Basic tools for share valuation- Dividend

Discount Model
Gladman Moyana
Monash South Africa
Semester 1, 2018, Corporate Finance A
 Key Concepts and Skills
Understand why share prices depend on future dividends and
dividend growth(Gordon’s Dividend Discount model)

Be able to compute share prices using the various forms of the

dividend growth model

Know how to use the free cash flow, Dividend Discount Model
and other valuation models

Understand how share markets work

Understand how share prices are quoted

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 Structure of lecture

 Slides 4 to 11 relates to all valuations

 Slides 12 to 35 are specific to DDM

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Quotations

“every individual
endeavor to employ
his capital so that it
“Beauty is in the
maybe of greatest
eyes of the
value…he only
beholder”
intends his security,
his gain”. Adam
Smith,

“there are many

ways to the top of
“He is not my type” the mountain-but
only one view-
Harry Milner

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Valuation is inherently subjective

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 Some Critical Concepts
 Valuation is futuristic in outlook and therefore the focus in on future
cash flows
 Because valuation is inherently futuristic, there is a huge emphasis on
maintainable or sustainable free cash flow (for free cash flow based
valuations), maintainable dividends (for dividend discount based
valuations) and maintainable earnings (for earnings based valuations).
 Maintainable earnings/dividends or cash flows as used above means
that the earnings are expected to be sustainable in future (for at least
the unforeseeable future) should be used in the valuation. Roughly, an
item is considered to be maintainable if it recurs in the future.
Valuations should therefore be adjusted for items of income and
expenditure that are not maintainable. Basing our valuation, and thus
extrapolating non- maintainable cash flows or earnings generally
tends to overstate the valuation.
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 Some Critical Concepts
 The term valuation as applies to any asset means that we are
calculating the present value of future cash flows using an appropriate
discount rate, which is usually the required rate of return. So it is
clear that they are two inputs to any valuation, namely the future cash
flows and the discount rate.
 Depending on the valuation method used, the cash flows are defined
differently .

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Alternative Valuation Methods
 Discounted cash flow valuations
– Free cash flow model
– Dividend discount model / “Dividend Yield”
 Price multiples valuations
– Price/ earnings ratios or earnings yield
– Price/cash earnings ratios
– Market/book ratios
– Price/sales ratios
 Balance sheet valuations(Net Asset Value Based Methods)
– Book value
– Liquidation value
– Replacement value
Prof Wiseman’s Tutorial note : How do we make a decision between the
alternative valuation methods( Refer to class discussion). The question
may not state the method to use. Use the decision three discussed in
lecture. You need to have a conceptual understanding of the methods-no
parrot fashion style …it is important to identify and isolate the cash
flows and appropriate discount rate for above methods, where
applicable. That is the key to successfully performing equity valuations.

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 Steps in carrying valuations- the considerations

 Purpose of valuation- for whom for what

 Date of valuation- will enable you to identify the base year.
 Parties involved, buyer, seller and reason for sale
 What is being valued; equity (10%, 100% etc, pref shares, bonds held y
company).
This will assist you to perform any sub-valuations. The key here is that
other investments that the main company has will be valued separately
as they have a different risk to the main business. They maybe valued
using a valuation method that is different from the main valuation of
company

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 Steps in carrying valuations- the considerations

 Choice of valuation method

 Sustainable/maintainable earnings- here we adjust for extraordinary
/unreasonable and non- recurring items in our earnings as earnings are
our starting point, we would need them to be representative of the
future earning potential of the business since we are valuing an income
stream ( of future cash flows).There will be some transitory, non
recurring items that are not sustainable. For earnings based valuations
such as the dividend yield and the Earnings yield/PE multiple, the net
profit should be used as a reasonability test.
 For Free cash flow valuations, we need to determine the “maintainable
free cash flow “
 Determine the reasonable rate of return- such as dividend yield,
earnings yield and WACC and cost of equity

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 Steps in carrying valuations- the considerations

 Perform the valuation(bulk of the marks lie here)

 Test for reasonableness using other methods not used in main
valuation. This is called stress testing
 Recommendation and negotiating factors- use the quantitative and
qualitative factors in the question such as the accumulated goodwill.

