FINVEST Discounted Dividend Valuation Slides

11/21/2009
1
Discounted Dividend Discounted Dividend
Valuation Valuation
Investment Analysis and Portfolio Management (FINVEST)
K31 & K32 - 2
nd
Term - AY 2009-2010
Mr. Clive Manuel O. Wee Sit, CTP
Discounted Cash Flow Models Discounted Cash Flow Models
In DCF models, the value of any asset is
the present value of its (expected) future
cash flows
where V
0
is the value of the asset as of
t=0 (today), CF
t
is the (expected) cash
flow at time t, and r is the discount rate
or required rate of return
( )
= +
=
1
0
1 t
t
t
r
CF
V
Alternative Cash Flows Alternative Cash Flows
Several alternative streams of expected
cash flows can be used to value equities:
Dividends
Free Cash Flow
Residual Income
Discounted Dividend Approach Discounted Dividend Approach
A discounted dividend approach is most
suitable for:
Dividend-paying stocks
Companies with a discernable dividend policy
that has an understandable relationship to the
companys profitability
Firms where investors have a non-control
(minority ownership) perspective
Free Cash Flow Approach Free Cash Flow Approach
The free cash flow approach (FCFF or
FCFE) might be appropriate when:
Company does not pay dividends
Dividends differ substantially from FCFE
Free cash flows align with profitability
Investor takes a control (majority ownership)
perspective
Residual Income Approach Residual Income Approach
The residual income approach can be
useful when:
Company does not pay dividends (as an
alternative to a FCF approach)
Free cash flow is negative
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Required Rate of Return, Required Rate of Return,
The required rate of return is the
minimum rate of return that an investor
would anticipate receiving in order to
invest in an asset.
The two major approaches to determining
the cost of equity are an equilibrium
method (CAPM or APT) and the bond yield
plus risk premium method.
Equity Risk Premium Equity Risk Premium
The equity risk premium for use in the
CAPM approach can be based on historical
return data or based explicitly on
expectational data.
DDM for a Single Holding Period DDM for a Single Holding Period
The DDM with a single holding period
gives stock value as
where D
t
is the expected dividend at time
t (here t=1) and V
t
is the stocks
(expected) value at time t
( ) ( ) ( )
1
1 1
1
1
1
1
0
1 1 1 r
P D
r
P
r
D
V
+
+
=
+
+
+
=
Problem 1:
Suppose that you expect Carrefour SA
(NYSE Euronext Paris: CA) to pay a C1.10
dividend next year. You expect the price
of CA stock to be C53.55 in one year. The
required rate of return for CA stock is 9
percent. What is your estimate of the
value of CA stock?
Solution to Problem 1:
( ) ( )
14 . 50
09 . 1
65 . 54
09 . 0 1
55 . 53 10 . 1
1
1 1
1 1
0
= =
+
+
=
+
+
=
r
P D
V
Expected HPR for Single Holding Expected HPR for Single Holding
Period DDM Period DDM
Assuming that V
0
is equal to todays
market price, P
0
, the expected holding
period return is
0
0 1
0
1
0
1 1
1
P
P P
P
D
P
P D
r

+ =
+
=
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Problem 2:
The current stock price of DaimlerChrysler
AG ADR (NYSE: DCX) 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 DCX at the
current market price, what return do you
expect to earn over one year?
% 27 . 14 1427 . 0
1 1427 . 1
1
70 . 44
08 . 51
1
70 . 44
00 . 49 08 . 2
1
0
1 1
= =
=
=
+
=
+
=
P
P D
r
The expected return of 14.27
percent is the sum of the
expected dividend yield of
D
1
/P
0
= 2.08/44.70 = 4.65
percent and the expected
capital appreciation of (P
1
-
P
0
)/P
0
= (49.00-44.70)/44.70 =
9.62 percent.
Expected HPR differs from required rates
of return when price does not exactly
reflect value.
When price does not equal value, there
will generally be an additional component
to the expected holding period return
reflecting the convergence of price to
value.
General Form of DDM General Form of DDM
The expression for the DDM for any finite
holding period n and the general
expression for the DDM are, respectively,
( ) ( )
=
+
+
+
=
n
t
n
n
t
t
r
P
r
D
V
1
0
1 1
( )
=
+
=
1
0
1
t
t
t
r
D
V
Problem 3:
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 required
return on equity is 10 percent, what is the
value of this stock?
( ) ( ) ( ) ( ) ( ) ( )
76 . 34
10 . 1
00 . 40
10 . 1
75 . 3
10 . 1
50 . 3
10 . 1
20 . 2
10 . 1
10 . 2
10 . 1
00 . 2
5 5 4 3 2 1 0
= + + + + + = V
The five dividends have a total present value of $9.926 and the terminal
stock value has a present value of $24.837, for a total stock value of
$34.76.
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Forecasting Dividends Forecasting Dividends
There are two main approaches to the
problem of forecasting dividends:
First Approach: Assign the entire stream of
expected future dividends to one of several
stylized growth patterns
Leads to Gordon growth model and multistage
dividend discount models
Forecasting Dividends Forecasting Dividends
There are two main approaches to the
problem of forecasting dividends:
Second Approach: Forecast a finite number of
dividends individually up to a terminal point,
valuing the remaining dividends by assigning
them to a stylized growth pattern, or
forecasting share price as of the terminal point
of our dividend forecasts
Spreadsheet modeling
Gordon Growth Model Gordon Growth Model
The Gordon growth model assumes that
dividends grow at a constant rate g
forever, so that . The dividend
stream in the Gordon growth model has a
value of
where r > g.
( ) g D D
t t
+ =

