Question

1. What are the relevant cash flows for valuing a stock using different valuation methods (Free Cash Flow to Equity and Dividend Discount Model)?

2. What are the different ways you can find cost of equity? Which is your preferred method?

3. When is a dividend discount model most suitable? When is it not suitable?

4. What would be the input to Excel Rate function if you are trying to find yearly dividend growth rate for a company which paid $2.5 as dividend exactly 4 years ago and has paid $3.5 today?

5. What is the difference between unsystematic and systematic risk according to the Capital Asset Pricing model?

Answer 1

1. (A) FREE CASH FLOW METHOD:- UNDER THIS METHOD VALUATION WILL BE DONE USING CASH FLOW OF A PARTICULAR STOCK IN A GIVEN PERIOD OF TIME. PRICE OF STOCK IS COMPLETELY DEPENDS ON CASH FLOW FREQUENCY OF THAT STOCK.

(B) DIVIDEND DISCOUNT MODEL:- IT IS A FINANCIAL MODEL THAT VALUES SHARES AT DISCOUNTED VALUE OF THE FUTURE DIVIDEND PAYMENTS. UNDER THIS MODEL PRICE OF A SHARE WILL BE CALCULATED BY NET PRESENT VALUE OF ALL EXPECTED FUTURE DIVIDEND PAYMENT DISCOUNTED BY AN APPROPRIATE RISK ADJUSTED RETURN.THE DIVIDEND DISCOUNT PRICE IS THE INTRINSIC VALUE OF THE STOCK.

2. METHOD TO FIND COST OF EQUITY:-

(A) KE= D/P-F

HERE

D= DIVIDEND

P= PRICE

F= FLOTATION COST

(B) KE= D1/P-F+G

D1= EXPECTED DIVIDEND

G= GROWTH RATE

(C) KE= RF +BETA(RM-RF) (CAPM MODEL)

RF= RISK FREE RATE

RM= MARKET RISK

RM-RF= RISK PREMIUM

MOST SUITABLE METHOD IS CAPM MODEL

3. DIVIDEND DISCOUNT MODEL IS SUITABLE TO CALCULATE FUTURE EXPECTED VALUE OF A STOCK. THIS MODEL IS SUITABLE WHEN GROWTH RATE IS GIVEN. IF GROWTH RATE IS NOT CONSIDERED THAN IT IS NOT SUITABLE.

4. KE=D1/P+G

5. DIFFERENCE BETWEEN SYSTEMATIC AND UNSYSTEMATIC RISK=

• Systematic Risk does not have a specific definition but is inherent risk existing in the stock market. These risks are applicable to all the sectors but can be controlled. If there is an announcement or event which impacts the entire stock market, a consistent reaction will flow in which is a systematic risk. For e.g. if Government Bonds are offering a yield of 5% in comparison to the stock market which offers a minimum return of 10%. Suddenly, the government announces an additional tax burden of 1% on stock market transactions, this will be a systematic risk impacting all the stocks and may make the Government bonds more attractive.
• Unsystematic Risk is an industry or firm-specific threat in each kind of investment. It is also known as “Specific Risk”, “Diversifiable risk” or “Residual Risk”. These are risks which are existing but are unplanned and can occur at any point of causing widespread disruption. For e.g. if the staff of the airline industry goes on an indefinite strike, then this will cause risk to the shares of the airlines industry and fall in the prices of the stock impacting this industry.