Risk and Return Measures - Dividend Growth Models

  1. 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.
    1. 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.
    2. 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.
  1. 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.
    1. Price/Earnings: price per share/earnings per share. This is a relative valuation model.
    2. Price/Free Cash Flow (FCF): cash flow is less susceptible to manipulation than earnings, when the appeal of this metric.
    3. 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.
    4. Price/Earnings/Growth (PEG): used to compare firms with different growth rates. PEG ratios can be used to determine possible value opportunities for analysts.

  2. 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.

  3. 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.
Sample Questions 1 - 5
Related Articles
  1. Investing Basics

    Fee-Only Financial Advisors: What You Need To Know

    Are you considering hiring a fee-only financial advisor or one who is compensated via commissions? Read this first.
  2. Investing

    Time to Bring Active Back into a Portfolio?

    While stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
  3. Retirement

    Two Heads Are Better Than One With Your Finances

    We discuss the advantages of seeking professional help when it comes to managing our retirement account.
  4. Personal Finance

    How the Social Security Reboot May Affect You

    While there’s still potential for some “tweaking” around your Social Security retirement benefits, I’d like to share some insight on what we know now.
  5. Chart Advisor

    Now Could Be The Time To Buy IPOs

    There has been lots of hype around the IPO market lately. We'll take a look at whether now is the time to buy.
  6. Entrepreneurship

    Creating a Risk Management Plan for Your Small Business

    Learn how a complete risk management plan can minimize or eliminate your financial exposure through insurance and prevention solutions.
  7. Investing Basics

    5 Tips For Diversifying Your Portfolio

    A diversified portfolio will protect you in a tough market. Get some solid tips here!
  8. Entrepreneurship

    Identifying And Managing Business Risks

    There are a lot of risks associated with running a business, but there are an equal number of ways to prepare for and manage them.
  9. Active Trading

    10 Steps To Building A Winning Trading Plan

    It's impossible to avoid disaster without trading rules - make sure you know how to devise them for yourself.
  10. Trading Strategies

    How to Trade In a Flat Market

    Reduce position size by 50% to 75% in a flat market.
  1. Equity Risk Premium

    The excess return that investing in the stock market provides ...
  2. Net Line

    The amount of risk that an insurance company retains after subtracting ...
  3. Political Risk Insurance

    Coverage that provides financial protection to investors, financial ...
  4. Maximum Drawdown (MDD)

    The maximum loss from a peak to a trough of a portfolio, before ...
  5. Gross Exposure

    The absolute level of a fund's investments.
  6. Priori Loss Estimates

    A technique used by insurance companies to calculate loss reserves.
  1. Are secured personal loans better than unsecured loans?

    Secured loans are better for the borrower than unsecured loans because the loan terms are more agreeable. Often, the interest ... Read Full Answer >>
  2. Which mutual funds made money in 2008?

    Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
  3. Why are mutual funds subject to market risk?

    Like all securities, mutual funds are subject to market, or systematic, risk. This is because there is no way to predict ... Read Full Answer >>
  4. Why have mutual funds become so popular?

    Mutual funds have become an incredibly popular option for a wide variety of investors. This is primarily due to the automatic ... Read Full Answer >>
  5. Can your car insurance company check your driving record?

    While your auto insurance company cannot pull your full motor vehicle report, or MVR, it does pull a record summary that ... Read Full Answer >>
  6. Do financial advisors work only in banks?

    While the majority of financial advisors work for financial institutions such as banks, a large proportion of them are self-employed ... Read Full Answer >>
Hot Definitions
  1. Bar Chart

    A style of chart used by some technical analysts, on which, as illustrated below, the top of the vertical line indicates ...
  2. Bullish Engulfing Pattern

    A chart pattern that forms when a small black candlestick is followed by a large white candlestick that completely eclipses ...
  3. Cyber Monday

    An expression used in online retailing to describe the Monday following U.S. Thanksgiving weekend. Cyber Monday is generally ...
  4. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  5. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
Trading Center