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Slide 15.1

Investments

Chapter 15: Stocks: Valuation and Selection

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Slide 15.2

Dividend Discount Models (DDMs)

Models based on the principle that the intrinsic value of an asset is the present

value of all its expected future cash flows.

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Slide 15.3

Generalized DDM

• where E(DPSt) is the expected dividend per share paid at the end of Year t,

• and k is the proper discount rate at which the cash flows are discounted.

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Slide 15.4

The Constant Dividend Growth Model: I

• Also known as the Gordon Growth Model.

• Assumes that a firm’s expected earnings per share grow at a constant growth rate (g) and that it pays a constant percentage of its earnings as dividends:

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Slide 15.5

The Constant Dividend Growth Model: II

The general DDM equation then reduces to the following simplified valuation equation:

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Slide 15.6

Estimating the Inputs: g

1. Historical extrapolation:

2. Implied values:

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Slide 15.7

Estimating the Inputs: k

1. Based on the CAPM:

2. Implied values:

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Slide 15.8

Super-growth Firms• A super-growth firm can increase the

growth rate of the EPS and DPS with no change in their dividend policy.

• For the valuation of super-growth firms, the following equation applies:

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Slide 15.9

Multi-stage Growth Models

• Two-stage growth modelsFirm assumed to first experience super-growth and then normal growth.

• Three-stage growth modelsFirm assumed to evolve through three stages: growth, transition and maturity.

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Slide 15.10

Weaknesses in DDMs

1. DDMs do not explain why mispricing occurs or when it will be corrected.

2. The discount rate may change over time.3. DDM results are highly sensitive to the

choice of input parameters.4. The DDM is forward-looking, while most

investors base their estimates on the past.5. It’s difficult to assess the performance of

the DDM.

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Slide 15.11

The Free Cash Flow Model• Values a firm ‘as if’ it distributes the maximum

sustainable amount of dividend, this maximum is known as the free cash flow.

• The value of a normal-growth firm can then be calculated as:

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Slide 15.12

Valuation Multiples: I

• A value driver is a variable that is supposed to measure the intrinsic value of a firm’s equity.

• Multiples are the ratio of the market price of a share, or the market price of a firm, to a value driver.

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Slide 15.13

Valuation Multiples: II

1. The price/earnings (P/E) ratio.

2. The dividend yield.

3. Tobin’s q.

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Slide 15.14

Security Analysis

Three approaches to security analysis:

1. Firm-level analysis.

2. Industry analysis.

3. Macroeconomic analysis.