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Hong KongValuing equities: dividend models, multiples and the inputs that break them
The constant growth dividend model values a share as next year's dividend divided by the required return less the growth rate. Multiples such as price-to-earnings and price-to-book compare relative value rather than computing it.
Two families: models that compute a value, and multiples that compare one.
The constant growth dividend model
Value equals next year's expected dividend, divided by the required return less the constant growth rate.
Next year's dividend, not this year's - so where a question gives the dividend just paid, grow it by one year first. That single step is where most wrong answers come from.
The model requires the growth rate to be below the required return. Where it is not, the formula returns a negative or infinite value, which is the model telling you the assumption is wrong rather than the company being worthless.
When the required return and growth rate are close, a small change in either moves the value enormously. That is a genuine limitation and it is why the model suits stable dividend payers and not growth companies.
Where it does not work
- Companies paying no dividend.
- Growth rates above the required return, even temporarily.
- Irregular or unpredictable dividends.
- Early-stage companies with no stable pattern.
Multi-stage models address the temporary high-growth case by valuing the high-growth period explicitly and applying the constant growth model to the stable period after it.
The multiples
| Multiple | Uses | Watch for |
|---|---|---|
| Price to earnings | Most common; comparison within a sector | Meaningless with negative earnings; accounting choices |
| Price to book | Financials and asset-heavy businesses | Book value ignores intangibles |
| Price to sales | Companies with no earnings | Ignores profitability entirely |
| Price to cash flow | Less exposed to accounting choices | Definitions of cash flow vary |
| PEG ratio | Adjusts price to earnings for growth | Depends on a growth forecast |
Multiples compare. They do not value. A share on a low multiple is cheaper than its peers, which is not the same as being cheap.
The required return
Usually from CAPM: the risk-free rate plus beta times the equity risk premium. Which connects equity valuation directly to the portfolio theory material and is why questions frequently chain the two.
Growth
Sustainable growth is often estimated as the return on equity multiplied by the retention ratio - the share of earnings not paid out as dividends.
A company paying out everything cannot grow from retained earnings, which is the intuition behind the formula and the way it is usually tested.
Technical analysis
Support and resistance, moving averages, relative strength, chart patterns. Assumes past prices predict future prices, which weak-form market efficiency denies.
It appears on the exam as terminology to recognize rather than as a recommended method, and a question offering technical analysis as the basis for advice is usually testing whether you know that.
Dollar limits and rate thresholds here are indexed annually. Confirm the current figure before relying on it, and expect the exam to test the rule rather than the number.
Common questions
What is the constant growth dividend model?
Value equals next year's expected dividend divided by the required return less the constant growth rate. It requires growth to be below the required return.
What is the most common error using it?
Using the dividend just paid rather than next year's. Where a question supplies the dividend already paid, grow it by one year first.
When does the dividend model fail?
For companies paying no dividend, growth rates at or above the required return, irregular dividends, and early-stage companies. Multi-stage models address temporary high growth.
Do multiples value a company?
No, they compare it. A share on a low price-to-earnings ratio is cheaper than its peers, which is not the same as being cheap.
How is sustainable growth estimated?
Return on equity multiplied by the retention ratio. A company paying out all its earnings cannot grow from retained earnings, which is the intuition behind it.