Chapter 2

Discounted Dividend
Valuation
 Challenges

 Defining and forecasting CF’s

 Estimating appropriate discount rate
 Basic DCF model
 An asset’s value is the present value of its
(expected) future cash flows

CFt
V0  
t 1 (1  r ) t
Comments on basic DCF model

 Flat term structure of discount rates versus

differing discount rates for different time
horizons
 Value of an asset at any point in time is
always the PV of subsequent cash flows
discounted back to that point in time.
Three alternative definitions of cash
flow

 Dividend discount model

 Free cash flow model
 Residual income model
Dividend discount model
 The DDM defines cash flows as dividends.
 Why? An investor who buys and holds a share of
stock receives cash flows only in the form of
dividends
 Problems:
• Companies that do not pay dividends.
• No clear relationship between dividends and
profitability
DDM (continued)
 The DDM is most suitable when:
• the company is dividend-paying
• the board of directors has a dividend
policy that has an understandable
relationship to profitability
• the investor has a non-control perspective.
Free cash flow
 Free cash flow to the firm (FCFF) is cash
flow from operations minus capital
expenditures
 Free cash flow to equity (FCFE) is cash
flow from operations minus capital
expenditures minus net payments to
debtholders (interest and principal)
Free cash flow
 FCFF is a pre-debt cash flow concept
 FCFE is a post-debt cash flow concept
 FCFE can be viewed as measuring what a
company can afford to pay out in dividends
 FCF valuation is appropriate for investors
who want to take a control perspective
FCF valuation
 PV of FCFF is the total value of the
company. Value of equity is PV of FCFF
minus the market value of outstanding debt.
 PV of FCFE is the value of equity.
 Discount rate for FCFF is the WACC.
Discount rate for FCFE is the cost of equity
(required rate of return for equity).
FCF (continued)
 FCF valuation is most suitable when:
• the company is not dividend-paying.
• the company is dividend paying but dividends
significantly differ from FCFE.
• The company’s FCF’s align with company’s
profitability within a reasonable time horizon.
• the investor has a control perspective.
 FCF valuation is very popular with analysts.
 Which is best, DDM, FCF, or
RI?
 One model may be more suitable for a particular
application.
 Analyst may have more expertise with one model.
 Availability of information.
 In practice, skill in application, including the quality
of forecasts, is decisive for the usefulness of an
analyst’s work.
Discount rate determination
 Jargon
• Discount rate: any rate used in finding the present
value of a future cash flow
• Risk premium: compensation for risk, measured
relative to the risk-free rate
• Required rate of return: minimum return required by
investor to invest in an asset
• Cost of equity: required rate of return on common stock
Discount rate determination
• Weighted average cost of capital (WACC):
the weighted average of the cost of equity,
after-tax cost of debt, and cost of preferred
stock
 Two major approaches for cost of
equity
 Equilibrium models:
• Capital asset pricing model (CAPM)
• Arbitrage pricing theory (APT)

 Bond yield plus risk premium method

(BYPRP)
CAPM
 Expected return is the risk-free rate plus a risk
premium related to the asset’s beta:
 E(Ri) = RF + i[E(RM) – RF]

 The beta is i = Cov(Ri,RM)/Var(RM)

 [E(RM) – RF] is the market risk premium or the
equity risk premium
 CAPM
 What do we use for the risk-free rate of return?
• Choice is often a short-term rate such as the 30-
day T-bill rate or a long-term government bond
rate.
• We usually match the duration of the bond rate
with the investment period, so we use the long-
term government bond rate.
• Risk-free rate must be coordinated with how the
equity risk premium is calculated (i.e., both
based on same bond maturity).
 Equity risk premium
 Historical estimates: Average difference between
equity market returns and government debt returns.
• Choice between arithmetic mean return or geometric
mean return (see Table 2-2 p. 50)
• Survivorship bias
• ERP varies over time
• ERP differs in different markets (see Table 2-3 p. 51)
 Equity risk premium
 Expectational method is forward looking instead
of historical
 One common estimate of this type:
• GGM equity risk premium estimate
= dividend yield on index based on year-ahead
dividends
+ consensus long-term earnings growth rate
- current long-term government bond yield
 Dividend discount models
(DDMs)
 Single-period DDM:
D1 P1 D1  P1
V0  1
 1
 1
(1  r ) (1  r ) (1  r )
 Rate of return for single-period DDM

