CHAPTER FIFTEEN

DIVIDEND DISCOUNT
MODELS

1 1
 CAPITALIZATION OF INCOME
METHOD
• THE INTRINSIC VALUE OF A STOCK
– represented by present value of the income
stream

2 2
 CAPITALIZATION OF INCOME
METHOD
• formula


Ct
V  t 1 (1  k ) t
where
Ct = the expected cash flow
t = time
k = the discount rate

3 3
 CAPITALIZATION OF INCOME
METHOD
• APPLICATION TO COMMON STOCK
– substituting
D1 D2 D
V   ... 
(1  k ) 1
(1  k ) 2
(1  k ) 

Dt
  (1  k )
t 1
t

determines the “true” value of one share

7 4
 CAPITALIZATION OF INCOME
METHOD
• A COMPLICATION
– the previous model assumes can forecast
dividends indefinitely
– a forecasting formula can be written
Dt = Dt -1 ( 1 + g t )
where g t = the dividend growth rate

8 5
THE ZERO GROWTH MODEL
• ASSUMPTIONS
– the future dividends remain constant such that
D1 = D2 = D3 = D4 = . . . = DN

9 6
THE ZERO GROWTH MODEL
• Applying to V
D1
V 
k

12 7
THE ZERO GROWTH MODEL
• Example
– If Zinc Co. is expected to pay cash dividends of
$8 per share and the firm has a 10% required
rate of return, what is the intrinsic value of the
stock?
8
V 
.10
 $80

13 8
THE ZERO GROWTH MODEL
• Example(continued)
If the current market price is $65, the stock is
underpriced.

Recommendation:
BUY

14 9
 THE CONSTANT-GROWTH
MODEL
• ASSUMPTIONS:
• growth rate in dividends is
constant
• earnings per share is constant
• payout ratio is constant

* 10
 CONSTANT GROWTH
MODEL
• In General

Dt = D0 (1 + g)t

16 11
 CONSTANT GROWTH
MODEL
• Using the infinite property series,
if k > g, then


(1  g ) t 1 g
 (1  k )
t 1
t

k g

18 12
 CONSTANT GROWTH
MODEL
• since D1= D0 (1 + g)

D1
V
kg

20 13
Constant Perpetual Growth Model
Example
Suppose D(0) = $2; k = 12%; g = 6%.

D(1) = ($2.00 x 1.06) = $2.12

V(0) = $2.12 / (.12 - .06) = $35.33

* 14
 Constant Perpetual Growth
• Advantage
– easy to compute
• Disadvantages
– not usable for firms paying no dividends
– not usable when g > k
– sensitive to choice of g and k
– k and g may be very difficult to estimate
– constant perpetual growth is often unrealistic

* 15
 THE MULTIPLE-GROWTH
MODEL
• ASSUMPTION:
– future dividend growth is not constant
• Model Methodology
– to find present value of forecast stream of
dividends
– divide stream into parts (lifecycle stage)
– each representing a different value for g

21 16
 THE MULTIPLE-GROWTH
MODEL
• Finding PV of all forecast dividends paid
after time t
– next period dividend Dt+1 and all thereafter are
expected to grow at rate g

 1 
VT  DT 1  
kg
23 17
 Two-Stage (any number)
Dividend Growth Model
If you have two different growth rates, one for
an early period and one for a later period, you
would use the two-stage model

* 18
 Two-Stage Growth Model
Example
Suppose D(0) = $2; k = 12%; g1 = 11%; g2 =
6%; and g1 continues for 4 years .

V(0) = $41.90

* 19
 Two-Stage Growth
• Advantage
– allows for two different growth rates
– g can be greater than k during period 1
• Disadvantages
– not usable for firms paying no dividends
– sensitive to choice of g and k
– k and g may be difficult to estimate

* 20
 Estimating the Discount Rate
Start with the CAPM (covered later):
Discount rate =
Risk-free rate + (Stock beta x Market risk premium)
where:
Risk-free rate = U.S. T-bill rate, which is the wait component
or time value of money.
Stock beta measures the individual stock’s risk relative to the
market.
Market risk premium measures the difference in return
between investing in the market and investing in T-bills.
* 21
 Discount Rate Example
Assume T-bills yield 4.5%; KO’s beta is 1.15; and the
market risk premium = 8%
Discount rate = 4.5% + (1.15 x 8%) = 13.70%
Using the CPGM with D(0) = $2 and g = 6%:
V(0) = $2(1.06)/(.1370 - .06) = $27.53
What if the MRP were 9%?
DR = 4.5% + (1.15 x 9%) = 14.85%
V(0) = $2(1.06)/(.1485 - .06) = $23.95
What if g = 7%?
V(0) = $2(1.07)/(.1370 - .07) = $31.94

* 22
 MODELS BASED ON P/E
RATIO
• PRICE-EARNINGS RATIO MODEL
– Many investors prefer the earnings multiplier
approach since they feel they are ultimately
entitled to receive a firm’s earnings

26 23
 MODELS BASED ON P/E
RATIO
• PRICE-EARNINGS RATIO MODEL
– EARNINGS MULTIPLIER:
= PRICE - EARNINGS RATIO

= Current Market Price

27 24
 PRICE-EARNINGS RATIO
MODEL
• The P/E Ratio is a function of
– the expected payout ratio ( D1 / E1 )
– the required return (k)
– the expected growth rate of dividends (g)

30 25
High vs. Low P/Es
• A high P/E ratio:
– indicates positive expectations for the future of the company
– means the stock is more expensive relative to earnings
– typically represents a successful and fast-growing company
• A low P/E ratio:
– indicates negative expectations for the future of the
company
– may suggest that the stock is a better value or buy

* 26
 PRICE-EARNINGS RATIO
MODEL
• The Model is derived from the Dividend
Discount model:

D1
P0 
kg
28 27
 PRICE-EARNINGS RATIO
MODEL
• Dividing by the coming year’s earnings
D1
P0 E1

E1 kg

29 28
 SOURCES OF EARNINGS
GROWTH
• What causes growth?
• assume no new capital added
• retained earnings used to pay firm’s new investment
• If pt = the payout ratio in year t
• 1-pt = the retention ratio

35 29
 SOURCES OF EARNINGS
GROWTH
• Growth rate depends on
– the retention ratio
– average return on equity

42 30
 Sustainable Growth Rate
Using the sustainable growth rate to estimate g:

Sustainable growth rate = ROE x retention ratio

* 31
 Sustainable Growth Rate
Example
Assume ROE = 11%; EPS = $3.25; and
D(0) = $2.00

SGR = .11 x (1 - 2.00/3.25) = 4.23%

* 32
 Price Ratio Analysis
• Price/Cash flow ratio
– cash flow = net income + depreciation = cash flow
from operations or operating cash flow
• Price/Sales
– current stock price divided by annual sales per
share

* 33