By Jan Viebig, Thorsten Poddig, Armin Varmaz
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Extra resources for Equity Valuation: Models from Leading Investment Banks (The Wiley Finance Series)
Expected div idends are the product of expected earnings multiplied by an expected payout ratio. If companies are not expected to distribute earnings to shareholders over an extended period of time in the future, it is often practically impossible to apply dividend discount models. Dividends are the amount of cash which a company actually distributes to its share holders. Free cash flows to equity (FCFE), on the other hand, are cash flows after invest ment and after interest payments to debt holders which a company could distribute to its shareholders.
The DuPont formula helps investors to better understand the sources of ROE. The discounted terminal value represents over 86% of the fundamental value of Deutsche Bank’s shares. This illustrates how important input factors are which go into the termi nal value calculation. By definition, ROE equals costs of equity in the terminal value period: ROETV = iE,TV . The retention ratio bTG during the terminal value period can be calculated by applying the fundamental growth equation. 23 At the beginning of 2006, shares of Deutsche Bank traded at EUR 82.
However, Deutsche Telekom might not be able to pay dividends in the future if, for example, price pressures in the telecom industry increase further, or if Deutsche Telecom has to invest more in its infrastructure to stay competitive. When applying dividend discount models, analysts typically assume that companies pay a certain amount of dividends in the future without carefully analyzing the true earnings poten tial of a firm. Formulating free cash flow models, on the other hand, forces analysts to carefully analyze the revenue potential, the cost structure and the investment needs of a firm.
Equity Valuation: Models from Leading Investment Banks (The Wiley Finance Series) by Jan Viebig, Thorsten Poddig, Armin Varmaz