DISCOUNTED DIVIDEND

VALUATION
Presenter
Venue
Date

DISCOUNTED CASH FLOW MODELS
2
CHOICE OF DISCOUNTED CASH FLOW
MODELS
3
VALUING COMMON STOCK USING
A MULTI-PERIOD DDM
4
EXAMPLE: VALUING COMMON STOCK USING
A MULTPERIOD DDM








0 1 2 3
D $1.00 $1.05 $1.10
P $20.00
EXAMPLE: VALUING COMMON STOCK USING
A MULTPERIOD DDM








0
2 3
0
$1.00 $1.05 $21.10
1.10
1.10 1.10
$17.63
= + +
=
V
V
VALUING COMMON STOCK USING
THE GORDON GROWTH MODEL








0 1
0
(1 ) +
= =

D g D
V
r g r g
EXAMPLE: VALUING COMMON STOCK USING
THE GORDON GROWTH MODEL








Risk-free rate 3 .0%
Equity risk premium 6 .0%
Beta 1 .20
Current dividend $2 .00
Dividend growth rate 5 .0%
Current stock price $24 .00
VALUING COMMON STOCK USING
THE GORDON GROWTH MODEL








0
$2.00(1 0.05) $2.10
$40.38
0.102 0.05 0.102 0.05
+
= = =

V
CAPM: = 3% + 1.2(6%) = 10.2% r
EXAMPLE: VALUING PREFERRED STOCK








0
$2.00
$19.61
0.102 0
= =

V
EXAMPLE: CALCULATING THE IMPLIED GROWTH
RATE USING THE GORDON GROWTH MODEL
$2.00(1 )
$24
0.102
2.448 24 2.00(1 )
26 0.448
1.72%
g
g
g g
g
g
+
=

= +
=
=
Using the previous common stock example and the current stock price of $24,
what is the implied growth rate?






CALCULATING THE IMPLIED REQUIRED RETURN
USING THE GORDON GROWTH MODEL
1
0
1
0
=

= +
D
V
r g
D
r g
P
EXAMPLE: CALCULATING THE IMPLIED REQUIRED
RETURN USING THE GORDON GROWTH MODEL
Using the previous common stock example and the current stock price of $24,
what is the implied required return?






1
0
2.10
0.05
24
8.75% 5% 13.75%
= +
= +
= + =
D
r g
P
r
r
PRESENT VALUE OF GROWTH
OPPORTUNITIES








1
0
1
0
PVGO
PVGO
= +
=
E
V
r
E
P
r
PRESENT VALUE OF GROWTH
OPPORTUNITIES








1
0
0
1 1
PVGO
1 PVGO
= +
= +
E
V
r
P
E r E
EXAMPLE: PRESENT VALUE OF GROWTH
OPPORTUNITIES








Stock price $80 .00
Expected earnings $5 .00
Required return on stock 10 %
EXAMPLE: PRESENT VALUE OF GROWTH
OPPORTUNITIES








1
0
PVGO
5
PVGO $80 $30
0.10
=
= =
E
P
r
EXAMPLE: PRESENT VALUE OF GROWTH
OPPORTUNITIES








0
0
1 PVGO
1 30
0.10 5
16 10 6
= +
= +
= +
P
E r E
P
E
USING THE GORDON GROWTH MODEL TO
DERIVE A JUSTIFIED LEADING P/E








1
0
0 1 1
1
0
1
1
=

D
V
r g
P D E
E r g
P b
E r g
USING THE GORDON GROWTH MODEL TO
DERIVE A JUSTIFIED TRAILING P/E








0
0
0 0 0
0
0
0
(1 )
(1 )
(1 )(1 )
+
=

+
=

+
=

D g
V
r g
P D g E
E r g
P b g
E r g
EXAMPLE: USING THE GORDON GROWTH
MODEL TO DERIVE A JUSTIFIED P/E








Stock price $50 .00
Trailing earnings per share $4 .00
Current dividends per share $1 .60
Dividend growth rate 5 .0%
Required return on stock 9 .0%
EXAMPLE: USING THE GORDON GROWTH
MODEL TO DERIVE A JUSTIFIED LEADING P/E








0
1
0
1
1
$1.60 $4.00
10.0
0.09 0.05

= =

P b
E r g
P
E
EXAMPLE: USING THE GORDON GROWTH
MODEL TO DERIVE A JUSTIFIED TRAILING P/E








0
0
0
0
(1 )(1 )
($1.60 / $4.00)(1.05)
10.50
0.09 0.05
Actual P/E = $50.00/$4.00 = 12.50
+
=

= =

P b g
E r g
P
E


ISSUES USING THE GORDON GROWTH MODEL

Strengths
Simple and applicable to
stable, mature firms
Can be applied to entire
markets
g can be estimated using
macro data
Can be applied to firms that
repurchase stock
Limitations
Not applicable to non-
dividend-paying firms
g must be constant
Stock value is very sensitive
to r g
Most firms have nonconstant
growth in dividends
CHOICE OF DISCOUNTED CASH FLOW
MODELS









Rapidly | earnings
Heavy reinvestment
Small or no dividends
Growth
Earnings growth
slows
Capital reinvestment
slows
FCFE & dividends |
Transition
ROE = r
Earnings & dividends
growth matures
Gordon growth model
useful
Maturity
GENERAL TWO-STAGE DDM








