The Basic DCF models
The value of a firm is the Present value of all the expected future cash flows and if we are an investor and hold an equity share then what do we get, what is our cash flow? Till the time we hold the stock the only cash flow we receive is the Dividend, hence the starting point and simplest way of valuing an equity Investment is Dividend Discount Model.
Like in Bonds, the person buying stock expects two kinds of cash flows one the regular dividends and the price at the end of the period and can be easily expressed and the future price is nothing but the present value of all the dividends till infinity.
Value per share=∑_(t=1)^(t=∝)▒〖E(DPSt〗)/ (1+Ke) ^t
DPSt=Expected Dividend per share
Ke= cost of Equity
As far as this model
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The companies which generally pay a lesser dividend then they really can, would be underestimated by this model.
Two stage Dividend Discount Model:
This model tries to address the concerns which were there in the first model, this model has 2 stages one an initial high growth period and then the company stabilises to stable growth rate which is expected to continue forever. The companies which do not do well in the beginning and then attain maturity after some time may also employ this model successfully.
Since this model is based on 2 stages hence the value of the stock relation has to be modified to incorporate this change, conceptually the relation can be described as under:
Value of Stock=PV of dividends in extraordinary phase+ PV of terminal value.
The mathematical relation would look like as
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Sometimes companies do have other alternative of giving the money back to shareholders and buybacks are an example of that, but they are inconsistent, hence we can make a little adjustment in the payout ratio to adjust the differences, which is as under
Augmented Dividend payout= (Dividends+ Stock buybacks-Long term debt issues)/Net Income
H Model:
This model was devised to address the issue of sudden migration from Initial high growth to Stable growth rate in a 2 stage model. This model suggests that Initial growth rate does not have a sustained high growth rate but falls linearly over the period of time till it reaches a stable growth rate.
This model proposes that the growth will fall linearly but the payout ratio will remain constant, which is not true,since the payout ratio should increase with decreasing growth rate.
Due to this reason this model is inappropriate and does have very limited applicability.
Three Stage Model:
This model combines the features of earlier two models and also attempts to overcome the shortcomings of the earlier