Equity Valuation Inputs for Single-Stage Dividend Discount Model (DDM)

Additional Inputs to Estimate the Value of TMQ Utilities

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Question

As an analyst for Donavan Financial Advisors, Lou Marvin must estimate the appropriate inputs for the firm's equity valuation models. Donavan's preferred valuation model is the single-stage dividend discount model (DDM). Members of Marvin's valuation team have supplied him with several pieces of data related to

TMQ Utilities, including the company's earnings and dividends from the most recent year, the expected real risk-free rale, and the expected nominal growth in net income. To estimate the value of TMQ Utilities, additional inputs to the DDM that will be necessary include the:

Answers

A. price-to-cash flow ratio and the expected cash flow per share.

B. expected rate of inflation and the expected earnings retention rate.

C. historical growth rates in dividends and the required return on the Utility bond index.

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Explanations

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A. B. C.

To estimate the value of TMQ Utilities using the single-stage dividend discount model (DDM), certain inputs are required. The DDM is a valuation model that calculates the present value of all expected future dividends to determine the intrinsic value of a stock. The additional inputs needed for the DDM in this case are as follows:

Answer: B. expected rate of inflation and the expected earnings retention rate.

Explanation:

Expected Rate of Inflation: The expected rate of inflation is necessary to adjust the nominal growth rate in net income to a real growth rate. The nominal growth rate represents the growth rate of a company's net income without considering inflation. However, since the DDM requires inputs in real terms (i.e., adjusted for inflation), the expected rate of inflation is necessary to convert the nominal growth rate to a real growth rate.
Expected Earnings Retention Rate: The earnings retention rate refers to the portion of a company's earnings that is retained and reinvested back into the business rather than paid out as dividends. It represents the percentage of earnings that are plowed back into the company for future growth. In the DDM, the expected earnings retention rate is used to determine the portion of earnings that will contribute to future dividends. It is an important input because it affects the dividend growth rate, which is a key factor in valuing the stock.

These inputs, along with the company's earnings and dividends from the most recent year, the expected real risk-free rate (used as the discount rate), and the expected nominal growth in net income, are necessary to perform the valuation using the single-stage DDM.

Option A (price-to-cash flow ratio and the expected cash flow per share) is incorrect because the DDM specifically focuses on dividends rather than cash flow. Option C (historical growth rates in dividends and the required return on the Utility bond index) is incorrect because it does not include the necessary inputs related to inflation and earnings retention rate, which are critical for the DDM valuation.

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