1
1
( )
g r
g D
V
+
=
1
0
0
g r
D
V
=
1
0
Problem 4:
- Sonoco Products Companys (NYSE: SON)
most recent quarterly dividend was $0.26.
- Its forecasted dividend growth rate is 6.0
percent per year.
- Its beta is 1.13, the equity risk premium
is 4.5 percent, and the risk-free rate is 5
percent.
Questions for Problem 4:
Calculate the Gordon growth model value
for SON stock.
The current market price of SON stock is
$30.18. Using your answer to the
previous question, judge whether SON
stock is fairly valued, undervalued, or
overvalued.
Solution to Question 1 of Problem 4:
Solution to Question 2 of Problem 4:
The market price of $30.18 is $3.29 or
approximately 12 percent more than the Gordon
growth model intrinsic value estimate of $26.89.
SON appears to be overvalued.
( )
89 . 26 $
041 . 0
10 . 1 $
06 . 0 101 . 0
06 . 1 04 . 1 $ 1
0
0
= =
+
=
g r
g D
V
11/21/2009
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Perpetual Preferred Stock Perpetual Preferred Stock
Valuation Valuation
The value of a fixed rate perpetual
preferred stock is
where D is the stocks (constant) annual
dividend
r
D
V =
0
Valuation Valuation
Problem 5:
The Royal Bank of Scotland Preferred J
(NYSE: RBS-J) stock pays an annual
dividend of $2.36 and has a required
return of 9.06 percent. What is the value
of this preferred stock?
Valuation Valuation
Answer to Problem 5:
05 . 26 $
0906 . 0
36 . 2
0
= = =
r
D
V
Expected Rate of Return Estimate Expected Rate of Return Estimate
(GGM) (GGM)
Assuming that price equals value, the
Gordon growth model estimate of a
stocks expected rate of return is
( )
g
P
D
g
P
g D
r + = +
+
=
0
1
0
0
1
(GGM) (GGM)
Problem 6:
The FPL Group, Inc. (NYSE: FPL) paid
dividends of $2.24 during the past year,
and the current stock price is $56.60.
Analysts estimate of the companys long-
term earnings and dividend growth rate is
5.50 percent. Using the Gordon growth
model, what is FPLs expected rate of
return?
(GGM) (GGM)
FPLs expected rate of return
is 9.67 percent. The total
return can be broken down
into two components, the
dividend yield (D
1
/P
0
= 4.17
percent) and the capital gains
yield (g = 5.50 percent).
% 67 . 9 0967 . 0
055 . 0 0417 . 0
055 . 0
60 . 56
363 . 2
0
1
= =
+ =
+ =
+ = g
P
D
r
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Implied Dividend Growth Rate Implied Dividend Growth Rate
(GGM) (GGM)
Given an estimate of the next-period
dividend and the stocks required rate of
return, we can use the Gordon growth
model to estimate the dividend growth
rate implied by the current market price
(making a constant growth rate
assumption).
(GGM) (GGM)
Problem 7:
Suppose a company has a required rate of
return of 12.2 percent. The current
dividend of $2.00 is expected to grow at 5
percent indefinitely. What is the value of
the companys stock? The price of the
stock is $40; what dividend growth rate
would be required to justify a $40 price?
(GGM) (GGM)
17 . 29 $
072 . 0
10 . 2
05 . 0 122 . 0
) 05 . 1 ( 00 . 2
1
0
= =
=
g r
D
V
( )
% 86 . 6 0686 . 0
88 . 2 42
2 2 40 88 . 4
122 . 0
1 00 . 2
40
= =
=
+ = =
+
=
g
g
g g
g
g
Present Value of Growth Present Value of Growth
Opportunities (PVGO) Opportunities (PVGO)
The present value of growth opportunities
(PVGO) is the part of the stocks total value, V
