Personal Investment Management
ADMS 3531 Fall 2011 – Professor Dale Domian
Lecture 3, Part 2 – Common Stock Valuation – Sept 27
Chapter Seven Outline
The dividend discount model.
The twostage dividend growth model.
The residual Income Model.
Price ratio analysis.
Common Stock Valuation
Our goal in this chapter is to examine the methods commonly used by financial analysts
to assess the economic value of common stocks.
These methods are grouped into two categories:
o Dividend discount models.
o Price ratio models.
Fundamental analysis is a term for studying a company’s accounting statements and other
financial and economic information to estimate the economic value of a company’s stock.
The basic idea is to identify ‘undervalued’ stocks to buy and ‘overvalued’ stocks to sell.
In practice however, such stocks may in fact be correctly priced for reasons not
immediately apparent to the analyst.
The Dividend Discount Model
The dividend discount model (DDM) is a method to estimate the value of a share of stock
by discounting all expected future dividend payments.
Estimating the Growth Rate
The growth rate in dividends can be estimated in a number of ways.
o Using the company’s historical average growth rate.
o Using an industry median or average growth rate.
o Using the sustainable growth rate.
The Sustainable Growth Rate
Sustainable growth rate = ROE [x] Retention Ration Sustainable growth rate = ROE [x] (1 – Payout Ratio)
Return on Equity (ROE) = Net Income / Equity.
Payout Ration = Proportion of earnings paid out as dividends.
Retention Ratio = Proportion of earnings retained for investment.
The TwoStage Dividend Growth Model
The twostage dividend growth model assumes that a firm will initially grow at a rate 1
for T years, and thereafter grow at a rate2g