Section 1.4Economic Factors & Business Information

Equity Valuation Models: DDM, DCF & NPV

Examines analytical valuation frameworks including the Dividend Discount Model, Discounted Cash Flow analysis, Net Present Value, and market multiples.

Key Exam Takeaways

Gordon Growth Model: P0 = D1 / (k - g), where D1 is next year's expected dividend.
Net Present Value (NPV) = Present Value of Cash Inflows minus Initial Cash Outlay.
If NPV > 0, the project or asset earns a return exceeding the discount hurdle rate and should be accepted.

Common Exam Traps

Never plug last year's dividend (D0) into the Gordon Growth formula; always calculate D1 = D0 * (1 + g).
A P/E ratio is a relative valuation metric, not an absolute intrinsic valuation tool like DCF.

Fundamental equity valuation seeks to determine an asset's intrinsic economic value independent of current market price fluctuations. The Dividend Discount Model (DDM) values a share of stock as the sum of all its projected future dividend payments discounted to the present.

The Gordon Growth Model assumes dividends grow at a constant annual rate in perpetuity (P0 = D1 / (k - g)). When an adviser evaluates a firm that pays stable, growing dividends, this model isolates the exact fair value supported by cash distributions.

Discounted Cash Flow (DCF) analysis projects free cash flows over a forecasting horizon and discounts them using a required hurdle rate (or WACC). Net Present Value (NPV) subtracts the upfront investment cost from total discounted inflows. A positive NPV signifies that the investment adds economic surplus.

🎯 Knowledge Checkpoint

Knowledge Checkpoint • Section 1.4

An analyst is valuing a regulated utility stock that recently paid an annual dividend of $4.00 per share (D0). Dividends are projected to grow at a constant annual rate of 5% in perpetuity. If the client's required rate of return for this risk profile is 9%, what is the intrinsic value per share of the stock using the Gordon Growth Model?