Chapter

4 Dividend Discounted
Model approach

Instructor: Pham Ha
4.1 Equity Valuation
• Book Value
• Net worth of common equity according to a
firm’s balance sheet
• Limitations of Book Value
• Liquidation value: Net amount realized by selling
assets of firm and paying off debt
• Replacement cost: Cost to replace firm’s assets
• Tobin’s q: Ratio of firm’s market value to
replacement cost

2
Table 4.1 Apple and Alphabet Financial Highlights, April 2017

3
4.2 Intrinsic Value versus Market Price

• = expected dividend per share

• = current share price
• = expected end-of-year price
Example: Suppose you purchased a share of DAR Inc. for $40 in January. You
expect to sell it for $42 in December and expect to receive a dividend of $2.42
during that year. What is your expected HPR?

E ( D1 ) + [ E ( P1 ) − P0 ] $2.42 + $42 − 40
HPR = E (r ) = = = .1105 = 11.05%
P0 40
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4.2 Intrinsic Value versus Market Price
• Intrinsic Value
• Present value of firm’s expected future net cash
flows discounted by required RoR
• Market Capitalization Rate
• Market-consensus estimate of appropriate
discount rate for firm’s cash flows

5
4.2 Intrinsic Value versus Market Price
• Intrinsic Value
𝐸 𝐷1 +𝐸(𝑃1 )
• 𝑉0 =
1+𝑘
• For holding period H
𝐷1 𝐷2 𝐷𝐻 +𝑃𝐻
• 𝑉0 = + +⋯+
1+𝑘 (1+𝑘)2 (1+𝑘)𝐻

• Dividend Discount Model (DDM)

• Formula for intrinsic value of firm equal to
present value of all expected future dividends

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4.3 Dividend Discount Models
• Constant-Growth DDM
• Form of DDM that assumes dividends will grow
at constant rate
𝐷1
• 𝑉0 =
𝑘−𝑔

• Implies stock’s value greater if:

• Larger dividend per share
• Lower market capitalization rate, k
• Higher expected growth rate of dividends

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4.3 Dividend Discount Models: Stock Value

• The Constant Growth Model states that a stocks value will

be greater
• The larger its expected dividend per share.

• The lower the market capitalization rate, k.

• The higher the expected growth rate of dividends.

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The Dividend Discount Model

• The Dividend Discount Model (DDM) is a method to estimate

the value of a share of stock by discounting all expected future
dividend payments. The basic DDM equation is:

D1 D2 D3 DT
P0 = + + +
(1 + k ) (1 + k ) (1 + k )
2 3
(1 + k )T
• In the DDM equation:
• P0 = the present value of all future dividends
• Dt = the dividend to be paid t years from now
• k = the appropriate risk-adjusted discount rate

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Example: The Dividend Discount Model
• Suppose that a stock will pay three annual dividends of
$100 per year; the appropriate risk-adjusted discount rate,
k, is 15%.

• In this case, what is the value of the stock today?

D1 D2 D3
P0 = + 2 +
(1 + k ) (1 + k ) (1 + k )3

$100 $100 $100

P0 = + + 3 = $228.32
(1.15) (1.15) (1.15)
2

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The Dividend Discount Model: The Constant Growth Rate
Model

 Assume that the dividends will grow at a constant growth rate g.

The dividend in the next period, (t + 1), is:

D t +1 = D t  (1+ g)

So, D2 = D1  (1+ g) = D0  (1+ g)  (1+ g)

 For constant dividend growth for “T” years, the DDM formula is:

D0 (1+g) 1+g T
P0 = 1− if k ≠ g
k−g 1+k

P0 = T × D0 if k = g

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Example: The Constant Growth Rate Model
• Suppose the current dividend is $10, the dividend growth rate
is 10%, there will be 20 yearly dividends, and the appropriate
discount rate is 8%.

• What is the value of the stock, based on the constant growth

rate model?

D 0 (1 + g)   1 + g  
T

P0 = 1 −   
k − g   1 + k  

$10  (1.10 )   1.10  

20

P0 = 1 −    = $243.86
.08 − .10   1.08  

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 The Dividend Discount Model:
The Constant Perpetual Growth Model
• Assuming that the dividends will grow
forever at a constant growth rate g.

