DISCOUNTED DIVIDEND

VALUATION

Presenter
Venue
Date
DISCOUNTED CASH FLOW MODELS

2
CHOICE OF DISCOUNTED CASH FLOW
MODELS

3
VALUING COMMON STOCK USING
A MULTIPERIOD DDM

4
EXAMPLE: VALUING COMMON STOCK USING
A MULTIPERIOD DDM

0 1 2 3

D $1.00 $1.05 $1.10

P $20.00
EXAMPLE: VALUING COMMON STOCK USING
A MULTPERIOD DDM

$1.00 $1.05 $21.10

V0 2
3
1.10 1.10 1.10
V0 $17.63
 VALUING COMMON STOCK USING
THE GORDON GROWTH MODEL

D0 (1 g ) D1
V0
rg rg
EXAMPLE: VALUING COMMON STOCK USING
THE GORDON GROWTH MODEL

Risk-free rate 3.0%

Equity risk premium 6.0%

Beta 1.20

Current dividend $2.00

Dividend growth rate 5.0%

Current stock price $24 .00

 VALUING COMMON STOCK USING
THE GORDON GROWTH MODEL

CAPM: r = 3% + 1.2(6%) = 10.2%

$2.00(1 0.05) $2.10

V0 $40.38
0.102 0.05 0.102 0.05
EXAMPLE: VALUING PREFERRED STOCK

$2.00
V0 $19.61
0.102 0
 EXAMPLE: CALCULATING THE IMPLIED GROWTH
RATE USING THE GORDON GROWTH MODEL
Using the previous common stock example and the current stock price of $24,
what is the implied growth rate?

$2.00(1 g )
$24
0.102 g
2.448 24 g 2.00(1 g )
26 g 0.448
g 1.72%
CALCULATING THE IMPLIED REQUIRED RETURN
USING THE GORDON GROWTH MODEL

D1
V0
rg
D1
r g
P0
 EXAMPLE: CALCULATING THE IMPLIED REQUIRED
RETURN USING THE GORDON GROWTH MODEL
Using the previous common stock example and the current stock price of $24,
what is the implied required return?

D1
r g
P0
2.10
r 0.05
24
r 8.75% 5% 13.75%
PRESENT VALUE OF GROWTH
OPPORTUNITIES

E1
V0 PVGO
r
E1
PVGO P0
r
PRESENT VALUE OF GROWTH
OPPORTUNITIES

E1
V0 PVGO
r
P0 1 PVGO

E1 r E1
EXAMPLE: PRESENT VALUE OF GROWTH
OPPORTUNITIES

Stock price $80 .00

Expected earnings $5 .00

Required return on stock 10%

EXAMPLE: PRESENT VALUE OF GROWTH
OPPORTUNITIES

E1
PVGO P0
r
5
PVGO $80 $30
0.10
EXAMPLE: PRESENT VALUE OF GROWTH
OPPORTUNITIES

P0 1 PVGO

E r E
P0 1 30

E 0.10 5
16 10 6
USING THE GORDON GROWTH MODEL TO
DERIVE A JUSTIFIED LEADING P/E

D1
V0
rg
P0 D1 E1

E1 rg
P0 1 b

E1 rg
USING THE GORDON GROWTH MODEL TO
DERIVE A JUSTIFIED TRAILING P/E

D 0 (1 g )
V0
rg
P0 D 0 (1 g ) E0

E0 rg
P0 (1 b)(1 g )

E0 rg
EXAMPLE: USING THE GORDON GROWTH
MODEL TO DERIVE A JUSTIFIED P/E

Stock price $50 .00

Trailing earnings per share $4 .00

Current dividends per share $1.60

Dividend growth rate 5.0%

Required return on stock 9.0%

 EXAMPLE: USING THE GORDON GROWTH
MODEL TO DERIVE A JUSTIFIED LEADING P/E

P0 1 b

E1 r g
P0 $1.60 $4.00
10.0
E1 0.09 0.05
 EXAMPLE: USING THE GORDON GROWTH
MODEL TO DERIVE A JUSTIFIED TRAILING P/E

P0 (1 b)(1 g )

E0 rg
P0 ($1.60 / $4.00)(1.05)
10.50
E0 0.09 0.05
Actual P/E = $50.00/$4.00 = 12.50
ISSUES USING THE GORDON GROWTH MODEL

Strengths Limitations
Simple and applicable to Not applicable to non-
stable, mature firms dividend-paying firms

Can be applied to entire

g must be constant
markets

g can be estimated using Stock value is very sensitive

macro data to r g

Can be applied to firms that Most firms have nonconstant

repurchase stock growth in dividends
 CHOICE OF DISCOUNTED CASH FLOW
MODELS

Rapidly increasing
Transition ROE = r
earnings Earnings and
Heavy reinvestment Earnings growth dividends growth
Small or no dividends slows matures
Capital reinvestment Gordon growth model
slows useful
FCFE and dividends
increasing
Growth Maturity
GENERAL TWO-STAGE DIVIDEND DISCOUNT
MODEL (DDM)

