Finance Essays - Valuation Discount Model

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Valuation Discount Model


Valuation is the process of approximating the fair price of a financial asset or liability. According to finance, valuations can be done in assets like stocks, options, patents, trademarks or business firms or liabilities like in bonds contingent liabilities, warranties and leases. There is a great deal of significance in valuation. It assist in analyzing the investments, budgeting for the capital, preparing mergers and even acquiring various forms of transactions, giving various financial reports, taxable burden and litigation of cases.

Valuation can be done using various methods like discounted cash flows which determines the value of the company basing it to predicted future cash flows. The opportunity cost of capital is evaluated in comparison to the risk and returns. This method will compensate the investor more in case exists more risks. The value of the company is computed only for similar companies by looking the prices of related firms.

Dividend Discount Model of business valuation refers to a system that approximates the value that a collection should be doing business at by finding the current value of all prospect dividends. The mock-up assumes that dividends will develop at a stable rate and that development will persist for an endless time. It also presumes that the requisite rate of return is higher than the countless expansion rates. Residue Income Valuation model has two components: the current book value of equity and the present value of upcoming residual income. While discounted free cash flow model is based upon the premise that the only cash flows received by stockholders is dividends. Even if modified version of model whereby stock paybacks are treated as dividend may disvalue firm hence causing less or more than the can to its stakeholders.

Dividend Discount Model (DDM)

This is where the stock's price is valued by using predicted dividends, and discounting them to present value. It should be noted that if dividend discounting model is higher than what the shares are being exchanged the stock is undervalued.( Ohlson E, & Firthlow, G 2005 )

Value of stock = dividend per share (dps) / Discount Rate - Dividend growth rate

That is stock price = Div/(r - g)

This equation is the one used to find the value of capital by making r the subject of the formula. i. e. r = (Div/stock price) + g

Where g is the assumed growth rate of dividend

Div is the dividend given and

r is the rate of discount.

From the equation above it is evident that, rate of discount cannot be less than growth.


This model is more conservative: This is because the share of stock is valued to its present value of its future dividends rather than its earnings.

The dividend discount model can be applied successfully only when a corporation is already distributing a significant amount of salary as dividends. But eventually earnings turn into dividends. That's because once a company reaches its maturity it won't need to reinvest in its expansion, so administration can begin handing out cash to the shareholders.

The manager may follow some vague acquisition to satisfy his distended ego. This may be as a result of conservatism.

Subjective contributions can lead to unparticular models and poor results

Over-reliance on a assessment that is the core to an estimate

Elevated understanding to minute variation in input assumptions


There is flexibility when approximating the future dividend calculations.

It gives valuable estimations even when inputs are excessively made easy

Can be inverted so that the present stock value can be used to charge market assumptions for expansion and predicted return

Shareholders are able to suit their model to their anticipation rather than force-fit hypothesis into the model

Underlying specified assumptions that gives way for sensitivity examination and scrutinizing market responses to changing conditions

Comparing discounting free cashfows to equity with the modified dividend discounting model

The supply paybacks (return of excess cash accumulated largely as a consequence of not paying out free cash flows to equity as dividends)will embody curved out computes of what companies can give back to their stockholders over time as dividends.

Residual income valuation model (RIVM)

Residual income refers to the net income less charge for common shareholders' opportunity cost which is used to produce net income. Some authors refer it as valuation approach, economic profit and abnormal earnings.

Advantages of Residual Income Valuation Model

Terminal value is a comparatively less part of current value

It requires the only available data to prepare accounting transactions

The companies which either pays dividend or don't pay can use this model

This model is appropriate even when cash flows are changeable in the company. That is to say that

It mainly focuses on the economic value of the asset

A company does not pay rewards if bonuses are not expected

Free cash flow is unconstructive over a contented forecast horizon hence the need to use residual income valuation model in valuation of properties.

There is high unpredictability in estimating terminal values

Disadvantages of residual income valuation model

Since it uses already available accounting data that has been manipulated then it may fail to give accurate results.

When alterations are available, accounting data may require some adjustments failure to which unreliable information is attained.

This model needs a clear excess relation to hold that is to say that all manipulations to residue value other than possession transactions run throughout the earnings

It is hard to predict book value and return on investments for the firm.

There are immense departures from spotless excess accounting.

Discounted Free Cash flow models (DFCFM)

The prospect cash flow set is dogged to estimate time and a continuing worth that signifies the cash flow torrent after the forecast period. This can be divided into two that is free cash flow to equity discount models; based on the argument that the only cash

Flow received by stockholders is dividends. To measure how much to give to stockholders in form of dividends the quantity of cash available to be paid to stakeholders after reinvestment needs are met. It should be noted that increases in working capital reduces firms' cash flows and in case working capital reduces the cash flow available to stockholders in creases. The second is discounting to free cash flow to firm model. Usually done to firms with high leverage and expect to go reducing their value with time. The firm may decide to do this because debt payments must not be factored and the cost of capital may not be varying with time. (Olson E, & Firthglow, G 2005)

This can be classified as growth model which should be applied only when cash flows are positive.. Two stage models must be used only when the company is growing at a moderate rate (more than 8% of the constant development rate) and three stage models must be applied only when the company is developing at a higher than stable speed (Kaplan F, & Rubak 2000b)

Advantages of using discounted free cash flow models in valuation

Better for the firms which pay substantial dividends which are more than the free cash flow to equity. Dividends can be substantial if they are less than 75% of free cash flow for equity or dividend are greater are more than free capital for equity. (Herning, et al 2007)

It is appropriate for the firms which free cash flow are hard to estimate, for instance, in banks and other financial companies.

