Risk and Return Measures - Dividend Growth Models
- Dividend Growth Models - Equity valuation is a subject of great depth and complexity. Valuation entails understanding a business; forecasting its performance, selecting the appropriate valuation model; converting such forecasting to a valuation and making a recommendation whether or not to purchase. Valuation models are as nuanced as the companies to which their application would appear to be best suited. For the purpose of the CFP® examination, candidates are expected to demonstrate proficiency in the basic mechanics and application of the dividend discount model which utilizes a firm's cost of capital to discount dividends to arrive at an approximate intrinsic value of the company.
- Constant (Gordon) Dividend Growth Model:
Where: P=security\'s price; D=dividend payout ratio; k=required rate of return (derived from the capital asset pricing model; g=dividends\' expected growth rate.
The model's assumptions are that: (i) the dividend growth rate is constant; the growth rate cannot equal or exceed the required rate of return; the investor's required rate of return is both known and constant. In practice, a company's earnings and growth rates are not known and not constant.
- Multi-stage Dividend Discount Models:
P=D(1+g)/(1+k) + D(1+g)(1+g)/(1+r)(k-g)
Where:P=security\'s price; D=dividend payout ratio; g=dividends\' expected growth rate; k=required rate of return.
Multistage models can accommodate any number of patterns of future streams of expected dividends. Spreadsheets enable the analyst to build and analyze many permutations on such models. However, care must be taken when choosing the model's inputs, lest the results become meaningless.Spreadsheets are susceptible to data errors which can result in erroneous valuations.
Sample Questions 1 - 5
- Ratio Analysis - ratio analysis is also discussed in Chapter 7 "Portfolio Development and Analysis", but more from the standpoint of evaluating the company's financial health. The ratios to be discussed below, analysts use as alternative valuation measures to the dividend discount models and fall under the rubric of market-based valuation tools.
- Price/Earnings: price per share/earnings per share. This is a relative valuation model.
- Price/Free Cash Flow (FCF): cash flow is less susceptible to manipulation than earnings, when the appeal of this metric.
- Price/Sales: how much an investor is paying for sales revenue. A drawback to this ratio is that this considers price as a multiple of top line growth, whereas net income (bottom line growth) may be negative.
- Price/Earnings/Growth (PEG): used to compare firms with different growth rates. PEG ratios can be used to determine possible value opportunities for analysts.
- Book Value - The company's equity after subtracting liabilities. Book value is an inaccurate measure of a company's value as assets are recorded at historical cost on the company's balance sheet and generally accepted accounting principles may produce different company valuations, depending on the pronouncements that the company follows.
- Liquidation Value - The value of the business once discontinued when assets are sold off. The actual value may be a distressed one or one in which the sum of the parts is greater than the whole. The process can be quite subjective.