Javier Cuadra

Investments
Jacob Tenney

CHAPTER 11 DISCUSSION QUESTIONS

1. Explain how companies can be valued using the dividend discount model.

The dividend discount model (DDM) is a way of valuing the stock price of an company based on
the assumption that the stock is worth the amount of all the possible dividend dividends,
discounted down to its present value. In other words, securities are used to measure on the
basis of the net present value of the potential dividends.

2. Discuss when it is appropriate to value a company using a fair market value model.

So, Fair market value is the price at which properties on the free market will sell at. FMV is an
approximation of a property's market value based on what an informed, capable, and
unpressed buyer and seller might agree to, each behaving in their own best interest. And, in my
opinion, the right time to evaluate a company should be when the economy is stable. We are
currently experiencing a pandemic and technically the market crashed.

3. Explain the relationship between the required return and expected growth rates in the
dividend discount model.

The dividend discount model computes value as the present value of an infinite growing
dividend stream. The required return rate is the minimum return that an investor hopes to
obtain by investing in a project. Usually, an investor sets the necessary rate of return by
applying a risk premium to the amount of interest that may be received from spending surplus
funds in a risk-free investment. For investors, growth rates usually reflect the cumulative
annualized growth rate of a company's income, profits, dividends or even macro terms, such as
GDP and retail sales. Planned growth rates for the leading or trailing are two specific forms of
growth rates used for research.

So, Stock value = Dividend per share / (Required Rate of Return – Dividend Growth Rate). The
model assumes a constant dividend growth rate in perpetuity. This assumption is generally safe
for very mature companies that have an established history of regular dividend payments. ...
The model also fails when companies may have a lower rate of return (r) compared to the
dividend growth rate (g).
 4. Define an undervalued firm in the context of its intrinsic value.

An undervalued asset is an property capable of being acquired for less than its intrinsic worth.
For examples, if a corporation has an intrinsic value of $11 per share but can be bought at $8
per share, it is considered undervalued.

5. Discuss the critical input variables a financial analyst must use in order to estimate a
company’s sustainable growth rate.

The rate of sustainable development is an measure of what level a company is in during its life
cycle. It's important to consider where a company is in its life cycle. The position also sets
priorities for corporate finance, such as which financing mechanisms to use, dividend payment
plans and overall business strategy. The sustainable rate of growth can be determined by
multiplying the retained rate of the company's profits by the return on equity. ROE blends the
financial statement and the balance sheet as the net benefit or profit along with the equity of
the owners.

6. Describe the difference between using dividends and free cash flows in discount
valuation models.

Free cash flow specifies what the firm has at hand after paying all its business costs, thus it is
some indicator of the financial stability of the firm.

Some businesses could be in debt but tend to pay dividends off borrowed money to
demonstrate stability for the underlying company. Dividends are just a means of spreading
capital and not a success metric for the company. Here's how dividends impact market share
values and investor feelings.

Investors use the dividend-discount model (DDM) to calculate the valuation of a portfolio. It is
similar to the valuation approach of discounted cash flow (DCF); the distinction is that DDM
relies on earnings, while the DCF relies on cash flow.

7. Identify the main reason that the H Model is used to value a firm.

The H-model is used to analyze and measure a stock in a company. Similar to the dividend
discount formula, the formula theorizes the stock is worth the amount of all possible dividend
checks, excluded from the current value. Thus, it offers a more practical approach to valuing a
company's assets in certain scenarios.
 8. Describe how an investor can value a firm with substantial growth for a few years
followed by more normal growth afterwards.

The Sustainable Growth Rate (SGR) is the highest growth rate that a business or social
enterprise can maintain without additional equity or debt needing to fund growth. The SGR
means optimizing growth in profits and income without rising financial flexibility. Attaining the
SGR will help a company avoid overleveraging and prevent financial distress.

For example, Exxon Mobil Corporation (XOM) is an oil and gas firm which has paid a dividend
for more than 100 years. Depending on the performance of the SGR model, the business will
expand at a reasonable pace with no requirement to raise new equity or take on additional
debt.

9. Explain the concept of free cash flow to equity.

Free cash flow to equity (FCFE) is the volume of capital generated by a company which can be
allocated directly to shareholders. That also reflects the value of the remaining assets minus the
liabilities. We get Stockholders Equity = Assets-Liabilities by rearranging the initial accounting
equation.

10. Compare and contrast PE, PS, PCF, and PB ratios.

The price-to-earnings ratio (PE ratio) is the calculation for the value of a business comparing the
present share price according to its earnings per share (EPS). The price-to-earnings ratio is often
often referred to as the variable price, or variable earnings. Investors use PE ratios to assess the
relative worth of an apples-to-apples analysis of a company's stock. It may also be used to
equate a business with its own past record, or to equate overall markets or over time.

The price-to-sales ratio (PS) is a cost measure relating the purchase price of a company to its
revenues. It is an measure of the amount of a company's earnings or profits on a bill. The price-
to-cash flow ratio (PCF) is an metric of stock pricing or multiple that calculates the value of the
price of a stock compared to its operating cash flow per share. The formula uses operating cash
flow and adds back to net income non-cash expenditures including depreciation and
amortization. It is especially useful for valuing stocks which have a good cash flow but are not
competitive due to high non-cash payments.

Companies use the price-to-book ratio (PB ratio) to equate the market capitalization of a
business with its asset value. It is determined by dividing the purchase price per share of the
company by the book value per share (BVPS). The accounting value of an asset on the balance
sheet is equal to its carrying interest, and businesses measure this netting the asset against its
accrued depreciation.