The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

KEY POINTS

• The basis for the dividend discount model is simply the application of present value analysis, which asserts that the fair price of an asset is the present value of its expected cash flows.

• Most dividend discount models use current dividends, some measure of historical or projected dividend growth, and an estimate of the required rate of return. The three most common dividend measures are dividends per share, dividend yield, and dividend payout.

• Variations of the dividend discount models allow an analyst to vary assumptions regarding dividend growth to accommodate different patterns of dividends. Popular models include the finite-life general dividend discount model, the constant growth dividend discount model, and multiphase dividend discount model.

• A dividend discount model can be recast in terms of expected return. The expected return is found by calculating the interest rate that will make the present value of the expected cash flows equal to the market price.

• An alternative valuation method to the dividend discount model is the use of multiples that have price or value as the numerator and some form of earnings or cash flow generating performance measure for the denominator and that are observable for other similar or like-kind companies. These multiples are sometimes called “price/X ratios,” where the denominator X is the appropriate cash flow generating performance measure.

• The essence of valuation by multiples assumes that similar or comparable ...