Equity valuation is a subject of great depth and complexity. Valuation entails understanding a business; forecasting its performance, selecting the appropriate valuation model; converting such forecasting to a valuation and making a recommendation whether or not to purchase. Valuation models are as nuanced as the companies to which their application would appear to be best suited. For the purpose of the CHO examination, candidates are expected to demonstrate proficiency in the basic mechanics and application of the dividend discount model which utilizes a firm’s cost of capital to discount dividends to arrive at an approximate intrinsic value of the company. Constant (Gordon) Dividend Growth Model:
P=D/k-g
Where:
P=security’s price;
D=dividend payout ratio;
k= required rate of return (derived from the capital asset pricing model);
g=dividends’ expected growth rate.
The dividend growth rate is constant; the growth rate cannot equal or exceed the required rate of return; the investor’s required rate of return is both known and constant. In practice, a company’s earnings and growth rates are not known and not constant. Multi-stage Dividend Discount Models:
P=D(1 +g)/( 1 +k) + D( 1 +g)( 1 +g)/( 1 +r)(k-g)
Multistage models can accommodate any number of patterns of future streams of expected dividends. Spreadsheets enable the analyst to build and analyze many permutations on such models. However, care must be taken when choosing the model’s inputs, lest the results become meaningless. Spreadsheets are susceptible to data errors which can result in erroneous valuations.
