Case Study 1

Nikhil Maheshwari

Division A – Roll No. 31

PRN: 18020341031
What is the purpose of Dividend Discount Model?
Dividend Discount Model is a way of valuing a company based on the theory that intrinsic
value of a stock can be estimated by the expected value of the cash flows it will generate in
the future. It is used to evaluate stocks based on the net present value of the future dividends.

It is used by investors to make efficient stock investment decisions by comparing the present
value of future dividends and current market value of the stock. If calculated future dividend
is greater than the current value, stock is marked as undervalued and if future dividend is less
than the current value, stock is marked as overvalued.

What are the advantages and disadvantages of the method?

Advantages:
 Widely accepted by analysts
 Inputs like dividend and ROE easy to obtain
 Easy to comprehend
 Keeps Investors focused in Dividend Paying Stocks

Disadvantages:
 Based on too many assumptions that are beyond investors control
 It only works on dividend paying shares while many smaller companies don’t pay
dividends
 DDM output is very sensitive to the inputs
 It ignores the effect of stock buybacks

What are the zero-growth, the constant-growth, and the

supernormal growth models under the dividend discount model?
How do we proceed with each of them?
The zero-growth model assumes that the dividend is a constant amount and the price of the
stock is found out by the formula P = D/r, where D is the dividend which is constant
perpetually and r is the discount rate.
The constant growth model assumes that the dividends grow at a particular rate ‘g’
perpetually. The price then is calculated as D1/(r-g), D1 being the next expected dividend. It
assumes that dividends grow by a specific percentage each year, and is usually denoted as g,
and the capitalization rate is denoted by k.
The supernormal growth model assumes that the dividends grow at a super normal rate for
the first few years which then gives way for a subsequent period into perpetuity at a normal
rate.
The price of the stock today will be the sum of below:
1. The PV of each year’s dividend during the period of super normal growth, discounted
at the required rate of return
2. The PV of the price of the stock using the constant growth model when the growth
rate becomes constant, discounting the price so found at the beginning of the constant
growth period to t=0, by discounting it at the required rate of return.
Which model would give a higher estimated value: the zero-
growth model or the constant-growth model? With which model
would we have a higher chance of giving a “buy”
recommendation for the stock?
The constant growth model would likely lead to a higher estimated value than zero-growth
model because it requires growth rate to be subtracted from the return whereas zero-growth
model only has return on denominator side’s. It leads to high intrinsic values which may be
lower than market price thus pointing to high recommendation to buy. Following calculation
can help us understand the reason behind it:

Property Calculation using

Zero-growth Model Constant-growth Model
D for year 2013 2.24
Growth Rate of Dividend (g) 6%
P $82.94
Formula D/r D1/(r-g)
Calculation r = (D/p) + g D1 = 2.24 * 1.06
= (2.24/82.94) + = $2.38
0.06
r = 8.7%
Stock Value:
Stock Value: 2.38/(0.087-0.06)
2.24/0.087 = $25.74 = $88.15

Therefore, constant growth model gives higher estimated value. So, constant growth model
have higher chance of giving a BUY recommendation for the stock.
Estimate the annual growth rate in TystCo’s dividends over the
2008-2013 period using the data given in the case. Calculate both
the arithmetic average and the geometric average annual growth
rates in TystCo’s dividends over the period, and then take the
average of those two measures as your best estimate for TystCo’s
expected growth over the next 4 years (i.e. 2014- 2017)

Year Dividend Growth Rate

2008 1.65
2009 1.78 7.87
2010 1.89 6.18
2011 2.03 7.40
2012 2.13 4.92
2013 2.24 5.16

Arithmetic Average = (7.87+6.18+7.4+4.92+5.16)/5 = 6.3%

Geometric Average = 5th root of multiplication of all growth rate values = 6.196%

Average of both = 6.3 + 6.196 = 6.25%

So, expected growth rate of next four years is 6.25%.

Year Dividend
2014 2.38
2015 2.53
2016 2.68
2017 2.85

What are the ways to estimate the cost of common stock (i.e. or
the required return on common stock)? We can use the dividend
growth model formula P=D1/(r-g) to estimate the cost of common
stock (r). We know TystCo’s actual closing stock price on
12/31/2013.
To estimate the cost of common stock (i.e. or the required return on common stock), use the
dividend growth model formula P=D1/(r-g) to estimate the cost of common stock (r). We
know TystCo’s actual closing stock price on 12/31/2013 = $82.94

D1 = $2.38 calculated in above question.

Given, G = 6%
Therefore, r = (D1/P) + g

r = (2.24/82.94) + 0.06 = 8.7%

Estimate the value of TystCo shares using the following models:

The zero-growth model, The constant-growth model, The

supernormal growth model
Zero-growth Model = $25.74

Constant-Growth model = $88.15

Super Nominal model = P = D1/ (1+r) + D2/ (1+r)2 + D3/ (1+r)3 + P4/ (1+r)3

P = $91.72 (IN NEXT 4 YEARS)

Based on each model, what would be the investment advice for

potential investors in TystCo shares?
Observing the zero-growth model calculations, investor should not invest (SELL) as it is
giving loss.

And on basis of constant growth and super nominal model investor must invest (BUY).
Q9. If we want to go ahead with the supernormal growth model,
what would be our decision?
Is the stock a good buy?” Mary Ann concluded.

John was excited: “Wow, you are so organized! Now, I think

these questions will better guide us through this process. Let’s get
to work then!”
Answer:

If we want to go with supernormal growth model it would be recommended that shares be

bought as intrinsic value would be higher than the market price of the stock.