Dividend Discount Model and Net Asset Value Method

Sarah Martin

30 years: Corporate Valuations

In this video, Sarah continues discussion of equity multiple valuation methods and introduces the dividend discount model and the net asset value method. She will explain why each of these methods are used, illustrate their working and discuss the drawbacks associated.

M&A

Subscribe to watch

Access this and all of the content on our platform by signing up for a 7-day free trial.

Dividend Discount Model and Net Asset Value Method

11 mins 55 secs

Key learning objectives:

Understand the dividend discount model and its drawbacks
Understand the net asset value method and its drawbacks
Understand the scenarios where the net asset value method can be used

Overview:

Different types of equity multiples are used based on the user of the valuation and purpose of the valuation. Two of the commonly used methods by practitioners are the dividend discount model and the net asset value method. To gain a holistic view of equity multiples it is important to understand why these methods are used and also see the drawbacks and considerations that need to be kept in mind when using each of these methods.

Subscribe to watch

Access this and all of the content on our platform by signing up for a 7-day free trial.

Summary

What is the dividend discount model (DDM), and when is it used?

The dividend discount model (DDM) is used to value the equity of a firm with a low growth rate and high dividend pay-out. DDM provides a base or floor valuation based on the outlook for future dividend payments. Essentially, it is a perpetuity valuation for the equity value of the firm, based on the required return on equity to the investor.

What are some of the main drawbacks to the dividend discount model?

Assumes a constant growth rate in dividends. In reality, firms may increase or reduce the growth rate of its dividend pay-out.
Does not factor in potential rises or falls in the underlying share price.
The dividend discount method of valuing firms does not work if the firm does not pay a dividend.
Does not work for firms that are trying to balance growth with also paying a dividend, as growth in net income should also lead to a rise in the share price.
If interest rates rise, the dividend yield on the stock may become less attractive and investors may be inclined to sell the stock and place their funds in a higher-yielding cash account., leading to a fall in the stock’s valuation.

What is the net asset value method?

The net asset value of a firm is also known as the book value of its equity (total assets on the balance sheet less non-equity on-balance sheet liabilities). It is also known as shareholders’ funds. The net asset value method of valuation takes the book value of the firm’s equity to derive a market valuation for its equity.

What are some of the drawbacks of the net asset value method?

Investors buying shares of companies, are not concerned about the value of the underlying assets. They are concerned about the future earnings and cash flows that those assets will generate.
Book value of equity may materially understate the market value of equity as firms value their assets at historical cost, less depreciation and impairments.
It cannot be used on brand value which is intangible unless it has been acquired. Thus it cannot be used to reflect the value of internally developed brands.

When can the net asset value method be used to derive the market value of a firm?

Property investment firms – As these firms normally report updated asset values for their property portfolio every 6 to 12 months, the book value of the property company’s assets is normally close to the market value
Firm due to be liquidated - In this scenario, the book value of assets and liabilities should be revalued to market or liquidation values and the updated net asset value derived.
Shell companies with no real underlying business either existing or planned and some cash in the bank. In this instance, the valuation could be based on the book value of equity.
For firms whose market valuation is trading at a discount to its book value of equity. Usually means the market is concerned about the firm’s outlook and is expecting future losses and write-downs.

What are the adjustments that may need to be made to the net asset value method?

Anticipated changes in underlying asset values - Valuation should be adjusted up or down to reflect these changes.
Tax purposes - If a commercial property company would incur significant tax liabilities from selling its properties, these should be deducted from the valuation.
Off-balance-sheet liabilities - If there is a more than 50% probability that these may crystallise, then a provision should have been taken and valuers may deduct contingent liabilities.

Subscribe to watch

Access this and all of the content on our platform by signing up for a 7-day free trial.

Sarah Martin

Sarah Martin has a degree in economics from the London School of Economics and stock exchange and regulatory qualifications from London and New York. She has worked in investment banking for 17 years, as well as private equity transactions and as an expert witness in financial trials. She became a financial trainer 15 years ago and specialises in credit, distressed debt, and valuation. Recent assignments have included the European Central Bank, the European Investment Bank, the EBRD, Gibbs Business School in Johannesburg, the Bahrain Institute of Business Finance, the Bank of China, BBVA, the African Development Bank, Siemens, Carnegie Bank, Rand Merchant Bank, the Hamburg Central Bank, and Mizuho Bank.

There are no available Videos from "Sarah Martin"