A transaction can raise earnings per share while earning too little on the purchase price. An accretion/dilution screen and economic profit answer those different questions, so your valuation method must answer the question the buyer actually faces.
You may need to value a mature company whose owners receive predictable cash distributions. The dividend discount model (DDM) values equity by discounting expected future dividends to today. When you model dividends per share, the answer is equity value per share.
The dividend discount model uses the cost of equity, the return shareholders require for bearing the investment's risk. Discounting reduces future dividends because investors require compensation for waiting and accepting uncertainty. A higher required return lowers today's value, holding expected dividends constant.
The constant-growth dividend discount model, also called the Gordon growth model, assumes dividends grow at one sustainable rate forever. Use the next expected annual dividend, rather than the dividend already paid. For more worked cases, see Damodaran's valuation examples.
Common mistakes
- Using the last dividend in the DDM numerator. In Example 1, $1.50 ÷ 0.05 = $30 is the trap; advance the dividend first.
- Confusing yield with payout. The same $1.50 dividend produces 5% yield and 50% payout because the denominators differ.
- Treating LBO enterprise value as sponsor equity. Example 2 requires $210 million of sponsor equity, not the $500 million operating valuation.
Bottom line
- Constant-growth DDM uses next year's dividend and requires cost of equity above perpetual growth.
- Dividend yield divides dividends by price; dividend payout ratio divides common dividends by common earnings.
- LBO value depends on leverage, cash flows, holding period, exit assumptions, and the sponsor's required return.
- MOIC measures proceeds relative to invested equity; IRR also incorporates timing.
Exam shortcut
Circle the requested output before calculating: share value, enterprise value, sponsor equity return, or buyer EPS. Carry that label through every step. For DDM, mark “just paid” or “next expected.” Advance only the former. Check the rate gap before dividing. For LBO questions, write entry equity and exit equity on separate lines. Count elapsed years, then inspect the stem for interim distributions.
The full lesson (about 3,754 words, 25 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- A9
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