Reading 40: Discounted Dividend Valuation-LOS n, (Part 1) 习 center, return, required, div, increase

土豆妮

Session 11: Equity Valuation: Industry and Company Analysis in a Global Context
Reading 40: Discounted Dividend Valuation

LOS n, (Part 1): Explain how to estimate a required return based on any DDM.

 

 

 

If we increase the required rate of return used in a dividend discount model, the estimate of value produced by the model will:

A) decrease.

B) increase.

C) remain the same.

---

 

The required rate of return is used in the denominator of the equation. Increasing this factor will decrease the resulting value.

土豆妮

Which of the following groups of statistics provides enough data to calculate an implied return for a stock using the two-stage DDM?

A) Short-term growth rate, long-term growth rate, stock price, trailing 12-month profits.

B) P/E ratio, trailing 12-month profits, short-term PEG ratio, long-term PEG ratio, yield.

C) Yield, stock price, historical dividend-growth rate, historical profit-growth rate.

---

To calculate an implied return using the two-stage DDM, we need the stock price, the dividend, a short-term growth rate, and a long-term growth rate. In the correct answer, we can derive the stock price from the P/E ratio and profits, then derive the dividend from the price and the yield. Given the P/E ratio, we can also distill growth rates using the PEG ratios. Admittedly, earnings-growth rates aren’t the same as dividend-growth rates, but analysts routinely use either in their models. More to the point, this is the only answer in which we can come up with even imperfect data for all the needed variables. One choice does not provide us with a way to find the dividend. The other option does not give us the needed short-term and long-term growth rates.

土豆妮

In using the capital asset pricing model (CAPM) to determine the appropriate discount rate for discounted cash flow models (DCFs), the asset’s beta is used to determine the amount of:

A) the expected return in addition to the return required by the risk of the position.

B) equity premium.

C) risk-free rate applicable to the time period of the investment.

---

Beta measures the correlation between the equity market or index for which the market risk premium is calculated and the particular asset being valued. Beta is used to approximate the proportion of the equity risk premium applicable to the asset (in relation to the market or index used).

土豆妮

Analyst Kelvin Strong is arguing with fellow analyst Martha Hatchett. Strong insists that the dividend discount model can be used to calculate the required return for a stock, though only if the growth rate remains constant. Hatchett maintains that while such models are useful for calculating the value of a stock, they should not be used to calculate required returns. Who is CORRECT?

Strong

Hatchett

A) Correct Incorrect

B) Incorrect Incorrect

C) Incorrect Correct

---

Dividend discount models can be used to calculate required returns, assuming you have the stock price, dividends, and dividend-growth rates, so Hatchett is wrong. Strong is right about the fact that a DDM can calculate required returns, but wrong about the growth rate assumption. Multistage dividend discount models can account for expected changes in the growth rate.

土豆妮

Which of the following groups of statistics provides enough data to calculate an implied return for a stock using the two-stage DDM?

A) Short-term growth rate, long-term growth rate, stock price, trailing 12-month profits.

B) P/E ratio, trailing 12-month profits, short-term PEG ratio, long-term PEG ratio, yield.

C) Yield, stock price, historical dividend-growth rate, historical profit-growth rate.

---

To calculate an implied return using the two-stage DDM, we need the stock price, the dividend, a short-term growth rate, and a long-term growth rate. In the correct answer, we can derive the stock price from the P/E ratio and profits, then derive the dividend from the price and the yield. Given the P/E ratio, we can also distill growth rates using the PEG ratios. Admittedly, earnings-growth rates aren’t the same as dividend-growth rates, but analysts routinely use either in their models. More to the point, this is the only answer in which we can come up with even imperfect data for all the needed variables. One choice does not provide us with a way to find the dividend. The other option does not give us the needed short-term and long-term growth rates.

土豆妮

If we know the forecast growth rates for a firm’s dividends and the current dividends and current value, we can determine the:

A) net margin of the firm.

B) sustainable growth rate.

C) required rate of return.

---

Just as we can determine the current value of the shares from the current dividends, growth forecasts and required return, we can solve for any one of them if we know the other three factors.

土豆妮

Which of the following is least likely a valid approach to determining the appropriate discount rate for a firm’s dividends?

A) Capital asset pricing model (CAPM).

B) Free cash flow to firm (FCFF).

C) Asset pricing theory (APT).

---

FCFF is another discounted cash flow model, not a method to determine required returns. Each of the other answers is a valid approach to determining an appropriate discount rate.

土豆妮

If the risk-free rate is 6%, the equity premium of the chosen index is 4%, and the asset’s beta is 0.8, what is the discount rate to be used in applying the dividend discount model?

A) 7.80%.

B) 9.20%.

C) 10.80%.

---

The discount rate = risk-free rate + beta (return expected on equity market less the risk-free rate). Here, discount rate = 0.06 + (0.8 × 0.04) = 0.092, or 9.2%.