Calculating Free Cash Flow to the Firm: Method #2: Cash Flow From Operations
February 12, 2025
The put call ratio is the only financial ratio that does not compare the current market price to any financial statement item. Rather it compares what investors plan to do with a given stock or an index at a later date. Put and call are derivative options. The put option gives the seller a right […]
The valuation of a sports franchise is a very difficult task. This is because a lot of the rules that are applicable while valuing other businesses are not relevant when it comes to valuing sports franchises. One such example is the widespread usage of the price-to-revenue ratio in deriving the valuation of a franchise. In […]
In this entire module on personal finance, we have written several articles on steps that need to be taken to ensure that a person has a good future. However, in the field of personal finance, it is almost as important to not do certain things as it is to do certain others. Financial mistakes can […]
The Gordon growth model is a well known and widely known model for valuing equity securities. However, as with every model, there are some pros and cons that need to be understood before this model is applied. Understanding of these pros and cons will help differentiating between situations wherein it would be prudent to apply […]
In the previous article, we have studied about how vendor financing is being used as an alternate mechanism of finance in the infrastructure financing community. Similarly, leasing is also being used as a method of raising finances for infrastructure projects. Leasing is primarily used because this method allows conserving capital as well as provides many […]
We are now aware of the various models that are used for equity valuation like Gordon model, H model, 2 stage model etc. in each of these models, we were assuming that the given inputs are dividend, dividend growth rates and time horizon, The output that we expected from these models was the current stock price. While this is true most of the time, it may not always be correct.
The very same model that can be used to calculate share price can also be used in the reverse to figure out the rate of dividend growth that is being implied in the calculation. This may be a handy calculation to undertake. Let’s have a closer look at this concept in this article.
The logic behind the calculation is simple. If all inputs except the growth rate are available then we can solve for the growth rate. This growth rate will be called the implied dividend growth rate as it is not directly mentioned. Instead it is included in the price. Instead of using the growth rate to move forward towards the share price, we can use the share price to move backwards towards the growth rate.
The implied dividend growth rate provides a great mechanism to check for sanity behind our assumptions and calculations. This is because it is empirically known that in the long run no company can grow at a rate which is much faster than the GDP. For instance, if the GDP growth is expected to be 4% over a long period of time, companies may grow at 3% of 6% i.e. one or two percentage points here and there.
However it would be downright impossible for any company to grow at 25% over an extended period of time when the GDP is growing at 4%. Hence if we take the current stock price from the market and solve for implied growth rate to find it at exorbitant levels like this, we immediately know that the share is overvalued. This provides an efficient sanity check mechanism and allows us to rule out obvious asset bubbles.
It is possible to calculate the implied rate of dividend growth, no matter which dividend discount model is being used.
The bottom line, therefore is that regardless of the type of model that has to be used, backward calculations are possible. Also, it does make sense to conduct these calculations. It reveals one of the fundamental assumptions built in the market price and therefore reveals its sanity!
Your email address will not be published. Required fields are marked *