Escolar Documentos
Profissional Documentos
Cultura Documentos
• f a preferred share of stock pays dividends of $1.80 per year, and the
required rate of return for the stock is 8%, then what is its intrinsic value?
• Solution:
• Here we use the dividend discount model formula for zero growth
dividend,
• Dividend Discount Model Formula = Intrinsic Value = Annual Dividends /
Required Rate of Return
• Intrinsic Value = $1.80/0.08 = $22.50.
• The shortcoming of the model above is that you’d expect most companies
to grow over time.
#2 – CONSTANT-GROWTH RATE DDM MODEL
• This model is designed to value the equity in a firm, with two stages of
growth, an initial period of higher growth and a subsequent period of
stable growth.
• Two-stage Dividend Discount Model; best suited for firms paying residual
cash in dividends while having moderate growth. For instance, it is more
reasonable to assume that a firm growing at 12% in the high growth period
will see its growth rate drops to 6% afterwards
• My take is that the companies with a higher dividend payout ratios may fit
such a model. As we note below such two companies – Coca-Cola and
PepsiCo. Both companies continue to pay dividends regularly and their
dividend payout ratio is between 70-80%. In addition, these two companies
show relatively stable growth rates.
ASSUMPTIONS Two stage Dividend Discount
Model DDM
•
• Higher growth rate is expected the first period.
• This higher growth rate will drop at the end of the first period to a
stable growth rate.
• The dividend payout ratio is consistent with the expected growth rate.
Two-stage DDM model – Example
• Sound Logic – The dividend discount model tries to value of the stock
based on all the future cash flow profile. Here the future cash flows is
nothing but the dividends. In addition, there is very less subjectivity in the
mathematical model, and hence, many analyst show faith in this model.
• Mature Business – The regular payment of dividends does imply that the
company has matured and there may not be much volatility associated
with the growth rates and earnings. This is important for investors who
prefer to invest in stocks that pay regular dividends.
• Consistency – Since dividends in most cases is paid by cash,
companies tend to keep their dividend payments in sync with the business
fundamentals. This implies that companies may not want to manipulate
dividend payments as they can directly lead to stock price volatility.
LIMITATIONS OF DIVIDEND DISCOUNT MODEL
• CEO Warren Buffett mentions that dividends are almost a last resort
for corporate management, suggesting companies should prefer to
reinvest in their businesses and seek “projects to become more
efficient, expand territorially, extend and improve product lines, or to
otherwise widen the economic moat separating the company from its
competitors.”
• By holding onto every dollar of cash possible, Berkshire has been able
to reinvest it at better returns than most shareholders would have
earned on their own.
• Amazon, Google, Biogen are other examples that don’t pay dividends and
have given some amazing returns to the shareholders.
• Can only be used to value Mature Companies – This model is efficient in
valuing companies that are mature and cannot value high growth
companies like Facebook, Twitter, Amazon and others.
LIMITATIONS OF DIVIDEND DISCOUNT MODEL
• The sensitivity of Assumptions – As we saw earlier, fair price is highly
sensitive to growth rates and required rate of return. 1 percent change in
these two can affect the valuation of the company by as much as 10-20%.
• May not be related to earnings – In theory, dividends should be correlated
to the earnings of the company. On the contrary, companies, however, try
to maintain a stable dividend payout instead of the variable payout based
on earnings. In many cases companies have even borrowed cash to pay
dividends.
Problem: Two-stage dividend growth
• A stock currently pays a dividend of $2 for the
year.
• Expected dividend growth is 20% for the next
three years and then growth is expected to
revert to 7% thereafter for an indefinite amount
of time.
• The appropriate required rate of return is 15%.
What is this stock’s intrinsic value?
Solution:
Note that the dividend in the fourth period is affected by the dividend growth in the
first stage as well as the dividend growth in the second stage, or D4 = D0 (1 + g1)n1
(1+g2).
Problem
• The Bulldog Company paid $1.5 of dividends this year.
• If its dividends are expected to grow at a rate of 3 percent per year,
what is the expected dividend per share for Bulldog five years from
today?
• D5 = D0 (1 + g) 5
• =$1.5 (1 + 0.03)5
• = $1.5 × 1.15927
• = $1.73891
Problem
• The current price of XYZ stock is $25 per share.
• If XYZ’s current dividend is $1 per share and investors’ required rate of
return is 10 percent,
• what is the expected growth rate of dividends for XYZ, based on the
constant growth dividend valuation model?
• P0 = D0 (1 + g)/ (re – g)
• $25 = $1 (1 + g) / (0.10 – g)
• $25 (0.10-g) = $1 + g
• $2.5 – 25g = $1 + g $1.5
• = 26 g
• g = 5.7692%
• Consider each of the above stocks,
Problem and solve for the missing element:
Problem Quiz
5-minute work-out: Stock valuation