DISCOUNTED DIVIDEND

VALUATION

Presenter
Venue
Date

DISCOUNTED CASH FLOW MODELS

CHOICE OF DISCOUNTED CASH FLOW

MODELS

VALUING COMMON STOCK USING

A MULTIPERIOD DDM

EXAMPLE: VALUING COMMON STOCK USING

A MULTIPERIOD DDM

0
D
P

$1.00

$1.05

$1.10
$20.00

EXAMPLE: VALUING COMMON STOCK USING

A MULTPERIOD DDM

$1.00 $1.05 $21.10

V0

2
3
1.10 1.10
1.10
V0 $17.63

VALUING COMMON STOCK USING

THE GORDON GROWTH MODEL

D0 (1 g )
D1
V0

rg
rg

EXAMPLE: VALUING COMMON STOCK USING

THE GORDON GROWTH MODEL
Risk-free rate

3.0%

Equity risk premium

6.0%

Beta

1.20

Current dividend
Dividend growth rate
Current stock price

$2.00
5.0%
$24 .00

VALUING COMMON STOCK USING

THE GORDON GROWTH MODEL

CAPM: r = 3% + 1.2(6%) = 10.2%

$2.00(1 0.05)
$2.10
V0

$40.38
0.102 0.05
0.102 0.05

EXAMPLE: VALUING PREFERRED STOCK

$2.00
V0
$19.61
0.102 0

EXAMPLE: CALCULATING THE IMPLIED GROWTH

RATE USING THE GORDON GROWTH MODEL
Using the previous common stock example and the current stock price of $24,
what is the implied growth rate?

$2.00(1 g )
$24
0.102 g
2.448 24 g 2.00(1 g )
26 g 0.448
g 1.72%

CALCULATING THE IMPLIED REQUIRED RETURN

USING THE GORDON GROWTH MODEL

D1
V0
rg
D1
r
g
P0

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?

D1
r
g
P0
2.10
r
0.05
24
r 8.75% 5% 13.75%

PRESENT VALUE OF GROWTH

OPPORTUNITIES

E1
V0
PVGO
r
E1
PVGO P0
r

PRESENT VALUE OF GROWTH

OPPORTUNITIES

E1
V0
PVGO
r
P0 1 PVGO

E1 r
E1

EXAMPLE: PRESENT VALUE OF GROWTH

OPPORTUNITIES
Stock price
Expected earnings
Required return on stock

.
$80 00
.
$5 00
10%

EXAMPLE: PRESENT VALUE OF GROWTH

OPPORTUNITIES

E1
PVGO P0
r
5
PVGO $80
$30
0.10

EXAMPLE: PRESENT VALUE OF GROWTH

OPPORTUNITIES

P0 1 PVGO

E r
E
P0
1
30

E 0.10 5
16 10 6

USING THE GORDON GROWTH MODEL TO

DERIVE A JUSTIFIED LEADING P/E

D1
V0
rg
P0
D1 E1

E1
rg
P0
1 b

E1
rg

USING THE GORDON GROWTH MODEL TO

DERIVE A JUSTIFIED TRAILING P/E

D 0 (1 g )
V0
rg
P0
D 0 (1 g ) E0

E0
rg
P0
(1 b)(1 g )

E0
rg

EXAMPLE: USING THE GORDON GROWTH

MODEL TO DERIVE A JUSTIFIED P/E
Stock price
Trailing earnings per
share
Current dividends per
share
Dividend growth rate
Required return on
stock

$50 .00
$4 .00
$1.60
5.0%
9.0%

EXAMPLE: USING THE GORDON GROWTH

MODEL TO DERIVE A JUSTIFIED LEADING P/E

P0
1 b

E1
rg
P0
$1.60 $4.00

10.0
E1
0.09 0.05

EXAMPLE: USING THE GORDON GROWTH

MODEL TO DERIVE A JUSTIFIED TRAILING P/E

P0 (1 b)(1 g )

E0
rg
P0 ($1.60 / $4.00)(1.05)

10.50
E0
0.09 0.05
Actual P/E = $50.00/$4.00 = 12.50

ISSUES USING THE GORDON GROWTH MODEL

Strengths
Simple and applicable to
stable, mature firms

Limitation
s
Not applicable to nondividend-paying firms

Can be applied to entire

markets

g must be constant

g can be estimated using

macro data

Stock value is very sensitive

to r g

Can be applied to firms that

repurchase stock

Most firms have nonconstant

growth in dividends

CHOICE OF DISCOUNTED CASH FLOW

MODELS

Rapidly increasing
earnings
Heavy reinvestment
Small or no dividends

Growth

Transition
Earnings growth
slows
Capital reinvestment
slows
FCFE and dividends
increasing

