Dividend Discount Model

Advanced Valuation Course
Pristine For Advanced Valuation Course (Confidential)
Pristine www.edupristine.com
Agenda
Value perspective
Types of valuation models
Absolute valuation models

Valuation using Dividend Discount Models
Valuation using Free Cash Flow
Mistake in Valuation
Relative valuation models
Enterprise multiples
Price multiples
Typical valuation scenarios
Valuation in emerging market
Valuing a private company
Why value creation is important?

There are problems of not valuing a company
Market bubbles
Year 2000 saw many internet companies go out of business

despite the bubble created from 1995-2000. Laws of
economics always prevail, it was clear that many internet
business did not have competitive advantage required to earn
even the modest return and revenue growth, hence had to go
out of business.
Financial crises and leverage
There were fundamental flaws in the assumptions by various
banks in 2008 financial crisis. Firstly, securitized home loans
made the home loans more valuable. Secondly, using leverage
to make an investment in itself creates value.
Applying principles of value creation

means relying on data, thoughtful analysis,
and a deep understanding of the
competitive dynamics of a company
Financial crises and markets

True, the equity market did not predict the economic crisis in
2008, however equity market has not been unreasonable.
Pillars of value creation

Profitability and growth
The combination of growth and return, and resulting cash flow, drives value creation. This
explains why some companies typically trade at high P/E multiples despite low growth
Rearranging investors claim doesnt matter
Value is created when companies generate higher cash flows, not by rearranging investors'
claims on those cash flows
Market expectation
The higher the stock markets expectations for a company's share price become, the better a
company has to perform just to keep up
Best ownership
A business's value is relative to who owns it or might own it. Different owners will generate
different cash flows for a business based on the strategies they pursue and their unique abilities
to add value.
Agenda
Value perspective
Types of valuation models

Valuation using Dividend Discount Models
Valuation using Free Cash Flow
Mistake in Valuation
Relative valuation models
Enterprise multiples
Price multiples
Typical valuation scenarios
Valuation in emerging market
Valuing a private company

An absolute valuation model is a model that specifies an assets intrinsic value
A Present value model or discounted cash flow model of equity valuation views the
value of common stock as being the present or discounted value of its future cash flows
Present value model based on dividends are called dividend discount models
Present value model based on free cash flows are known as free cash flow model
Absolute valuation
models
Dividend discount
model
Free cash flow

models
How to choose from various valuation method

Each stock is different, and each industry sector has unique properties that
may require varying valuation approaches . Valuation methods typically fall
into two main categories:
1. Absolute valuation models: Absolute valuation models attempt to
find the intrinsic or "true" value of an investment based only on
fundamentals. Looking at fundamentals simply mean you would only
focus on such things as dividends, cash flows and growth rate for a single
company, and not worry about any other companies
2. Relative valuation models: These models operate by comparing the
company in question to other similar companies. These methods
generally involve calculating multiples or ratios, such as the price-toearnings multiple, and comparing them to the multiples of other
comparable firms. For instance, if the P/E of the firm you are trying to
value is lower than the P/E multiple of a comparable firm, that company
may be said to be relatively undervalued
Dividend Discount Model

Generally, the definition of returns as dividends, and the DDM, is most suitable when:
The company is dividend paying
Dividend policy bears an understandable and consistent relationship to the companys

profitability
The investor takes a non-control perspective
Often, companies with established dividends are seasoned companies, profitable but operating
outside the economys fastest-growing subsectors
The formulas used for dividend discount model
One Period DDM
V0
D1 P1
1 r
n
Multiple Period DDM
Dt
Pn
or
V0
t
n
(1 r )
t 1 (1 r )
V0
t 1
Dt
(1 r )t
Dividend Discount Model in action