• For constant perpetual dividend growth, the

DDM formula becomes:

D 0  (1 + g) D1
P0 = = (Important : g  k)
k−g k−g

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Example: Constant Perpetual Growth Model

• Think about the electric utility industry.

• In 2019, the dividend paid by the utility company, DTE Energy (DTE),
was $3.78.
• Using D0 =$3.78, k = 5%, and g = 2%, calculate an estimated value
for DTE.

= $128.52

Note: the actual early-2019 stock price of DTE was $109.17.

What are the possible explanations for the difference?

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4.3 Dividend Discount Models
• For stock with market price = intrinsic value,
expected holding period return
• 𝐸 𝑟 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 + 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛𝑠 𝑦𝑖𝑒𝑙𝑑
𝐷1 𝑃1 −𝑃0 𝐷1
• + = +𝑔
𝑃𝑜 𝑃0 𝑃0

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4.3 DDM with growth opportunity
• Stock Prices and Investment Opportunities
• Dividend payout ratio
• Percentage of earnings paid as dividends
• Plowback ratio/earnings retention ratio
• Proportion of firm’s earnings reinvested in
business
• Present value of growth opportunities (PVGO)
• Price = No-growth value per share + PVGO
𝐸1
• 𝑃0 = + 𝑃𝑉𝐺𝑂
𝑘
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4.3 Dividend Discount Models
• Life Cycles and Multistage Growth Models
• Two-stage DDM
• DDM in which dividend growth assumed to
level off only at future date
• Multistage Growth Models
• Allow dividends per share to grow at several different
rates as firm matures

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4.3 Dividend Discount Models: Two Stage Example
• Consider the following information:
• The firm’s dividends are expected to grow at g = 20% until t = 3 yrs.
• At the start of year four, growth slows to gs= 5%.
• The stock just paid a dividend Div0 = $1.00
• Assume a market capitalization rate of k = 12%

• What is the price, P0, of this stock?

D0  (1 + g ) D0  (1 + g )t D0  (1 + g )t  (1 + g s )
P0 = + ... + +
(1 + k ) (1 + k ) t
(1 + k )t  ( k − g s )
$1 (1 + .2) $1 (1 + .2) 2 $1 (1 + .2) 3 D0  (1 + .2)3  (1 + .05)
= + + +
(1 + .12) (1 + .12) 2
(1 + .12) 3
(1 + .12) 3  (.12 − .05)
= $1.07 + $1.15 + $1.23 + $18.45 = $21.90

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The Dividend Discount Model: Estimating the Growth Rate

The growth rate in dividends (g) can be

estimated in a number of ways:

• Using the company’s historical average growth

rate.

• Using an industry median or average growth rate.

• Using the sustainable growth rate.

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 The Historical Average Growth Rate
• Suppose the Broadway Joe Company paid the following
dividends:

• 2019: $2.20 2016: $1.75

• 2018: $2.00 2015: $1.70
• 2017: $1.80 2014: $1.50

• The spreadsheet Year:

below shows
Dividend: Pct. Chg: how to estimate historical
average growth rates,
2019 using10.00%
$2.20 arithmetic and geometric averages.
2018 $2.00 11.11%
2017 $1.80 2.86% Grown at
2016 $1.75 2.94% Year: 7.96%
2015 $1.70 13.33% 2014 $1.50
2014 $1.50 2015 $1.62
2016 $1.75
Arithmetic Average: 8.05% 2017 $1.89
2018 $2.04
Geometric Average: 7.96% 2019 $2.20

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Copyright © 2021 McGraw-Hill 20
 The Sustainable Growth Rate

Sustainable Growth Rate = ROE  Retention Ratio

= ROE  (1 - Payout Ratio)

• Return on Equity (ROE) = Net Income / Equity

• Payout Ratio = Proportion of earnings paid out as dividends

• Retention Ratio = Proportion of earnings retained for

investment (i.e., NOT paid out as dividends)

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Copyright © 2021 McGraw-Hill 21
Example: Calculating and Using the Sustainable Growth
Rate, I.

• In 2019, American Electric Power (AEP) had an ROE of 10.5%,

had earnings per share of $3.97, and had a dividend level of
$2.68. What was AEP’s:
• Retention rate?
• Sustainable growth rate?

