Explain what spreadsheet modelling, the H-model, the two-stage DDM and the three-stage DDM assume, and argue for choosing one to value a firm's shares
The idea
Each multistage model encodes a pattern of growth. The two-stage model assumes high growth for a set period and then an abrupt drop to a stable rate, which fits a company whose advantage, such as a patent, ends on a known date. The H-model assumes growth falls in a straight line from a high rate to the stable rate, which fits an advantage that erodes gradually; it is an approximation that works best when the period is short or the gap between rates is small. The three-stage model adds another phase, for example high growth, then a linear decline, then stable growth. Spreadsheet models allow any pattern year by year. The trap is choosing an abrupt drop when growth will fade gradually.
In the app: 1 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →More in Discounted Dividend Valuation
- Contrast dividends, residual income and free cash flow as DCF inputs and say in which investment settings each one fits
- Work out the value of a common share with the dividend discount model (DDM) over one holding period and over several, and explain the result
- Value a common share with the Gordon growth model, explaining what that model assumes
- Value perpetual preferred stock that pays a fixed rate and cannot be called
- Set out what the Gordon growth model does well and badly and argue for using it to value a firm's common shares
- Use the current share price and the Gordon growth model to back out the implied dividend growth rate, and explain it
- Work out PVGO (the present value of what future growth opportunities are worth) and the share of the leading P/E it accounts for, and explain both
- Derive justified leading and trailing P/Es from the Gordon growth model and explain what they mean
- Back out a required return from any DDM, including the H-model and the Gordon growth model
- Judge from a DDM value whether the market is pricing a stock too high, too low or fairly
- Explain the growth, transition and maturity phases a business passes through
- Explain terminal value and the different ways of setting it in a DDM
- Value common shares with the H-model, the two-stage DDM and the three-stage DDM, and explain the results
- Explain how spreadsheet models are used to project dividends and value common shares
- Work out a firm's sustainable growth rate and explain it, showing how DuPont analysis can be used to estimate that rate