Discounted Dividend Valuation

 

Summaries

 

Dividend is easy to predict and also meaningful. But dividend cannot be used for company not paying dividend. Also for minority shareholders, they cannot control the dividend payout policy in relation to the profitability of the company.

 

To use dividend discount model,

1)      firm should have dividend payment history

2)      policy is clear and related to the firm’s earning

3)      when valuating from the perspective of minority shareholders

 

FCF

1)      from the perspective of controlling shareholders

2)      FCF is related to the firm’s profitability

3)      No or unclear dividend history

 

Residue income

1)      good for firm with –ve CFC and no dividend payment

2)      transparent accounting

 

How to calculate the required rate of return?

 

1. CAPM:

1)      historical data – use geometric mean (although CAPM is a single period model) (to estimate the excess return, not the premium)

2)      expectational data: Gordon Growth Model

a.      market premium estimate = one-year forecasted dividend yield on market index + long-term earnings growth rate – long-term government bond yield

 

2. APT models:

 

1)      Fama and French

a.      RMRF (return of value-weighted index – treasury bills)

b.      SMB (return of 3 small cap portfolios – 3 big portfolios)

c.      HML (return of high B/P – return of low B/P)

2)      BIRR model (Burmeister, Roll and Ross)

a.      Investor confidence factor (spread of 20 year corp and gov bonds)

b.      Time horizon factors spread of 20-year and 30-day bill

c.      Inflation factor

d.      Business cycle factor

e.      Market timing factor

 

3. Bond yield + risk-premium method (BYPRP)

 

E(r) = firm’s long term bond yield + estimated equity risk premium (in excess of the cost of debt)

 

*** so the default risk and equity risk have been taken into account

 

Ex Ante Alpha = Expected return (given expected dividend and price) – Required return (to compensate the systematic risk, representing opportunity cost)

 

Expected return = required return + the convergence of price during the holding period

 

GGM (Gordon Growth Model)

- make sure growth rate < long term nominal GDP growth rate

 

Justified P/E ratios (*** these are theoretical ratios from GGM, not real Price/Earning ratio): Leading and Trailing P/E ratios

 

Present Value of Growth Opportunities Model (PVGO)

 

V = E/ r + PVGO

 

(Similar to Franchise Model)

 

Models:

2-stage

3-stage (Initial growth, transition, maturity)

H-stage (2-stage with 1^st stage gradually decreasing to the value of 2^nd stage)

Spreadsheet (but need very accurate prediction of the growth rate at each stage)

 

Terminal values can be estimated by GGM or Multiples

 

H-Model:

 

V = D0(1+gl)/(r-gl) + D0*t/2*(gs-gl)/(r-gl)

 

Sustainable Growth Rate (SGR) = ROE x retention ratio

-                telling how quickly can a firm growth with the internally generated funds

 

DuPont Model

 

ROE = Profit Margin (P) x Asset Turnover (A) x Financial Leverage (T)

 

Sustainable growth rate = retention rate (R) x ROE = PRAT