Question

You have been asked to perform and present a stock valuation to the CEO 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. Please include reference to back it up.

Answer 1

The dividend discount model discounts the future dividends which will be paid by the company to value the company. Under this model the future dividends are discounted at a predefined rate of interest to arrive at the present value of dividend which is the value of the firm.

Under the cash flow model the future free cash flows of the business are discounted at the cost of capital to derive the value of the company. The benefit of this model is that it values the company on the basis of it's cash flows and not on the basis of dividends paid out. Hence a company can be valued even if it does not pay dividends which is not the case in the dividend discount model.