Here, we are presenting a method of valuation for companies that already pay dividends to their shareholders. The dividend discount models use forecasted dividends as the estimate of cash flow to the shareholders.
The primary advantage of dividends as a measure of cash flow is that dividends are less volatile than other measures (earnings, free cash flows), and therefore the value estimates derived from dividend discount models are less volatile and reflect the long-term earning potential of the company.
Dividend valuation models are appropriate for:
A company that has a history of dividend payments
The dividend policy is clear and related to earnings of the company
The Perspective is that of a minority shareholder
Example
Let’s consider Company XYZ that has the following earnings per share and dividends per share:
Earnings have grown every year while dividends have been constant, resulting in a decrease in the dividend payout ratio. Therefore, we see that the dividend policy is not consistent with the earning trend, which indicates that dividend discount model is not appropriate for this case.
It is important to emphasize that two important assumptions must be taken at the initial stage of the valuation:
Determine the appropriate discount rate to apply
Determine the estimated company’s sustainable growth rate
Those two factors could impact drastically the valuation of your company if they are wrongly estimated. The key to reduce the risk of error is to mandate Business Analysts who combine their high level of experience in your industry with the use Monte Carlo Simulation.
One-Period DDM
We can calculate the value of the stock today (V0) given the expected dividend in one year (D1), the expected price in one year (P1) and the required return (r):
Example
Let’s consider that Company XYZ is expected to pay a dividend at the end of the year of $ 1.00. The analyst estimates the required return to be 10% and the expected price at the end of the year to be $20.00. The current price is $ 18.00.
According to the One-Period DDM, the current value of the stock must be equal to
V0 = ($ 1.00 + $ 20.00)/1.10 = $ 19.09
XYZ is therefore undervalued. The current market price of $ 18.00 is less than the fundamental value of $ 19.09.
Multi-Period DDM
We can calculate the value of the stock today (V0) given the expected dividends in years i (Di), the expected price at the end of year n (Pn) and the required return (r):
Example
Company XYZ is expected to pay dividends of $ 1.00 and $ 1.50 at the end of the next two years. The analysts expect the price of stock at the end of this 2-year holding period to be $ 20.00. The required rate of return is 10%.
According to the Multi-Period DDM, the current value of the stock must be:
V0 = ($ 1.00/1.1) + ($ 1.50 + $ 20.00)/(1.10²) = $ 18.68
The DDM requires to accurately forecast dividends for many periods, which is difficult to do in practice. Solutions exist to forecast dividends up to the end of the investment horizon:
Gordon constant growth model
Two-stage growth model
H-model
Three-stage growth model
Gordon Constant Growth Model
The Gordon Growth Model assumes that dividends increase at a constant growth rate indefinitely (g) and the growth rate is less than the required return.
We can calculate the value of the stock today (V0) given the dividend just paid, the dividend growth rate (g) and the required return (r):
A company’s growth rate projections can be compared to the growth of the economy to determine if it can continue indefinitely. In general, if g > 5% it is suspect.
The Gordon constant growth model is:
Applicable to stable, mature and dividend-paying firms
Appropriate for valuing market indices
Very sensitive to estimates of growth rates and required rates of returns
Example
Company XYZ paid recently a dividend of $1.00. The analysts expect that the dividend rate will grow at constant rate of 4% indefinitely and the required return is 10%.
According to Gordon constant growth model, the current value of the stock must be:
V0 = ($ 1.00 x 1.04)/(0.10-0.04) = $ 17.33
Two-Stage Growth Model
The two-stage growth model assumes the company grows at a high rate (gS) for a relatively short period of time (the first stage) and then reverts to a long-run perpetual growth rate (gL) (the second stage).
This situation would apply to a company which has a patent that will expire.
H-Model
The H-model approximates the value of a company assuming that an initially high rate of growth declines linearly over a specified period. With H=t/2, the half-life (in years) of high-growth period.
Three-Stage Growth Model
A three-stage model can be used to estimate the value of the company. This method is identical to the two-stage model.
Article written by Tristan Van Iersel
Sources: CFA curriculum 2015