273: M5 - Dividend Discount Model Flashcards
Basis of valuation for the dividend discount model
the basis for valuation is the premise that the value of any security is the present value of future cash flows which accrue to the holder of the investment.
Since dividends are much less certain and are completely discretionary and not required, what does the analyst have to do?
For stocks, future cash flows, in the form of dividend payments, are much less certain as dividend payments are completely discretionary and not required. This means the analyst needs to determine the appropriate discount rate as well as forecast dividend payments to utilize the dividend discount model.
What do investors use dividend payments as an indicator as?
Investors use dividend payments as an indicator of the overall financial health of the company, reductions in dividends have a strong, negative effect on stock prices. Thus, companies avoid reducing dividends unless it is absolutely unavoidable and only increase dividends when they are confident that the new dividend level will be sustainable.
Two types of dividends
Dividends can be distributed in the form of cash (cash dividend) or through the issuance of additional shares (stock dividend).
Company options in respect to cash flow
A company that generates cash flow has a couple of options with respect to the use of that cash flow. Excess cash flow can be reinvested back into the business to grow the business with the intention of increasing future cash flows. For this to be a viable option the expected return on investment should be greater than the company’s cost of capital.
If the company determines that growth opportunities are limited, management should make the decision to distribute excess cash flow to its’ shareholders in the form of dividends.
Drawback to Dividend discount model
An obvious drawback to the dividend discount model is it doesn’t seem to apply very well to companies that don’t pay dividends. The biggest drawback of the model is the sensitivity of the model to the discount rate. Very small changes in the discount rate can have massive impacts on the valuation. Further, the model is only as accurate as the dividend forecasts.
What is the historic equity risk premium
Historically, the equity risk premium has been approximately 5% so this should be viewed as a starting point for discount rates when using the DDM.
What is the gordon growth model?
GGM assumes that dividends grow at a constant rate in perpetuity and solves for the present value of the infinite series of future dividends.
Assumptions of the DDM
The model assumes the following:
that r > gr>g
that gg is constant
Note that if r<g then the value of the asset is infinite as the asset grows at a rate greater than its discount rate. It also critical that gg not be greater than a reasonable forecast for the long-term growth rate of the underlying economy. The logic is that a company cannot grow faster than the economy in perpetuity and therefore, its dividend growth rate is also limited to the growth of the economy.
Payout ratio
The payout ratio is calculated as Total Dividends /Net Income. A sustainable payout ratio is usually considered to be less than 50%. A ratio less than 50% allows the Company to reinvest the remainder into the business to maintain some growth.
Payout ratio analysis
A sustainable payout ratio is usually considered to be less than 50%. A ratio less than 50% allows the Company to reinvest the remainder into the business to maintain some growth.
Preferred shares risk
Preferred shares are LESS risky than common shares but are MORE risky than long-term debt
If a preferred share will pay a set dividend for a set period of time what happens to the growth rate
With a set dividend rate, the growth rate defaults to ZERO
what model do you use when there is no set maturity date for a preferred share? what about when there is a set maturity date?
No set date = perpetuity formula
Set date = annuity formula
what is the cost of capital in preferred shares
the cost of capital in preferred shares is the market yield
