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Lecture 4 - DCF Valuation (The Discounted Dividend Model)

 When is it best to use DDM to arrive at the equity value of a company and why?
o Dividend paying company
 Important since dividends is a form of return investors would expect
to return
 Companies reinvest retained earnings to support growth in future
earnings, dividends and stock price, hence capital gain is implicit in
the model
 Dividends are less volatile than free cash flows, the other form of
return considered by the other two DCF models -> depends on
investment environment
 In theory, we can use DDM for a non-dividend paying stock, as we
can infer an educated guess, but in practice this is different. This is
due to:
 Highly speculative and unreliable to predict timing of dividend
 No past dividend policy to estimate the size of future
o Company has an established, reasonable dividend policy that is
understandable and bears a consistent relationship to the company’s
 Future earnings can be forecasted under a relatively stable and
constant dividend payout ratio, 𝑘 where =𝑘
 Considerations
o Does the company have the relevant cash flows
(liquidity), franking credits from tax and sufficient
o Actual distributions, including dividends and buybacks, are close to FCFE over
an extended period
 We use FCFE since accounting profits are accrual. It represents the
maximum amount a company can afford to distribute to its common
shareholders without any impact on its operating and investment
needs and capital management decisions
 DDM is suitable if:
𝑇𝑜𝑡𝑎𝑙 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑎𝑛𝑑 𝐵𝑢𝑦𝑏𝑎𝑐𝑘𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑙𝑎𝑠𝑡 5 𝑦𝑒𝑎𝑟𝑠
80% ≤ ≤ 110%
𝑇𝑜𝑡𝑎𝑙 𝐹𝐶𝐹𝐸 𝑖𝑛 𝑡ℎ𝑒 𝑙𝑎𝑠𝑡 5 𝑦𝑒𝑎𝑟𝑠

 FCFE = Net Profit + net non-cash charges (no cash flow associated
with the expense in the income statement e.g. depreciation) –
investments in fixed and working capital – (debt repayment – new
loan) -> (financing decisions)
 If a company pays a significantly higher/lower amount of distributions
of dividends and buybacks in excess of FCFE -> intrinsic value
greater/lower than market value -> undervalued/overvalued stock
 Variants of the Discounted Dividend Model
o Gordon (one-stage) growth model
𝐷𝑃𝑆0 (1 + 𝑔) 𝐷𝑃𝑆1 𝐸𝑃𝑆1 × 𝑘
𝑃0 = = =
𝑘𝑒 − 𝑔 𝑘𝑒 − 𝑔 𝑘𝑒 − 𝑔
 Implications:
 Stock price will grow at the same constant rate as dividends
( 𝑡+1 − 1 = 𝑔)
 Total stock return will remain constant since dividend yield (if
you look at the ratio of div. yield between years it is equal to
1) and capital growth is constant by the same reason
 Earnings will grow at the same rate as dividends
o In a low interest rate environment, high dividend
paying stocks (infrastructure, mature stocks) can be
computed using the one stage DDM model, however if
interest rates rise, the cost of debt rises and thus, the
ability to payout a high dividend yield comes into
 When is it best to use the Gordon growth model to value stocks?
 The current expected earnings growth rate of the company is
less than equal to the growth rate of the economy
o These type of firms are generally well-established,
mature firms who represent the average firm in the
industry and thus are bounded by the growth of the
 What are the types of stocks that the Gordon growth model works
best for?
 Valuing broad equity market indices in developed stock
markets - represent a large percentage of the overall
corporate sector, these indices would reflect average
economic growth rate – depends on the level of development
of equity markets
 Companies that provide an essential service in a regulated
environment tend to have modest and stable earnings growth
due to limited bargaining power (growth is constrained) – tend
to be mature, profitable and dividend paying.
o These companies can afford a consistent dividend
policy that aims to maintain or increase the dividend
per share at a rate that is close to or equal to the
growth rate of the economy
 How do we arrive at the growth rate of the economy for use in DCF
 For companies that operate on a global scale; we find the
sales revenue weighted nominal GDP growth rate as the
upper bound
 To find the earnings growth, we use Dupont’s model
o 𝑔𝑡 = 𝑏𝑡−1 × 𝑅𝑂𝐸𝑡 where 𝑏 is the earnings retention
ratio (i.e. 1 – Payout Ratio) and
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
𝑅𝑂𝐸 = 𝑺𝒂𝒍𝒆𝒔 × 𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔 × 𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓𝒔′ 𝑬𝒒𝒖𝒊𝒕𝒚
o This model highlights all the possible growth sources
(i.e. from retained earnings, net profit margin, total
asset turnover, leverage)
 Net profit margin (NPM) is the amount of net
income obtained from each dollar of sales. NPM
is dependent on the firm’s competitive position.
