25 Questions Investments Exam Three Study Guide Dividend Discount Model Application Limitations of Dividend Discount Model Chapter 13 Dividend Discount Model DDM A formula for the intrinsic value of a firm equal to the present value of all expected future dividends o A procedure for valuing the price of a stock by using predicted dividends and discounting them back to present value The idea is that if the value obtained from the DDM is higher than what the shares are currently trading at then the stock is undervalued Consider a company with a 1 annual dividend If you figure the company will pay that dividend indefinitely you must ask yourself what you are willing to pay for that company Assume expected return or more appropriately in academic parlance the required rate of return is 5 According to the dividend discount model the company should be worth 20 because 1 00 05 o Zero Growth P0 DIV Discount Rate This is the application of the formula Doesn t work for companies that don t pay out dividends Dividend is set by the board Some industries have solid dividends o The obvious shortcoming of the model is that you d expect most companies to grow over time If you think this is the case then the denominator equals the expected return less the dividend growth rate This is known as the constant growth DDM Constant Growth DDM A form of the dividend discount model that assumes dividends will grow at a constant rate Value of Stock Dividend Per Share Discount Rate Dividend Growth Rate OR V0 D0 1 g k g Simplified version to know D1 k g o Also called the Gordon Model o Implies that stock value will be greater o The larger its expected dividend share o The lower the market capitalization rate k o The higher the expected growth rate of dividends o Another implication is that the stock price is expected to grow at the same rate as dividends o Say you think the company s dividend will grow by 3 annually o The company s value should then be 1 05 03 50 25 Questions o The classic dividend discount model works best when valuing a mature company that pays a hefty portion of its earnings as dividends such as a utility company o Proponents of the dividend discount model say that only future cash dividends can give you a reliable estimate of a company s intrinsic value One big assumption that the DDM makes is that dividends are steady or grow at a constant rate indefinitely Still tricky to forecast the future always uncertainty o Simply put predicting the time of dividend without prior dividend data or dividend policy is generally not practical For a non dividend paying company analysts usually prefer a model that defines returns at the company level rather than at the stockholder level Calculate FCFF Chapter 13 An alternative approach to the dividend discount model values the firm using free cash flow that is cash flow available to the firm or the equity holders net of capital expenditures o Free cash flow FCF represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value Without cash it s tough to develop new products make acquisitions pay dividends and reduce debt Useful for firms that pay no dividends Valid for any firm Can provide insight that the DDM can t FCFF EBIT 1 Tc Depreciation Capital Expenditures Increase in NWC o EBIT earnings before interest and taxes o Tc corporate tax rate o NWC net working capital Some investors believe that FCF gives a much clearer view of the ability to generate cash and thus profits It is important to note that negative free cash flow is not bad in itself If free cash flow is negative it could be a sign that a company is making large investments If these investments earn a high return the strategy has the potential to pay off in the long run o FCF is a better indicator than the P E Ratio Investment Return Price Volatility Bond Components Price Volatility Chapter 11 You should already know that there is an inverse relationship between bond prices and yields and that the interest rates can fluctuate substantially 25 Questions o As interest rates rise or fall bondholders experience capital gains or loss This makes fixed income investments risky even if the coupon and principal payments are guaranteed as in the case with Treasury bonds Remember that stocks don t mature bonds do o Coupon is set but the interest rate floats Low coupon is more volatile and fat coupons get your money back faster Know These Rules o Bonds prices and yields are inversely related As yields increase bond prices fall as yields fall bond prices rise Yield Bond Price Yield Bond Price o An increase in a bond s yield to maturity results in a smaller price change than a decrease in yield of equal magnitude YTM Smaller Price Change than YTM of same magnitude o Prices of long term bonds tend to be more sensitive to interest rate changes than prices of short bonds Longer Bonds More Price Sensitivity to Interest Rate Changes Shorter Bonds Less Price Sensitivity to Interest Rate Changes Faster at paying money back o The sensitivity of bond prices to changes in yields increases at a decreasing rate as maturity increases In other words interest rate risk is less than proportional to bond maturity o Interest rate risk is inversely related to the bonds coupon rate Prices of low coupon bonds are more sensitive to changes in interest rates than prices of high coupon rates Low Coupon More Sensitive to changes in Interest Rates High Coupon Less Sensitive to changes in Interest Rates o The sensitivity of a bond s price to change in its yield is inversely related to the yield to maturity at which the bond currently is selling These six propositions confirm that maturity is a major determinant of interest rate risk however they also show that maturity alone is not sufficient to measure interest rate sensitivity For maturities beyond one year the price of the zero coupon bond falls by a greater proportional amount than the price of the 8 coupon bond page 340 Calculate Modified Duration Chapter 11 Macaulay s Duration A measure of the effective maturity of a bond defined as the weighted average of the times until each payment with weights proportional to the present value of the payment 25 Questions Another definition The weighted average term to maturity of the cash flows from a bond The weight of each cash flow is determined by dividing the