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APA, 1 reference, approximately 200 words.
Initial 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.
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The difference in the two valuation methods is based on the assumptions made in the valuation process. The dividend discount model discounts future dividend payments as opposed to free cash flows. Which in turns means that the value of a stock today is the summation of the present value of its future dividends. The primary difference between these two methods is the distributing all of its cash flows as a dividend, which is something the company may not due. The assumptions used in the two models may pose a challenge because the Dividend discount model is based on the presumption of a stable and continuous growth rate which are lower than the cost of capital which may not be a reasonable assumption. As well, if there is no current dividend being paid by the stock, like many growth stocks, generic versions of the discounted dividend model will be necessary to value the stock. The Discounted cash flow model is a mechanical valuation tool, which in turns means that it is subject to the rule of garbage in, garbage out. Even the Smallest changes in flow can result in significant changes in the value of the company. As opposed to trying to predict the cash flows to eternity, terminal value methods can be used. As an example, simple perpetuity is used to approximate the terminal value of the last ten years. This reason for this is that it is much more difficult to find an accurate cash flows since as time goes on it includes calculating the length of time to recoup the initial expense. Another shortcoming is that the Discounted Cash Flow Valuation should only be used as a method of intrinsic valuation for companies with a predictable, although it does not have to be a stable, cash flow. The Discounted Cash Flow valuation method is commonly used in valuing mature companies in a stable industry like a Utility company. At the same time, this method is often applied to the valuation of high growth technology companies. On the other hand, valuing young companies which do not have a cash flow track record, the Discounted Cash Flow method may be used sometimes to assess some possible future outcomes, like the best, worst and most likely case scenarios.The adjusted estimates may not be the stock price today, or any day at that because of the assumptions are taken. If cash flows are unpredictable, discount cash flow is not appropriate. Discount cash flow should be used if small changes in the risk-adjusted rate of return or if future growth rates change today’s value dramatically. As well investment returns rely on investors buying your shares at a higher price. If you do not find a buyer, there is no way of converting your shares into cash. Dividends must be predictable and sustainable if the dividend growth or their payout ratios change intensely, the Dividend discount Model will not work. The method which dividends are reinvested are very important to cumulative returns but are overlooked by the model. Dividends are taxed based on the year they are incurred while capital appreciation is not taxed until it is realized as a capital gain (Brigham & Ehrhardt, 2017).
Brigham, E. F., & Ehrhardt, M. C. (2017). Financial management: Theory and practice (15th ed.). Mason, OH: South-Western.