Professor K.

Ozgur Demirtas
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CHAPTER 12 - EQUITY VALUATION

A. The Dividend Discounting Model

a. Advantages and Disadvantages of the DDM

Advantages:

1. Very intuitive - it is easy to understand the DDM in that dividends are cash flows paid
directly to shareholders.
2. Easy to apply - as we will see below, the DDM is straightforward in its use.

Disadvantages:

1. Obviously, the DDM only works for firms which pay dividends. Many firms do not pay
dividends.
2. This model does not explicitly account for risk. We know that the discount rate impounds
risk to some extent, but we do not understand the exact relationship between risk and return.
3. As we will see below, often, we need to make an estimate of the firm’s growth rate, g. This
can be difficult to do in practice.
4. As seen in point (2) above, we are not able to explicitly account for risk. This implies there
is uncertainty about estimating an appropriate discount rate, r. This is another potential
source of error in valuing stocks through the DDM.
5. Estimates of the stocks’ value are very sensitive to our estimates of g and r. The latter
estimates can be problematic as seen in points (3) and (4) above.

b. Constant Dividends Paid

The simplest application of the DDM is for dividends that do not change. While this is
seldom true for common equity, this is what we see for preferred equity. Here, we simply take
the present value of a perpetuity, where the cash flow is the stock’s constant dividend.

P = D/r

where D = constant dividend

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Example: suppose a firm’s preferred stock pays an annual dividend of $1.75. The shareholders
require a return of 14% on this stock. Find the stock’s price needed to provide that return.

P = 1.75/0.14 = 12.50 per share

c. Constantly Growing Dividends (Gordon Growth Model)

One stated goal of virtually every firm is to grow. Expected firm growth should than be
impounded in the share price. For firms that are expected to grow at a constant rate (g),

P = D0(1+g) + D0(1+g)2 + ... + D0(1+g)

(1+r) (1+r)2 (1+r)

(We will focus on the details of the above representation in class)

Solving this equation appears intractable since there are an infinite number of terms in the
equation. Fortunately, this equation reduces to a simplified form known as the Gordon growth
model.

P = P0 = D0(1+g) = D1
r-g r-g

where D1 = next period’s dividend

r = D1 + g
P0

income growth

Put another way, the shareholders’ required rate of return equals the dividend yield plus the
growth rate (capital gains rate).

What about g? Net income belongs to S/H. The firm can do 2 things with the net income:
spend it or save it. Spending it is analogous to paying dividends. Saving it is analogous to
retaining earnings. This addition to retained earnings divided by the total net income is the
plowback ratio and is denoted by b.

Why wouldn’t S/H want to get all the net income paid out in dividends? If the firm’s
management can reinvest the earnings and get a return > r, S/H come out ahead for a given level
of risk equal to the firm’s level of risk. This comes from a firm accepting positive NPV projects,

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which by definition provide a rate of return greater than r. This discount rate often comes from
CAPM.

Example: suppose a firm has just paid a dividend of 2.50. The firm is expected to grow at 8%
per year for the foreseeable future. An appropriate discount rate is 12%.

P0 = 2.50(1+0.08) = 2.70 = 67.50

0.12-0.08 0.12-0.08

Example: above, we described a disadvantage of the DDM, namely that the valuations were
sensitive to estimates of growth rates and discount rates. This example illustrates the point.
Consider a firm with an estimated dividend paid next year of $1.35. Estimates of the discount
rate for equity range from 13% to 15% and estimates of growth range from 7% to 11%. Let’s
look at the highest and lowest possible share prices and see what the difference is:

Plowest = 1.35 = 16.875

0.15-0.07

Phighest = 1.35 = 67.50

0.13-0.11

Depending on the estimates of g and r, we see that a share price of anywhere between 16.875 and
67.50 is justifiable!

Constant Growth DDM (Gordon Model) Assumptions

1. Annual growth of dividends is constant, indefinitely.

2. Price appreciation is constant, indefinitely.
3. Dividend payout ratio is constant, indefinitely.
4. ROE is constant, indefinitely.
5. r is constant, indefinitely.
6. r > g, indefinitely.

Advantages and Disadvantages of Constant Growth DDM

Advantages of the constant growth model include:

1) logical, theoretical basis
2) simple to compute, and
3) inputs can be estimated.

