IFM2 - Equity Valuation Model - Stock and DDM

The Models for Analysing & Evaluating the
Financial Assets II
Stock and Dividend Discount Model
Van Quy NGUYEN
Actuary program - NEU
December 2022
Van Quy NGUYEN IFM course December 2022 1 / 61

Contents
1 Stocks
2 Dividend Discount Model
3 Gordon Growth Model
Constant-growth rate
PVGO
Price–Earnings Ratio
4 Multistage Dividend Discount Model
The first two-stage DDM
The H-model
Spreadsheet Modeling
Finding Rates of Return for Any DDM
Multistage DDMs
The Financial Determinants of Growth Rates

Contents
1 Stocks
2 Dividend Discount Model
3 Gordon Growth Model
PVGO
4 Multistage Dividend Discount Model
The H-model
Spreadsheet Modeling
Finding Rates of Return for Any DDM
Multistage DDMs
The Financial Determinants of Growth Rates

Stocks

Stocks
Common stocks represent ownership in a corporation; they are

often referred to as equities .
The stockholders have the right to elect the board of directors of
the corporation, and can participate in the management of the
firm.
The stockholders receive dividends. However, the company does
not guarantee dividends, and some companies do not pay any
dividends at all.
The stockholders are taking on more risk than bondholders
because their dividends are dependent on uncertain cash flows.
The cash flows for a stock are quite random.
Stocks have unlimited maturity, stockholders can receive the
dividends in infinite number of times.

Stock prices
Stock prices are affected by many factors such as economic,

political, future information, etc; but mainly determined by the
supply and the demand in the stock market.
The market price per share of stock, or the share price, is the
most recent price that a stock has traded for.
The intrinsic value, or reasonable price of a stock is its true
value at which a stock should be priced.
Three prominent theories to determine the intrinsic value:
Fundamental Analysis, Technical Analysis and Random Walk
Theory.

Fundamental Analysis
This approach underlines that share price of security is affected

by economic factors, industry factors and company’s factors.
Fundamental theory assumes that share prices have a tendency
to regress towards intrinsic values.
Fundamental analysis is a logical way to estimate the true value
of a growing concern.
However, it must be noted that under an ideal condition,
fundamental analysis can suggest only a range of prices rather
than specific value.

Technical Analysis
Technical analysis involves studying the history of share price

with an objective of tracking the future behaviour of a share or
group of shares.
This theory assumes that movement of share price makes some
pattern, and in future same pattern are repeated.
The technical analysis is based on charts and graphs.
The major criticism: it is not necessary that past prices patterns
could predict the future prices.

Random Walk Theory
The RWT states that current stock prices fully reflect all
available information. However, it has no empirically testable
implications.
The theory assumes that in an efficient market, securities are
correctly priced and the prices fully reflect all variable
information.
If security prices fully reflect all variable information in an
efficient market then any trading system based on the
information already impounded in prices will be a fair game.

Dividend Discount Model

Rate of return
Let P0 be the current price. The expected holding-period

return, or simply expected return, E (r ), equals to the sum of
the expected dividend yield, D1 /P0 , and the expected rate of
price appreciation, the capital gains yield, (P1 − P0 )/P0 :
D1 + P1
E (r ) = −1
P0
Required rate of return, k, is based on the CAPM or another

model. For example, in CAPM, k = rf + β (E (rM ) − rf ) where
rf is the risk-free rate of return,
E (rM ) is the expected return on the market portfolio,
β is the asset’s sensitivity to returns on the market portfolio.

Example
Example
The current stock price of ABC is $44.70. You expect a dividend of
$2.08 in one year. You forecast the stock price to be $49.00 in one
year. If you purchase ABC’s stock at the current market price, what
return do you expect to earn over one year?

Example
The expected one-year return on ABC is

2.08 + 49.00
E (r ) = − 1 = 0.1427 = 14.27%
44.70
The expected return of 14.27 percent is the sum of the expected
dividend yield of 2.08/44.70 = 4.65 percent and the expected capital
appreciation of (49.00 − 44.70)/44.70 = 9.62 percent.

Example
Suppose that rf = 6%, E (rM ) = 5%, and the beta of ABC is

β = 1.2. Then the value of cost of capital k is
k = 6% + 1.2 × (11% − 6%) = 12%
The rate of return the investor expects exceeds the required rate
based on ABC’s risk by a margin of 2.27%. Naturally, the investor
will want to include more of ABC stock in the portfolio than a
passive strategy would indicate.

