The dividend discount models - Essay Example

This model calculates the value of common stock as follows. V0 =At 5%, 6% and 4% successive dividend growth rates from first year to third year, and D0 given, we can estimate D1, D2, and D3; and given g we can estimate the value of stock (V0) as per the equation. The Dividend Discount Models are not very accurate mainly because of the difficulty of estimating a rate of growth of dividends, and unpredictability of stock markets, which may overbid or underbid prices of stocks. 2.2 The FCFF Model This model calculates the present value of all future free cash flows minus the market value of outstanding debt and preferred stock.

Value of Operations = Value of Equity = Value of Operations - Value of Debt Value per Share = Value of Equity / Total Common Stock Outstanding2.3 Multiples ApproachAnalysts many times use price multiples to value stocks. These multiples may be Price/Earning, Price/ Cash Flow, Price/Revenue, Price/ Book, Price/ Sales, Price/ Earnings Growth (PEG). ( Using Ratios and Multiples, n.d.) The most popular P/E Ratio is shown below: P/E = (Stock Price/ EPS) EPS = Earnings per shareHigher P/E ratio denotes better growth prospects and vice versa.

The drawback of this method is that it becomes meaningful only with context. The context may be skewed. Reported earnings may sometimes be inflated or depressed. Firms that go through turbulent business cycles require more investigation. Other shortcomings of multiples method is that comparable firms are hard to find within an industry or industries. 2.4 Yield Based Valuation ModelsThese models include the Cash Return method (Cash Return = Free Cash Flow + Net Interest. Common Stocks represent an ownership position in a firm.

This position entitles the holder to several privileges. An important part of value investing is valuation of common stock. There are several methods of common stock valuation, some of which we discuss in this paper.The Dividend Discount Models mainly predict the dividends, and net present value of a common stock. According to this method, the value of a dividend is the sum of all future dividends. Three types of discount models predict future dividends or value of a stock as outlined below. There are several methods, of common stock valuation, available to investors or analysts.

Some of the methods outlined above are more popular ones. These methods present a more or less accurate estimate of the value of a common stock. Gordon Growth Model: This model works best for firms which show stable growth rates (not higher than that of the economy in the long term); which pay out large dividends; and which have a stable leverage. For other firms it is not very reliable.Variable Growth model: This model is most reliable for firms with unstable but moderating growth rates, and which pay dividends that equal FCFE or where FCFE are difficult to estimate.

Advantages: 1. The sales numbers are more or less exact and not subject to manipulation or assumption. 2. Sales are not volatile as earnings may be. 3. Sales is a much more stable benchmark.