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The Idea behind DDM Valuation
 If you buy a share, you can receive cash in two ways
– The company pays dividends
– You sell your shares, either to another investor in the
market or back to the company
 As with bonds, the price of the share is the present value
of these expected (future)cash flows

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One Period Example
 Suppose you are thinking of purchasing the shares from
Ncube Oil and you expect it to pay a R2 dividend in one
year and you believe that you can sell the share for R14 at
that time. If you require a return of 20% on investments of
this risk, what is the maximum you would be willing to
pay?
– Compute the PV(MV) of the expected cash flows

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Two Period Example
 Now what if you decide to hold the
shares for two years? In addition to the
dividend in one year, you expect a
dividend of R2,10 in year 2 and a share
price of R14,70 at the end of year 2. Now
how much would you be willing to pay?

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Developing the Dividend Discount Model(DDM)

 You could continue to push back when you would sell the shares
 You would find that the price of the shares is really just the present
value of all expected future dividends

 So, how can we estimate all future dividend payments?

 Prof Wiseman’s Tutorial Note: company might not be currently paying
dividends and we thus we might need to make certain assumptions
about future dividends. Valuation is forward looking, thus future
dividends affect value. Sometimes we know the dividend but not the
expected pattern of dividend growth. Refer to the next slide on these
special assumptions about dividend growth.

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 Some thoughts on DDM and all discounted cash flow (DCF)
methods
 The rational for discounting dividends and all other future cash flows arise
from the fact that money has time value, a rand in two years’ time is not worth
a rand today
 A DCF method requires two inputs, a cash flow and a discount rate used to
take time value of money into account.
 If the investment is not risk free, then one of two adjustments need to be made
 Adjust the cash flow
 Adjust the discount rate
 DO NOT ADJUST BOTH AS THAT CAUSES DOUBLE COUNTING.
 The basic premise of DDM method is that the major cash flows arise from
dividends and the sale of the share where applicable. Does this method
ignore the retained earnings (earnings not used to pay dividends)?

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 Relevance of current dividends
 Can a non dividend paying company use DDM
 10% cumulative preference shares with a nominal value of R4 200 000
issued on 30 June 2015.Preference share dividends will not be paid in
2016, 2017. The outstanding preference dividends, together with the
2018 dividends will be paid in 2018 and from 2019 onwards, the usual
dividend will resume. The market related dividend rate is 15%.
 Required
 (a) Discuss whether DDM can be used to value these pref shares
 (b) Calculate the value of these pref share using DDM

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 The Dividend Discount Model
 Dividend discount model / “Dividend Yield” – present value a
dividend paying company using an appropriate discount rate.

Cash Flow Discount rate

Forthcoming or future Dividend Yield or more
dividends, which are based appropriately the required
on maintainable earnings. rate of return on equity
(calculated from CAPM,
M&M’s proposition 11 or the
rate implied by using a
futuristic dividend discount
model

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Variations of DDM

Dividend Yield
Valuation

Supernormal Constant
Growth Growth
model Model

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 Variations of the Dividend Discount Model(DDM)

1. Dividend yield Valuation

 Share price will be = P0 = D1/ Re. Essentially, we are valuing a
perpetuity. Most important thing is to calculate maintainable earnings on
which to base sustainable dividend( Remember DPO* EPS= DPS)
 Required Rate of Return (RE)= D1/PO.
 Therefore there is no growth in dividends
 This is used to value minority shareholding, for a dividend paying firm,
for which there is no growth
 This can also be referred to as the “constant dividend” valuation method
– The firm will pay a constant dividend forever
– This is like preferred shares
– The price is computed using the perpetuity formula

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 Summary - Dividend yield valuation

Cash Flow Discount rate

Forthcoming or future dividends, which The rate implied by using a futuristic

are based on maintainable earnings. dividend discount model

RE= D1/PO

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The basic formation of Dividend yield valuation-Zero
Growth

 If dividends are expected at regular intervals forever, then this is like

preferred shares and is valued as a perpetuity
 P0 = D / R
 Suppose shares are expected to pay a R0,50 dividend every quarter
and the required return is 10% with quarterly compounding. What is
the price?
P0 = 0,50 / (0,1 / 4) = R20
 The dividend of 50cents should be based on sustainable earnings
and sustainable Dividend Payout Rate (DPO).
DPS= DPO*EPS

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 Variations of DDM
2. Constant dividend growth
Gordon’s growth Model : P0 = D1 / Re-g
The firm will increase the dividend by a constant percent every period
Gordon’ growth Model Inputs
 R- Discount rate( required rate of return)
 D0- Dividend just paid/last dividend/this year’s dividend
 g- dividend growth rate/ sustainable growth rate(ROE*RR)
 D1- forthcoming/future dividend= D0(1+g) (g is expressed in percent)
 The implicit assumption is that the share price will grow at the same
rate as the dividend growth rate.

