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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.

These methods are grouped into four categories:

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:

Using the companys historical average


growth rate.

Using an industry median or average


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

ROE (1 - Payout Ratio)

Return on Equity (ROE) = Net Income / Equity

Payout Ratio = Proportion of earnings paid out as


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.

Per share dividend just paid were $5.

The required rate of return is 20%.

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


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

First, calculate the total dividends over the supernormal


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.

Two-Stage Dividend Growth Model:

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.