It tends to mean revert over time due to
entrance of competitors or existing competitors
adopting the same strategy
 Total asset turnover (TAT) is the amount of
sales generated by each dollar of invested
asset. TAT is largely industry-specific. It tends to
be stable over time and may differ across firms
due to their different strategies
 Leverage is the amount of assets funded by
common equity. Leverage tends to be stable
over time and largely industry-specific, e.g.,
financial firms tend to have larger leverage than
biotech firms.
o Two-Stage DDM
 There are two stages of dividend growth – an initial extraordinary
growth phase that lasts for a short term of n years with dividend
growing at a different rate (𝑔𝐻𝐺 ) from (usually but not necessary
larger than) the 2nd and final phase of stable growth during which the
growth rate (𝑔𝑆𝐺 ) remains unchanged over the long term
 Three cases:
 Growth rate increases linearly during the initial extraordinary
phase of 𝑛 years
 Growth rate remains stable during the initial extraordinary
phase of 𝑛 years (Basic Version)
𝐷𝑃𝑆𝑛 (1 + 𝑔𝑆𝑇 )
𝑡 [ ]
𝐷𝑃𝑆0 (1 + 𝑔𝐻𝐺 ) 𝑘𝑒,𝑆𝑇 − 𝑔𝑆𝑇
𝑃0 = ∑ 𝑡 + 𝑛
𝑡=1 (1 + 𝑘 𝑒,𝐻𝐺 ) (1 + 𝑘𝑒,𝐻𝐺 )
 Growth rate decreases linearly during the initial extraordinary
phase of 𝑛 years (H-Model)
 Considering the basic version and assuming that the payout ratio
remains unchanged throughout both growth phases:
𝐸𝑃𝑆𝑛 (1 + 𝑔𝑆𝑇 ) × 𝑃𝑎𝑦𝑜𝑢𝑡𝑆𝑇
(1 ) 𝑡 [ ]
𝐸𝑃𝑆0 + 𝑔𝐻𝐺 × 𝑃𝑎𝑦𝑜𝑢𝑡𝐻𝐺 𝑘𝑒,𝑆𝑇 − 𝑔𝑆𝑇
𝑃0 = ∑ 𝑡 + 𝑛
𝑡=1 (1 + 𝑘𝑒,𝐻𝐺 ) (1 + 𝑘𝑒,𝐻𝐺 )
 The same property of a one-stage model applies (i.e DPS and
EPS grow at their respective growth rates in each phase)
 When is it best to use the 2-stage dividend growth model to value
 𝑔𝑒𝑐𝑜𝑛𝑜𝑚𝑦 ≤ 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 ≤
𝑔𝑒𝑐𝑜𝑛𝑜𝑚𝑦 + 10%
 Generally companies that:
o Possess patent rights to very profitable products
(biotech companies)
o Industry with significant barriers to entry due to legal
(limited licenses) or infrastructure (high startup costs)
 These companies are likely to enjoy high growth (above the
growth rate of the economy) over the short term. When the
patents expire and the barriers to entry are removed abruptly
or gradually, their earnings growth will fall back into stable
 How best to estimate the inputs of the basic version (equally
applicable to the H-model)?
