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120 Part One FinoncialSatemen* andYaLuation

Many investmenttexts focus on the dividend discount model in their fundamental analysis
chapter.At first sight, the model is very appealing. Dividends arc the cashr9owsthat share-
holdersget from the firm, the distributions to shareholdersthat are reported in the cashflow
ns ger
statement.In valuing bonds we forecastthe cashflows from the bond, so, in valuing stocks. firceanm
why not forecast the cash flows from stocks? rdE
The dividend discount model values the equity by forecasting future dividends:

Value ofequity = Presentvalue ofexpected dividends (4.1)

,F = i*
d1 dz dj da,
't , L* , L* r t * "' mf|st

(The ellipsis in the formula indicates that dividends must be forecast indefinitely into the t!il1tne
fitture, for years 5, 6, and so on.) The dividend discount model instructs us to forecast div-
idends and to convert the forecaststo a value by discounting them at the equity cost ofcap-
ital, pp. One might forecastvarying discount rates for future periods but for the moment we
will treat the discount rate as a constant.The dividend discount model is a straight applica-
Rttilrn i
tion of the bond valuation model to equity. That model works for a terminal investment.
Will it work for a going-concern investmentunder the practical criteria we laid down at the
end of the last chapter? nurE (
Well, going concerns are expectedto pay out dividends for many (infinite?) periods in bfr
the future. Clear|y,forecasting for infinite periods is a problem. How would we proceed by cakdahr
forecasting for a finite period, say l0 years?Look again at the payoffs for an equity invest-
ment in Figure 3.4 in the last chapter.For a finite horizon forecast of Zyears, we might be
able to predict the dividends toYear Z but we are left with a problem: The payofffot Tyears
includes the terminal price, P7, as well as the dividends, so we also need to forecastPr, the
price at which we might sell at the forecast horizon. Forecastingjust the dividends would
be like forecastingthe coupon paymentson a bond and forgetting the bond repayment.This
last component,the terminal payoff, is also called the terminal value. So we havethe prob-
lem of calculatins a terminal value such that

Value of equity : pr"r"n, value of expecteddividends to time Z @2)

+ Presentvalue of expectedterminal value at T

,F dr dz,dj ,dr Pr
I i =.-rt - -t- -;

rV"\i /--<p,
t\-\tr pL pr' PT pL
You can seethat this model is technically correct, for it is simply the presentvalue of all
the payoffs from the investment that are laid out in Figure 3.4. The problem is that one of
those payoffs is the price that the sharewill be worth Zyears ahead,P7. This is awkward, to
say the least: The value of the shareat time zero is determined by its expectedvalue in the
future, bui it is the value we are trying to assess.To break the circularity, we must investi-
gate fundamentalsthat determine value.
A method often suggestedis to assumethat the dividend at the forecast horizon will be
the same forever afterward. Thus

v" o E =lt*4 *+ * *+ *[ d ' .' ,]tp L (4.3)

Pc, P'E P'E PE \P e -t,/
; ffi l:l::
;Ti:,; :''?,';':.
il.#l :;[' returnadjusted'""";_:Era

{ t |{))


-: [ ffiT:ilJl ;;;;E*'ff
r:T1,TH#iJ,',:'#'TIlil:ffi i":,.'
. ; dividend
,, ,t:,;.t-=1;ch yearforeverandthe coNsrANTGRowrH MoDELs
is",10%pervear' thenthevalue
of theperpe- ,times
.-' ;tfil"t jl,T"#s
lnT-T,1]::j;:,5,"'jj,#-;il re-

lfitif*ii:{"ff gg,flgffi
:# f+:H#:: lthtr*#Tih;;i,
Kr:{x constantgroMh is expecte

The terminal value here (in the bracketed term) is the value of perpetuity,
a calculared
by capitalizing the forecasteddividend at T + 7 at the cost of caplial.
ihis terminal value is
then discountedto presentvalue.
This perpetuity assumption is a bord one. we are guessing.How
do we know the firm
will maintain a constantpayout? If there is less than full payoit of
earnings,one would ex-
pect dividends to grow as the retained funds earn more in the
firm. This idea can be ac-
commodatedin a terminal value calcuration that incorporatesgrowth;

.h.(#+),,, (4.4)

where g is 1 plus a forecastedgrowth rate.l The terminal value here

is the value of a per-
petuiQ with growth. If the constant growth starts in the
first period the entire series
collapsesb V{ = 6r11p, g), which is sometimesreferred to as the
Gordon growth model.
SeeBox 4. I .
what would we do, however,for a firm that might be expectedto have
zero payout fbr a
very long time in the future? For a firm that has exceptionally
high payout that can,t be
maintained? What if payout comes in stock repurchasei
lthat iypiJaty aon,t affect share-
holder value) rather than dividends?
The truth of the matter is that dividend payout over the foreseeable
future doesn,tmean
much. Somefirms pay a lot of dividends,othersnone.A firm that is very profitable
and worth
lT h e c a p i ta l i z a ti o n ra te i n th e d e nomi natorof
thetermi nal
val uecanbeexpressedas(pr-1)
-(s_l ),
whichisthesameaspt - g.