An analyst has been asked to evaluate the investment merits of X, Inc, a fast growing biotech firm. The company doens’t post a profit, but does have a good pipeline of potential new drugs. The analyst is given the choice of using: 1. The gordon growth model 2. The two stage dividend discount model 3. The three stage dividend discount model. A. Select the model to evaluate X, Inc and justify your selection B. Describe and discuss the H model c. Discuss three problems with using the dividend discount model.
A. I would say two stage. No drugs . . . . . then all of a sudden you are making profit. That is assuming they actual pay dividends. B. H-Model is used when dividends are growing at high rate and will decline linearly to a sustainable growth rate over a certain number of years. C. If dividends aren’t aligned with profitability the model isn’t useful. The terminal value is where the bulk of the value comes from in this model which is hard to estimate accurately. The terminal value is also very sensitive to changes in the spread between the required rate of return and g.
Also, r must be greater than g. I would probably use a two stage model, but in order to do that we would need to have positive earnings first. I would think using RI model in this scenario would be the most practical, or FCF could be a candidate. I would think GGM would be the least likely valuation model to be used in this case.
nice analysis, Niblita!
Niblita75 Wrote: ------------------------------------------------------- > A. I would say two stage. No drugs . . . . . then > all of a sudden you are making profit. That is > assuming they actual pay dividends. Wouldn’t that be 3 stage in a sense? 1- No drugs/current growth (ie. 7%) 2- Drugs/fast growth (ie. 12%) 3- Constant growth (3%)
^^ But for current stage (no drugs) they don’t even have a profit much less a dividend to discount. Also, I have never seen a 3 stage valuation model be the correct answer in any of these questions.
Thats debatable if there was a patent on the drug as well. No drug . . . drug with patent . . . patent expires and then boom, drugs like cialis come in. edit: I’m with lance, whenever I choose 3 stage its wrong.
this is dumb… If there are no profits/dividends, your not going to use the Div. disc. Model… thats it… You would however use a mulitstage FCF or RI model…
Thats true. The hard part about valuing a non dividend paying stock with a DDM is predicting when in the future dividends will be paid, but we didn’t have that option.
You can still use the DDM but it doesn’t work real well. As Nib pointed out you have to project when dividends will start, discount the CF to that point in time and then discount that to the present to get your value estimate. But of course as you use more and more projections the usefullness goes way down and a FCF or RI model will likely work better.