IV.%20DDM

IV.%20DDM - IV. DDM and FCFF Growth Model We examine some...

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1 IV. DDM and FCFF Growth Model We examine some growth valuation models; A. The DDM- dividend discount model B. FCFF growth model C. Super-to-normal FCFF growth model D. Finding DDM from FCFF model E. Spreadsheet versus model approach F. Application to terminal value estimation
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2 A. DDM model We use the following notation to model stock price P t = stock price at the end of period t d t = dividend at the end of period t eps t = eps at the end of period t r S = the required return on equity g = the growth rate b = retention ratio (= (eps-d)/eps) 1-b = payout ratio (= d/eps)
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3 Stock Price In general, the stock pays dividends in perpetuity DDM dividends grow at a constant rate, g, forever. ... ) r 1 ( d ... ) r 1 ( d ) r 1 ( d P t S t 2 S 2 1 S 1 0 + + + + + + + =
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4 The base DDM From the constant perpetual dividends grow, (hence, earnings per share = eps growth), we have the DDM 1 1 S S 1 1 t t 1 S d eps (1 b) P , r g r g since, d eps ( r g 1 b), and d d (1 g) we require - - = = - - = - + > =
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5 Example IV.1, DDM THE CO. just paid a $1.60 dividend, and dividends grow at a constant rate of 12%, what are dividends per share for the next three years? d 1 = $1.60(1.12) = $1.79 d 2 = $1.60(1.12) 2 = $2.01 d 3 = $1.60(1.12) 3 = $2.25
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6 Example IV.2, DDM If the interest rate is 16%, what is the price of one share of THE CO. s stock? P o = d 1 /(r S - g) = 1.60(1.12)/(.16 - .12) = $44.80
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7 Stock price and growth option We can decompose price into the value of assets in place plus an option For high growth firms most value is in the option 1 o S * S 1 1 S S S eps P Growth Option r b(r r ) eps eps r r r g = + Ø ø - = + Œ œ - º û
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8 B. FCFF Growth Model We examine how to use structured valuation models. 1. FCFF constant growth firm 2. What underlies the FCFF growth firm
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9 1. The FCFF, constant growth firm The firm invests annually at the same rate, g, earning r* on that investment and on all other assets, in perpetuity. FCFF is discounted at r A . Leverage is maintained at the target ratio. t 1 o t t 1 A A o o A 1 o A FCFF FCFF V r g (1 r ) EBIT (1 T)(1-b)(1+g) V r g EBIT (1 T)(1-b) V r g ¥ = = = & - + - = - - = -
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10 2. What underlies the FCFF model? Balance sheet entries grow at g
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This note was uploaded on 03/09/2008 for the course FINC 725 taught by Professor Hansen during the Spring '08 term at Tulane.

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IV.%20DDM - IV. DDM and FCFF Growth Model We examine some...

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