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Disadvantages include
1) very sensitive to the difference between r and g
2) g and r difficult to estimate accurately
3) result is meaningless if g > r,
4) constant growth is an unrealistic assumption
5) dividend payout must remain constant
6) not usable for firms paying no dividends

d. Supernormal Growth (Multistage Growth Model)

Some firms, such as Microsoft, experience periods of explosive (supernormal) growth.

The use of the constant growth model is inappropriate because (1) growth is not constant - the
growth is too high to be sustainable and (2) the growth rate would exceed the discount rate (r).
When the firm’s growth rate exceeds r, the use of the constant growth model would lead to a
negative share price. Obviously, this is not appropriate, thus we must do something else to value
such firms’ stock.

What we need to do here is to estimate and discount each period’s dividend over the
length of time the growth is supernormal. After this time, growth should level off to a steady-
state (g) and the constant growth model may then be applied to discount the remaining dividends.

Example: suppose Growth Unlimited has just paid a $1 dividend. Over the next 3 years, you
estimate the dividends will increase 50%, 25% and 20% respectively. After that, dividends
should grow at 10% per year. An appropriate discount rate for this firm is 15%. Find the stock
price.

P0 = D1 + D2 + D3 + D4 1
(1+r) (1+r)2 (1+r)3 (r - g) (1+r)3

D1 = 1(1.50) = 1.50
D2 = 1(1.50)(1.25) = 1.875
D3 = 1(1.50)(1.25)(1.20) = 2.25
D4 = 1(1.50)(1.25)(1.20)(1.10) = 2.475

P0 = 1.50 + 1.875 + 2.25 + 2.475 1 = 36.75

(1.15) (1.15)2 (1.15)3 0.15-0.10 (1.15)3

Aside: since we already know that P0 = D1/(r-g), it is easy to extend this logic to say that

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P3 = D4/(r-g). Thus, we can rewrite this valuation formula to read:

P0 = D1 + D2 + D3 + P3
(1+r) (1+r)2 (1+r)3 (1+r)3

Advantages with the two-stage model relative to the constant growth model include:

1. The two-stage model is more realistic. It accounts for low, high, or zero growth in the first
stage, followed by constant long-term growth in the second stage.

2. The model can solve for stock value when the growth rate in the first stage exceeds the
required rate of return.

e. Sustainable Growth Rate Estimation

A firm’s sustainable growth rate (g) is defined as the growth rate the firm can achieve
without increasing financial leverage. This growth rate may also be thought of as the growth rate
of the book value of equity. In equation form,

g = b*ROE

where:

b = fraction of net income retained by the firm (plowback ratio)

ROE = return on equity (net income/book value of equity)

The more of its earnings a firm retains, the more the book value of equity will rise. However, as
this plowback ratio rises, the fraction of net income paid in dividends necessarily falls. In effect,
this is a “There’s no such thing as a free lunch” argument. When a firm has a positive net
income, it can retain it (increasing retained earnings, thus increasing the book value of equity) or
it can spend it (paying out dividends). If the fraction of earnings retained increases, the fraction
paid in dividends must decrease.

What effect does this decision on what the retention ratio will be have on share price? The
answer hinges upon whether the ROE is greater than, less than or equal to the required rate of
return (r). If the ROE exceeds r, the firm is investing the shareholders’ money wisely and the
firm should retain more of its earnings. If the ROE is less than r, the firm is doing a poor job
with shareholders’ money, hence the firm should pay out a greater fraction of earnings in
dividends. If the ROE is equal to r, then it doesn’t matter what fraction of net income is retained
versus paid out in dividends.

ROE is a measure of what S/H earn for a return. If the firm pays all its income as dividends, it
will not grow (assuming no external equity financing). Thus, growth is financed by retaining

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earnings. I have left debt financing out of this argument because we are valuing just equity.
Growth here is defined by increases in dividends, so we focus on ROE since dividends only
accrue to S/H, we look at just the rate of return on equity itself, not total assets.

Hence, g = b * ROE

Ex: assume that discount rate (capitalization rate) is 12.5% and a company pays all of its
earnings as dividends which amounts to $5 per share. Find the current stock price. What will
happen to the stock price if the company managers think that there are good investment
opportunities and retain 60% of the earnings (plowback ratio), when the return on equity of the
stock is ROE=0.15 ? Why do you think the stock price increase, when the dividends paid to
investors decrease?

