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Business Finance DDM model Essay Sample

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Business Finance DDM model Essay Sample

Part One :
1) Artic Cooling 2) National Heating & Cooling 3) HVAC Corp \$15.19\$0.82 = 18.52
\$12.49\$1.32 = 9.46 \$48.6\$2.34 = 20.77
PE ratio = 18.52
PE ratio = 9.46
PE ratio = 20.77
Industry Simple Average PE Ratio:
18.52+9.46+20.773 = 16.25
Ragan’s Stock Price:
EPS of Ragan = \$320,00050,000 X 2 = \$3.2
Stock Price based on Industry Benchmark PE:
16.25 = Stock Price3.2 = 52
Thus , the stock price is \$52 if the firm’s earning is 320,000.

Part Two
“Caution is warranted when using PE ration to value stocks”.There are two main reasons: PE Ratio cannot show the value of stock comprehesively
In some cases, there will be a fall or up of share prices because of some market fears about the economy even the company still has a stable situation.Sometimes, when there is economic crisis all over the world, there will be a fall in stocks price and value investor will buy the stocks in a large amount.Focusing on the PE ratio is a good way to make the decision on buying the stock. 2. PE ratio could be meaningless to the decision

It is very difficult to say whether a high or low PE ratio is good time for investment.The point is that we should find out that what is the cause of high PE ratio or low PE ratio. For example, a company has sold part of their brand to other firms and result in a strong earning. This increase EPS greatly.However, the decrease in market price will be followed as a weaker performanace will be forseened.Overall , the stock price will decrease and it results in a lower PE ratio.It may mislead some of investors to buy the stock. Apart from PE ratio, Dividend Discount Model (DDM) will be a better way to value the stock price. The DDM model seeks to value a stock by using predicted dividends and discounting them back to their present value. The Formula of DDM is Dividend per share over discount rate minus dividend growth rate. Value of Stock = D1

R- G
Where,
• DPS (1) = Dividends per share expected to be received in one year
• R = The required rate of return for the investment
• G = Growth rate in dividends = ROE x earnings retention (or 1 minus dividend payout ratio) By the information given , we can there calculate the stock price. Assumptions:

1. The first big assumption that the DDM makes is that dividends are fix and are not likely to change in the future .This means it has a constant growth rate indefinitely. DDM requires forecast the future dividends.But even for steady, reliable, utility-type stocks, it can be tricky to forecast exactly what the dividend payment will be next year.For example , company will pay fewer dividends if they want more equity to expand. 2.Also, the divident payment may grow as small but constant rate.With tis second approach,the equity of the company is considered to be perpetuity. 3. Apart from this, it assumes dividends are the only way investors receive money from the companies and any re-investment would be ignored. Limitations:

1)Underestimation of the value of stock
The DDM has a strict reliance on dividends means that the value of stock will be underestimated if the companies pay out less than they can afford and causing accumulation in the equity. For example, Amazon earned large profit but they choose to reserve the equity rather than paying out so much dividends. 2)Unapplicable to companies which do not pay dividends.

Some companies may not pay dividends in order to maintain the liquitity of the company or suffering the loss. Thus,2 DDM model cannot apply to these companies. 3) Ignores Buybacks
A firm may buy back a large amount of stock in one year and not buy back stock for the next 3 years. For that reason, a much better estimate of the modified payout ratio is likely to be obtained by looking at the average value. 4)Assumption Dependent

There are lots of assumptions to be made (E.G. growth rates, time frame, or the required rate of return), and the models can be very sensitive to those assumptions. Even a very small mistake can result in overvaluing or undervaluing a stock in a very large extent. 5)Too conservative in estimating the stock value:

Dividend discount model does not reflect the value of unutilized assets or intangibles, for example, patents and reputations. In conclusion, dividend discount model is another way of valuing the stock price based on the information given. However, there are still some limitations to DDM.

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