SIGNIFICANCE OF DIFFERENCE

How significant are the valuation differences between the conventional approach used by leading equity research organizations and the affordable dividend approach? In typical applications of the conventional approach, earnings growth rates are forecast to decrease gradually toward a perpetuity rate, while the dividend payout rate correspondingly increases gradually toward a perpetuity rate. Because the conventional approach focuses on earnings and dividends, without taking explicit account of sales growth, investment requirements, and capital structure, direct comparisons are difficult. We do know from Equation (4.6), however, that valuation differences are potentially largest when large changes in sales growth rates are forecast and when the company under consideration is relatively investment-intensive.

Analysts who link the dividend discount model to Modern Portfolio Theory often determine the difference between the expected return on a stock and the market’s required return—i.e., the stock’s “alpha.” The expected return is simply the discount rate that equates the present value of the projected dividends with the current market price of the stock. The required return is the risk-free rate of return plus the market equity risk premium adjusted for the expected riskiness of the individual stock.

Differences between the expected and required rates of return are due to differences between the analyst’s projected dividend schedule and that attributed to ...

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