Dividend Discount Model (DDM)
The valuation is made, following fundamental analysis, is

centered on present value, which is computed as the discount
value of future cash flows.
The valuation is made on the basis of holding period of security.
During the holding period, investor earns dividend, and on sale
of these shares, he received cash, or sale value.
Putting these two inflows on the time frame and expected rate
of return, we may compute present value of the share.

One year holding
An investor wishes to buy a share of stock and hold it for one

year.
Expected dividend per share is D1 , and the expected price at the
end of a year is P1 .
The value of that share of stock today is the present value of the
expected dividend to be received on the stock plus the present
value of the expected selling price in one year.
D1 + P1
V0 =
1+k
where k is required rate of return or cost of equity.

General formula
For an n-period model, the value of a stock is the present value of

the expected dividends for the n periods plus the present value of the
expected price in n periods (at t = n).
D1 Dn Pn
V0 = + ··· + +
1+k (1 + k)n (1 + k)n
If we let the holding period extend into the indefinite future

(unknown sales price at the horizon date), we have the general form
of the dividend discount model
D1 D2 D3
V0 = + 2
+ + ··· (DDM)
1 + k (1 + k) (1 + k)3

Example
Example
For the next five years, the annual dividends of a stock are expected
to be $2.00, $2.10, $2.20, $3.50, and $3.75. In addition, the stock
price is expected to be $40.00 in five years. If the cost of equity is 10
percent, what is the value of this stock?
The present values of the expected future cash flows can be written
out as
2.00 2.10 2.20 3.50 3.75 40.00
V0 = + + + + + = $34.76.
1.1 1.12 1.13 1.14 1.15 1.15
The five dividends have a total present value of $9.926 and the
terminal stock value has a present value of $24.837.

DDM formula
DDM focuses exclusively on dividends and ignores capital gains

as a motive for investing in stock.
Indeed, the price at which you can sell a stock in the future Pn is
the present value at time n of all dividends expected to be paid
after the horizon date. That value is then discounted back to
today, time 0.
The DDM asserts that stock prices are determined ultimately by
the cash flows accruing to stockholders, and those are dividends

Drawbacks of DDM
The DDM is still not very useful in valuing a stock because it

requires dividend forecasts for every year into the indefinite
future.
To use the DDM, we must simplify the forecasting problem.
There are two broad approaches:
We can forecast future dividends by assigning the stream of
future dividends to one of several stylized growth patterns.
We can forecast a finite number of dividends individually up to
a terminal point, using pro forma financial statement analysis,
for example.

Gordon Growth Model

The growth rate of dividend at period t is defined as
Dt − Dt−1
gt =
Dt−1
The simplest pattern we can assume in forecasting future

dividends is growth at a constant rate, i.e., gt = g for all t.
Dt = Dt−1 (1 + g )
Note that g can be computed as ROE × b where b is the

plowback ratio/retention rate.
For any t, Dt = D0 (1 + g )t where D0 is the current dividend.
Constant-growth DDM
Intrinsic DDM value becomes

D0 (1 + g ) D0 (1 + g )2 D0 (1 + g )3
V0 = + + + ···
1+k (1 + k)2 (1 + k)3
This equation can be simplified to
D0 (1 + g ) D1
V0 = =
k −g k −g
If dividends were expected not to grow, then the dividend stream

would be a simple perpetuity and V0 = Dk1 .

Example
If growth rate of dividend is g = 0.05, and the most recently paid

dividend was D0 = 3.81, expected future dividends are
D1 = D0 (1 + g ) = 3.81 × 1.05 = 4.00

D2 = D0 (1 + g )2 = 3.81 × 1.052 = 4.20
D3 = D0 (1 + g )3 = 3.81 × 1.053 = 4.41
...
If the cost of equity is k = 12%, the intrinsic value is

4.00
V0 = = 57.14
0.12 − 0.05

Constant-growth DDM
The constant-growth DDM is valid only when g is less than k.

