Seminar 5

Question 1

3 types of discounted CF model + in what in situation/conditions are each model most appropriate

Answer 1

1) Dividend discount model (DDM)
- dividend paying company
- dividend related to earnings
- noncontrolling perspective

2) Free cash flow model to firm/shareholders (FCFF/E)
- small/no dividend
- positive CF related to earnings
- controlling perspective

3) Residual income model (RI)
- small/no dividend
- negative FCF
- high quality accounting disclosures

Question 2

Why dividend paying companies are viewed upon favourably?

Answer 2

Firm:

• credible dividend policy demonstrate financial discipline of mgmt
• signal capital efficiency, ability and willingness to distribute returns to S/H
• indicate strong CF generation, “real” economic earnings

S/H:

• div paying shares yield higher returns
• defensive qualities to cushion portfolio in decline – sustainable and meaningful yield during economic downturn
• reinvest dividend at lower price during bear markets

Question 3

List types of DDM models (4)

Answer 3

1. Basic = D1 / (1 + r)^1 + …
2. Gordon growth model = D1 / (r - g)
3. 2 stage model
   - 3.1: Traditional 2 stage model
   - 3.2: H-model

Question 4

Pros and Cons of Gordon Growth DDM

Answer 4

Pros:

1) Simplicity and clarity of relationships between V, r, g, and D
2) Good for valuing stable-growth, dividend-paying companies
3) Good for valuing indexes

Cons:

4) Calculated values are very sensitive to assumed values of g & r
5) Is not applicable to non-dividend-paying stocks
6) Is not applicable to unstable-growth, dividend paying stocks

Question 5

Use what to calculate implied growth rate?

Answer 5

r = (D1/P0) + g

Question 6

Dissect share price

Answer 6

Share price = (P)Value of stock with no growth opportunities + (P)Value of growth opportunities

• (P)Value of stock with no growth opportunities = E1/r

Question 7

Use what to calculate PV of growth opportunities of stock?

Answer 7

V0 = E1/r + PVGO
=> PVGO = P0 - E1/r
- E1/r: value of firm with no growth opportunities (perpetuity of E/r)
- PVGO: value of growth opportunities

Question 8

(2) justified P/E formula derived from Gordon Growth model

Answer 8

1) Justified trailing P/E ratio = (D0/E0)(1 + g) / (r - g) = (1 + b)(1 + g) / (r - g)
2) Justified leading P/E ratio = (D1/E1) / (r - g) = (1 + b) / (r - g)

Question 9

Assumptions and examples of traditional 2 stage model

Answer 9

Assumptions:
- abrupt transition from 1st to 2nd stage

Examples:

• suitable for firms with temporary advantage in market
• eg. expiry of patents
• eg. new competitors enter the market

Question 10

Pros and Cons of 3 stage model

Answer 10

Pros:

• accommodate variety of patterns of future dividend streams
• forces to specify explicit assumptions about growth profile of firm

Cons:
- if inputs are not economically meaningful, outputs will be of questionable value

Question 11

3 approaches of estimating growth rate – which would be the most appropriate and insightful?

Answer 11

1) Sustainable growth rate: g = ROE x (1 - Payout)
2) Historical rates
3) Company and industry fundamentals: assume firm’s g is related to industry and economy

Question 12

Estimating sustainable growth rate using DuPont

Answer 12

g = ROE x (1 - Payout)

= (NI/Sales) x (Sales/Assets) x (Assets/SHE) x (1 - Div/NI)

Question 13

What is equity multiplier?

Answer 13

Assets / Shareholder’s equity