Valuing stocks: dividends, payouts, and free cash flow

Valuing stocks: dividends, payouts, and free cash flow

1. 1. A stock will pay $4 in dividends next year, growing 4% forever. Cost of equity is 10%. Using the Gordon growth model, what is the fair value per share? Answer in dollars.

   $

2. 2. A firm earns EPS_1 = $5 with cost of equity 10%. It is deciding whether to retain and reinvest some earnings. Reinvested funds would earn a 7% return. What does retaining do to the share price relative to paying everything out?

   Raises it: any positive growth adds valueLowers it: the reinvestment return (7%) is below the cost of equity (10%), so growth destroys valueLeaves it unchanged: payout policy never affects valueRaises it: retaining always funds higher future dividends

3. 3. A firm reinvests 40% of its earnings (retention b = 0.40) at a return on new investment of 15%. What is its dividend growth rate g, in percent?

   %

4. 4. Apple returns far more cash through share repurchases than through dividends. What does this imply for valuing its equity with a pure dividend-discount model?

   Nothing: buybacks and dividends are valued the same way automaticallyA pure DDM understates the equity, because it ignores the cash returned via repurchases; use the total-payout modelA pure DDM overstates the equity, because buybacks reduce sharesBuybacks make the stock worth zero under the DDM

5. 5. In the discounted free cash flow (enterprise) model, why are free cash flows discounted at the WACC rather than the cost of equity?

   Because the WACC is always lower, giving a higher valuationBecause free cash flow belongs to all investors (debt and equity), so the discount rate must reflect bothBecause equity is riskier than the firm's assetsBecause the WACC already subtracts net debt

6. 6. A multi-stage DDM: Div_1 = $2, growing 12% per year for 5 years (so Div_5 = $3.15), then 3% forever. r_E = 10%. What is the terminal value at the end of year 5 (the Gordon value at that date)? Answer in dollars.

   $