D1  P1 D1 P1  P0
r 1  
P0 P0 P0
More DDMs
 Two-period DDM:
D1 D2 P2 D1 D2  P2
V0  1
 2
 2
 1

(1  r ) (1  r ) (1  r ) (1  r ) (1  r ) 2

 Multiple-period DDM:
D1 Dn Pn
V0  1
 n

(1  r ) (1  r ) (1  r ) n
n
Dt Pn
V0   
t 1 (1  r ) t
(1  r ) n
Indefinite HP DDM
 For an indefinite holding period, the PV of
future dividends is:
D1 Dn
V0  1
 n

(1  r ) (1  r )


Dt
V0   .
t 1 (1  r )
t
Forecasting future dividends
 Using stylized growth patterns
• Constant growth forever (the Gordon
growth model)
• Two-distinct stages of growth (the two-
stage growth model and the H model)
• Three distinct stages of growth (the three-
stage growth model)
Forecasting future dividends
 Forecast dividends for a visible time horizon,
and then handle the value of the remaining
future dividends either by
• Assigning a stylized growth pattern to
dividends after the terminal point
• Estimate a stock price at the terminal point
using some method such as a multiple of
forecasted book value or earnings per share
Gordon Growth Model
 Assumes a stylized pattern of growth,
specifically constant growth:
Dt = Dt-1(1+g)
Or
Dt = D0(1 + g)t
Gordon Growth Model
 PV of dividend stream is:
D0 (1  g ) D0 (1  g ) 2 D0 (1  g )n
V0    
(1  r ) (1  r ) 2
(1  r ) n

 Which can be simplified to:

D0 (1  g ) D1
V0  
rg rg
Gordon growth model

 Valuations are very sensitive to inputs.

Assuming D1 = 0.83, the value of a stock is:
g = 3.45% g = 3.70% g = 3.95%

r = 5.95% $33.20 $36.89 $41.50

r = 6.20% $30.18 $33.20 $36.89

r = 6.45% $27.67 $30.18 $33.20

Other Gordon Growth issues
 Generally, it is illogical to have a perpetual
dividend growth rate that exceeds the growth
rate of GDP
 Perpetuity value (g = 0): D1
V0 
r
 Negative growth rates are also acceptable in
the model.
Expected rate of return
 The expected rate of return in the Gordon growth
model is:

D0 (1  g ) D1
r g g
P0 P0
 Implied growth rates can also be derived in the
model.
PV of growth opportunities
 If a firm has growing earnings and dividends,
it can be worth more than a non-growing firm:
 Value of growth = Value of growing firm –
Value of assets in place (no growth)
 OR

E
V0   PVGO
r
Gordon Model & P/E ratios
 If E is next year’s earnings (leading P/E):

P0 D1 / E1 (1  b)
 
E1 rg rg
 If E is this year’s earnings (trailing P/E):

P0 D0 (1  g ) / E0 (1  b)(1  g )
 
E0 rg rg
Strengths of Gordon growth model

 Good for valuing stable-growth, dividend-paying

companies
 Good for valuing indexes
 Simplicity and clarity, also helps understanding
of relationships between V, r, g, and D
 Can be used as a component in more complex
models
Weaknesses of Gordon growth
model
 Calculated values are very sensitive to
assumed values of g and r
 Is not applicable to non-dividend-paying
stocks
 Is not applicable to unstable-growth,
dividend paying stocks
Two-stage DDM
 The two-stage DDM is based on the multiple-period
model:
n
Dt Pn
V0   
t 1 (1  r ) (1  r )
t n

 Assume the first n dividends grow at gS and dividends

then grow at gL. The first n dividends are:

Dt  D0 (1  g S ) t
Two-stage DDM (cont)
 Using Dn+1, the value of the stock at t=n is
D0 (1  g S ) n (1  g L )
Pn 
r  gL

