Question5 An analyst is valuing two firms in the same industry. Firm A pays steady, predictable dividends and has a long track record of stable growth. Firm B is a high-growth startup that has not paid dividends and reinvests most of its earnings. The analyst considers both the Dividend Discount Model (DDM) and the Method of Comparables (e.g., using P/E and EV/EBITDA multiples).Which of the following best describes the most appropriate valuation approach and its rationale?Select one alternative: Use DDM for Firm A due to its stable dividend policy, and Method of Comparables for Firm B due to lack of dividends and early-stage uncertainty. Use the Method of Comparables for Firm A and DDM for Firm B, since comparable multiples are better for valuing firms that reinvest profits. Use DDM for both firms, since dividends are the ultimate return to shareholders and represent intrinsic value. Use the Method of Comparables for both firms, as relative valuation always produces more market-relevant results than intrinsic valuation models. ResetMaximum marks: 1 Flag question undefined

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BlackTom AI · Accepted Answer

The scenario presents two firms in the same industry but with very different cash return profiles, so the most appropriate approach typically aligns with each firm’s dividend policy and growth characteristics.
Option 1: 'Use DDM for Firm A due to its stable dividend policy, and Method of Comparables for Firm B due to lack of dividends and early-stage uncertainty.' This reasoning aligns with core valuation practices: the Dividend Discount Model is well-suited for firms with predictable, ongoing dividends and stable growth, such as Firm A. For Firm B, which reinvests earnings and pays no dividends, a discounting framework anchored on expected dividends is not applicable; instead, relative valuation using comparables (P/E, EV/EBITDA, etc.) is often more informative because it relies on how similar firms are valued by the market, even when dividends are absent and growth is uncertain. The emphasis on lack of dividends and early-stage uncertainty for Firm B is a key justification for switching to comparables.
Option 2: 'Use the Method of Comparables for Firm A and DDM for Firm B, since comparable multiples are better for valuing firms that reinvest profits.' This is problematic. Firm A has stable, ongoing dividends, for which DDM is typically preferred, not comparables alone. Moreover, Firm B does not pay dividends, so applying DDM here is impractical or highly unreliable because there is no dividend stream to discount. The claim that comparables are universally superior for reinvesting firms ignores situations where dividend-based valuation is informative and where relative metrics may be distorted by growth or capital structure differences.
Option 3: 'Use DDM for both firms, since dividends are the ultimate return to shareholders and represent intrinsic value.' This ignores the reality that Firm B does not pay dividends and may not have a reliable or meaningful dividend policy to discount. Relying on DDM for a non-dividend, high-growth startup can produce meaningless or misleading values because the input stream (dividends) is absent or highly uncertain.
Option 4: 'Use the Method of Comparables for both firms, as relative valuation always produces more market-relevant results than intrinsic valuation models.' This statement overstates the universality of relative valuation. While comparables are powerful, intrinsic valuation like DDM can be very informative for firms with stable dividends. Moreover, using only relative valuation ignores potential differences in growth, risk, or payout policies that may be captured by a dividend model. Therefore, this option overlooks the nuanced applicability of each method depending on firm characteristics.

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