Sunday, 30 April 2017

Applying Present Value Models

1.  Where Gordon Growth Model is highly appropriate

The Gordon Growth Model is highly appropriate for valuing dividend-paying stocks that are relatively immune to the business cycle and are relatively mature (e.g., utilities).

It is also useful for valuing companies that have historically been raising their dividends at a stable rate.

2.  Where DDM or Gordon Growth Model is difficult to use

Applying the DDM is relatively difficult if the company is not currently paying out a dividend.  

A company may not pay out a dividend because:

  • It has a lot of lucrative investment opportunities available and it wants to retain profits to reinvest them in the business.
  • It does not have sufficient excess cash flow to pay out a dividend.
Even though the Gordon Growth Model can be used for valuing such companies, the forecasts used are generally quite uncertain.

Therefore, analysts use one of the other valuation models to value such companies and may use the DDM model as a supplement.

3.  Multi-stage DDM can be employed 

The DDM can be extended to numerous stages.  For example:

A.   A three-stage DDM is used to value fairly young companies that are just entering the growth phase.  Their development falls into three stages - 
  • growth (with very high growth rates), 
  • transition (with decent growth rates) and 
  • maturity (with a lower growth into perpetuity).
B.  A two-stage DDM can be used to value a company 
  • currently undergoing moderate growth, but 
  • whose growth rate is expected to improve (rise) to its long term growth rate.

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