D0 1 g S D0 1 g S 1 g L
n t n
V0
t 1 1 r t
1 r r g L
n
EXAMPLE: GENERAL TWO-STAGE DDM
 EXAMPLE: GENERAL TWO-STAGE DDM

Step 1: Calculate the first three dividends:

D1 = $2.00 x (1.15) = $2.30
D2 = $2.30 x (1.15) = $2.6450
D3 = $2.6450 x (1.15) = $3.0418
Step 2: Calculate the Year 4 dividend:
D4 = $3.0418 x (1.04) = $3.1634
Step 3: Calculate the value of the constant growth
dividends:
V3 = $3.1634 / (0.10 0.04) = $52.7237
EXAMPLE: GENERAL TWO-STAGE DDM

$2.30 $2.6450 $3.0418 $52.7237

V0
1.10 1.102 1.103 1.103
V0 $46.17
 EXAMPLE: GENERAL TWO-STAGE DDM

Using the previous example, now well use the trailing

P/E to determine the terminal value
D4 is $3.1634
Assume also that the projected P/E is 13.0 in Year 4
and that the firm will pay out 60% of earnings as
dividends
Year 4 earnings are then $3.1634/0.60 = $5.2724
The stock price in Year 4 is then $5.2724 13 = $68.54
 EXAMPLE: GENERAL TWO-STAGE DDM

$2.30 $2.6450 $3.0418 $3.1634 $68.54

V0 2
3

1.10 1.10 1.10 1.10 4
V 0 $55.54
 TWO-STAGE H-MODEL

D0 1 g L D0 H g S g L
V0
r gL
 EXAMPLE: TWO-STAGE H-MODEL

Current dividend $3.00

gs 20%
gL 6%
H 5
Required return on stock 10%
Current stock price $120
 EXAMPLE: TWO-STAGE H-MODEL

D0 1 g L D0 H g S g L
V0
r gL

$3 1 0.06 $3 5 0.20 0.06

V0
0.10 0.06
V0 $79.50 $52.50 $132.00
 SOLVING FOR THE REQUIRED RETURN USING
THE TWO-STAGE H-MODEL

D0
r 1 g L H g S g L g L
P0

3
r 1 0.06 5 0.20 0.06 0.06 10.40%
120
 EXAMPLE: THREE-STAGE MODEL
Firm pays a current dividend of $1.00
Growth rate is 20% for next two years
Growth then declines over six years to a stable
rate of 5%
Required return is 10%
Current stock price is $50
 THREE-STAGE MODEL
Assumes three distinct growth stages:
First stage of growth
Second stage of growth
Stable phase of growth

H-model can be used for last two stages if growth

declines linearly
 THREE-STAGE MODEL EXAMPLE

$1 1.20 $1 1.20
2
V0
1.10
1.10 1 2

2 6
$1 1.20 0.20 0.05 $1 1.20 1.05
2
2
1.10 0.10 0.05 1.10 0.10 0.05
2 2

V0 $1.09 $1.19 $10.71 $24.99 $37.98

 ESTIMATING THE GROWTH RATE

g = b ROE
Industry or DuPont formula
Macroeconomic ROE = r
Average ROE = industry ROE
 THE SUSTAINABLE GROWTH RATE

g b ROE
 THE DUPONT MODEL

Net income Total assets

ROE =
Total assets Shareholders' equity

Net income Sales Total assets

ROE =
Sales Total assets Shareholders' equity

Net income Dividends Net income Sales Total assets

g

Net income Sales Total assets Equity
 EXAMPLE: DUPONT MODEL

Net profit margin 5.00%

Total asset turnover 1.5

Equity multiplier 2.0

Retention ratio 60%

 EXAMPLE: DUPONT MODEL

Net income Dividends Net income

g
Net income Sales
Sales Total assets

Total assets Equity
g 0.60 5% 1.5 2.0

g 9.0%
 SUMMARY

Choice of Discounted Cash Flow Models

Dividend discount models, free cash flow models,

residual income models
Dividend models most appropriate for
Mature, profitable, dividend-paying firms
Noncontrolling shareholder perspective

Gordon Growth Model

Assumes constant g and r > g

Applicable to mature, stable firms
Estimated value very sensitive to r g denominator
 SUMMARY

Uses of Gordon Growth Model

Preferred stock valuation where g = 0

PVGO Value from future growth
Justified leading and trailing P/Es
Implied r and g

Phases of Growth

Growth
Transition
Maturity
 SUMMARY
Multistage Models

General two-stage model: growth abruptly

declines
H-model: growth gradually declines
Three-stage model: can use general or H-model

Sustainable Growth Rate

g = Retention ratio ROE

DuPont analysis:
ROE = Profit margin Asset turnover Equity
multiplier