ch 3 PYQ

what can we deduce from the dividend discount model about the factors which affect the value of a stock?

tells us that the value of the stock is determined by:

• dividends paid by the company to infinity (assuming company has infinite life)

note: due to discounting contribution of a future dividend, price declines over time so near dividends have the greatest influence

• required yield on the stock

  • captures the risk of the stock to the investor

discuss the problems of valuing common stocks, preferred stocks & corporate bonds

the fundamental value of securities is determined by calculating the PC of FCF generated by the security

main problem → the degree of uncertainty of those FCF

common stocks	highly uncertain FCF (dividends) have to make assumptions about the evolution of future dividends (eg/ constant growth, 0 growth, etc.) in some cases: dividends may not be paid at all
preferred stocks	more certain CF ∵dividends are paid @ constant rate (but may not be paid at all in some years)
corporate bonds	certain FCF (coupons) BUT risk of default that needs to be accounted for in the valuation

how realistic are the 3 assumptions for the evolution of dividends?

1. unlikely to be constant is not very realistic ∵in this case purchasing power of those dividends would reduce over time due to inflation

2. constant growth is more realistic

   • ∵dividends likely to grow over time ∵earnings of the company grow

   • however constant growth rate may not be realistic for all companies

   • possible for companies that are mature but not for start ups

3. dividend growth @ diff rates for diff periods may work better for start ups with rapid growth early on which settles into a slower growth as company matures

what kind of companies might the gordon growth model be suitable to value?

companies that: are expected to have stable & predictable dividend payments over time

• particularly suitable for valuing mature, well-establish companies → have a history of paying dividends & expected to continue doing so in the foreseeable future

such companies include:

• large blue-chip stocks: well established mature companies

• utility companies: known for stable CF

• consumer goods companies: companies producing everyday necessities with steady sales & earnings growth

briefly discuss the assumption of a constant rate of growth in the gordon growth model

2 main determinants of a firms’ growth rate:

• size of new investments made by a firm

• ROR of new investments

1 problem: firms growth may not be constant

• small firms w new product: exp rapid growth in their early years & then growth may slow down to more normal levels before possibly declining

2: some firms may not pay dividends ∴ the model cannot be used here

discuss the limitations of the gordon growth model for the valuation of stocks

• company must have paid dividends (to determine growth rate)

• assumes that dividend growth is constant (may not be true, may be diff rates of growth over the diff periods)

• cannot be used if growth rate of dividends > required return on equity

why might a company not pay dividends>

often reinvest their earnings back into the business for growth opportunities, debt reduction/ other strategic initiatives

such companies include

• high growth tech companies

  • often choose to reinvest their profits into R&D, acquisitions & expansion

• biotechnology & pharmeceutical companies

  • often priorities reinvestment in R&D

  • length & costly dev process → company retain its earnings for future projects rather than paying dividends

• start ups & newly listed companies

  • priorities using their earnings to fuel growth, build infrastructure, establish mkt presence

• highly leverage company (w significant debt obligations)

  • may choose to allocate their eaenigns toward debt reduction