Common Stock Valuation 6-8
It is more realistic because it allows for two growth rates.
It allows the first-stage growth rate to be greater than the discount rate.
This model is also sensitive to the choice of the growth and discount rates, and it
requires that the firm pay dividends to be used.
B. The H-Model
In most two-stage models, the assumption is two distinct growth rates. In reality,
though, there may be beginning and ending growth rates, with growth between
these times changing to approach the more constant ending growth rate. If we
assume a linear change over time, this is the H-Model.
C. Discount Rates for Dividend Discount Models
Beta: measure of a stock's risk relative to the stock market average.
Beta and the Capital Asset Pricing Model (CAPM) are introduced in this section.
It is a brief introduction, with the full development left for chapter 18. This model
is introduced to allow the calculation of the required return or discount rate for the
dividend discount models, as follows:
Discount rate = U.S. T-bill rate + (Stock beta x Stock market risk premium)
Remember that the risk-free rate (T-bill rate) is the "wait" component (or time-
value-of-money), and the beta times the market risk premium is the "worry"
component (or risk premium).
Lecture Tip: To help show the sensitivity of these models to the choice of growth
and discount rates it is useful to do a few examples. The constant perpetual
growth model is simple enough that one can vary the growth and discount rates
several times, and do the calculations in a few minutes. For example, start with
D1=$1.00, k=10%, and g=5%, which gives a stock value of $20. Now increase g
to 6% and decrease k to 9% and the stock value is $33.33. Now decrease g to
4% and increase k to 11% and the stock value is $14.29. This gives a range of
stock values from $14 to $33, which is not much help in determining if this stock
is overvalued or undervalued. This dramatically shows students how sensitive
the stock price is to the estimate of the growth and discount rates.
D. Observations on Dividend Discount Models
Financial analysts readily acknowledge the limitations of dividend discount
models. Consequently, they also turn to other valuation methods to expand their
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