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In: Accounting

You have been asked to perform and present a stock valuation to the CEO prior to...

You have been asked to perform and present a stock valuation to the CEO prior to the annual shareholders meeting next week. The two models you have selected to value the firm are the dividend discount model and the discounted cash flow model. Explain why the estimates from the two valuation methods differ. Address the assumptions implicit in the models themselves as well as those you made during the valuation process.

Solutions

Expert Solution

1) Dividend discount model:

The dividend discount model 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

Its formula is : P = D1/ (r-g)

where D1 is expected dividend for next year, r is Cost of equity and g is growth rate.

2) Discounted Cash flow method

CF analyses use future free cash flow projections and discounts them, using a required annual rate, to arrive at present value estimates.

Its formula is : DCF = [CF1 / (1+r)1] + [CF2 / (1+r)2] + ... + [CFn / (1+r)n]

where, CF = Cash flow, r= discount rate (WACC).

1) Assumptions is Dividend discount method:

  • It presumes that there will be steady growth rate.
  • The investor motive is to earn dividends
  • It presumes that company will pay dividend.

2) Assumptions in Discounted Cash Flow model

  • It is more realistic method of valuation, because it at end of each year, there can be different cash flow, which are discounted to arrive at present value
  • It values the enterprise as a whole
  • It estimates the terminal value of business, which may be errorneous.

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