Question

Which valuation approach would you use for the following types of investments? Justify your choice.

a. A mature, stable, dividend paying “Blue Chip” stock in the Dow Jones Industrial Average

b. A cyclical large cap stock

c. A rapidly growing small cap stock.

Valuation Approaches to Pick From are:

Present Value of Dividends

Present Value of Free Cash Flow to Equity

Present Value of Free Operating Cash Flow to the Firm

Price/Earnings

Ratio Price/Cash Flow Ratio

Price/Book Value Ratio

Price/Sales Ratio

Answer 1

For a mature and stable stock which pays dividend regularly, dividend discounting model shall be appropriate to find value of the stock. Further we can also calculate payout ratio so as to compare that dividend rate is growing as the earnings grow.

For cyclical large cap stock, valuation on the basis of earnings shall be most appropriate method because the price of stock here shall be volatile with ups and down of the economy.

For rapid growing small cap stock.

Discounted cash flow approach shall be most suitable method because the growth of price shall highly depends on sales and profits of company.