The stock’s value will be greater if:
The larger its expected dividend per share.
The lower the cost of equity k.
The higher the expected growth rate of dividends g .
The intrinsic value grows at the same rate g .
We can compute k or E (r ) based on the dividend yield, D1 /P0 ,
and estimating the growth rate of dividends g by using the
discounted cash flow (DCF) formula at intrinsic value
D1
E (r ) = k = +g
P0

Present Value of Growth Opportunities

PVGO
The value of the firm as the sum of the value of assets already
in place, or the no-growth value of the firm, plus the net
present value of the future investments the firm will make, which
is the present value of growth opportunities, or PVGO.
E1
P0 = + PVGO
k
where E1 = ROE × Equity is the no-growth earnings in dividends.
The higher the PVGO, the more earnings should be invested
rather than issuing dividends to shareholders (and vice versa).

PVGO
D1
If P0 = V0 , PVGO = k−g − Ek1 gives the market’s estimate of
the value of the company’s growth.
Whenever we calculate a stock’s value, V0 , whether using the
Gordon growth or any other valuation model, we can calculate
the value of growth.

PVGO
Example
Company XYZ has expected earnings in the coming year of $5 per
share. XYZ will engage in projects that generate a return on
investment of 15%, which is greater than the required rate of return,
k = 12.5%. XYZ chooses a lower dividend payout ratio (the fraction
of earnings paid out as dividends), reducing payout from 100% to
40%, maintaining a plowback ratio (the fraction of earnings
reinvested in the firm) at 60%. Compute the PVGO of this company.

PVGO
No-growth value
E1 5
= = $40
k 0.125
Growth rate g = ROE × b = 0.15 × 0.6 = 0.09 The future value
with project
D1 2
= = $57.14
k −g 0.125 − 0.09
PVGO is $27.14, which is about 47%.

Price-Earning Ratio

P/E model is easy to calculate and is more realistic.

P/E model uses only the information obtained from the financial
statement of a company.
P/E model express the P/E ratio, the ratio of price per share to
earnings per share (EPS):
Market price of share

P/E ratio =
Earnings per share
A high P/E ratio could mean that a stock’s price is high relative
to earnings and possibly overvalued. Conversely, a low P/E ratio
might indicate that the current stock price is low relative to
earnings.

Connection to Gordon model
Let b as the retention rate/plowback rate.
The dividend payout ratio is then 1 − b.
The dividends equal the earnings that are not reinvested in the
firm: D1 = E1 × (1 − b), and g = ROE × b.
DDM formula P0 = D1 /(k − g )
The (justified) leading P/E, current price divided by next year’s
earnings
P0 1−b
=
E1 k − ROE × b
The (justified) trailing P/E, current price divided by current

earnings
P0 (1 − b)(1 + g )
=
E0 k −g

Comments
P/E ratio increases with ROE.

High ROE projects give the firm good opportunities for growth.
We also can verify that the P/E ratio increases for higher b as
long as ROE exceeds k.
When a firm has good investment opportunities, the market will
reward it with a higher P/E multiple if it exploits those
opportunities more aggressively by plowing back more earnings
into those opportunities.

Example
Company X has
Current stock price =$56.94
Estimated earnings per share for the current year =$1.837
Dividends for the current year = $0.575
Dividend growth rate = 8.18%
Risk-free rate = 5.34%
Equity risk premium = 5.32%
Beta = 0.83
What are the justified trailing and leading P/Es based on the Gordon
growth model?

The cost of equity k = 5.34% + 0.83(5.32%) = 9.76%
The dividend payout ratio 1 − b = 0.313
The justified leading P/E=19.8
The justified trailing P/E=21.4, which is smaller than actual trailing
P/E=31. So the stocks of company X is overvalued.

Summarize
Strengths
The Gordon growth model is often useful for valuing stable growth,
dividend-paying companies.
The model features simplicity and clarity; it is useful for
understanding the relationships among value and growth, required
rate of return, and payout ratio.
It provides an approach to estimating the expected rate of return
given efficient prices
Weaknesses
Calculated values are very sensitive to the assumed growth rate and
required rate of return.
The model is not applicable, in a practical sense, to
non-dividend-paying stocks, or to unstable-growth, dividend-paying
stocks
Multistage Dividend Discount Model

Two-Stage Dividend Discount Model
There are two common versions of the two-stage DDM.

The first model assumes a constant growth rate in each stage.
For example, 15% in Stage 1 and 7% in Stage 2.
The second model assumes a declining dividend growth rate in
Stage 1 followed by a fixed growth rate in Stage 2 (called The
H-Model).
For example, the growth rate could begin at 15% and decline
continuously in Stage 1 to 7%. Then it grows forever at 7% in
Stage 2.

There are two dividend growth rates.

