Page 20 - FINAL CFA II SLIDES JUNE 2019 DAY 7

LOS 29.a: Compare dividends, free cash flow, and residual
income as inputs to discounted cash flow models and READING 29: DISCOUNTED DIVIDEND VALUATION
identify investment situations for which each measure is
suitable. MODULE 29.1: DDM BASICS

EXAMPLE: Identifying the appropriate valuation model: Based on the financial information on Eastern Consolidated, Inc. provided in the
following table, determine whether or not a dividend discount model is the appropriate model to value Eastern Consolidated common stock.

Answer:
Earnings have grown at a compound rate of ($7.50 ÷ $5.00) 1/4 − 1 = 0.107 =
10.7% over the four years while dividends have been constant, resulting in a
decrease in the dividend payout ratio.

A dividend discount model is not appropriate in this case because the firm’s
dividend policy is not consistent with its profitability trend.

LOS 29.b: Calculate and interpret the value of a common stock using the dividend discount model (DDM) for single and multiple holding periods.
One-Period DDM: We can rearrange the holding period formula to solve for the value today of the stock given the expected dividend, the
expected price in one year, and the required return:

where:
V = fundamental value
0
D = dividends expected to be received at end of Year 1
1
P = price expected upon sale at end of Year 1
1
r = required return on equity
EXAMPLE: Calculating value for a one-period DDM: BuyBest shares are expected to pay a dividend at the end of the year of €1.25. The analyst
estimates the required return to be 8% and the expected price at the end of the year to be €28.00. The current price is €26.00. Calculate the value of the
shares today, and determine whether BuyBest is overvalued, undervalued, or properly valued.

BuyBest is undervalued.
The current market price of €26.00 is less than the fundamental value of €27.08.