The Cost of Capital Approach

In the cost of capital approach, the value of the firm is obtained by discounting the free cashflow to the firm at the weighted average cost of capital. Embedded in this value are the tax benefits of debt (in the use of the after-tax cost of debt in the cost of capital) and expected additional risk associated with debt (in the form of higher costs of equity and debt at higher debt ratios). Just as with the dividend discount model and the FCFE model, the version of the model used will depend...

Applicability of the Dividend Discount Model

While many analysts have abandoned the dividend discount model, arguing that its focus on dividends alone is too narrow, the model does have its proponents. In fact, many in the Ben Graham school of value investing swear by the dividend discount model and its soundness. In this section, we will begin by considering the advantages of the dividend discount model and then follow up by looking at its limitations. We will end the section by looking at scenarios where the dividend discount model is...

Extensions of the Dividend Discount Model

One reason for the fall of the dividend discount model from favor has been the increased used of stock buybacks as a way of returning cash to stockholders. A simple response to this trend is to expand the definition of dividends to include stock buybacks and to value stocks based on this composite number. In this section, we will consider the possibilities and limitations of this expanded dividend discount model and also examine whether the dividend discount model can be used to value entire...

Volume of data in financial statement

A simplistic (but surprisingly effective) measure of complexity is the volume of data in a financial statement. For instance, the 10K filings made by firms with the Securities and Exchange Commission (SEC) range in size from less than 200 pages to in 17 We just took the debt of the books to reduce the interest rate that we pay, they will claim, but we did mention it in a footnote. In response, we would argue that investors should not have to troll through footnotes to find out how the firm...

Variations on the Dividend Discount Model

Since projections of dollar dividends cannot be made through infinity, several versions of the dividend discount model have been developed based upon different assumptions about future growth. We will begin with the simplest - a model designed to value stock in a stable-growth firm that pays out what it can afford to in dividends and then look at how the model can be adapted to value companies in high growth that may be paying little or no dividends. The Gordon growth model relates the value of...

Beta

The final set of inputs we need to put risk and return models into practice are the risk parameters for individual assets and firms. In the CAPM, the beta of the asset has to be estimated relative to the market portfolio. In the APM and Multi-factor model, the betas of the asset relative to each factor have to be measured. There are three approaches available for estimating these parameters one is to use historical data on market prices for individual assets the second is to estimate the betas...

FCFE Potential Dividend Discount Models

The free cash flow to equity model does not represent a radical departure from the traditional dividend discount model. In fact, one way to describe a free cash flow to equity model is that it represents a model where we discount potential dividends rather than actual dividends. Consequently, the three versions of the FCFE valuation model presented in this section are simple variants on the dividend discount model, with one significant change - free cashflows to equity replace dividends in the...

Should capital structure affect value

The opening salvo in this debate was fired by Merton Miller and Franco Modigliani in their seminal paper published in 1958, where they showed that in a world without taxes, default risk and agency problems, the value of a firm was determined by the quality of its investments and not by the mix of debt and equity used to fund them. The argument they used was simple and powerful. They conceded that debt is cheaper than equity but noted that borrowing money makes equity earnings more volatile and...