P=$5/0.125= $40 (price with no growth)

growth=ROE*b=0.15*0.60= 9%

P=$2/(0.125-0.09)=$57.14 (price with growth where ROE>r)

Observe that the dividends falls from $5 to $2=$5*(1-plowback ratio=b)

( will solve couple of examples in class)

Alternative Valuation Methods

a. The Price/Earnings Ratios
(i) The Price/Earnings Ratio and Growth Opportunities
The Price/Earnings Multiple is:

Price Price per share

P/E = Earnings = Earnings per share

Or, rewriting, we get:

 
P0 1 PVGO 
E1 = 1 + E1 
r 
 r 

where PVGO = present value of growth opportunities.

(Don’t worry, I will go over PVGO in detail !!)

If PVGO = 0, then:

P0 = E1/r = E1 [1/r], that is, a perpetuity of value E1.

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and the P/E ratio is then simply 1/r.

As PVGO rises, the P/E ratio rises.

Another way to interpret P/E is:

Recall that:

P0 = D1 = (1-b)E1
r-g r-g

This implies that the P/E is:

P0 = 1 - b
E1 r-g

As ROE rises, the P/E ratio rises.

As b rises, P/E rises as long as ROE > r.

What if ROE<=r ?

Use of the P/E multiple in equity valuation

Suppose a firm’s P/E ratio have averaged a given value over the past several years
and you feel that this value remains appropriate at the present time. To value the
stock using this value, multiply your earnings per share forecast by this P/E ratio
to estimate the stock price.

Example: suppose for your firm of interest, the average P/E ratio has been 18.5. You
forecast that the firm should earn $4.20 per share next year. The share price should be:

P = (P/E) * EPS
P = 18.5 * 4.20
P = 77.70

ii. Pitfalls in P/E Analysis

1. The P/E ratio is based on accounting earnings. These numbers can be

manipulated.
2. P/E ratios tend to be lower when inflation is higher; that is, earnings in
periods of higher inflation are perceived of as of lower quality, or distorted

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by inflation, resulting in lower P/E ratios.

3. P/E ratios assume that earnings increase at a constant rate; in reality,
earnings fluctuate.
4. The P/E ratios discussed above are based upon forecasted earnings; P/E
ratios published in the financial pages of the newspaper are based upon
historical earnings.
5. Firm earnings might vary dramatically over time.

iii. Combining P/E Analysis and the DDM

The P/E ratio can be used (with caution) to forecast the horizon value (P/E x EPS)
of the stock as shown in the equation below:

P0 = D1 + D2 + D3 + (P/E)(EPS)
(1+r) (1+r)2 (1+r)3 (1+r)3

b. The Price/Book Ratio

Here, the stock price is divided by the book value per share. Well-managed firms will
have a price/book (P/B) ratio greater than one since good management will add value to the firm.
Skilled management will be able to successfully exploit such opportunities. This is impounded
in the share price.

The biggest advantage of the P/B method over the P/E method is that accounting earnings
can be extremely volatile. If earnings are very low or even negative, the P/E ratio can become
astronomically higher, or even negative. These problems do not exist when the book value of
equity is used.

c. The Price/Sales Ratio

This model is another alternative to examine whether the stock is overvalued or

undervalued.

To conclude, be careful in your analysis, however. Earnings can be manipulated via inventory or
depreciation method changes, deferring preventive maintenance, cutting back on R&D... Note
that all of these methods are perfectly legal. There are of course a number of illegal ways of
doing this as well. Inflation is also a concern in that it can artificially inflate earnings. Focus on

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the buying power of earnings as we had done earlier in the course when we talked about bond
coupon reinvestment risk.

If a firm does not pay dividends, discount the free cash flow for the firm at the weighted average
cost of capital, then subtract the debt’s value to get the value of equity.

In this analysis, since the firm is being valued, a discount rate appropriate for the firm as a whole
should be used. This is the weighted average cost of capital, as noted above.

One can use these valuation models and compare the results to the current market price and see if
you feel shares are mispriced. It’s probably a good idea to use 2 or 3 models and see how wide
the estimates are spread. You may find that your estimate differs quite a bit from the market’s.
You may be right (though I must admit, I would go over my dividend growth estimates and/or
earnings estimates carefully). I make no pretenses that I believe market efficiency is perfect,
especially at the firm level. My main point is this: do your due diligence. There is hope yet for
those willing to do their homework.