Question

Critically discuss the merits and limitations of the Discounted Cash Flow, Dividend Discount and Residual Income valuation models, both from the theoretical and practical perspectives. In your answer you need to demonstrate familiarity with the relevant literature!!!

Answer 1

Dividend discount Model-

Merits: (1) good for evaluating companies with history of consistent dividend payments.

(2) good for evaluating companies where board has a well-defined dividend policy consistent with profitability.

(3) good for valuing profitable, mature firms.

limitations: (1) There are companies that do not pay dividends, and may reinvest a substantial portion of earnings back to firm. Also if dividends don't have a consistent relationship with earnings, then we might not be able to use this method to accurately predict future dividends.

(2) Assumptions need to be made for variables like earning growth. Model is as good as assumptions made.

Free Cash Flow Models-

Merits: (1) This method can be used for valuing companies that don't pay dividends or when dividends are unpredictable.

(2) This method is useful when company pays dividends but dividends paid differ significantly from the company's capacity to pay dividends.

(3) This method might be used when valuing a firm with controlling perspective. After the firm is acquired, investor might modify the dividend policy and hence FCF valuation might be favorable.

limitations: (1) some companies might have negative FCF within analyst forecast horizon.

(2) Assumptions need to be made for some variables (like when determining terminal value). Model is as good as assumptions made.

Residual income Models-

Merits:  (1) This method can be used for valuing companies that don't pay dividends or when dividends are unpredictable.

(2) This method can be used for valuing companies that have negative FCFs.

(3) It can be used to measure impairment and goodwill that appear on company's balance sheet.

(4) It can be used to measure internal corporate performance.

(5) Value is recognized earlier then in DDM. In DDM terminal value has significant weight.

(6) This method may be used when there is uncertainty determining terminal values in other methods.

limitations:

(1) Application of this model needs clean surplus relationship to hold good. Analysts will be required to make appropriate adjustments otherwise.

(2) this model assumes constant growth rate through time.

(3) This model assumes ROE will continue to be above cost of equity indefinitely. ROE is likely to revert over mean value over time.

(4) Accounting standards may vary internationally, resulting into different measures of book value. Analysts should make appropriate adjustments for comparability.