Question

Critically analyze the strengths and weakness of different stock valuation methods: Discounted Cash Flow (DCF), Dividend Discount Model (DDM), Residual Income Model (RMI), and Valuation Ratios.

Answer 1

Strengths of DCF
DCF model can provide a useful valuation estimate if the user follows these principles:
1. Invest in companies that have a sustainable competitive advantage.
2. As Buffett said in his 1994 letter, certainty in the business is essential. I therefore look at different measures of stability in revenues, earnings, book value and free cash flow.
3. Conduct thorough due diligence in analyzing companies' financials
4. Look at simple relative valuation metrics such as P/E, EV/EBITA, PEPG, P/B, etc.
5. Employ conservative assumptions of growth and a discount rate between 8-13%.
6. Always uses margin of safety
Weakness of DCF
1.The first is that it requires us to predict cash flows or earnings long into the future.
2.The second challenge is determining the appropriate discount rate.
3. Finally, the problem with determining a feasible growth rate is that a DCF will simulate the growth rate to be eternal.

strength of DDM

The strength of the Gordon Growth Model is that it is the most commonly used model to calculate share price and is therefore the easiest to understand. It values a company's stock without taking into account market conditions, so it is easier to make comparisons across companies of different sizes and in different industries.

There are many weakness to the Gordon Growth Model. It does not take into account nondividend factors such as brand loyalty, customer retention and the ownership of intangible assets, all of which increase the value of a company. The Gordon Growth Model also relies heavily on the assumption that a company's dividend growth rate is stable and known.

If a stock does not pay a current dividend, such as growth stocks, an even more general version of the Gordon Growth Model must be used, with an even greater reliance on assumptions. The model also asserts that a company's stock price is hypersensitive to the dividend growth rate chosen and the growth rate cannot exceed the cost of equity, which may not always be true.

strengths and weakness of RMI

The residual income approach offers both positives and negatives when compared to the more often used dividend discount and DCF methods. On the plus side, residual income models make use of data readily available from a firm's financial statements and can be used well with firms who do not pay dividends or do not generate positive free cash flow. Most importantly, as we discussed earlier, residual income models look at the economic profitability of a firm rather than just its accounting profitability. The biggest drawback of the residual income method is the fact that it relies so heavily on forward looking estimates of a firm's financial statements, leaving forecasts vulnerable to psychological biases or historic misrepresentation of a firms financial statements.