• Payout ratio = $2.68/ $3.97 = .675 or 67.5%

• So, retention ratio = 1 − .675 = .325 or 32.5%

• Therefore, AEP’s sustainable growth rate = .105  .325 =

.0341, or about 3.41%

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Example: Calculating and Using the Sustainable Growth
Rate, II.

• What is the value of AEP stock using the perpetual growth model and
a discount rate of 5.00%?

$2.68×1.0341
𝑃0 = = $174.30
.05−.0341

The actual early-2019 stock price of AEP was $73.05.

• In this case, using the sustainable growth rate to value the stock gives
an extremely poor estimate.

• What can we say about the values of g and k in this example?

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Analyzing ROE
• To estimate a sustainable growth rate, you need the (relatively stable)
dividend payout ratio and ROE.
• Changes in sustainable growth rate likely stem from changes in ROE.
• The DuPont formula separates ROE into three parts: profit margin, asset
turnover, and equity multiplier

Net Income Net Income Sales Assets

= ROE =  
Equity Sales Assets Equity

• Managers can increase the sustainable growth rate by:

• Decreasing the dividend payout ratio

• Increasing profitability (Net Income / Sales)

• Increasing asset efficiency (Sales / Assets)

• Increasing debt (Assets / Equity)

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The Two-Stage Dividend Growth Model

• The two-stage dividend growth model

assumes that a firm will initially grow at a
rate g1 for T years, and thereafter, it will
grow at a rate g2 < k during a perpetual
second stage of growth.
D 0 (1 + g1 )   1 + g1    1 + g1  D 0 (1 + g 2 )
T T

P0 = 1 −   + 
k − g1   1 + k    1 + k  k − g2
• The Two-Stage Dividend Growth Model
formula is:
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Using the Two-Stage Dividend Growth Model, I.

• Although the formula looks complicated, think of it as two parts:

• Part 1 is the present value of the first T dividends (it is the same
formula we used for the constant growth model).
• Part 2 is the present value of all subsequent dividends.

• So, suppose Tower Inc., has a current dividend of

D0 = $5, which is expected to shrink at the rate, g1 = −10%, for
5 years then grow at the rate, g2 = 4%, forever.

• With a discount rate of k = 10%, what is the present value of

the stock?

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Using the Two-Stage Dividend Growth Model, II.

D 0 (1 + g1 )   1 + g1    1 + g1  D 0 (1 + g 2 )
T T

P0 = 1 −   + 
k − g1   1 + k    1 + k  k − g2

$5.00(0.90)   0.90    0.90 5 $5.00(1.04)

5

P0 = 1 −   + 
0.10 − (−0.10)   1.10    1 . 10  0.10 − 0.04

= $14.25 + $31.78

= $46.03.

The total value of $46.03 is the sum of a $14.25 present value of the
first five dividends, plus a $31.78 present value of all subsequent
dividends.

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Example: Using the DDM to Value a Firm Experiencing
“Supernormal” Growth, I.

• Chain Reaction, Inc., has been growing at a phenomenal rate

of 30% per year.

• You believe that this rate will last for only three more years.

• Then, you think the rate will drop to 10% per year.

• Total dividends just paid were $5 million.

• The required rate of return is 20%.

• What is the total value of Chain Reaction, Inc.?

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Example: Using the DDM to Value a Firm Experiencing
“Supernormal” Growth, II.
• First, calculate the total dividends over the “supernormal” growth period:

Year Total Dividend: (in $millions)

1 $5.00 × 1.30 = $6.50
2 $6.50 × 1.30 = $8.45
3 $8.45 × 1.30 = $10.985

• Using the long run growth rate, g, the value of all the shares at Time 3
can be calculated as:

P3 = [D3 × (1 + g)] / (k − g)

P3 = [$10.985 × 1.10] / (0.20 − 0.10) = $120.835

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Example: Using the DDM to Value a Firm Experiencing
“Supernormal” Growth, III.

• To determine the present value of the firm today, we need the present
value of $120.835 and the present value of the dividends paid in the
first 3 years:
D1 D2 D3 P3
P0 = + + +
(1 + k ) (1 + k )2 (1 + k )3 (1 + k )3

$6.50 $8.45 $10.985 $120.835

P0 = + + +
(1 + 0.20 ) (1 + 0.20 )2 (1 + 0.20 )3 (1 + 0.20 )3

= $5.42 + $5.87 + $6.36 + $69.93

= $87.58 million.