2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
ABC Corp.
EPS ($)
DPS ($)
Payout ratio (%)
0.41
1
244%
0.12
1
833%
-0.36
1
n/m
1.31
1
76%
1.86
1
54%
0.39
1
256%
0.88
1
114%
1.58
1
63%
4.26
1
23%
4.92
1
20%
XYZ Corp.
EPS ($)
DPS ($)
Payout ratio (%)
0.62
0.18
29%
0.66
0.22
33%
0.77
0.25
32%
0.72
0.29
40%
0.52
0.3
58%
0.72
0.39
54%
1.11
0.33
30%
1.2
0.35
29%
1.3
0.37
28%
0.77
0.25
32%
State whether a dividend discount model is appropriate choice for ABC corp. or XYZ corp. ?
Dividend Discount Model solution
Based on the data provided, DDM does not appear to be an

appropriate choice for ABC corp. ABCs dividend does not bear an
understandable and consistent relationship to earnings. Dividend
payout ratios have varied from 20% to 833%.
XYZs dividend has generally followed its growth in earnings. XYZ
corps dividend paying and dividends bear an understandable and
consistent relationship to earnings. Therefore, DDM is more suitable
for XYZ, however analyst might want to research a divergent
movement in 2007-2008
Gordon Growth Model (GGM)

Assumptions
Firms pays dividend D 1 a year from now.
Dividends grow at constant rate, g, till infinity

Suited for companies whose expected growth is same as economic growth
Cost of Equity > Dividend growth rate
V0 D0 *
1 g
rg
D1
rg
Do = Dividend at time 0
D1 = Dividend at time 1
g = dividend growth rate
r = required return of equity
10
Strengths And Limitations Of The Gordon Growth Model (GGM)

Strengths
Suitable for stable, mature, dividend-paying firms
Easy to understand and explain

Estimate implied growth rate
Limitations
Intrinsic value extremely sensitive to g and r estimate
Not useful for non- dividend paying stocks .

Not useful for multistage growth firm where growth changes or when growth is
unpredictable.
11
Multi Stage DDM Models

Multi Stage Models:
An equity valuation model that builds on the GGM by applying varying growth rates
to the calculation.
Under the multistage model, changing growth rates are applied to different time
periods
Forms
Two stage
Three stage
Spread sheet modeling
12
Forecasting Dividends Using Spread Sheet Modeling

In practice, spread sheet modeling is the most common approach for equity
valuation by analysts.
More than 3 growth rates can be used
Spread sheet models are very flexible
Step 1:
Enter the base dividend. This is most likely the last paid dividend
Step 2:
Estimate future dividends during the firms supernormal growth period.
A different growth rate can be applied for each year
Step 3:
Determine a Terminal Value by estimating a growth rate at the end of the
supernormal growth period.
Step 4:
Find the present value of all the estimated future cash flows.
13
Valuing using Dividend Discount Model
Estimate Terminal Value using GGM
Estimate Future Dividends
Present Value of all the Estimated Future Cash Flows
14
Valuing using Dividend Discount Model

Ross and company has a current dividend of $1 and a required rate of return of 12%.
A dividend growth rate of 15% is projected for next 2 years, followed by a 10%
growth rate for the next four years before setting down to a constant 4% growth rate
thereafter. Calculate the current value of Ross and company
15
Thank you!
Contact:
Paramdeep Singh
Pawan Prabhat
paramdeep@edupristine.com
pawan@edupristine.com
+91 989 298 0608
+91 986 762 5422
Pristine
702, Raaj Chambers, Old Nagardas Road, Andheri (E), Mumbai-400 069. INDIA
www.edupristine.com
Ph. +91 22 3215 6191
Pristine www.edupristine.com

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Advanced Valuation Course

Pristine For Advanced Valuation Course (Confidential)

Absolute valuation models

Pristine For Advanced Valuation Course (Confidential)

Why value creation is important?

Year 2000 saw many internet companies go out of business

Applying principles of value creation

Financial crises and markets

Pillars of value creation

Absolute valuation models

Pristine For Advanced Valuation Course (Confidential)

Absolute valuation models

Pristine For Advanced Valuation Course (Confidential)

Free cash flow

How to choose from various valuation method