Financial Management

It normalizes earnings and determines a capitalization rate

security value=E1

Capitalization rate

Where E1 –next year normalized earnings

Capitalization rate =k_e-g

Hence the above equation=E1

Ke-g

Ke-cost of equity and g-growth rate in earnings

If capital expenses equal depreciation in all then revenue and expenses represent cash flow and all earnings are distributed as cash flow to owners

PART 1

Divided growth model

Methods of determining the hidden value of the stock based on future dividends that grow constantly. Given a dividend payable in a year’s time which grows constantly in perpetuity this method solves for Present Value of infinite future dividends

P=D₁

K-g

D₁- expected dividend in 1 year

K- Cost of equity

g- Growth rate

Developed by Myron .J. Gordon

It assumes that the cost of equity will be constant and dividend growth rate is constant and that the dividend growth rate is less than the cost of equity

The assumption that the cost of equity and dividend growth rate is constant is not realistic because it keeps on changing from year to year

This model cannot be used to value shares that pay no dividends e.g. growth shares because it tends to double count earnings if the dividends irrelevance theory is assumed

It is one of the best methods of stock valuation, theoretically.

PART 2

In real estate the income (rent) is not constant, as it is reviewed after a specified period of time for example after 3 years in this case

Gordon’s dividend valuation model assumes a constant growth at constant cost of capital for perpetuity. This means that the formula as it is cannot be used to value the real estate

P = D₁

K_e-g

It has to be modified in order to be used. The market capitalization rate in real estate terms is called equated yield

The rent in this case remains constant for 3 years and then it increases. The formula we are going to use to calculate the value of such an investment is;

Earnings

Capitalization rate+ present value growth opportunities

The earning in this case will be equal to the rent paid now

Present value of growth opportunities is the expected increase the rent in the future (after year 3) calculated in present value terms.

Hence the value of the real estate

Earnings

Capitalization rate       + present value of growth opportunities

PART 3

Capitalization of earnings

A representative level of income is capitalized into perpetuity at a capitalization rate determined by the difference between the appropriate discount rate and a constant sustainable level of growth (price to earnings multiple)

Security value=CF1

Ke-g

CF1 – next year cash flow to equity holders.

Limitation

In the above assumption, then it means that the entire cash is paid out to the shareholders

This is inappropriate since the business need to retain some cash to finance growth capitalization earnings method is not sufficiently flexible when earning varies over time because of the assumption of a single growth rate over all periods of time.

There is no real method of determining the discounting rate to apply to net income. Compared with cash flows

If depreciation expense is different from capital purchases with all other assumption held, then the capitalized earnings methods would be inappropriate since it would ignore the differences in earnings and cash flow actually distributed to the shareholders resulting from difference in depreciation & actual capital...

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