1. Dividend Growth ModelThe basic assumption in the Dividend Growth Model is that the dividend is expected to grow at a constant rate. That this growth rate will not change for the duration of the evaluated period. As a result, this may skew the resultant for companies that are experiencing rapid growth. The Dividend Growth Model is better suited for those stable companies that fit the model. Those that are growing quickly or that don’t pay dividends do not fit the assumption parameters, and thus this model cannot be used. In this model, a company may not exceed the market growth rate.
In addition, since the dividend growth rate is expected to remain constant indefinitely, the other measures of performance within the company are also expected to maintain the same growth rate. If in the current state, the dividend rate is greater that earnings, in time this model will show a dividend payout greater than the earnings of the company. Conversely, if earnings are growing faster than dividends, the payout rate will converge towards zero.
In summary, the Dividend Growth Model works well for those companies growing at a rate equal to or lower than that of the economy and have an established and stable dividend payout.
In order to estimate the cost of equity using the Dividend Growth Model, we simply adjust the model’s equation for estimating the price of a stock, given as such:P = D1 / (r – g)Where P = the price of the stockD1 = the expected Dividend in one yearr = the required rate of returng = the expected Growth ConstantBy solving the equation for k we get the following:P(r – g) = D1r – g = D1 / Pr = (D1 / P) + gTherefore in order to estimate the cost of equity through the Dividend Growth Model, we simply add the constant growth rate and the projected dividend yield in one year.
2. Capital Asset Pricing ModelThe assumptions used in the Capital Asset Pricing Model (CAPM) are similar in that they assume an almost “perfect world” scenario.
Initially, CAPM assumes that all investors have the same rational expectations of returns, and that these returns are in line with the best prediction for future returns as based on the available information. It also makes the assumption that the dividends are paid normally, that assets are fixed, and that the market is efficient and in equilibrium with no inflation or change in the interest rate. CAPM additionally makes the important assumption that the evaluated stock is properly priced and that the risk level has been properly assessed.
Another major assumption is that there are no taxes, transaction fees, or arbitrage opportunities during the evaluation period. This is a huge assumption which is generally incorrect. Almost all transactions within the market have some sort of tax or fee associated with it.
Within CAPM, the required rate of return is found in the following equation:r = rf + B (rm – rf)Where r = the required rate of returnrf = the risk free rateB = the stock’s Beta valuerm = The Market returnIn essence CAPM evaluates a stock based on its risk and potential return compared to a risk-free market portfolio.
3. CAPM and the Modern Portfolio TheoryModern Portfolio Theory is an attempt to balance the risks and rewards of investment portfolios through the use of diversification to lower the risk of the entire portfolio while maintaining high returns. The use of Beta is a key concept in Modern Portfolio Theory. It uses CAPM as its basis to select investments within a portfolio; seeking to mix stocks with both positive and negative Betas to construct a portfolio with a minimal Beta for the group of stocks as a whole. Theoretically, the returns from stocks with both positive and negative betas do not cancel each other out, but rather the portfolio is constructed that the returns are independent of the other stocks held, yet complimentary in accumulation of returns.
4. Estimation of Untraded Stocks.
The general standard for estimating the cost of equity of a non-traded company is through the Market Approach. The basis of this approach is that the stocks of publicly traded companies, engaged in the same of comparable business, are a valid indicator of performance for a non-traded company.
Under the Market Approach, there are two commonly used valuation methods; the Guideline Public Company method, and the Merger and Acquisition Method.
The Guideline Public Company method consists of finding a comparable company and applying that companies financial data to the non-traded company. A company chosen to provide a reasonable basis for comparison should ideally be in the same industry as the non-traded company. However, if there are no companies with sufficient data available, as company in a similar industry may be selected. A similar industry should be one that had identical investment characteristics such as markets, growth, and product lines. The difficulty in using this method lies in identifying a public company that is sufficiently comparable.
According to the American Institute of Certified Public Accountants Statement onStandards for Valuation Services, the following should be considered when using guideline companies:”A. Price information of the guideline company must be related to the appropriate underlying financial data of the company evaluatedB. The valuation ratios for the guideline company and the comparative analysis of qualitative and quantitative factors should be used together to determine appropriate valuation ratios to be applied to the subject company.
C. Several valuation ratios may be selected for application to the subject company, and several value indications may be obtained. The appraiser should consider the relative importance accorded to each of the value indications used in arriving at the opinion or conclusion of value.
D. To the extent that adjustments for dissimilarities with respect to minority and control, or marketability, have not been made earlier, appropriate adjustments for these factors must be made, if applicable.”The key to obtaining the most accurate results when using the Guideline Company Method is to use the most comparable company as the guideline company. The closer to the evaluated company in all areas, the more accurate the result.
The merger and acquisition method evaluates a company based on actual merger and acquisition transactions that involve entire companies or controlling interests in companies. This method may include companies that were either public or private prior to the control transaction. When using this method, all of the underlying information relating to a particular merger or acquisition may not be known. The motives of the buyer or seller may cause the transaction amounts to be skewed; this will be transparent to the evaluator and can cause an inaccurate evaluation.
By using either of the Market Approach methods, it is still a “best guess” based on the best available information. The more accurate and comparable the comparison study is, the better the resulting evaluation.
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