0
,
that comes from profitable future growth
opportunities in contrast to the value associated
with assets already in place. The relationship is
where E/r is defined as the no-growth value per
share.
PVGO
r
E
V + =
0
Problem 8:
Connecticut Water Service, Inc., (Nasdaq
NMS: CTWS) has current earnings of
$1.27 and a current price of $30. What is
the present value of CTWSs growth
opportunities assuming a 6.2 percent
required rate of return?
52 . 9 $ 48 . 20 $ 30 $
48 . 20 $ 30 $
0
= =
+ =
+ =
PVGO
PVGO
PVGO
r
E
V The market assigns 32
percent of the companys
value to the value of
growth ($9.52/$30) =
0.317.
11/21/2009
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Justified Price Justified Price--Earnings Ratio Earnings Ratio
We can express the leading price-earnings ratio (P
0
/E
1
) and
the trailing price-earnings ratio (P
0
/E
0
) in terms of the
Gordon growth model as, respectively,
The above expressions give a stocks justified price-
earnings ratio based on forecasts of fundamentals (given
that the Gordon growth model is appropriate)
g r
b
g r
E D
E
P
=
1 /
1 1
1
0
( ) ( )( )
g r
g b
g r
E g D
E
P
+
=
+
=
1 1 / 1
0 0
0
0
Problem 9:
An analyst wants to use the Gordon
growth model to find the justified P/E for
the French Company Carrefour SA
(Euronext: CA). He assembled the
following information: r = 9.76 percent;
P
0
= C56.94; E
0
= C1.837; D
0
= C0.575; g
= 8.18 percent.
( ) 313 . 0
837 . 1
575 . 0
1
0
0
= = =
E
D
b
( )
8 . 19
0818 . 0 0976 . 0
313 . 0 1
1
0
=
=
g r
b
E
P
( )( ) ( )
4 . 21
0818 . 0 0976 . 0
0818 . 1 313 . 0 1 1
0
0
=
+
=
g r
g b
E
P
Based on a current price
of 56.94 and trailing
earnings of 1.837, the
trailing P/E is 56.94/
1.837 = 31.0. Because
the actual P/E of 31.0 is
> the justified trailing P/E
of 21.4, CA appears to be
overvalued.
Strength of Gordon Growth Model Strength of Gordon Growth Model
The Gordon growth model may be useful
for valuing broad-based equity indexes
and the stock of businesses with earnings
that we expect to grow at a stable rate
comparable to or lower than the nominal
growth rate of the economy.
Weakness of Gordon Growth Model Weakness of Gordon Growth Model
Gordon growth model values are very
sensitive to the assumed growth rate and
required rate of return.
( )
g r
g D
V
+
=
1
0
0
Stages of Growth for a Company Stages of Growth for a Company
Growth Phase. Company enjoys an abnormally
high growth rate in earnings per share, called
supernormal growth.
Transition Phase. Earnings growth slows.
Mature Phase. Company reaches an equilibrium
in which factors such as earnings growth and the
return on equity stabilize at levels that can be
sustained long term.
Analysts often apply multistage DCF models to
value the stock of a firm with multistage growth
prospects
11/21/2009
8
Two Two--Stage Dividend Discount Stage Dividend Discount
Model Model
The two-stage dividend discount model
assumes different growth rates in Stage 1
and Stage 2
where g
s
is the expected dividend growth
rate in the first period and g
L
is the
expected growth rate in the second period
( )
( )
( ) ( )
( ) ( )
= +
+ +
+
+
+
=
n
t
L
n
L
n
s
t
t
s
g r r
g g D
r
g D
V
1
0 0
0
1
1 1
1
1
Terminal Stock Value, Terminal Stock Value,
The terminal stock value, V

