115 CFA
File: Equity Investments - Reading 41 - 2. Present Value Models The Dividend Discount Model

2. Present Value Models: The Dividend Discount Model

c. explain the rationale for using present value models to value equity and describe the dividend discount and free-cash-flow-to-equity models;

e. calculate and interpret the intrinsic value of an equity security based on the Gordon (constant) growth dividend discount model or a two-stage dividend discount model, as appropriate;

f. identify characteristics of companies for which the constant growth or a multistage dividend discount model is appropriate;

How is the dividend discount model used to determine the value of a stock?
The value of a common stock is the present value of all future dividends. If the stock is sold at some point in the future, its value at that time will be the present value of all future dividends.

What is the definition of a Growth Company?
Growth companies are firms that have the opportunities and abilities to earn rates of return on investments that are consistently above their required rates of return.

How is a company's dividend growth rate determined?
The dividend growth rate is determined by:
- The proportion of earnings paid out in dividends (the payout ratio);
- The growth rate of the earnings.

What are the two factors that an earnings growth rate depends on? What is the formula?
- The proportion of earnings retained and reinvested (the retention ratio);
- The rate of return on new investments.
- g = Retention Rate (b) x Return on Equity (ROE)

What is the formula for Return on Equity (ROE)?
ROE = Profit Margin (Net Income/Sales) x Total Asset Turnover (Sales/Total Assets) x Financial Leverage (Total Assets/Equity)

What is Free Cash Flow to Equity?
Free Cash Flow to Equity (FCFE) is cash available to stockholders after payments to and inflows from bondholders. It is the cash flow from operations net of capital expenditures and debt payments (including both interest and repayment of principal).

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