It is not easy to change dividend value in free cash flow model

The investor is able to receive his dividends and he trust with the company

Dividend per share is commonly available

Earnings per share is commonly available this shows that the returns are high.

Earnings should symbolize both cash flow and the sum that can be compensated out as dividends

Free cash flow is less subject to handling than wages.


Companies are typically able to disburse additional dividends than they really do, so the gauge is often too conventional

Dishonest administration can influence reported earnings to benefit them and even misuse some funds.

Investors are never given benefits as a ready money run.

Not broadly detailed. Because future cash flow is the one used to determine the present

Shareholders do not receive free of charge cash flow.

Comparing and contrasting when each model is appropriate

Dividend discount model does better:

When growth rate in company's earnings is constant i.e. (growth of the firm in economy is more than 1% Kaplan F, & Rubak 2000b)

When bonuses are close to free cash flow to equity or future cash flow to equity is hard to calculate.

When leverage is unwavering

When growth speed of company earnings is sky-scraping

Future cash flow to equity does better when:

Growth rate of the enterprise earnings is increasing.

Dividends are incredibly diverse from free cash flow or dividends are not available for the private company

Control is even

Growth rate of the company earnings is reasonable.

Dividends are exceptionally dissimilar from Free Cash Flow Equity or Dividends not accessible to Private firms.

Influence is constant and it is not easily changeable

Growth speed of the company's returns is sky rocketing

Free capital flow to the firm does better when.

Growth rate of the company's returns is constant but more than 1%.

Leverage is elevated and predictable to transformation over time is unbalanced

Growth rate in the company wages is elevated

Reasons why a firm may decide to pay less dividends to shareholders

Desire for stability: Dividends are considered sticky i.e. not responsive to change because when there is a variation in dividends is substantially lower cash flows. Also firms do not always increase dividends even when the capital increases.

Future needs of investments: The firm may hold the dividends which it is supposed to pay to stockholders if it has a plan of investing and acquiring more returns. Also, if the company is unsure of its spending plan it may be left with some csh to meet these contingent liabilities.

Tax factors: when stockholders are in high tax bracket and dividends are taxed highly than capital gains the company may decide to pay less as dividend and retain more of cash. When laws are favouring payments of dividends then the company may pay stakeholders more than it is retaining.

Signaling privileges

When there is an increased dividend an indication of good performance of the firm is signaled and if a low dividend is paid it signals poor performance of the company. The use of payment of dividend as signals may direct to distinction amid dividends and free cash flow to equity.

Managerial self interest

If administration retain cash it will be at a better position than when it has disbursed the entire amount or some of it as dividends, this is because they can invest it and earn more profits.

Similarities of valuation methods

Existing experiential evidence advises that residual income assessment models based on historic cost accounting considerably underestimate equity standards. It has also been established that price rises causes no precise function in the valuation of structures that arise from the residual income reformulation of the payment valuation model: provided that internally dependable definitions are used, it matters little whether the accounting system used is based on historic cost accounting conventions or adjusted for inflation ( Herning, et al 2007).

Examining the role of inflation in residual income valuation using both replication and theoretical models reveals that, although the basic assessment structures of residual income models stay unchanged inflation alters the linear energetic such that even in a relatively low inflationary surroundings residual income models are likely to create strict under-valuations

Value to price ratio can foresee abnormal returns in either model of valuation Lee (1999) Lee argues that in three models valuation can be done for simple markets and hence the results lead to a cross-section forecasting in abnormal future date returns.

Differences of valuation methods

Where there are palpable dissimilarities between the properties, you will require building modifications to get to the correct evaluation amount. Possessions are not always homogenous and not many properties are truly the same. This means making contrast is extremely skewed. (Kaplan F, & Rubak 2000b)

This makes valuation an art because the results got are not precise. Different valuers can look at the similar assets and come up with different figures, and in theory at least, they are all right!

In making alterations the enticement might be to knock off a small piece to allow for the price of maintenance and improvements. What the valuer will be prepared to pay is the market value of the asset and he will not be in a position to find out what is missing in the asset and deduct to find the value that he is supposed to pay. This is the reason why property valuer argue that cost of the property is not always equal to its value.

The more distinctive belongings are, the less likely they will be able to find directly applicable verification, and the more modifications will call for. In other words, the more the assets are unique the decisions are required to be used and often there is no surrogate for knowledge

Different valuation methods will come up with different figures depending on place where the property, the class of the people, its future among others. Hence no certainty can be used to get the same values when valuing property at all.


Valuing of assets or liabilities is very vital to any kind of finance management. It is evident that more than one method may be used to come up with good and reliable results. This can be done by valuing the property using the three models and then finding the average of the three models.

Where there are blatant dissimilarities between the properties, you will require building modifications to get to the accurate appraisal amount. Possessions are not always homogenous and not many properties are truly the same.

Otherwise, all the methods of valuing properties have some similarities like they will produce good price if the economy is growing .Hence, a great need to compare the models to get similarities and differences is vital to get better values. Most of the research carried out ranks Free cash flow model to be the best. (Kaplan F, & Rubak 2000b)


Lee, JB 1999, Reviewing Williams Theory of Investment Value. McGraw, Tokyo.

Herning, et al 2007 valuation tangible and intangible assets Simpletiom press, Delhi.

Olson E, & Firthglow, G 2005 Modern valuation models: Critical Analysis on merits and demerits. Kenya Literature Bureau, Nairobi.

Kaplan F, & Rubak 2000b Comparison of valuation models. Oxford University Press, Oxford.