DIVIDEND DISCOUNT MODEL

INRODUCTION
Definition: A procedure for valuing the price of stock by using predicting dividends and discounting them back to present value.

formulae
Intrinsic Value = Sum of Present Value of Future Cash Flows Intrinsic Value = Sum of Present Value of Dividends + Present Value of Stock Sale Price

3 MODELS
ZERO GROWTH MODEL CONSTATNT GROWTH MODEL VARIABLE GROWTH MODEL

Zero growth model

Assumption: dividend always stays the
same, the stock price is equal to the annual dividends divided by the required rate of return.

Stocks Intrinsic Value = Annual Dividends / Required Rate of Return

Example:
If 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?

Intrinsic Value of Preferred Stock = $1.80/0.08 = $22.50.

CONSTANT GROWTH MODEL

(Gordon Growth Model)

1st stage high growth phase 2nd stage- stable growth phase

VARIABLE GROWTH MODEL

1st stage- High Growth Phase
2nd stage- Declining growth phase

3rd stage- stable growth phase

Ex. Coca Cola

Earning per share in 2000= Dividend per share in 2000= Payout ration in 2000= $1.56 $0.69 44.23%

Return on Equity=
Beta= Risk free rate= Risk premium Risk premium
high growth= stable growth=

23.37%
0.80 5.4% 5.6% 5.0%

 Cost of equity

high growth

=5.4%+0.8(5.6%)=9.88% Cost of equity stable growth =5.4%+0.8(5.0%)=9.4%

Expected growth rate=Return on equity*Retention ratio

=0.2337*(1-0.4423) = 13.03%

DURING TRANSITION PHASE

Growth rate comes down to 5.5% as stable growth rate Assume ROE Retention ratio =20% (stable growth phase) =Exp. Growth rate/ ROE = 5.5%/20%=27.5%

Dividend Payout Ratio= 1-retention ratio = 1-27.5=72.5%

Terminal Price at the end of year 10

Cost of equity= EPS= Stable growth rate= Payout Ratio= Dps =4.33*72.5%=

9.4% $4.33 5.5% 72.5% $3.13

 PV of dividends in high growth phase = PV of dividends in transition phase=

$3.76 $5.46

PV of terminal price at the end of the transition phase=

$33.50

VALUE OF THE STOCK=$42.72

Wrong assumptions and limitations

Assumption-Companys growth rate always lower than Expected growth rate.

Stable growth rate over the next infinite years

Limitation of second stage growth model Valuing non-dividend paying or low dividend paying stocks