You have been asked to perform a stock valuation prior to th

You have been asked to perform a stock valuation prior to the annual shareholders meeting next week. The two models you have selected to value the firm are the dividend discount model and the discounted cash flow model. Explain why the estimates from the two valuation methods differ. Address the assumptions implicit in the models themselves as well as those you made during the valuation process.

Solution

Dividend discounted model uses dividend pay-out and their growth discounted at the cost of equity to calculate te price of share. Since dividend are not regular and don\'t have fixed growth it is very difficult to predict the price of share.
Discounted cash uses future cash flow discounted at WACC to give enterprise value which when divided by number of shares outstanding gives the share price. This is better indicator of share price.

Assumption is that the cash flows generated through business are reinvested at the rate of WACC. The WACC is calculated on the target debt equity ratio of the company which may keep on changing throughout the life of the firm. The DDM model assumes that there is fixed or growing dividend throughout the life of the firm. The cost of Equity can be calculated through CAPM method.

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