Dividend Discount model

■ This expression represents dividend discount model.

■ Current price = present value of future dividend payments

■ Limitations
– Ignores Capital gain as we might want to sell the stock in near future
– Many companies may not pay dividends
■ Such companies may reinvest their earnings for better future projects
■ Sometimes instead of paying dividends company might repurchase stocks of existing share
holders
– because management might considers them undervalued. I.e. they might see high
prices in future
Dividend Discount model

■ Let dividend cash flows be :

– DIV1, DIV2, DIV3, ………………………………………………..

– Let us say dividends are growing at a rate g
– Recall the growing perpetuity formula
■ Rearranging this equation
Dividend yield

■ Hence, Expected return (r) = Dividend yield + growth in dividends (g)

■ Will Co. is expected to pay a dividend of $2 per share at the end of year 1(D1), and
the dividends are expected to grow at a constant rate of 4% forever. If the current
price of the stock is $20 per share, calculate the expected return or the cost of
equity capital for the firm.

■ Answer: r = [(D1/P0 ) + g] = (2/20) + 0.04 = 14%.

Estimating dividend growth

■ A stock was selling for Rs.42.45 per share at the start of 2009. Dividend payments for the next
year were expected to be Rs.1.68 a share. Find the dividend yield and expected return.
– 1.68/42.45 = .04 or 4%
– How to estimate the growth rate (g)?
– One may use forecast by experts
– Alternative approach is using payout ratio
– Payout Ratio = percentage of Earning per share given away in dividends
– Payout Ratio = DIV/EPS
– Let us assume that payout ratio for this company is .60
– This means that 60% of earnings is given in dividends while remaining 40% is plowed
back into the business.
Estimating dividend growth
■ A stock was selling for Rs.42.45 per share at the start of 2009. Dividend payments for the next year were
expected to be Rs.1.68 a share. Find the dividend yield and expected return.

■ Let us say that ROE for this company is 11%

■ Book equity = Assets – Liabilities (Total worth of company in books)

■ Company is earning 11% of book equity and reinvests 40% of income.
■ This 40% becomes part of book equity.
■ Hence, book equity will increase by .11 * .40 = .044 or 4.4% (Growth rate of company)
■ Earnings and dividends per share (for upcoming year) will also increase by 4.4% (same as growth rate of
company)
■ Hence, we may say:

■ This growth rate is also called sustainable growth rate.

– Firm can sustain/grow at this rate without borrowing money from outside.

■ Therefore, expected return (r) = DIV1/ P0 + g

– r = .040 + .044 = 8.4%
■ https://www.investopedia.com/terms/s/sustainablegrowthrate.asp
Issues with constant growth (g)
■ Consider Growth-Tech, Inc., a firm with DIV1 = $.50 and P0 = $50. The firm has plowed back
80% of earnings and has had a return on equity (ROE) of 25%.

■ Dividend growth rate= plowback ratio * ROE= .80 * .25 = .20

■ This assumption is not ideal for companies with fluctuating dividend growth rates or irregular
dividend payments, as it increases the chances of imprecision.
■ Usually, growth rate declines as company matures:
■ Otobai Motor Company just paid a dividend of $1.40. Analysts expect its dividend to
grow at a rate of 18% for the next three years and then a constant rate of 5%
thereafter. What is the expected dividend per share at the end of year 5?

■ Answer: D5 = (1.40) × (1.18^3) × (1.05^2) = 2.54.

■ A company has just paid dividend of Rs. 1.5 per share. Dividends are expected to grow by 20%
per annum for next 3 years., followed by a 10% growth for next two years and then growth
stabilizes at 4% per annum.
If cost of equity is 12%. Find the current price using DDF model.

D1= 1.5*1.2 = 1.80

D2=1.5 * (1.2)^2= 2.16
T=0 1 2 3 4 5 6
D3= 1.5 *(1.2)^3= 2.592
D4= 1.5 * (1.2)^3 * (1.1)=2.851
D5= 1.5 * (1.2)^3 * (1.1)^2= 3.1363
D6= 3.1363* 1.04 = 3.261

At T=6 cash flows become growing perpetuity.