n
, is
sometimes found with the Gordon growth
model or with some other method, such
as applying a P/E multiplier to forecasted
EPS as of the terminal date.
Problem 10:
In the past year, DuPont (NYSE: DD) paid
a $1.40 dividend that an analyst expects
to grow at 9.3 percent annually for the
next four years. At the end of year 4, the
analyst expects the dividend to equal 40
percent of EPS and the trailing P/E for DD
to be 11. What is the terminal stock
value?

( ) ( )
9472 . 54 0 . 11 9952 . 4 /
9952 . 4
40 . 0
9981 . 1
40 . 0
40 . 0
9981 . 1 093 . 0 1 40 . 1 1
4 4
4
4
4 4
4 4
0 4
= = =
= = =
=
= + = + =
E P E V
D
E
E D
g D D
HH--Model Model
The H-Model assumes that the dividend
growth rate declines linearly from a high
supernormal rate to the normal growth
rate during Stage 1, and then grows at a
constant normal growth thereafter:
( ) ( )
( ) ( )
L
L s L
L
L s
L
L
g r
g g H D g D
g r
g g H D
g r
g D
V
+ +
=
+
=
0 0
0 0
0
1
1
HH--Model Model
Problem 11:
You are valuing Siemens AG (Frankfurt:
SIE) with the H-model approach. Current
dividend is C1.00; the dividend growth
rate is 29.28 percent, declining linearly
over a 16-year period to a final and
perpetual growth rate of 7.26 percent;
required rate of return is 12.63 percent.
Use the H-model to value SIE.
11/21/2009
9
HH--Model Model
( ) ( )
( ) ( )( )
77 . 52 80 . 32 97 . 19
0726 . 0 1263 . 0
0726 . 0 2928 . 0 8 00 . 1
0726 . 0 1263 . 0
0726 . 1 00 . 1
1
0 0
0
= + =
+
=
L
L S
L
L
g r
g g H D
g r
g D
V
Three Three--Stage Dividend Discount Stage Dividend Discount
Models Models
There are two basic types of three-stage
models:
Growth rate is constant in each of the three
stages
Growth rate is constant in stage 1, declines
linearly in stage 2, and becomes constant and
normal in Stage 3
Spreadsheet Modeling Spreadsheet Modeling
Spreadsheet models are very flexible,
providing the analyst with the ability to
value any pattern of expected dividends.
Expected Rates of Return for DDMs Expected Rates of Return for DDMs
In addition to valuing equities, DDMs are useful to
find expected rates of return. For simpler models
(like the one-period model, the Gordon growth
model, and the H-model), well-known formulas may
be used to calculate these rates of return.
For many dividend streams, however, the rate of
return must be found by trial and error, producing a
discount rate that equates the present value of the
forecasted dividend stream to the current market
price.
Adjustments to the expected return estimates may be
needed to reflect the convergence of price to value.
Expected Rate of Return for H Expected Rate of Return for H--
Model Model
For the H-model, the expected rate of
return can be derived as
When the short- and long-term growth
rates are the same, the model reduces to
the Gordon growth model.
( ) ( ) [ ]
L L S L
g g g H g
P
D
r + + +
= 1
0
0
Model Model
Problem 12:
For a security with a current dividend of
$1, a current price of $20, and an
expected short-term growth rate of 10
percent declining over 10 years (H=5) to
6 percent, what is the expected rate of
return?
11/21/2009
10
Model Model
( ) ( ) [ ] % 3 . 12 06 . 0 06 . 0 10 . 0 5 06 . 0 1
20
1
= + + +
= r
Multistage Dividend Discount Models Multistage Dividend Discount Models
Multistage DDM models can accommodate
a wide variety of patterns of expected
dividends.
Even though such models may used
stylized assumptions about growth, they
can provide useful approximations.
Multistage Dividend Discount Models Multistage Dividend Discount Models
Values for multistage DDMs are generally
sensitive to assumptions.
The usefulness of such values reflects the
quality of the inputs.
Sustainable Growth Rate, Sustainable Growth Rate,
We define the sustainable growth rate as
the rate of dividend (and earnings) growth
that can be sustained for a given level of
equity, keeping the capital structure constant
over time and without issuing additional
common stock.
The reason to study this concept is that it can
help us estimate a stable growth rate in a
Gordon growth model valuation, or the
mature growth rate in a multistage DDM in
which we use the Gordon growth model
formula for the terminal value of the stock.
A practical logic for defining sustainable in
terms of growth through internally
generated funds (retained earnings) is
that external equity (secondary issues of
stock) is considerably more costly than
internal equity (reinvested earnings),
because of the investment banker fees.
Dividend growth rates can be obtained from
analyst forecasts, from statistical forecasting
models, or from company fundamentals.
The sustainable growth rate depends on the ROE
and the earnings retention rate, b: g = b x ROE.
This expression can be expanded further, using
the DuPont formula, as
SHE
Assets
Assets
Sales
Sales
NI
NI
Div NI
g
=
11/21/2009
11
Problem 13:
Beggai Enterpises has an ROA of 10
percent, retains 30 percent of earnings,
and has an equity multiplier of 1.25.
Mondale Enterprises also has an ROA of
10 percent, but it retains two-thirds of
earnings and has an equity multiplier of
2.00. What dividend growth rates should
these two companies have?
Answers to Problem 13:
Baggai:
Mondale:
% 75 . 3 25 . 1 % 10 30 . 0 = = g
( ) % 33 . 13 00 . 2 % 10 3 / 2 = = g
References References
Equity Asset Valuation by Stowe,
Robinson, Pinto, & McLeavey, 2007
Equity, CFA Program Level 2 Curriculum
(2010)

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11/21/2009

The terminal stock value, V

Answer to Problem 10:

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