The most appropriate model for analyzing a profitable high-tech firm is the: A) zero growth cash flow model. B) Gordon growth model. C) H model. D) three-stage DDM. The answer is D. My only problem is that the CFAI readings say that an analyst should not try to estimate when a stock will start paying dividends for several reasons. The analysts don’t know when the dividends will begin and the analysts also does not know what the policy will be (stable/reflects the firms long term profitability or erratic etc . . .) I would assume the appropriate answer would be using multiple comparisons or some cash flow technique. Just would like to hear your thoughts. This was a question from Schweser Qbank.
I’ll give it a shot: A highly profitable high-tech firm would have supernormal growth in early years, (New companies will jump on the bandwagon), a decreasing growth in 2nd stage (as the number of firms keep on increasing), and a more stable growth in 3rd stage (mature stage). So three-stage DDM is suitable. I think the question is trying to assess which is an appropriate model to value a firm - either the investing client is looking for current income or capital growth doesn’t matter. comments are welcome.
I understand that, but the stock is not paying a dividend now. The terminal value in a DDM is the most important value in a discounted cash flow analysis. If you can’t accurately predict when and how the dividends are going to be paid out, whats the use? Anyone else like to chime in or am I being too critical of a simple question (should this have been a gimme?).
In my opinion, the question is way to vague, no mention of dividends, no mention of expected growth rates, no metion of profitable products they are developing. Investors might have a control perspective. Sure you haven’t left part of the question out?
Thats the whole question. Here is their answer: Most of high-tech firms grow at very high rates and are expected to grow at those rates for an initial period. These rates are expected to decline as the firm grows in size and loses its competitive advantage. Of the models provided, the three-stage DDM is most appropriate to analyze high-tech firms because of its flexibility. H model may not be appropriate, because a linear decline from the high growth rate to the constant growth rate cannot be assumed and the dividend payout ratio is fixed.
Still think its a rubbish question, the answer assumes all sorts of things not mentioned in the question. First off “profitable high tech firm” for me doesn’t translate into a company thats in its growth phase and is consequently earning abnormal profits. There are many tech companies out there that are high profitable but also in the mature industry phase. Second “dividend payout ratio is fixed”, where did that come from? That little assumption knocks off A as a potential solution, but not B, C, or D. Always open to the possibility that I’m missing something, but dont think I am this time.
This is multiple choice, people! The question asks which is the most appropriate, not which is correct. I don’t think anyone can define what the ‘correct’ approach would be to value a high-tech firm with no dividends (and likely no earnings). As the answer states, this is the only model in the list that has the flexibility to handle the supposed course of growth for a high growth firm.