PV of this perpetuity @ T=5 = 3.261/(r-g) = 3.261/(.12 -.04)= 40.76
Price= 1.8/(1.12) +2.16/(1.12^2) + 2.592/(1.12^3) + 2.85/(1.12^4)+ (3.13+40.76)/(1.12^5)
=31.88
Growth Opportunities
■ Investors separate growth stocks from income stocks.
– Growth Stock – Provide capital gains by change in price
– Income stocks- primarily for the cash dividends

– We already know,

■ Imagine a case where g=0. I.e. a company that does not grow at all.
– I.e. All earnings are distributed through dividends

– Also, Current Price, P0= EPS1/r

Growth Opportunities
Stock price is the capitalized value of average earnings under a no-growth policy, plus
PVGO, the net present value of growth opportunities

No Growth value Growth Opportunities value

The Practical Aspect of Stock Prices

■ Dividend Discount model and PVGO analyses provide basic understanding of

intrinsic / fundamental values of stock prices.

■ The question is: Do stock prices are same or different from their fundamental value?
– If they are different then why ?
■ What Is Market Efficiency?

– Market efficiency refers to the degree to which market prices reflect all
available, relevant information.
 Efficient Market Hypothesis
■ Efficient Market Hypothesis has been developed by Prof. E. Fama.
■ The efficient market hypothesis (EMH), alternatively known as the efficient market theory, is a
hypothesis that states that share prices reflect all information and consistent alpha generation is
impossible.
■ What is alpha/ Excess return?
𝛼 = 𝑅𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 − 𝑅𝐵𝑒𝑛𝑐ℎ𝑚𝑎𝑟𝑘 𝐼𝑛𝑑𝑒𝑥
𝑅𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = Return of portfolio, 𝑅𝐵𝑒𝑛𝑐ℎ𝑚𝑎𝑟𝑘 𝐼𝑛𝑑𝑒𝑥 = Market return e.g. Return on Nifty 50 Index

– EMH says one cant generate positive alpha i.e. excess return with respect to market
– This means that no strategy can beat the market.
– Example: if Annual returns on Nifty 50 Index is 7%, Then as per EMH nobody can generate a
return more than 7% from their portfolio of stocks (i.e. a positive 𝛼) (assuming that risk of
portfolio and Nifty 50 index are same)
■ The EMH hypothesizes that stocks trade at their fair market value on exchanges.
■ New information comes into the market and it will be reflected into share price
instantly and constantly.
■ For Example : If stock X has intrinsic value of Rs. 100, then the market price will also
be around Rs. 100 and the market price will change only if intrinsic value changes.
■ stocks trade at the fairest value, meaning that they can't be
purchased undervalued or sold overvalued
Assumptions of EMH

■ All market participants have equal access to historical data on stock prices, and
both public and private information is available.
■ The efficient market hypothesis only holds if investors are rational, i.e., investors are
risk averse.
■ No individual investor can impact prices of stocks.
■ https://www.investopedia.com/terms/e/efficientmarkethypothesis.asp
■ Fama classified market efficiency on the basis of information set, into three groups:

– Weak-Form Efficiency;
– Semi-Strong Form Efficiency; and
– Strong-Form Efficiency
Random Walk of stock prices/ Weak
Form

■ In 1953 Maurice Kendall, a British statistician, presented a controversial paper to the Royal
Statistical Society on the behaviour of stock and commodity prices.

■ He proposed that prices of stocks and commodities seemed to follow a random walk.

■ Random walk theory infers that the past movement or trend of a stock price or market cannot
be used to predict its future movement.

■ It says Markets are efficient.

■ https://www.investopedia.com/terms/r/randomwalktheory.asp
Weak-Form Efficiency/ Random Walk

■ Current market price reflects all information of past history of security price.
■ Markets have no memory
■ It should not be possible to make consistent excess returns (Alpha) on securities by using the
past history of share price movement.
■ Information Set  = Past Information

■ Suppose you observe that a particular stock always declines on Friday and rises on market
opening on Monday.
– In order to make profit, you buy 100 shares on this stock on Friday evening hoping that on
Monday morning the price will rise.
– Unfortunately, on Monday morning the price further declines.
– The market seems to be weak-form efficient, because it is not letting you earn excess
return by just picking stocks based on some past price pattern.