Dividend discount model: Value is estimated as the present value of expected future dividends plus the present value of a terminal value.
A stock paid a $10 dividend last year. The next year’s dividend will be 8% higher and the stock will sell at $150 at year-end. Calculate the value of this stock if the required rate of return is 12%.
D1 = D0 x (1 + dividend growth rate) = $10 x 1.08 = $10.8
Free cash flow to equity model: Value is estimated as the present value of expected future free cash flow to equity. FCFE is the cash available to the firm’s equity holders after a firm meets all its other obligations.
FCFE = CFO – FCInv + Net borrowing
Estimating the required rate of return for equity: CAPM is often used to calculate the required rate of return for a security.
Required rate of return = risk free rate + β [market risk premium]