 The value at t = 0 is
n
D0 (1  g S ) D0 (1  g S ) (1  g L )
t n
P0   
t 1 (1  r ) t
(1  r ) n
(r  g L )
Two-stage DDM example
 Assume the following values
• D0 is $1.00
• gS is 30%
• Supernormal growth continues for 6 years
• gL is 6%
• The required rate of return is 12%
 Two-stage DDM example

Present Values
Time Value Calculation Dt or Vt Dt/(1.12)t or Vt/(1.12)t
1 D1 1.00(1.30) 1.30 1.161
2 D2 1.00(1.30)2 1.69 1.347
3 D3 1.00(1.30)3 2.197 1.564
4 D4 1.00(1.30)4 2.856 1.815
5 D5 1.00(1.30)5 3.713 2.107
6 D6 1.00(1.30)6 4.827 2.445
6 V6 1.00(1.30)6(1.06) / (0.12 – 0.06) 85.273 43.202
Total 53.641
“Shortcut” two-stage DDM
(not in the book)
 If gS is constant during stage 1, this works:

D0 (1  g S )  (1  g S ) n  D0 (1  g S )n (1  g L )
P0  1  n 

r  gS  (1  r )  (1  r )n (r  g L )

1.00(1.30)  (1.30)6  1.00(1.30)6 (1.06)

V0  1  
6 
0.12  0.30  (1.12)  (1.12)6 (0.12  0.06)

 For gS=30%, gL=6%, D0=1.00 and r=12%

85.274
V0  7.222  1.4454  6
 10.439  42.202  53.64
(1.12)
Using a P/E for terminal value
 The terminal value at the beginning of the
second stage was found above with a Gordon
growth model, assuming a long-term
sustainable growth rate.
 The terminal value can also be found using
another method to estimate the terminal value
at t = n. You can also use a P/E ratio, applied
to estimated earnings at t = n.
Using a P/E for terminal value
 For DuPont, assume
• D0 = 1.40
• gS = 9.3% for four years
• Payout ratio = 40%
• r = 11.5%
• Trailing P/E for t = 4 is 11.0

 Forecasted EPS for year 4 is

• E4 = 1.40(1.093)4 / 0.40 = 1.9981 = 4.9952
 Using a P/E for terminal value

Present Values
Time Value Calculation Dt or Vt
Dt/(1.115)t or Vt/(1.115)t
1 D1 1.40(1.093)1 1.5302 1.3724
2 D2 1.40(1.093)2 1.6725 1.3453
3 D3 1.40(1.093)3 1.8281 1.3188
4 D4 1.40(1.093)4 1.9981 1.2927
4 V4 11  [1.40(1.093)4 / 0.40] 54.9472 35.5505
= 11  [1.9981 / 0.40] = 11  4.9952
Total 40.88
Valuing a non-dividend paying
stock
 This can be viewed as a special case of the two-
stage DDM where the dividend in stage one is
zero:
n
Dt Pn
V0   
t 1 (1  r ) t
(1  r ) n

 Forecasting the length of stage one and the

dividend pattern in stage two are the challenges.
The H model
 The basic two-stage model assumes a
constant, extraordinary rate for the super-
normal growth period that is followed by a
constant, normal growth rate thereafter.
Three-stage DDM
 There are two popular version of the three-stage
DDM
• The first version is like the two-stage model, only the firm
is assumed to have a constant dividend growth rate in
each of the three stages.
• A second version of the three-stage DDM combines the
two-stage DDM and the H model. In the first stage,
dividends grow at a high, constant (supernormal) rate for
the whole period. In the second stage, dividends decline
linearly as they do in the H model. Finally, in stage three,
dividends grow at a sustainable, constant rate.
 Three-stage DDM with three
distinct stages
 Assume the following for IBM:
• Required rate of return is 12%
• Current dividend is $0.55
• Growth rate and duration for phase one are
7.5% for two years
• Growth rate and duration for phase two are
13.5% for the next four years
• Growth rate in phase four is 11.25% forever
 Three-stage DDM with three
distinct stages
Present values
Time Value Calculation Dt or Vt Dt/(1.12)t or
Vt/(1.12)t
1 D1 0.55(1.075) 0.5913 0.5279
2 D2 0.55(1.075)2 0.6356 0.5067
3 D3 0.55(1.075)2(1.135) 0.7214 0.5135
4 D4 0.55(1.075)2(1.135)2 0.8188 0.5204
5 D5 0.55(1.075)2(1.135)3 0.9293 0.5273
6 D6 0.55(1.075)2(1.135)4 1.0548 0.5344
6 V6 0.55(1.075)2(1.135)4(1.1125)/(.12 – .1125) 156.4620 79.2685
Total 82.3897
Spreadsheet modeling
 Spreadsheets allow the analyst to build very
complicated models that would be very
cumbersome to describe using algebra.
 Built-in functions such as those to find rates
of return use algorithms to get a numerical
answer when a mathematical solution
would be impossible or extremely
complicated.
Spreadsheet modeling