( )
( )
( ) ( )
( ) ( )
0 0
0
1
1 1 1
1 1
=
+ + +
= +
+ +

t n
n
S S L
t n
t
L
D g D g g
V
r r r g
EXAMPLE: GENERAL TWO-STAGE DDM






Current dividend = $2.00
Growth Current dividend = $2.00
Growth for next three years = 15 percent
Long-term growth = 4 percent
Required return = 10 percent
for next three years = 15 percent
Long-term growth = 4 percent
Required return = 10 percent
EXAMPLE: GENERAL TWO-STAGE DDM






Step 1: Calculate the first three dividends:
D1 = $2.00 x (1.15) = $2.30
D2 = $2.30 x (1.15) = $2.6450
D3 = $2.6450 x (1.15) = $3.0418
Step 2: Calculate the year 4 dividend:
D4 = $3.0418 x (1.04) = $3.1634
Step 3: Calculate the value of the constant growth
dividends:
V3 = $3.1634 / (0.10 0.04) = $52.7237
EXAMPLE: GENERAL TWO-STAGE DDM








0
2 3 3
0
$2.30 $2.6450 $3.0418 $52.7237
V
1.10
1.10 1.10 1.10
V $46.17
= + + +
=
EXAMPLE: GENERAL TWO-STAGE DDM






Using the previous example, now well use the trailing
P/E to determine the terminal value
The D4 is $3.1634
Assume also that the projected P/E is 13.0 in year 4 and
that the firm will pay out 60 percent of earnings as
dividends
Year 4 earnings are then $3.1634 / 0.60 = $5.2724
The stock price in year 4 is then $5.2724 13 = $68.54

EXAMPLE: GENERAL TWO-STAGE DDM








0
2 3 3
0
$2.30 $2.6450 $3.0418 $3.1634 $68.54
1.10
1.10 1.10 1.10
$55.54
+
= + + +
=
V
V
TWO-STAGE H-MODEL








( ) ( )
0 0
0
1
( (
+ +

=

L S L
L
D g D H g g
V
r g
EXAMPLE: TWO-STAGE H-MODEL








Current dividend $3 .00
g
s
20 %
g
L
6 %
H 5
Required return on stock 10 %
Current stock price $120
EXAMPLE: TWO-STAGE H-MODEL








( ) ( )
( ) ( )
0 0
0
0
0
1
$3 1 0.06 $3 5 0.20 0.06
0.10 0.06
$79.50 $52.50 $132.00
( (
+ +

=

( ( + +

=

= + =
L S L
L
D g D H g g
V
r g
V
V
SOLVING FOR THE REQUIRED RETURN USING
THE TWO-STAGE H-MODEL

( ) ( )
( ) ( )
0
0
1
3
1 0.06 5 0.20 0.06 0.06 10.40%
120

| |

(
= + + +
| `


\ .
)

| |
(
= + + + =
`
|

\ .
)
L S L L
D
r g H g g g
P
r
EXAMPLE: THREE-STAGE MODEL
Firm pays a current dividend of $1.00
Growth rate is 20 percent for next two years
Growth then declines over six years to stable rate
of 5 percent
Required return is 10 percent
Current stock price is $50



THREE-STAGE MODEL
Assumes three distinct growth stages:
First stage of growth
Second stage of growth
Stable-growth phase

H-model can be used for last two stages if growth
declines linearly


( ) ( )
( )
( ) ( )
( ) ( )
( )
( ) ( )
2
0
1 2
2
2
2 2
0
$1 1.20 $1 1.20
1.10
1.10
6
$1 1.20 0.20 0.05
$1 1.20 1.05
2
1.10 0.10 0.05 1.10 0.10 0.05
$1.09 $1.19 $10.71 $24.99 $37.98
| |
|
|
\ .

= + +


+

= + + + =
V
V
THREE-STAGE MODEL EXAMPLE

ESTIMATING THE GROWTH RATE
Industry or
Macroeconomic
Average
g = b ROE
DuPont formula
ROE = r
ROE = industry ROE
THE SUSTAINABLE GROWTH RATE
g b ROE
THE DUPONT MODEL
Net income Total assets
ROE =
Total assets Shareholders' equity
| |
| |
|
|
\ .
\ .
Net income Sales Total assets
ROE =
Sales Total assets Shareholders' equity
| |
| || |
| | |
\ .\ .
\ .
Net income Dividends Net income Sales Total assets
Net income Sales Total assets Equity
| | | | | | | |
=
| | |
|
\ .
\ . \ . \ .
g
EXAMPLE: DUPONT MODEL
Net profit margin 5 .00%
Total asset turnover 1 .5
Equity multiplier 2 .0
Retention ratio 60 %
EXAMPLE: DUPONT MODEL
( ) ( ) ( ) ( )
Net income Dividends Net income Sales Total assets
Net income Sales Total assets Equity
0.60 5% 1.5 2.0
9.0%
| | | | | | | |
=
| | |
|
\ .
\ . \ . \ .
=
=
g
g
g
Dividend discount models, free cash flow models,
residual income models
Dividend models most appropriate for
Mature, profitable, dividend-paying firms
Noncontrolling shareholder perspective
Choice of Discounted Cash Flow Models
Assumes constant g and r > g
Applicable to mature, stable firms
Estimated value very sensitive to r g denominator
Gordon Growth Model
SUMMARY
Preferred stock valuation where g = 0
PVGO Value from future growth
Justified leading and trailing P/Es
Implied r and g
Uses of Gordon Growth Model
Growth
Transition
Maturity
Phases of Growth
SUMMARY
General two-stage model: growth abruptly declines
H-model: growth gradually declines
Three-stage model: can utilize general or H-model
Multistage Models
g = Retention ratio ROE
DuPont analysis:
ROE = Profit margin Asset turnover Equity
multiplier
Sustainable Growth Rate
SUMMARY