 High growth period
o 𝑘𝑒,𝐻𝐺 – Estimate it using CAPM (see lecture 2)
o 𝐸𝑃𝑆0 – Collect the actual figure from the most recent
financial report
o 𝑝𝑎𝑦𝑜𝑢𝑡𝐻𝐺 – Study company’s dividend policy over the
last 5-10 years
o 𝑔𝐻𝐺 – DuPont’s model taking into consideration any
events affecting NPM, TAT and leverage or ROE as a
o 𝑛 - firms will take a longer time to reach stable growth
if they are relatively small in size -> market share
potential is high and their excess return (𝑅𝑂𝐸 >
𝑘𝑒,𝐻𝐺 ) and competitive position is relatively high and
 Stable growth period
o Lower investment needs so lower retention ratio and
higher payout ratio
o Projects that bring large NPV will be hard to find due to
erosion of competitive advantage -> 𝑅𝑂𝐸 → 𝑘𝑒,𝑆𝑇
o At best, 𝑔𝑆𝑇 = 𝑔𝑒𝑐𝑜𝑛𝑜𝑚𝑦 (for the year)
o The firm tends to have average risk with beta in the
range of 0.8-1.2
o Tend to have higher financial leverage – mature firms
tend to have better credit rating and thus, lower cost
of debt
o Two scenarios:
 When 𝑅𝑂𝐸𝑆𝑇 = 𝑘𝑒,𝑆𝑇
 𝑔𝑆𝑇 = 𝑔𝑒𝑐𝑜𝑛𝑜𝑚𝑦 (long term)
 When computing 𝑘𝑒,𝑆𝑇 :
o Adjust the bottom-up beta
computed for extraordinary
growth if it is not within the
range of 0.8-1.2 – if beta is
below/above 0.8/0.12, use a
larger/smaller beta closer to
o Average implied MRP
o Govt. bond series for risk-free
 When 𝑅𝑂𝐸𝑆𝑇 ≠ 𝑘𝑒,𝑆𝑇
 Then there is an incentive to reinvest
o Reinvestment Rate = 𝑅𝑂𝐸𝑆𝑇
o It represents the amount of
excess return you add to the cost
of equity to arrive at 𝑅𝑂𝐸𝑆𝑇
o A proxy that could be used the
average industry ROE
o Payout Ratio = 1 – Reinvestment
Rate (i.e. same as earnings
 The stable growth period valuation can be
simplified to:
(1 )
𝐸𝑃𝑆𝑛 + 𝑔𝑆𝑇 × 𝑃𝑎𝑦𝑜𝑢𝑡𝑆𝑇 𝐸𝑃𝑆𝑛 (1 + 𝑔𝑆𝑇 )
[ ] [ ]
𝑘𝑒,𝑆𝑇 − 𝑔𝑆𝑇 𝑘𝑒,𝑆𝑇
𝑛 = 𝑛
(1 + 𝑘𝑒,𝐻𝐺 ) (1 + 𝑘𝑒,𝐻𝐺 )
o Three-Stage DDM
 𝑔𝑠 ≥ 𝑔𝑒𝑐𝑜𝑛𝑜𝑚𝑦 + 10%
 Under the Bloomberg approach there are four variants classifying the
time spent in each stage of firm growth:
 Explosive growth: 3 years of gs / 14 years transition into
sustainable gL
 High growth: 5/10
 Average growth: 7/10
 Slow /mature growth: 9/6
Factors of determining the variants (metric for growth)
 Changes in EPS to price ratio (earnings yield) over past years
 Sales per share growth over the past 3 / 5 years
 % in change in price over the past 12 month
 I/ B/ E/ S forecast 2-year earnings growth

Process used to clarify a company to its appropriate DDM version

 Collect the sample average of the changes in earnings yield, sales per share growth,
% in change in price and the forecasted earnings growth of each firm in the industry
 Calculate the standard deviation of each metric and for the company measure the
number of standard deviations above or below the sample mean
 For each metric of growth, assign a score based on Bloomberg’s reference scores.
Then apply equal weights to each score (i.e. ¼) and then add the weighted scores
corresponding to each metric’s standard deviation
 Once we have all the scores of the firms used for peer comparison in the same
industry as our selected company, we need to assign a weight to each variant
 Assuming that ⅔ firms are average growth, we can weigh the other three variants as
a sum of the remaining third (i.e. 1/6, 1/12, 1/12)
 Partition the companies into their respective variants based on the weights of each
variant as well as the scores from highest to lowest (highest denoting explosive
growth and lowest denoting slow/mature growth)
 Determine which variant the chosen company belongs to base on its score relative to
its peer’s scores
 For stocks that exhibit large deviations from the mean, the greater likelihood the
share price will turn around in the upcoming years (anomaly from FINS2624
‘winner’s curse problem’)