Question

3) Chapter 9 goes to great lengths to describe two main methods of estimating a stock’s intrinsic value: 1) the Discounted Dividends Model and 2) the Enterprise-Based Approach to Valuation also know as the Corporate Valuation Model. Please explain the basic components of these two models, compare these two models, discuss which one is best in your opinion, and why.

Answer 1

The dividend discount valuation model uses future dividends to predict the value of a share of stock, and is based on the premise that investors purchase stocks for the sole purpose of receiving dividends. In theory, there is a sound basis for the model, but it relies on a lot of assumptions. Nevertheless, it is still often used as a means to value stocks.

Let’s take a look at the theory behind the dividend discount model, how it works, and if and when you should use it to evaluate whether to purchase a stock.

There are three major reasons why the dividend discount model is a popular valuation technique:

1. Simplicity of Calculations
Once investors know the variables of the model, calculating the value of a share of stock is very straightforward. It only takes a little bit of algebra to calculate the price of stock.

2. Sound and Logical Basis for the Model
The model is based on the premise that investors purchase stocks so that they can get paid in the future. Even though there are a number of reasons that investors may purchase a security, this basis is correct. If investors never received a payment for their security it wouldn’t be worth anything.

3. The Process Can Be Reversed to Determine Growth Rates Experts Predicted
After looking at the price of a share of stock, investors can rearrange the process to determine the dividend growth rates that are expected for the company. This is useful if they know the predicted value of a share of stock but want to know what the expected dividends are.

The dividend discount model is a logical and rational attempt to approximate the value of a company’s stock. In a simulated world, investing in a stock based solely on the value of their future dividends would be a perfect system.

Unfortunately, it is not always a reliable indicator in the real world. Investors are often irrational and variables are difficult to predict. These are challenges that all valuation models must contend with. Even if variables such as future dividends could be forecast accurately, it would still be impossible to know the true value of a share of stock in the market. However, investors must at least make an attempt to approximate a stock’s value before investing so that they can make an educated decision.

Corporate Valuation Model
The value of a business organization element in the overall outlook of the company. This is extremely critical in the case of financial dealings like selling or merging the company, taking loans or increasing credibility in the community. After knowing about the corporate valuation model companies can create their own model for improving the status in the concerned industry.

Assets In Place
The first step in the corporate valuation model is the determination of value of assets which are already known. Assets of a business include equipments, machinery, property, vehicles and inventory. The term Assets in Place explains the items which are actually used in the current operations. By this the items which are owned by you which helps in increasing the income and profit is considered and the value is calculated based on the original price for which it is bought and the depreciation.

Value of Operations
Every company will be having a current value based on the performance metrics. This depends on the Cash flow and growth rate of the business. It is also dependent on the capital invested in the business which is a one time value. The value of the operation is often expressed in millions and is calculated from the percentage of the above factors.

Present Value and Growth Opportunities
While buying more assets or taking over a company the income may increase at an annual rate and this figure can be added to the value of the company. The growth opportunities which are being undertaken also include international marketing and internet marketing activities etc. This value is dependent on the present value of operations, earnings from the operations and capital cost of the business.

Non Operating Assets
There might be some kind of assets which are not contributing to the operations of the company. This usually includes investment accounts, bonds, cash which is making interest and money invested in real estate which is owned by the company. The cash flow inside the company can cause variations and these fluctuations also affects the overall valuation of the company.