Estimating Inputs for the DCF Approach
by MaestroThree inputs are required to use the DCF approach: the current stock price, the current dividend, and the expected growth in dividends. Of these inputs, the growth rate is by far the most difficult to estimate. The following sections describe the most commonly used approaches for estimating the growth rate: (1) historical growth rates,(2) the retention growth model, and (3) analysts’ forecasts.
Historical Growth Rates First, if earnings and dividend growth rates have been relatively stable in the past, and if investors expect these trends to continue, then the past realized growth rate may be used as an estimate of the expected future growth rate. We explain several different methods for estimating historical growth in the Web Extension to this chapter, found on the textbook’s web site; the spreadsheet in the file Ch 06 Tool Kit.xls shows the calculations. For NCC, these different methods produce estimates of historical growth ranging from 4.6 percent to 11.0 percent, with most estimates fairly close to 7 percent.
As the Ch 06 Tool Kit.xls shows, one can take a given set of historical data and, depending on the years and the calculation method used, obtain a large number of quite different growth rates. Now recall our purpose in making these calculations: We are seeking the future dividend growth rate that investors expect, and we reasoned that, if past growth rates have been stable, then investors might base future expectations on past trends. This is a reasonable proposition, but, unfortunately, we rarely find much historical stability. Therefore, the use of historical growth rates in a DCF analysis must be applied with judgment, and also be used (if at all) in conjunction with other growth estimation methods as discussed next. Retention Growth Model Most firms pay out some of their net income as dividends and reinvest, or retain, the rest. The payout ratio is the percent of net income that the firm pays out as a dividend, defined as total dividends divided by net income; see Chapter 10 for more details on ratios. The retention ratio is the complement of the payout ratio: Retention ration (1 Payout ratio). ROE is the return on equit defined as net income available for common stockholders divided by common equity. Although we don’t prove it here, you should find it reasonable that the growth rate of a firm will depend on the amount of net income that it retains and the rate it earns on the retentions.
Taken From : Credit Repair by Attorneys Robin Leonard and Deanne Loonin
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