Stock valuation
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.
Sample Solution
The dividend discount model (DDM) and the discounted cash flow (DCF) model are two of the most common stock valuation methods used to assess a company’s worth. While both use future cash flows to calculate the present value, there can be some variation in the actual estimates produced by each method due to underlying assumptions as well as data inputs.
One reason for differences between DDM and DCF models is that they contain different implicit assumptions when it comes to calculating future cash flows. For example, DDM uses dividends or other distributions as its basis for estimating future values; whereas, DCF takes into account expected changes in operating performance over time such as revenue growth. Additionally, both models may produce different results based on varying assumptions about factors like cost of capital or inflation rate etc..
In addition to inherent differences between these two methods there can also be discrepancies arising from variations in data used during the estimation process—for instance if one model relies on more conservative estimates than another. Furthermore, even if identical data is utilized across both approaches certain considerations such as excluding non-cash expenses or reinvestment rates could still lead to slightly dissimilar outcomes.
Overall, while DDM and DCF models typically yield similar results there can be cases where this is not necessarily so depending on how they are applied; which means it is important to consider any potential sources of discrepancy before relying solely on either approach when performing valuations.