09 May Discussion Reply 3.1
The estimates from the two valuation methods differ mainly because of the assumptions taken in the valuation. The dividend discount model discounts future dividend payments instead of free cash flows. Thus, the value of a stock today is the sum of the present value of its future dividends. Moreover, the company might not be distributing all of its cash flows as dividend which is the basis difference in the two methods. The assumptions used in the two models may pose a challenge because:
Dividend discount model
a) The presumption of a steady and perpetual growth rate less than the cost of capital may not be reasonable.
b) If the stock does not currently pay a dividend, like many growth stocks, more general versions of the discounted dividend model must be used to value the stock.
Discounted cash flow model
a) DCF is merely a mechanical valuation tool, which makes it subject to the principle “garbage in, garbage out”. Small changes in inputs can result in large changes in the value of a company. Instead of trying to project the cash flows to infinity, terminal value techniques are often used. A simple perpetuity is used to estimate the terminal value past 10 years, for example. This is done because it is harder to come to a realistic estimate of the cash flows as time goes on involves calculating the period of time likely to recoup the initial outlay
b) Another shortcoming is the fact that the Discounted Cash Flow Valuation should only be used as a method of intrinsic valuation for companies with predictable, though not necessarily stable, cash flows. The Discounted Cash Flow valuation method is widely used in valuing mature companies in stable industry sectors such as Utilities. At the same time, this method is often applied to valuation of high growth technology companies. In valuing young companies without much cash flow track record, the Discounted Cash Flow method may be applied a number of times to assess a number of possible future outcomes, such as the best, worst and mostly likely case scenarios.
The prepared estimates may differ from the actual stick price today, or any given day because of the assumptions we have taken under the respective methods:
Discounted Cash Flow
1. If cash flows are erratic and unpredictable this method isn’t appropriate.
2. Small changes in the risk-adjusted rate of return or future growth rates will change today’s value dramatically.
3. Investment returns depend on other investors buying your shares at a higher price and the company’s management not going nuts. They control the equity, you don’t. If you can’t find a buyer, you have no way of converting your shares into cash.
Dividend discount Model
1. Dividends must be predictable and sustainable. If dividend growth or payout ratios change dramatically, the DDM model will not work.
2. How dividends are reinvested are very important to cumulative returns, but are ignored by the model.
3. Dividends are taxed based on the year they are incurred. Capital appreciation is not taxed until it is realized as a capital gain.
References:
Brigham, E. F., & Ehrhardt, M. C. (2017). Financial management: Theory & Practice, (15th ed.). Boston
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