A high growth rate for the initial period.
A sustainable and usually lower growth rate thereafter.
This model is based on the multiple-period model
n
X Dt Vn
V0 = t
+
t=1
(1 + k) (1 + k)n
where Vn is an estimate of Pn .

The first n dividends grow at an extraordinary short-term rate
gS :
Dt = D0 (1 + gS )t
After time n, the annual dividend growth rate changes to a

normal long-term rate gL .
The dividend at time n + 1 is
Dn+1 = Dn (1 + gL ) = D0 (1 + gS )n (1 + gL )
Using Gordon model, we can find

D0 (1 + gS )n (1 + gL )
Vn =
k − gL
Example
Example
Compute the intrinsic value of a stock with the cost of equity is
10.7% and the current dividend of $1.10. The dividends grow at 11%
for the next five years, and the growth rate will decline to 8% and
remain at that level thereafter.

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The Models for Analysing & Evaluating the

Van Quy NGUYEN

Actuary program - NEU

Van Quy NGUYEN IFM course December 2022 1 / 61

Van Quy NGUYEN IFM course December 2022 2 / 61

Van Quy NGUYEN IFM course December 2022 3 / 61

Van Quy NGUYEN IFM course December 2022 4 / 61

Common stocks represent ownership in a corporation; they are

Van Quy NGUYEN IFM course December 2022 5 / 61

Stock prices are affected by many factors such as economic,

Van Quy NGUYEN IFM course December 2022 6 / 61

This approach underlines that share price of security is affected

Van Quy NGUYEN IFM course December 2022 7 / 61

Technical analysis involves studying the history of share price

Van Quy NGUYEN IFM course December 2022 8 / 61

Van Quy NGUYEN IFM course December 2022 9 / 61

Van Quy NGUYEN IFM course December 2022 10 / 61

Let P0 be the current price. The expected holding-period

Required rate of return, k, is based on the CAPM or another

Van Quy NGUYEN IFM course December 2022 11 / 61

Van Quy NGUYEN IFM course December 2022 12 / 61

The expected one-year return on ABC is

Van Quy NGUYEN IFM course December 2022 13 / 61

Suppose that rf = 6%, E (rM ) = 5%, and the beta of ABC is

k = 6% + 1.2 × (11% − 6%) = 12%

Van Quy NGUYEN IFM course December 2022 14 / 61

The valuation is made, following fundamental analysis, is

Van Quy NGUYEN IFM course December 2022 15 / 61

An investor wishes to buy a share of stock and hold it for one

Van Quy NGUYEN IFM course December 2022 16 / 61

For an n-period model, the value of a stock is the present value of

If we let the holding period extend into the indefinite future

Van Quy NGUYEN IFM course December 2022 17 / 61

Van Quy NGUYEN IFM course December 2022 18 / 61

DDM focuses exclusively on dividends and ignores capital gains

Van Quy NGUYEN IFM course December 2022 19 / 61

The DDM is still not very useful in valuing a stock because it

Van Quy NGUYEN IFM course December 2022 20 / 61

Van Quy NGUYEN IFM course December 2022 21 / 61

The simplest pattern we can assume in forecasting future

Note that g can be computed as ROE × b where b is the

Intrinsic DDM value becomes

This equation can be simplified to

If dividends were expected not to grow, then the dividend stream

Van Quy NGUYEN IFM course December 2022 23 / 61

If growth rate of dividend is g = 0.05, and the most recently paid

D1 = D0 (1 + g ) = 3.81 × 1.05 = 4.00

If the cost of equity is k = 12%, the intrinsic value is

Van Quy NGUYEN IFM course December 2022 24 / 61

The constant-growth DDM is valid only when g is less than k.

Van Quy NGUYEN IFM course December 2022 25 / 61

Van Quy NGUYEN IFM course December 2022 26 / 61

Van Quy NGUYEN IFM course December 2022 27 / 61

Van Quy NGUYEN IFM course December 2022 28 / 61

Van Quy NGUYEN IFM course December 2022 29 / 61

Van Quy NGUYEN IFM course December 2022 30 / 61

Van Quy NGUYEN IFM course December 2022 31 / 61

P/E model is easy to calculate and is more realistic.

Market price of share

Van Quy NGUYEN IFM course December 2022 32 / 61

The (justified) trailing P/E, current price divided by current

Van Quy NGUYEN IFM course December 2022 33 / 61

P/E ratio increases with ROE.