Economics Question

Overview

Topic 3 DQ 1

Jun 13-15, 2024

You have been asked to perform a stock valuation prior to the annual shareholders' meeting next week. The two models you have selected to value the firm are the dividend discount model and the discounted cash flow model. Explain why the estimates from the two valuation methods differ. Address the assumptions implicit in the models themselves as well as those you made during the valuation process.

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Jun 13, 2024, 2:18 PM

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Clover Creighton

Jun 14, 2024, 8:47 AM

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Dr. Baker,

Dividend discount model

This is a quantitative method for predicting a companies stock price based on the current price is worth the total of all its future dividend payments when discounted back to their present value. This model has the presumption of a steady and perpetural growth rate less than the cost of capital which may not be reasonable. If the stock does not currently pay a dividend, like many growth stocks, more general versions of the discounted dividend model must be used to value the stock. For this model the dividends must be predictable and sustainable, if the changes are too dramatic then this model would not be appropriate.

Discounted cash flow model

This model is stating that a company is worth the total of its discounted future free cash flows. This is a mechanical valuation too which makes it subject to the principle of "garbage in, garbage out."(Streetofwalls) Small changes in inputs can result in large changes in the value of a company. Instead of trying to project the cash flows to infinity, termal value techniques are often used. A simple perpetuity is used to estimate the terminal value past 10 years. This is done because it is harder to come to a realistic estimate of the cash flows as time goes on involves calculating the period of time likely to recoup the intial outlay. Another shortfall of this model is that it should only be used as a method of intrinsic calculation for companies with predictable cash flows (Bringham & Ehrhardt, 2020). The DCF valuation method is widely used in calculating mature companies in stable industry sectors such as utilities. At the same time this method is often applied a number of times to assess a number of possible future outcomes such as best and worst case scenarios. If the cash flows are erratic and unpredictable this model would not be appropriate for the valuation. Small changes in the risk-adjusted rate of return or future growth rates will change today's value dramatically.

Another element to consider for both is the discount rate used in either model. This is based on the company's weighted aver cost of capital (WACC) which reflects the required return on the company's debt and equity. Both are solid tools and have their differences due to focusing on different aspects of a company's financial performance, making different assumptions.

Thank you for reading,

Clover Creighton

Brigham, E. F., and Ehrhardt, M. C. (2020). Financial management: Theory and practice [with MindTap] (16th ed.). Cengage Learning. ISBN-13: 9780357252680

Streetofwalls. Street Of Walls. (n.d.). https://www.streetofwalls.com/finance-training-courses/investment-banking-technical-training/discounted-cash-flow-analysis/#:~:text=This%20is%20quite%20possible%2C%20given,the%20result%20will%20be%20wrong.