Discussion Question Wk3: Dividend Discounted Model
Investors are often faced with the need to value a business before they make an investment in any business. One of the methods used in valuing a business is the dividend discounted model (DDM). DDM assumes that the only cash flow that shareholders get is the dividend (Tagliani, 2009, p.43). This models basis its valuation from the dividends that are expected from the business and then discounts them to the present equity cost. In undertaking this valuation, Damodaran (2012, p.323) explains that DDM involves the use of a business’ stocks value to determine its present value on which the dividends are expected. Some of the types Of DDM include such as discounted dividends, discounted cash flows and discounted abnormal earnings (Palepu & Healy, 2013, p.7-13). These types of DDM give similar results of value estimates as long as the same assumptions are made. However, there exist primary differences among them.
One of the differences among the DDM types involves variation in the structure and analysis required for valuation (Palepu & Healy, 2013, p.7-13). For instance, the forecast of dividends in the case of discounted dividend is required while discounted cash flow requires forecasting of working capital changes and income statements. On the other hand, the discounted abnormal earnings require balance sheets and pro forma income statements for forecasting future book value and earnings. The discounted abnormal earning also requires more analysis structure that helps it to avoid inconsistencies in the forecasts by predicting a firm’s future performance.
Palepu and Healy (2013, p.7-14) also highlight the differences in the implication of the terminal value of the various DDM types. Consequently, the abnormal earning’s value estimates give a smaller fraction of the total value as compared to dividend method and discounted cash flow. For instance, the terminal values of discounted cash flow comprise present value of expected cash flows beyond the horizon of a forecast. On the other hand, the abnormal earnings valuation, the estimated value is divided into the normal earnings’ present value and the abnormal value after the terminal year.
The various DDM types also have differences in their area of focus (Palepu & Healy, 2013, p.7-13).The different types of DDM valuation use different valuation frames and require focus on different areas. For instance, the earning based methods use accounting data such as book values and earnings for valuation. On the other hand, discounted cash flows method uses cash flows to determine the value of business.
The various forms of DDM vary from price multiple valuations in different ways. For instance, Madura (2008, p.265) accounts for the high dependence of DDM on growth rates and the required rates of return. On the other hand, the price multiple valuation methods are influenced by the mean multiple of the stock price of the competitors. Moreover, Baker and Powell (2005, p.150) explain that in the case of DDM, assumptions are explicit whereas they are implicit in the case of price multiple valuation methods. The core of DDM valuation methods is the forecast of various values. For price multiple valuation methods, the core of the valuation process is the choosing of comparable firms.
Bibliography
Baker, H. K., & Powell, G. E., 2005. Understanding Financial Management a Practical Guide. Oxford, Blackwell Pub. Available at: <http://public.eblib.com/choice/publicfullrecord.aspx?p=243549.> [Accessed 1 April 2016]
Damodaran, A., 2012. Investment valuation: Tools and techniques for determining the value of any asset. Hoboken, New Jersey: Wiley.
Madura, J., 2008. Financial markets and institutions. Mason Ohio, Thomson.
Palepu, K. G., & Healy, P. M. , 2013. Business analysis & valuation: Using financial statements.
Tagliani, M., 2009. The practical guide to Wall Street: Equities and derivatives. Hoboken, N.J: Wiley.
