Question

Mandy Herr -- an investment analyst at Crimson Investment Management (CIM) -- is currently following technology stocks. Herr works with her supervisor, Jeremy Sparks -- a portfolio manager for institutional investors -- to determine appropriate investments for their clients. Herr is tracking the stock of Crown Technologies (CT), a well-known competitor in the industry. She has compiled the following information about the stock.

While gathering information about Crown Technologies, Herr figured out that the company experienced a significant shift from equity to debt financing last year. This year, the CEO plans to issue a significant amount of equity to replace debt in its current capital structure. Herr found the financial statements of the firm difficult to interpret because of the poor quality of accounting disclosures. In addition, many items not presented in the financial statements were excluded from the footnotes.

Herr is also evaluating the stock of Paper and Plastic Manufacturing Company Limited (PPMCL). She has compiled the following information for her analysis:

• PPMCL’s EPS for the current year was $3.67.
• PPMCL’s dividend policy is to maintain the dividend payout ratio at 40%.
• Based on the firm’s pro forma financial statements, the expected long-term growth rate of earnings will be 6.5%.
• For the next three years, the company is expected to experience growth rates of 11%, 9%, and 10% respectively, after which earnings are expected to grow at their long-term estimated growth rate.
• The company’s beta relative to the local stock index is 2, and the market risk premium is 5.5%
• The U.S. Treasury rate is 3.75%.
• The current market price of the stock is $43.56.

Sparks wishes to estimate the value of Petroleum Exploration Limited (PEL) stock. The company earned an EPS of $5.12 and paid dividends of $2.34 over the past year. Based on his analysis, Sparks estimates the long-term earnings and dividend growth rate for the firm at 5.5%. The current market price of the stock is $65.78. Sparks’ estimate of the required rate of return for the stock is 12%.

Sparks has also been following a non-cyclical stock with a market price of $78.05. The stock has earned an average EPS of $1.56 over the past 5 years and is expected to earn a similar amount in the foreseeable future. The stock’s beta is 1.13, the market risk premium is 5.5%, and the risk-free rate is 4%.

While having lunch, Herr and Sparks discussed the appropriateness of the dividend discount model for valuation purposes. Herr made the following comments:

Statement 1: “The Gordon Growth Model is appropriate for use when the growth rate is less than the required rate of return. The model also accommodates the possibility of negative growth rates.”

Statement 2: “:Provided the DDM model is correctly applied, it’s appropriate for common stock valuation, even if the company being analyzed engages in share repurchases.”

question: Given the information about Crown Technologies, is the Dividend Discount Valuation Model or the FCFF Valuation Model more appropriate to value CT’s stock?

Exhibit 1

Year	EPS ($)	DPS ($)
20X3	3.75	1.50
20X4	4.68	1.60
20X5	4.70	1.40
20X6	4.50	1.50
20X7	4.43	1.50

Answer 1

Dividend Discount Model (DDM):

One of the most basic of the absolute valuation models. The dividend discount model calculates the "true" value of a firm based on the dividends the company pays its shareholders. The justification for using dividends to value a company is that dividends represent the actual cash flows going to the shareholder, so valuing the present value of these cash flows should give you a value for how much the shares should be worth.

The first step is to determine if the company pays a dividend.

The second step is to determine whether the dividend is stable and predictable since it's not enough for the company to just pay a dividend. The companies that pay stable and predictable dividends are often best suited for the DDM valuation model.

Free Cash Flow Model:

DCF model uses a firm's projected future cash flows to value the business. The big advantage of this approach is that it can be used with a wide variety of firms that don't pay dividends

The DCF model has several variations, but the most commonly used form is the Two-Stage DCF model. In this variation, the Free cash flows are generally forecasted for five to 10 years, and then a terminal value is calculated to account for all the cash flows beyond the forecasted period. The first requirement for using this model is for the company to have positive and predictable free cash flows.

Conclusion:

Since in the present case, Crown limited is not paying are not paying stable and predictable dividends , FCFF model will be more suitable than DDM model assuming that Crown limited being a well extablished company, it has regular and predictable future cash flows.