Lecture 8

By
Shobhit Aggarwal
Dividend discount model
Dividend Discount Model
 This is the simplest discounted cash flow method
which views dividend as the only cash flows from
a share
 The underlying principle is that the value of any
stock is the present value of all its expected
future dividends
 The model is from the perspective of a minority
shareholder
Dividend Discount Model
 The model represents the value of a stock as
 Value per share = DPS1/(1+ke) + DPS2/(1+ke)2 + ……
 The model has two basic inputs
 Expected dividends
 Estimated using growth rates and payout ratios
 Cost of equity
 Estimated through various cost of equity models
Dividend Discount Model

 Positives
 Dividends are less volatile than other measures of cash
flows
 Negatives
 Difficult to implement for firms that do not currently pay
dividends
 Dividend payout policy is not stable
 Takes the view of a passive shareholder
 Dividend policy is rarely a true reflection of earnings
capability
Gordon Growth Model
 Basic assumption
 Dividends will increase at a constant rate forever
 Value of stock = DPS1/(ke – g)
 Where DPS1 is the dividend expected in the next time
period, ke is cost of equity and g is sustainable growth
rate
 Positives
 Ease of understanding and application
 Can be used to determine implied rates of growth,
required rate of return and multiples
Gordon Growth Model
 Stable growth rate
 This growth rate would be similar to the growth rate of
other operating metrics of the firm
 It has to be lesser than or equal to the economy and
industry average growth rates
 For cyclical firms an average growth rate can be taken if
they are in mature phase
 This is because dividends are generally smooth even though
earnings vary
Gordon Growth Model
 When to use?
 Company has a history of dividend payments
 Dividend policy is clear and relates to earnings of the
firm
 Perspective is that of a minority shareholder
Gordon Growth Model - Illustration
 An electric utility which supplies power to
residential and commercial areas of a city and is
regulated by the government is a possible
candidate for DDM valuation
 ABC Electric’s average dividend payout ratio is
60%
 Last dividend paid was INR 5 per share
 Average ROE was 10%
 Risk free rate is 5.4%, risk premium is 4% and
beta is 0.9
Implied growth rate
 This model can be used to find what growth rates
is the market assuming given the current market
price, dividend and cost of equity
 Find the expected growth rates priced in the
market in the above example, if the current market
price is 90
Two stage DDM
 As the name suggests, this model assumes an
initial growth phase where the company’s growth
rate is different from the stable growth rate
 The initial phase growth rate can be higher, lower
or negative as well
 Assuming constant growth rate and cost of equity
in high growth phase, the price can be derived as
 P0 = DPS0 * (1+g) *[1 - {(1+g)/(1+kehg)}^n]/(kehg-g) +
DPSn+1/[(kest – g) * (1 + kehg)^n]
Two stage DDM
 The constraints on terminal growth rate and
payout ratios for the second phase are similar as
in the Gordon Growth Model
 The cost of equity in the stable phase should be
more stable brought about by a lesser beta
 Limitations of the model
 Length of the extraordinary growth
 The abrupt change from the extraordinary growth to
stable growth
 The value will be under-estimated for firms that pay-out
too little as dividends
Two stage DDM - Illustration
 A firm is estimated to have a high growth for the
next 5 years. The payout ratio in these five years
is estimated at 50% and the ROE at 24%. The
EPS is estimated to be USD 3 per share. For the
high growth phase, the beta is estimated to be 1.1,
the risk premium at 5% and the risk-free rate at
4%
 The payout in stable growth phase is expected to
be 70%, the ROE at 10%, the beta at 0.9 and the
other variable are expected to be constant
Valuing entire market
 Using the DDM, we can value the entire market as well
 By assuming a dividend yield and expected growth rate for
the entire market, any index can be valued
 The cost of equity model has to assume a beta of 1
 The growth rate has to be lesser than or equal to economy
growth rate
 Assume that an index trading at 5000, with a dividend yield
of 5%, a growth rate of 4%, risk-free rate of 4% and risk
premium of 4.5%. Find the fair value of the index
Finding value of growth
 Value of growth opportunities can be found out by
finding value with and without growth
 The value of growth depends on
 Growth rate during extraordinary period
 Length of extraordinary growth period
 Profitability of projects
 Riskiness of the firm
H-model
 The model assumes that growth starts at a high
growth rate of ga and declines linearly to a stable
growth rate of gst over 2H time periods
 Another assumption is that dividend payout and
cost of equity remain unaffected
 In such a case, the value can be represented as
 P0 = DPS0 * ( 1 + gst)/(ke – gst) + DPS0 * H * (ga – gst)/ (ke
– gst)
H-model - Illustration
 A firm pays a dividend of $0.72 and has its current
growth at 12%
 This growth in expected to reduce to 5% over 10
years
 The beta is 0.8, The risk-free rate is 5.1% and the
risk premium is 4%
 Find the value of the company’s share
Three stage model
 This model combines the features of the two-stage
and the H-model
 It assumes an initial high growth phase, a gradual
decline and a stable phase
 It puts no restrictions on the payout ratio
 The downside is that it requires a huge number of
inputs
 Appropriate for young and growing firms
Issues in DDM
 The model is not very effective when applied to
low-dividend or non-dividend paying companies
 The model is conservative in estimating value and
misses out other sources of value
 Brands
 Stock buybacks
 Unutilized assets
 Highly sensitive to growth and cost of equity
assumptions
Thank You