Question

Prompt: Valuation of stocks is an essential part of investment analysis and consideration. Write a paper about the Dividend Discount Model, Adjusted Dividend Model and the Free Cash Flow Model

Requirements: 500 words minimum, APA formatting and three peer-reviewed references are required

Please do not worry about the APA form

Answer 1

Stock Valuation

In financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit from price movement – stocks that are judged undervalued (with respect to their theoretical value) are bought, while stocks that are judged overvalued are sold, in the expectation that undervalued stocks will overall rise in value, while overvalued stocks will generally decrease in value.

Some of the methods used for stock valuation are

1. Dividend Discount Model
2. Adjusted Dividend Model and
3. Free Cash Flow Model.

We will discuss these in detail below:

i. Dividend Discount Model (DDM):-

The dividend discount model (DDM) is a method of valuing a company's stock price based on the theory that its stock is worth the sum of all of its future dividend payments, discounted back to their present value. In other words, it is used to value stocks based on the net present value of the future dividends.

The equation is:   

P is the Current Market Price.

D₁ is the next year’s dividend.

g is the constant growth rate.

              r is the constant cost of equity capital.

ii. Adjusted Dividend Model:

The Adjusted Dividend Model is a calculation of a stock's return that relies not only on capital appreciation but also the dividends that shareholders receive. This adjustment provides investors with a more accurate evaluation of the return of an income-producing security over a specified holding period.

Breaking Down Adjusted Dividend Model

An investor may begin calculating a simple return by taking the difference in market price and purchase price and dividing this by the purchase price. For example, say an investor purchases a share of Amazon (AMZN) on January 1, 2018, for $1,172.00 and sells it on July 11, 2018, for $1,755.00. The simple return would be ($1,755.00 - $1,172.00) / 1,172.00 = 49.74%. While Amazon does not presently pay dividends, if it did issue a $0.50/share quarterly dividend, and the investor received two distributions during the six months he held the stock, he could adjust his return by adding these to the sale price. His dividend-adjusted return would be ($1,756.00 - $1,172.00) / 1,172.00 = 49.83%.

Total return is a similar calculation, taking into account both the changes in market value and streams of income, expressed as a percentage (i.e., divided by the share price).

iii) Free Cash Flow Model (FCF):

Free cash flow represents the cash a company generates after cash outflows to support operations and maintain its capital assets. Unlike earnings or net income, free cash flow is a measure of profitability that excludes the non-cash expenses of the income statement and includes spending on equipment and assets as well as changes in working capital.

Interest payments are excluded from the generally accepted definition of free cash flow. Investment bankers and analysts who need to evaluate a company’s expected performance with different capital structures will use variations of free cash flow like free cash flow for the firm and free cash flow to equity, which are adjusted for interest payments and borrowings.

Similar to sales and earnings, free cash flow is often evaluated on a per share basis to evaluate the effect of dilution.

Because FCF accounts for changes in working capital, it can provide important insights into the value of a company and the health of its fundamental trends. For example, a decrease in accounts payable (outflow) could mean that vendors are requiring faster payment. A decrease in accounts receivable (inflow) means the company is collecting from its clients more quickly. An increase in inventory (outflow) could indicate a building stockpile of unsold products. Including working capital in a measure of profitability provides an insight that is missing from the income statement.

For example, assume that a company had made $50,000,000 per year in net income each year for the last decade. On the surface, that seems stable but what if FCF has been dropping over the last two years as inventories were rising (outflow), customers started to delay payments (outflow) and vendors began demanding faster payments (outflow) from the firm? In this situation, FCF would reveal a serious financial weakness that wouldn’t have been apparent from an examination of the income statement alone.