Equity Asset Valuation, Second Edition

CHAPTER 3

DISCOUNTED DIVIDEND VALUATION

LEARNING OUTCOMES

After completing this chapter, you will be able to do the following :

• Compare and contrast dividends, free cash flow, and residual income as measures of cash flow in discounted cash flow valuation, and identify the investment situations for which each measure is suitable.

• Determine whether a dividend discount model (DDM) is appropriate for valuing a stock.

• Calculate the value of a common stock using the DDM for one-, two-, and multiple-period holding periods.

• Calculate the value of a common stock using the Gordon growth model and explain the model’s underlying assumptions.

• Calculate the implied growth rate of dividends using the Gordon growth model and current stock price.

• Calculate and interpret the present value of growth opportunities (PVGO) and the component of the leading price-to-earnings ratio (P/E) related to PVGO, given no-growth earnings per share, earnings per share, the required rate of return, and the market price of the stock (or value of the stock).

• Calculate the justified leading and trailing P/Es based on fundamentals using the Gordon growth model.

• Calculate the value of noncallable fixed-rate perpetual preferred stock given the stock’s annual dividend and the discount rate.

• Explain the strengths and limitations of the Gordon growth model and justify the selection of the Gordon growth model to value a company’s common shares, given the characteristics of the company ...