The FCFE
model expands the definition of cash flows to include the balance of residual
cash flows after all financial obligations and investment needs have been met.
Thus the FCFE model explicitly recognizes the firm’s investment and financing
policies as well as its dividend policy.
In instances of a change of corporate
control, and therefore the possibility of changing dividend policy, the FCFE
model provides a better estimate of value. The DDM is biased toward finding
low P/E
ratio stocks with high dividend yields to be undervalued and
conversely, high P/E
ratio stocks with low dividend yields to be overvalued. It
is considered a conservative model in that it tends to identify fewer undervalued
firms as market prices rise relative to fundamentals.
The DDM does not allow
for the potential tax disadvantage of high dividends relative to the capital gains
achievable from retention of earnings.
i. Both twostage valuation models allow for two distinct phases of growth, an
initial finite period where the growth rate is abnormal, followed by a stable
growth period that is expected to last indefinitely.
These twostage models
share the same limitations with respect to the growth assumptions.
First, there
is the difficulty of defining the duration of the extraordinary growth period.
For
example, a longer period of high growth will lead to a higher valuation, and
there is the temptation to assume an unrealistically long period of extraordinary
growth.
Second, the assumption of a sudden shift form high growth to lower,
stable growth is unrealistic.
The transformation is more likely to occur
gradually, over a period of time.
Given that the assumed total horizon does not
shift (i.e., is infinite), the timing of the shift form high to stable growth is a
critical determinant of the valuation estimate.
Third, because the value is quite
sensitive to the steadystate growth assumption, over or underestimating this
rate can lead to large errors in value.
The two models share other limitations as
well, notably difficulties in accurately forecasting required rates of return, in
dealing with the distortions that result from substantial and/or volatile debt
ratios, and in accurately valuing assets that do not generate any cash flows.
11.
a.
The formula for calculating a price earnings ratio (P/E) for a stable growth
firm is the dividend payout ratio divided by the difference between the
required rate of return and the growth rate of dividends.
If the P/E is
calculated based on trailing earnings (year 0), the payout ratio is increased
by the growth rate.
If the P/E is calculated based on next year’s earnings
(year 1), the numerator is the payout ratio.
P/E on trailing earnings:
P/E = [payout ratio
×
(1 + g)]/(r
−
g) = [0.30
×
1.13]/(0.14
−
0.13) = 33.9
P/E on next year's earnings:
P/E = payout ratio/(r
−
g) = 0.30/(0.14
−
0.13) = 30.0
185
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The P/E ratio is a decreasing function of riskiness; as risk increases the P/E
ratio decreases.
Increases in the riskiness of Sundanci stock would be expected
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 Spring '13
 Ohk
 Dividend yield, P/E ratio, PEG ratio

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