Reading 60: Equity Valuation: Concepts and Basic Tools-LOS f 2011, companies, discount, center, growth

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Session 14: Equity Analysis and Valuation
Reading 60: Equity Valuation: Concepts and Basic Tools

LOS f: Identify companies for which the constant growth or a multistage dividend discount model is appropriate.

 

 

The constant-growth dividend discount model would typically be most appropriate in valuing a stock of a:

A) rapidly growing company.

B) new venture expected to retain all earnings for several years.

C) moderate growth, "mature" company.

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Remember, the infinite period DDM has the following assumptions:

• The stock pays dividends and they grow at a constant rate.
• The constant growth rate, g, continues for an infinite period.
• k must be greater than g. If not, the math will not work.

If any one of these assumptions is not met, the model breaks down. The infinite period DDM doesn’t work with growth companies. Growth companies are firms that currently have the ability to earn rates of return on investments that are currently above their required rates of return. The infinite period DDM assumes the dividend stream grows at a constant rate forever while growth companies have high growth rates in the early years that level out at some future time. The high early or supernormal growth rates will also generally exceed the required rate of return. Since the assumptions (constant g and k > g) don’t hold, the infinite period DDM cannot be used to value growth companies.

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Which of the following statements concerning security valuation is least accurate?

A) The best way to value a company with no current dividend but who is expected to pay dividends in three years is to use the temporary supernormal growth (multistage) model.

B) A firm with a $1.50 dividend last year, a dividend payout ratio of 40%, a return on equity of 12%, and a 15% required return is worth $18.24.

C) The best way to value a company with high and unsustainable growth that exceeds the required return is to use the temporary supernormal growth (multistage) model.

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A firm with a $1.50 dividend last year, a dividend payout ratio of 40%, a return on new investment of 12%, and a 15% required return is worth $20.64. The growth rate is (1 – 0.40) × 0.12 = 7.2%. The expected dividend is then ($1.50)(1.072) = $1.61. The value is then (1.61) / (0.15 – 0.072) = $20.64.

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Which of the following statements about the constant growth dividend discount model (DDM) in its application to investment analysis is least accurate? The model:

A) is best applied to young, rapidly growing firms.

B) can’t be applied when g > K.

C) is inappropriate for firms with variable dividend growth.

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The model is most appropriately used when the firm is mature, with a moderate growth rate, paying a constant stream of dividends. In order for the model to produce a finite result, the company’s growth rate must not exceed the required rate of return.

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Which of the following is NOT an assumption of the constant growth dividend discount model (DDM)?

A) The growth rate of the firm is higher than the overall growth rate of the economy.

B) Dividend payout is constant.

C) ROE is constant.

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Other assumptions of the DDM are: dividends grow at a constant rate and the growth rate continues for an infinite period.