What are the basic forecasting approaches?
Quantitative and qualitative
What is quantitative forecasting approach?
historical data from time-series or correlation information
What is qualitative forecasting approach?
opinions from experts, decision makers, or customers
What are the quantitative forecasting methods?
- Naïve approach (what happened in previous period is going to happen in the future)
- Moving averages (exponential smoothing)
- Trend projection
What are the qualitative forecasting methods?
- Executive opinion (executives making decisions/opinions)
- Delphi method (consumers/trusted advisors giving opinions)
- Sales force estimates (individuals from sales giving estimates of what will happen)
- Consumer surveys (would you purchase this?)
What is dividend discount model (DDM)?
- valuing a firm based on dividends that we’re expecting to occur
- Basic tool in valuing common stock
Formula for gordon growth model
P = D1 / (re – g)
- P – share price
- D1 – next year’s annual dividend per share
- re – cost of equity
- g – constant growth rate of dividends
- P = dividends per share in next period / cost of equity – growth rate expected for dividends
When are DDMs most appropriate?
- Firm has a history of dividend payments (Provides an analyst with a history from which to extrapolate future dividends) (It is difficult to forecast when a non-dividend-paying firm will start paying dividends and how much they will eventually be)
- Firm’s dividends have a consistent relationship with the firm’s earnings (Dividends should be related to firm earnings if they are to be a good indicator of future firm and shareholder wealth)
- Valuation perspective is that of a non-controlling shareholder (If the perspective is that of a controlling shareholder where firm cash flows can be controlled, a free cash flow model would be more appropriate)
Formula for gordon growth model
Value of common stock at Time 0 (V0) = dividend next period (D1) / (required return on common equity (r) - the constant growth rate for dividends (g))
Formula for CAPM
Required return on equity is the risk-free rate + beta x equity risk premiums
Issues with gordon growth method
Strengths:
- Simple and applicable to stable, mature firms (constant growth in dividends)
- Can be applied to entire markets
- g can be estimated using macro data (GDP growth)
- Can be applied to firms that pay dividends and repurchase stock
Limitations:
- Not applicable to non-dividend-paying firms (can’t forecast the future, should have a consistent relationship with firms’ earnings)
- g must be constant (cannot be applied with different future rates in dividends, r>g)
- Stock value is very sensitive to r-g
- Most firms have nonconstant growth in dividends
What is statutory tax rate?
imposed by law on taxable income that falls within a given tax bracket