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 Summary of Constant Growth Model
Cash Flow Discount Rate
D1- forthcoming/future dividend = Re – g

Re is the cost of equity.

D0(1+g) (g is expressed in percent)
g is the long term sustainable growth
rate

g= ROE * RR

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DGM – Example
 Suppose TB Pirates, Inc. is expected to
pay a R2 dividend in one year. If the
dividend is expected to grow at 5% per
year and the required return is 20%, what
is the price?

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Variations of DDM
 Supernormal growth
– Dividend growth is not consistent initially, but settles down to
constant growth eventually

Tutorial note: What is the implication of the dividend settling at this

constant growth for your methodology of valuation. Is this at all
different from the constant dividend? A third variation is
therefore the supernormal growth model that assumes that
growth fluctuates during the planning period and settles at a
lower long term sustainable growth rate from the representative
year onwards. This means that perpetuity has to be valued at
n-1.

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Supernormal (Non-constant Growth)

 Suppose a firm is expected to increase dividends by

20% in one year and by 15% in two years. After that
dividends will increase at a rate of 5% per year
indefinitely. If the last dividend was R1 and the
required return is 20%, what is the price of the
stock?
 Remember that we have to find the PV of all
expected future dividends.

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Prof Wiseman’s Tutorial note on:
Supernormal growth and intuitive valuation of related cash flows
 The intuition used to value any multi-stage(supernormal) cash flows is simple
– First identify and value the cash flows in the “planning period” when the
cash flow(dividend growth rate was not constant, in our example, the
related cash flows will be :
– D1 = C1=1(1,2) = R1,20
– D2 =C2= 1,20(1,15) = R1,38

– Second value the perpetuity in the representative year or mature phase

(year in which the growth rate stabilises), that is year 3 in our example,
– P2 = D3 / (R – g) = 1,449 / (0,2 – 0,05) = 9,66

– The present (current)value in year 0 (of the perpetuity) is calculated using

n-1. Thus the 9.66 perpetuity value in year 3 is present valued at n of 2,
thus

– C1= R1,20,C2= R1,38+ 9,66=11,04; PV@ 20% = 8.67

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Other useful concepts related to DDM

Using the
DGM to Find
RRR

Components
of the
required rate
of return

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 Using the DGM to Find R
 Start with the DGM:

D 0 ( 1  g) D1
P0  
R-g R -g
rearrange and solve for R
D 0 ( 1  g) D1
R g  g
P0 P0

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Finding the Required Return - Example

 Suppose a firm’s shares are selling for

R10,50. They just paid a R1 dividend and
dividends are expected to grow at 5% per
year. What is the required return?
– R = [1(1,05)/10,50] + 0,05 = 15%
 What is the dividend yield?
– 1(1,05) / 10,50 = 10%
 What is the capital gains yield?
– g =5%

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 Components of the required rate of return
 In valuations at this stage, we can assume RRR is given
 From Gordon’ Dividend Discount Model: P0= D1/R-g
 Thus R= D1/P0+ g
 D1/P0 is the dividend yield
 g is the capital growth(growth in the share price)- remember shares
grow at the same rate as the dividends
 Therefore RRR= Dividend yield plus Capital gains growth
 Illustration given P0= R20, dividend growth of 10% and next dividend of
R1

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 Some essential concepts relating to time period
 Remember, we have two time periods which affect the way we calculate the
value for the firm using a supernormal model:
 Planning period-period in which growth is still fluctuating- use the CF function to
value these cash flows. We might be required to determine these growth rates.
Lets leave it for third year!!
 Representative year- year in which growth has stabilized to its long run
sustainable level- use perpetuity formula (taking growth into account) to value
these cash flows and obtain the current value(year 0 value) using n-1. Note that
is a question does not give us this growth rate this is the rate implied by
ROE*RR
 NNB:Then add current value of cash flows in both these periods

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Relationship between Free Cash Flow Valuation and
DDM Supernormal Growth Model

Dividend Planning Representative Free Cash

Discount Model Horizon year Flow Valuation

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 Relationship between Free Cash Flow Valuation and DDM
Supernormal Growth Model-Concluding Remarks
 This relationship is explored further next week as we will discover that:

 FCF valuation only uses special definitions to determine the cash flow
that would be dividend in the other model. That is why the FCF
valuation and DDM are called Discounted Cash Flow (DCF) valuations
as they discount cash flows to their present values

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