Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

QUESTION AND ANSWER SESSION

Question: How does the DDM work if a company pays no dividend?

Martin: For a company with no cash dividends, such as Microsoft, we have to assume that during the first-stage period of supernormal growth, the company will reinvest all of its earnings back into the company at a high ROE. Then in the second-stage normalization process, or maturity process, we must make assumptions about the point at which the company will be mature enough that it decides to start paying out some dividends, what that rate will be, and how fast the rate of payout will increase to reach some normal payout level. Again, the model makes us explicitly think about where such a company is in its life cycle and what is likely to happen to its products and its profitability over time.

Question: What is the role of beta in these traditional models?

Martin: Beta has no role in the traditional valuation models, with the notable exception of the DDM because the DDM requires the explicit estimation of a discount rate. A discount rate can be derived in a number of ways, one of which is a CAPM approach. If we are going to use CAPM, we also have to use a company beta for each stock being considered.

Beta also can be calculated in several ways. Beta is supposed to be the amount of volatility in the stock price over some period of time relative to some benchmark, but historical betas that are calculated based on price typically are not good predictors of future betas. We all want to know what ...