVGO model?
* The value of its assets in place (E1/r), which is the present value of a perpetual cash flow of E1.
* The present value of its future investment opportunities (PVGO)
* A substantial portion of the value of growth companies is in their PVGO.
* Companies in slow-growth industries have low PVGO, and most of their value comes from their assets in place.
26
What are Justified P/Es using the Gordon growth model.
* The price-to-earnings (P/E) ratio is the most commonly used relative valuation indicator.
* Justified P/E derived based on the firm's fundamentals
27
What are the 2 forms of Justified P/E
* Leading P/E - based on the earnings forecast for the next period,
* Trailing P/E - based on the earnings for the previous perio
28
How to calculate Justified leading P/E and Justified trailing P/E
29
How to calculate the rentention ratio?
retention raio = b= [(earnings - dividends)/earnings]
30
How to Calculate the payout ratio
Payout ratio = (1-b) = [dividends/earnings]
31
What are Company patterns of growth:?
* Growth phase - the firm has rapidly increasing earnings, little or no dividends, and heavy reinvestment.
* Transition phase - earnings and dividends are still increasing but at a slower rate as competitive forces reduce profit opportunities and the need for reinvestment.
* Mature phase - earnings grow at a stable but slower rate, and payout ratios are stabilizing as reinvestment matches depreciation and asset maintenance requirements.
32
What model should be used based on the firm's growth phase
* Growth Phase - Three stage
* Transition Phase - two stage
* Maturity Phase - Gordon Growth model
33
Are the growth paterns predestined? Why or why not?
This pattern is not predestined
1. Many firms are successful in constantly adapting and entering into new growth opportunities
2. Mature firms may develop technology that forms the basis for a whole new product and market
34
What is the Two-stage DDM?
* Most basic multistage model
* Assumes the company grows at a high rate for a relatively short period of time (the first stage) and then reverts to a long-run perpetual growth rate (the second stage)
* The length of the high-growth phase is a function of the visibility of the company's operations;
35
What are the asusmptions with GGM and models?
* For most companies, the Gordon growth model assumption of constant dividend growth that continues into perpetuity is unrealistic.
* Forecasting dividends into the future and discounting them back to today to find intrinsic value.
* Over the long term, growth rates tend to revert to a long-run rate approximately equal to the long-term growth rate in real gross domestic product (GDP) plus the long-term inflation rate. Historically, that number has been between 2% and 5%. Anything higher than 5% as a long-run perpetual growth rate is difficult to justify.
36
What is the H-model?
* The H-model utilizes a more realistic assumption: the growth rate starts out high and then declines linearly over the high-growth stage until it reaches the long-run average growth rate.
37
What is the three-stage model?
* Appropriate for firms that are expected to have three distinct stages of earnings growth
* More complex refinement of a two-stage model.
38
What is spreadsheet modelling
* In practice we can use spreadsheets to model any pattern of dividend growth we'd like with different growth rates for each year because the spreadsheet does all the calculations for us
* Spreadsheet modeling is applicable to firms about which you have a great deal of information and can project different growth rates for differing periods
39
What is Terminal Value?
* Assumes dividends will begin to grow at a constant, long-term rate. Then the terminal value at that point is just the value derived from the Gordon growth model.
* two ways to do this:
1. Gordon growth model (Most common in the exam)
2. Market multiple approach - Many analysts also use market price multiples to estimate the terminal value rather than use the GGM method of discounting dividends.10
40
What are the assumptions of Two-stage fixed growth rate model
Assumption that the firm will enjoy an initial period of high growth, followed by a mature or stable period in which growth will be lower but sustainable.
41
What are the assumptions under H-model?
* The earnings growth of most firms does not abruptly change from a high rate to a low rate as in the two-stage model but tends to decline over time as competitive forces come into play.
Assumes that an initially high rate of growth declines linearly over a specified period.
42
How to calculate the Two-stage fixed growth rate model?
43
How to calculate the Valuation Using the H-Model?
44
What are the steps of the spreadsheet modelling
* Step 1:
Establish the base level of cash flows or dividends. In the case of dividends, this would ordinarily be either the amount paid over the preceding year or some normalized level based upon projected firm earnings.
* Step 2:
Estimate changes in the firm's dividends for the foreseeable future (also known as the supernormal growth period) and project future cash dividends on the basis of these estimates. Because the spreadsheet can be programmed in a virtually infinite series of combinations, any dividend pattern desired can be achieved.
* Step 3:
Because an equity security has an infinite life, the analyst needs to estimate what normalized level of growth will occur at the end of the supernormal growth period. This allows for an estimate of a terminal value, representing the cash flow (i.e., the firm's value if sold at this time) to be received at the end of the supernormal growth period.
* Step 4
Discount all projected dividends and the terminal value back to today to obtain an estimate of the firm's current value.
45
What is Sustainable growth Rate (SGR)
* Rate at which earnings (and dividends) can continue to grow indefinitely, assuming that the firm's debt-to-equity ratio is unchanged and it doesn't issue new equity
SGR = b x ROE
B=earnings retention rate - 1 - dividend payout rate = 1 - dividends/earnings
ROE = Net income/ Sales x [sales/total assets] x [ total asset/SE] = net income/SE
* Also been called the PRAT model,
* SGR is a function of the profit margin (P), the retention rate (R), the asset turnover (A), and financial leverage (T).
* 2 These factors can be used as building blocks in developing an estimate of a firm's growth.
* If the actual growth rate is forecasted to be greater than SGR, the firm will have to issue equity unless the firm increases its retention ratio, profit margin, total asset turnover, or leverage.
46
CFA Level II
flashcards
Decks in class (7)
# Cards
