DDM and valuation of a company
would you ever use a dividend discount model to value a company? i was wondering whether anyone has come across any articles and papers that describe valuation of a company through a DDM vs a DCF method.
DDM is which you derive the equity value, but DCF is how you derive the value of the company through the PV of its cash flows... are we comparing apples to oranges when you use DDM vs DCF? What are the pros / cons for each and when would you use DDM?
I know the basic argument for when not to use a DDM, is when the company you're valuing has high growth and unstable dividends... but wouldn't that be the same as a DCF too? It's hard to estimate value with unstable cash flows. Serious answers please - someone please clarify this for me. Thanks
I know that you should NOT use DDM for tech companies.
It is apples to oranges as DCF is an unlevered method of valuing where you strip out debt and look at the value the company provides to everyone (debt and equity holders). You are focused on cash and the cash flow generated by the operations of a business. A DDM only focuses on dividends and is more similar to FCFE where you are focused on the value brought to equity holders. The rational behind using a DCF vs DDM is that the capital structure of the firm should be irrelevant. Nobody that intrinsically values a firm will use a DDM. As a matter of fact, I don't really know anyone that uses a DDM and haven't heard of anyone using it to value. Doing a DCF is the standard.
You're right that a DDM shouldn't be used in a company that isn't in stable growth, but I wouldn't use DDM in a company that is either. If you have to value a company that is in stable growth you would use a two stage DCF model where you value the cash flows and then get a terminal value. If it's in a growth stage, you would use a multi stage model that values the cash flows for each different stage if growth, and then a final stage to get a terminal value once it gets to stable growth.
Hope that helps.
I think I've heard before that DDM is used when valuing banks/within FIG groups? Don't take my word for it though, I could be wrong.
It would make way more sense for financials since you have issues w/working cap and all that, but i would rather use multiples to value banks since DDM is still not a good indication of value.
Its a quick and dirty way to look at it, but there is way more in depth work that i would do than a simple ddm if i was interested in a financial.
You would use a DDM model to value a bank or insurance company generally. Really there are three interconnected issues here differentiate these from traditional companies for which you would preferably use FCF/DCF approach:
(1) Leverage and the capital structure is inherently part of the FIG business. In traditional valuation you want to separate the financing of a business from its operations, so you value the operations and independently deal with the financing/capital structure . However in FIG leverage and capital structure ARE the business as you make money from spread (banking) or float (insurance). Also, in a typical business it is not difficult to significantly alter the capital structure - LBOs are premised on this fact, but in a financial it is generally NOT possible to significantly alter the capital structure - this is a cost of actually doing business. Note for example that in a bank you don't have revenues and COGS, but their equivalent Interest Income and Interest Expense.
(2) Following from the above, there are capital structures imposed on these companies by regulatory authorities and by ratings agencies that will directly impact the operations of the company. A certain amount of "risk equity" is required in these businesses, so you will need to always maintain that PRIOR to having access to any cash flow. Typically what is done is a leverage target (i.e. target equity position) is set and then all other income assumed to be dividended out (a key assumption being that dividends can be financed - this is reasonable if the firm is a going concern).
(3) Besides the fact that it doesn't really matter (see points 1&2), it can be very difficult to find FCF (vs. Cash Flow to Equity "CFE") for a FIG company. For insurance companies you can generally find Cash Flow to Equity by projecting statutory income and if the company were relatively simple could back out certain elements of the capital structure to get FCF. However what is typically done is a projection of both STAT and GAAP income which allows you to find cash income (STAT is like cash accounting) that is then dividended to statutory equity using a target leverage ratio (this gets much more complicated because you also have to consider rating agency capital measured under GAAP, but its a similar concept). For a bank you can't find FCF and it is irrelevant - leverage is far too integrated into the operations of the firm (think deposits among other things). Generally for banks, you adjust net income to back out non cash items and then dividend cash income using a leverage target. While this is the typical approach, I have done valuations where we have projected cashflows for every bank asset, rolled this into GAAP income and projected a full set of financial statements - this is how banks manage themselves internally and is EXTREMELY complicated and really can only be done with lots of access to internal information.
Let me know if that is helpful - Happy to answer any questions.
One more point that relates to (1) above. The reason you want to use a DCF vs. DDM (btw some refer to the above described DDM model as a Free Cash Flow to Equity model) for most companies is that as mentioned you want to be able to look at pure value of operations regardless of who "owns" the company (i.e. a net borrower or net lender as an individual). In academic finance speak this is called for under the Fisher Separation Theorem and is supported by the Modigliani-Miller Theorem. Both of these theories in their basic form call for "perfect capital markets", so there is a lot more nuance here to get to real world, but the basics are as follows:
FST basically says that the value of a project is independent of the method used to finance it. Firms should make the decision to maximize PV by choosing good productive projects and only then decide how to finance them - i.e. investment (operations) and financing decisions should be separated out.
This is supported by M-M, which basically states that is you consider two identical firms, one with leverage and one without, then the value of the two firms should be identical. It is basically an arbitrage argument that says an investor could leverage himself similar to the levered company and achieve the same results.
There are a lot of assumptions made, but the general principal holds for modern valuation and capital structuring. In a business where you are producing widgets, you want to know the value of the widget factory itself, not value added by its access to capital markets/capital structure. After you know if the widget factory is valuable You then can separately look at the value added by access to capital markets and selected capital structure.
DCF vs. DDM ? (Originally Posted: 06/17/2013)
Hi,
Could someone please tell us why do we have two different valuations when using DCF and DDM to value a company (given the same assumptions) ?
Thanks for your help,
Who gets cash in a company? Debt and Equity Holders.
Who gets dividends? Equity holders.
DCF gets you business valuation. DDM gets you to equity valuation then you need to add the debt on top of it. There's no reason to think the two will be the same because you're working off of very different drivers of value and you're making assumptions on all of them. Valuation should always get you to a relevant range. Not an exact value.
Also, DDM is used for FIG companies while DCF is for valuation of the rest of the industries except oil&gas/RE
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