If there are 20 million shares outstanding, the price per share is $4.38.

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The H-Model, I.

• For Chain Reaction, Inc., we assumed a supernormal

growth rate of 30 percent per year for three years, and
then growth at a perpetual 10 percent.

• The growth rate is more likely to start at a high level

and then fall over time until reaching its perpetual level.

• There are many possible ways to assume how the

growth rate declines.

• A popular way is the H-model, which assumes a linear

growth rate decline.

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The H-Model, II.
• Let’s revisit Chain Reaction, Inc.

• Suppose the growth rate begins at 30% and reaches 10% in year 4 and beyond.

• Using the H-model, we would assume that the company’s growth rate would decline by 20% from the end of year
1 to the beginning of year 4.

• If we assume a linear decline:

• the growth rate falls by 6.67% per year (20%/3 years).

• growth estimates would be 30%, 23.33%, 16.66%, and 10%.

• Using these growth estimates, you should find that the firm value is $75.93 million, or
$3.80 per share.

• The value is lower than before because of the lower growth rates in years 2 and
3.

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Discount Rates for Dividend Discount Models
• The discount rate for a stock can be estimated using the
capital asset pricing model (CAPM ).
• We will discuss the CAPM in a later chapter.
• We can estimate the discount rate for a stock with this
formula:

Discount rate = time value of money + risk premium

= U.S. T-bill Rate + (Stock Beta × Stock Market Risk Premium)

T-bill Rate: return on 90-day U.S. T-bills

Stock Beta: risk relative to an average stock
Stock Market Risk Premium: risk premium for an average stock

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 Observations on Dividend Discount Models, I.

Constant Perpetual Growth Model:

• Simple to compute

• Not usable for firms that do not pay dividends

• Not usable when g > k

• Is sensitive to the choice of g and k

• k and g may be difficult to estimate accurately.

• Constant perpetual growth is often an unrealistic assumption.

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 Observations on Dividend Discount Models, II.

Two-Stage Dividend Growth Model:

• More realistic in that it accounts for two stages of growth

• Usable when g > k in the first stage

• Not usable for firms that do not pay dividends

• Is sensitive to the choice of g and k

• k and g may be difficult to estimate accurately.

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4.3 Dividend Growth and Reinvestment

36
13.4 Price-Earnings Ratios
• Price Earnings Ratio and Growth
Opportunities
• Price-earnings multiple
• Ratio of stock’s price to earnings per share
• Determinant of P/E ratio
𝑃0 1 𝑃𝑉𝐺𝑂
• = 𝐸1
𝐸1 𝑘
𝑘

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4.4 Price-Earnings Ratios
• P/E Ratio for Firm Growing at Long-Run
Sustainable Pace
𝑃0 1−𝑏
• =
𝐸1 𝑘−(𝑅𝑂𝐸×𝑏)

• PEG Ratio
• Ratio of P/E multiple to earnings growth rate

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Table4.3 Effect of ROE and Plowback on Growth and P/E Ratio

39
4.4 Price-Earnings Ratios

• P/E Ratios and Stock

𝑃 1−𝑏
• =
𝐸 𝑘−𝑔

• All else equal, riskier stocks have lower P/E

multiples, higher required RoR, k

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Figure 4.3 P/E Ratio and Inflation

41
4.4 Price-Earnings Ratios
• Pitfalls in P/E Analysis
• Earnings Management
• Practice of using flexibility in accounting rules
to improve apparent profitability of firm
• Large amount of discretion in managing
earnings

42
Figure 4.4 Earnings Growth for Two Companies

43
Figure 4.5 Price-Earnings Ratios

44
4.4 Price-Earnings Ratios
• Combining P/E Analysis and the DDM
• Estimates stock price at horizon date

• Other Comparative Valuation Ratios

• Price-to-book: Indicates how aggressively
market values firm
• Price-to-cash-flow: Cash flow less affected by
accounting decisions than earnings
• Price-to-sales: For start-ups with no earnings

45
Figure 4.6 Valuation Ratios for S&P 500

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 Thank you

See you next lecture