ROE = r
Earnings and
dividends growth
matures
Gordon growth model
useful

Maturity

GENERAL TWO-STAGE DIVIDEND DISCOUNT

MODEL (DDM)

V0

D0 1 g S

t 1

1 r

D0 1 g S 1 g L
n

1 r

r gL

EXAMPLE: GENERAL TWO-STAGE DDM

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

$2.30 $2.6450 $3.0418 $52.7237

V0

1.10
1.102
1.103
1.103
V0 $46.17

EXAMPLE: GENERAL TWO-STAGE DDM

Using the previous example, now well use the trailing
P/E to determine the terminal value
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% 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

$2.30 $2.6450 $3.0418 $3.1634 $68.54

V0

2
3
1.10
1.10
1.10
1.10 4
V 0 $55.54

TWO-STAGE H-MODEL

D0 1 g L D0 H g S g L
V0
r gL

EXAMPLE: TWO-STAGE H-MODEL

Current dividend
gs

$3.00
20%

gL
6%
H
5
Required return on stock
10%
Current stock price
$120

EXAMPLE: TWO-STAGE H-MODEL

D0 1 g L D0 H g S g L
V0
r gL
$3 1 0.06 $3 5 0.20 0.06

V0
0.10 0.06
V0 $79.50 $52.50 $132.00

SOLVING FOR THE REQUIRED RETURN USING

THE TWO-STAGE H-MODEL

D0

r 1 g L H g S g L g L
P0

1 0.06 5 0.20 0.06 0.06 10.40%

r

120

EXAMPLE: THREE-STAGE MODEL

Firm pays a current dividend of $1.00
Growth rate is 20% for next two years
Growth then declines over six years to a stable
rate of 5%
Required return is 10%
Current stock price is $50

THREE-STAGE MODEL
Assumes three distinct growth stages:
First stage of growth
Second stage of growth
Stable phase of growth
H-model can be used for last two stages if growth
declines linearly

THREE-STAGE MODEL EXAMPLE

2

$1 1.20 $1 1.20
V0

1
2
1.10
1.10
2 6
$1 1.20 0.20 0.05
2
2

1.10 0.10 0.05

$1 1.20 1.05
2

1.10 0.10 0.05

V0 $1.09 $1.19 $10.71 $24.99 $37.98

ESTIMATING THE GROWTH RATE

Industry or
Macroeconomic
Average

g = b ROE
DuPont formula
ROE = r
ROE = industry ROE

THE SUSTAINABLE GROWTH RATE

ROE

THE DUPONT MODEL

Net income

Total assets

ROE =

Total assets

Shareholders'
equity

Sales
Total assets
Net income

Sales
Total
assets
Shareholders'
equity

ROE =

Net income Dividends

Total assets
Sales
Net income

Total assets
Net
income
Sales
Equity

EXAMPLE: DUPONT MODEL

Net profit margin
Total asset
turnover

5.00%

Equity multiplier

2.0

Retention ratio

1.5

60%

EXAMPLE: DUPONT MODEL

Net income Dividends Net income

g

Net income
Sales

Sales Total assets

Total assets Equity

g 0.60 5% 1.5 2.0
g 9.0%

SUMMARY
Choice of Discounted Cash Flow Models

Dividend discount models, free cash flow models,

residual income models
Dividend models most appropriate for
Mature, profitable, dividend-paying firms
Noncontrolling shareholder perspective
Gordon Growth Model

Assumes constant g and r > g

Applicable to mature, stable firms
Estimated value very sensitive to r g denominator

SUMMARY
Uses of Gordon Growth Model

Preferred stock valuation where g = 0

PVGO Value from future growth
Justified leading and trailing P/Es
Implied r and g

Phases of Growth

Growth
Transition
Maturity

SUMMARY
Multistage Models

General two-stage model: growth abruptly

declines
H-model: growth gradually declines
Three-stage model: can use general or H-model
Sustainable Growth Rate

g = Retention ratio ROE

DuPont analysis:
ROE = Profit margin Asset turnover Equity
multiplier