Question

You are asked to apply dividend growth model to estimate the price of Beautiful Life Berhad given the next dividend per share of RM0.60. You are told that the required rate of return is 13 percent and a projected constant growth rate of 8 percent for Beautiful Life Berhad. Briefly describe four alternatives to stock common valuation.   

do not write less 350 to 400 words

Answer 1

The dividend growth model is one of the basic and absolute valuation technique which says that the price of the stock is the discounted value of all the future cash flow. The mathematical expression for the constant growth dividend model is:

Price = Next Year Dividend/(Cost of equity - growth) = 0.60/(0.13 - 0.08) = RM12

Four alternatives to common stock valuation are:

1. The discounted cash flow Model
2. Asset-Based Model
3. Residual Income Model
4. Relative valuation method

Discounted cash flow model (DCF): When a company doesn't have any dividend policy that is it pays irregular dividends then the Dividend growth model cannot be applied. So instead of looking at dividends cash flows to the firm should be considered and here comes the DCF technique of valuation. It can also be applied to firms that don't pay dividends at all. So first the future cash flow is forecasted and a terminal value is also calculated. The company's WACC (weighted average cost of capital) will be calculated and used as a discount factor to find the present values of all the future cash flows and terminal value. The sum of all the present values is the current value of the firm. So the only limitation to this technique is the prediction of future positive cash flows.

Asset-Based Model: In this technique, the fair value of the company's asset is found out. The fair value represents the market value. Assets can be tangible and intangible, in case of long term assets wear and tear happens. So there is some flexibility while the valuation of assets. There are two methods of asset-based valuation Asset accumulation valuation and excess earning valuation. In the assets accumulation method, all the assets and liabilities are assigned to a value whereas, in the excess earnings approach, income is also considered. This method is used during the times when the company is facing challenges to the liquidity of its assets.

Residual Income: It takes net income into account and in this process, the valuation of a company's stock is the book value plus the present value of future expected residual income. Residual income is the profit remaining after the deduction of the opportunity cost for all sources of capital. Residual income is calculated as net income less a charge for the cost of capital.

Relative Valuation Technique: Relative valuation is a very useful technique as it captures the current market expectations and reflects the fair value accordingly. Industry practice is to use multiples like Price to earning, Price to sales, Enterprise value to EBIDTA, etc. Each multiple has its own importance. If the earnings are negative then we can use Enterprise value to EBIDTA, or Price to sales for capital-intensive companies. If not then the P/E multiple is a very famous ratio. P/E tells that how much more or less currently the investors are willing to pay for the stock as per the latest earnings of the company.