 Because of their widespread use, several

analysts can work together or exchange
information through the sharing of their
spreadsheet models.
Finding r with trial & error
 Johnson & Johnson’s current dividend of
$.70 to grow by 14.5 percent for six years
and then grow by 8 percent into perpetuity.
J&J’s current price is $53.28. What is the
expected return on an investment in J&J’s
stock?
Finding r with trial & error
 For a good initial guess, we can use the
expected rate of return formula from the
Gordon model as a first approximation: r =
($0.70  1.145)/$53.28 + 8% = 9.50%. Since
we know that the growth rate in the first six
years is more than 8 percent, the estimated
rate of return must be above 9.5 percent.
 Let’s use 9.5 percent and 10.0 percent to
calculate the implied price.
Finding r with trial & error
The present value of the terminal value
= V6 / (1+r)6 = [D7/(r-g)]/(1+r)6
The calculations for 9.5% and 10.0% are shown in the
table. Actual r is 9.988%.
Time t Dt Present Value of Dt and V6 Present Value of Dt and V6
at r = 9.5% at r = 10.0%
1 $0.8015 $0.7320 $0.7286
2 $0.9177 $0.7654 $0.7584
3 $1.0508 $0.8003 $0.7895
4 $1.2032 $0.8369 $0.8218
5 $1.3776 $0.8751 $0.8554
6 $1.5774 $0.9151 $0.8904
7 $1.7035
6 $65.8838 $48.0805
Total $70.8085 $52.9245
Strengths of multistage DDMs
 Can accommodate a variety of patterns of
future dividend streams.
 Even though they may not replicate the future
dividends exactly, they can be a useful
approximation.
 The expected rates of return can be imputed
by finding the discount rate that equates the
present value of the dividend stream to the
current stock price.
Strengths of multistage DDMs
 Because of the variety of DDMs available,
the analyst is both enabled and compelled to
evaluate carefully the assumptions about the
stock under examination.
 Spreadsheets are widely available, allowing
the analyst to construct and solve an almost
limitless number of models.
Strengths of multistage DDMs
 Using a model forces the analyst to specify
assumptions (rather than simply using
subjective assessments). This allows
analysts to use common assumptions, to
understand the reasons for differing
valuations when they occur, and to react to
changing market conditions in a systematic
manner.
 Weaknesses of multistage
DDMs
 Garbage in, garbage out. If the inputs are
not economically meaningful, the outputs
from the model will be of questionable
value.
 Analysts sometimes employ models that
they do not understand fully.
 Valuations are very sensitive to the inputs
to the models.
 Weaknesses of multistage
DDMs
 Subjective assessments may be better than
systematic, quantitative assessments in
some cases.
 Programming and data errors in spreadsheet
models are very common. These models
must be checked very thoroughly.
 Weaknesses of multistage
DDMs
 The choice of model should be made very
carefully. There is a tendency to grab a
model, put in the data, get the results, and
use them without carefully justifying the logic
of the underlying model and the
appropriateness and realism of the values
inserted into the model.
Forecasting growth rates
 There are three basic methods for
forecasting growth rates:
• Using analyst forecasts
• Using historical rates (use historical
dividend growth rate or use a statistical
forecasting model based on historical data)
• Using company and industry fundamentals
Finding g
 The simplest model of the dividend growth
rate is:
• g = b x ROE
• where g = Dividend growth rate
• b = Earnings retention rate (1 – payout ratio)
• ROE = Return on equity.