DIVIDEND DISCOUNT MODELS I. Valuing Common Stock as Present Value Problem a. Identify amount and timing of CFs b. Identify a discount rate c. DDM views CFs as dividends i. Why? Shareholders who buy and hold the stock into perpetuity receive only cash dividends as return ii. What about earnings not distributed as dividends? 1. they provide the basis for increases in future dividends, which will be captured by the model. iii. What about capital gains? 1. when a stock a pays a dividend, the stock price decreases the amount of the dividend. Therefore, forecasting dividends into perpetuity captures capital gains, as well. 2. Explicit forecast period and terminal value (value of all dividends beyond the explicit forecast period.) d. DDM Most suitable when: i. Company pays dividend ii. Established dividend policy with a consistent relationship to earnings/profitability over the long run. (Ex2-2, p.43) iii. Non-controlling perspective e. Free Cash Flow to the Firm (FCFF) and Free Cash Flow to Equity (FCFE) i. Use measures of FCF as the CF in our PV model ii. FCFF = operating cash flow – capital expenditures iii. FCFE = operating cash flow – capital expenditures – Interest Expense and Debt Repayments iv. Sometimes is problematic for firms that have intensive cap. exp. in the forecasting period. v. Most suitable when: 1. company does not pay a dividend 2. if dividend falls significantly short of the FCFE 3. FCF is consistent with the profitability of the firm 4. or if the investor takes a control perspective f. We can view CFs alternatively as Residual Income (e.g., EVA) i. Residual Income = Earnings – Required Return ii. Economic Profit = (ROIC – WACC) x Invested Capital iii. Most suitable when: 1. Company does not pay a dividend 2. FCFs that are negative over the explicit forecasting period 3. Alternative to the FCF model Types of Dividend Discount Models
II.
a. b. c. d. III. IV. V. VI.
Gordon Growth Model (Single-stage growth model) Two-stage Growth Model H-model Three-stage Growth Model
PV of Growth Opportunities (p.68) GGM and P/E Ratio (p.69) Strengths and weaknesses of DDM (p.71) Estimating cost of equity a. Risk-free rate = rf b. Market Risk Premium = MRP = E(Rm) - rf c. Beta DCF Models and the Execution Stop Sort stock into groups of interest o Sectors o Industries o Beta levels Rank stock in each group according to alpha o Ex-ante Alpha = E(R) – Required Return Select highest alpha stocks in each group to achieve o Desired weighting across groups o Desired weighting of individual stocks Estimating Growth Rate (PRAT) for Dividend Discount Model or other valuation model We saw how important this input is to the DDM. That is, the results of the DDM are sensitive to the growth rate g = ROE (b) where b = retention ratio ROE can be examined using the DuPont Formula ROE = Profitability X Asset Turnover X Leverage ROE = (NI/Sales) X (Sales/TA) X (1 + D/E) So if you can estimate trends in ROE and/or its three components, you can combine this information with the retention ratio to forecast the growth rate.
VII.
VIII.