20: Discounted Dividend Valuation Flashcards
Dividends are appropriate as a measure of cash flow in the following cases:
The company has a history of dividend payments.
The dividend policy is clear and related to the earnings of the firm.
The perspective is that of a minority shareholder.
primary advantage of using dividends as the definition of cash flow
theoretically justified
dividends are less volatile than other measures
primary disadvantage of using dividends as the definition of cash flow
difficult to implement for firms that don’t currently pay dividends
takes the perspective of an investor who owns a minority stake in the firm and cannot control the dividend policy
three predominant definitions of future cash flows
dividends, free cash flow, and residual income
Free cash flow to the firm (FCFF)
cash flow generated by the firm’s operations that is in excess of the capital investment required to sustain the firm’s current productive capacity.
Free cash flow to equity (FCFE)
cash available to stockholders after funding capital requirements and expenses associated with debt financing.
Free cash flow models are most appropriate:
For firms that do not have a dividend payment history or have a dividend payment history that is not clearly and appropriately related to earnings.
For firms with free cash flow that corresponds with their profitability.
When the valuation perspective is that of a controlling shareholder.
Residual income
amount of earnings during the period that exceeds the investors’ required return
The residual income approach is most appropriate for:
Firms that do not have dividend histories.
Firms that have negative free cash flow for the foreseeable future (usually due to capital demands).
Firms with transparent financial reporting and high-quality earnings.
One-Period DDM
Multi-Period DDM
We can use one of several growth models, including the:
Gordon constant growth model.
Two-stage growth model.
H-model.
Three-stage growth model.
The Gordon growth model (GGM) assumes
dividends increase at a constant rate indefinitely
Example: Calculating value with the Gordon growth model
DownUnder Financial recently paid a dividend of 1.80 Australian dollars (A$). An analyst has examined the financial statements and historical dividend policy of DownUnder and expects that the firm’s dividend rate will grow at a constant rate of 3.5% indefinitely. The analyst also determines DownUnder’s beta is 1.5, the risk-free rate is 4%, and the expected return on the market portfolio is 8%. Calculate the current value of DownUnder’s shares.
Gordon growth model (GGM) formula
value of non-callable fixed-rate perpetual preferred stock.
The Gordon growth model (GGM) has a number of characteristics that make it useful and appropriate for many applications
Is applicable to stable, mature firms
There are also some characteristics that limit the applications of the GGM:
Valuations are very sensitive to estimates of r and g
The model cannot be easily applied to non-dividend-paying stocks.
Unpredictable growth patterns of some firms would make using the model difficult
Example: Calculating PVGO
Reliable, Inc.’s shares trade at 60.00 Swiss francs (Sf) with expected earnings of Sf 5.00 per share and a required return of 10%. Suppose that the shares are properly priced, so price is equal to fundamental value. Calculate the PVGO and the portion of the leading P/E related to PVGO.
present value of the growth opportunities (PVGO) formula
justified leading P/E
justified trailing P/E
Example: Calculating justified leading and trailing P/E
Alliance, Inc., is currently selling for $16.00 on current earnings of $3.00 and a current dividend of $1.50. Dividends are expected to grow at 3.5% per year indefinitely. The risk-free rate is 4%, the market equity risk premium is 6%, and Alliance’s beta is estimated to be 1.1. Calculate the justified leading and trailing P/E ratios of Alliance, Inc.
Example: Estimating terminal value
Level Partners is expected to have earnings in ten years of $12 per share, a dividend payout ratio of 50%, and a required return of 11%. At that time, the dividend growth rate is expected to fall to 4% in perpetuity, and the trailing P/E ratio is forecasted to be eight times earnings. Estimate the terminal value at the end of ten years using the Gordon growth model and the P/E multiple.
Two-Stage Model Formula
Example: Calculating value with a two-stage DDM
Sea Island Recreation currently pays a dividend of $1.00. An analyst forecasts growth of 10% for the next three years, followed by 4% growth in perpetuity thereafter. The required return is 12%. Calculate the current value per share.
Example: Valuing a non-dividend-paying stock
Arena Distributors is a new company and currently pays no dividends. The company recently reported earnings of $1.50 per share and is expected to grow at a 15% rate for the next four years. Beginning in Year 5, Arena is expected to distribute 20% of its earnings in the form of dividends and to have a constant growth rate of 5%. The required rate of return is 12%. Calculate the value of Arena shares today.
Valuation Using the H-Model
Example: Calculating value with the H-model
Omega Foods currently pays a dividend of €2.00. The growth rate, which is currently 20%, is expected to decline linearly over the next ten years to a stable rate of 5% thereafter. The required return is 12%. Calculate the current value of Omega.
sustainable growth rate (SGR)
rate at which earnings (and dividends) can continue to grow indefinitely
SGR Formula
SGR = b × ROE
where:
b = earnings retention rate = 1 − dividend payout rate
ROE = return on equity
demonstrate the use of DuPont analysis to estimate a company’s sustainable growth rate.
Example: Calculating ROE and SGR
Halo Construction has been successful in a mature industry. Over the last three years, Halo has averaged a profit margin of 10%, a total asset turnover of 1.8, and a leverage ratio of 1.25. Assuming Halo continues to distribute 40% of its earnings as dividends, calculate its long-term SGR.
Answer:
g = P × R × A × T
g = 0.10 × (1 − 0.4) × 1.8 × 1.25 = 0.135 = 13.5%
