Question

Analysts attempt to value ordinary shares, in order to determine if market values are correct. Identify and describe the more common methods of valuation. Include a detailed explanation of the dividend discount method of valuation.

Answer 1

Answer-

The various methods of valuing ordinary shares are

1) Dividend discount model (DDM) - This model define cash flows as the dividends to be received by shareholders. The shareholder who has investment in stock today is worth the pesent value of the future cash flows he expects to receive in the form of dividends over a period of time. Dividends are less volatile than earnings or free cash flows and reflects the long term earning potential of the company. The three categories of DDM are as follows

i) One period DDM
ii) Two period DDM
iii) Multi period DDM

2) Gordon Growth Model - This assumes that the dividends increase at a constant rate indefinitely. The growth rate can be expressed per period that is similar to the required return is evaluated.

3) Multi period models

i) Two stage DDM
ii) Three stage DDM
iii) H-Model

4) Free cash flow methods

5) Price and Enterprise value multiples ( Market based valuations) - like P/E, P/B, P/S, P/CF etc.

6) Residual Income Valuation