Brailsford3eSM_Ch11 - Chapter 11 Equity valuation models...

Copyright © 2006 Nelson Australia Pty Limited
Chapter 11
Equity valuation models
Learning objectives
After the completion of this chapter, you should be able to:
● understand the basic principles of equity valuation
● understand and be able to apply the present value (PV) model to equity valuation
● understand the development of the dividend discount model, earnings capitalisation model,
and free cash flow model
● explain the importance of key assumptions underpinning the dividend discount model,
earnings capitalisation model, and free cash flow model
● comprehend the issues associated with the practical implementation of equity valuation
models
● understand and apply asset backing models.
● explain the different types of forecasts of economic and company specific financial
variables and the advantages and disadvantages of the different forecasting procedures
Key points
1 The price of a share is dependent of the discounted future value (ie. present value) of the
cash flows accruing to the shareholder.
2 The models presented in the chapter are all variants of the present value model. The models
differ in terms of the underlying assumptions about the cash flows accruing to the
shareholder.
Chapter outline
11.1 Introduction
1 A key issue in investment is the determination of the correct price of a security.
2 This valuation is relevant to many areas of finance; portfolios, trading strategies, mergers
and acquisitions, valuation of private corporations and in situations where a market price is
unavailable or unreliable.
11.2 Present value analysis
1 Present value of equity found by discounting value of future cash flows.
11.3 Present value and ordinary equity
1 In the case of equity, the cash flows that accrue to the shareholder are dividends.
2 The value of equity is therefore the present value of future dividends.

2 Investments: Concepts and Applications Solutions Manual
Copyright © 2006 Nelson Australia Pty Limited
11.4 The dividend discount model
1 The dividend discount model builds on the present value model, by making an assumption
regarding the relationship between current and future dividends.
2 The time-series relationship is known as the growth rate in dividends.
3 The model is operationalised by assuming the firm is a going concern and hence applying
the perpetuity form of the present value model.
11.5 The earnings capitalisation model
1 Identical to the present value model, except that earnings are paid as dividends. Those
earnings that are retained are assumed to generate a return equal to the equity cost of capital.
2 Under the above assumptions, the DDM is equivalent to discounting the future value of
earnings.
3 The ECM is typically operationalised by estimating the zero growth and growth
opportunities separately.