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# Chapter 6 Set 1

## Dividend Discount Models

Common Stock Valuation

## Our goal in this chapter is to examine the methods

commonly used by financial analysts to assess
the economic value of common stocks.

## 1. Dividend discount models

2. Residual Income model
3. Price ratio models
Security Analysis: Be Careful Out
There
Fundamental analysis is a term for studying a
companys accounting statements and other
financial and economic information to estimate
the economic value of a companys stock.

## The basic idea is to identify undervalued stocks

to buy and overvalued stocks to sell.

## In practice however, such stocks may in fact be

correctly priced for reasons not immediately
apparent to the analyst.
The Dividend Discount Model

## The Dividend Discount Model (DDM) is a

method to estimate the value of a share of stock
by discounting all expected future dividend
payments. The basic DDM equation is:
D1 D2 D3
P0
1 k 1 k 2 1 k 3

## In the DDM equation:

P0 = the present value of all future dividends
Dt = the dividend to be paid t years from now
k = the appropriate risk-adjusted discount rate
The Dividend Discount Model:
the Constant Perpetual Growth Model

## Assuming that the dividends will grow

forever at a constant growth rate g.

## For constant perpetual dividend growth,

the DDM formula becomes:

D 0 1 g D1
P0 (Important : g k)
kg kg
The Dividend Discount Model:
Estimating the Growth Rate

## The growth rate in dividends (g) can be

estimated in a number of ways:

growth rate.

growth rate.

## Using the sustainable growth rate.

The Historical Average Growth
Rate
Suppose the Broadway Joe Company paid the following dividends:

## 2008: \$1.50 2011: \$1.80

2009: \$1.70 2012: \$2.00
2010: \$1.75 2013: \$2.20

## The spreadsheet below shows how to estimate historical average

growth rates, using arithmetic and geometric averages.
The Sustainable Growth Rate
Sustainabl e Growth Rate ROE Retention Ratio

dividends

## Retention Ratio = Proportion of earnings retained

for investment (i.e., NOT paid out as dividends)
Example: Using the DDM to Value a Firm
Experiencing Supernormal Growth, I.

## Chain Reaction, Inc., has been growing at a phenomenal

rate of 30% per year.

You believe that this rate will last for only three more
years.

Then, you think the rate will drop to 10% per year.

## What is per share price of Chain Reaction, Inc.?

Example: Using the DDM to Value a Firm
Experiencing Supernormal Growth, II.

growth period:

## Year Dividend per share

1 \$5.00 x 1.30 = \$6.50
2 \$6.50 x 1.30 = \$8.45
3 \$8.45 x 1.30 = \$10.985

Using the long run growth rate, g, the value of one share
of stock at Time 3 can be calculated as:

P3 = [D3 x (1 + g)] / (k g)

## P3 = [\$10.985 x 1.10] / (0.20 0.10) = \$120.835

Example: Using the DDM to Value a Firm
Experiencing Supernormal Growth, III.

## To determine the price per share today, we need the

present value of \$120.835 and the present value of the
dividends paid in theD1 first D 2 3 years:D3 P3
P0
1 k 1 k 2 1 k 3 1 k 3

## \$6.50 \$8.45 \$10.985 \$120.835

P0
1 0.20 1 0.20 1 0.20 1 0.20 3
2 3

## \$5.42 \$5.87 \$6.36 \$69.93

\$87.58
Discount Rates for
Dividend Discount Models

## The discount rate for a stock can be estimated

using the capital asset pricing model (CAPM ).
We will discuss the CAPM in a later chapter.
We can estimate the discount rate for a stock with
this formula:
Discount rate = Risk free rate + risk premium on
that particular stock
= U.S. T-bill Rate + (Stock Beta x Market
Risk Premium) Risk free rate: Use return on 90-day U.S. T-bills as a proxy for the
risk free rate.
Stock Beta: Systematic risk relative to the overall market. Use
S&P500 as a proxy for the overall market.
Market Risk Premium: Return of S&P500 Risk Free Rate
Observations on Dividend
Discount Models, I.

## Constant Growth Model:

Simple to compute
Not usable for firms that do not pay dividends
Not usable when g > k
Is sensitive to the choice of g and k
k and g may be difficult to estimate accurately.
Constant perpetual growth is often an unrealistic
assumption.
Observations on Dividend
Discount Models, II.

## More realistic in that it accounts for two stages of growth

Usable when g > k in the first stage
Not usable for firms that do not pay dividends
Is sensitive to the choice of g and k
k and g may be difficult to estimate accurately.