FINANCE 5.

Stock valuation - DDM

Professor Andr Farber Solvay Business School Universit Libre de Bruxelles Fall 2006

Stock Valuation
1. 2. 3. 4. 5. Objectives for this session : Introduce the dividend discount model (DDM) Understand the sources of dividend growth Analyse growth opportunities Examine why Price-Earnings ratios vary across firms Introduce free cash flow model (FCFM)

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DDM: one-year holding period

Review: valuing a 1-year 4% coupon bond Face value: 50 Bond price P0 = (50+2)/1.05 = 49.52 Coupon: 2 Interest rate 5% How much would you be ready to pay for a stock with the following characteristics: Expected dividend next year: 2 Expected price next year: 50 Looks like the previous problem. But one crucial difference: Next year dividend and next year price are expectations, the realized price might be very different. Buying the stock involves some risk. The discount rate should be higher.
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Dividend Discount Model (DDM): 1-year horizon

1-year valuation formula
Expected price

div1 P 1 P0 1 r
Back to example. Assume r = 10%

r = expected return on shareholders'equity = Risk-free interest rate + risk premium

2 50 P0 47.27 1 0.10

Dividend yield = 2/47.27 = 4.23%

Rate of capital gain = (50 47.27)/47.27 = 5.77%

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DDM: where does the expected stock price come from?

Expected price at forecasting horizon depends on expected dividends and expected prices beyond forecasting horizon

To find P2, use 1-year valuation formula again:

P1

div2 P2 1 r

Current price can be expressed as:

General formula:

P0

div1 div2 P2 1 r (1 r ) 2 (1 r ) 2

P0

div1 div2 divT PT ... 1 r (1 r ) 2 (1 r ) T (1 r ) T

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DDM - general formula

With infinite forecasting horizon:
P0 div3 divt div1 div2 ... ... 2 3 t (1 r ) (1 r ) (1 r ) (1 r )

Forecasting dividends up to infinity is not an easy task. So, in practice, simplified versions of this general formula are used. One widely used formula is the Gordon Growth Model base on the assumption that dividends grow at a constant rate. DDM with constant growth g Note: g < r

div1 P0 rg

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DDM with constant growth : example

Data Next dividend: 6.00 Div.growth rate: 4% Discount rate: 10% Year 0 1 2 3 4 5 6.00 6.24 6.49 6.75 7.02 0.9091 0.8264 0.7513 0.6830 0.6209 Dividend DiscFac Price 100.00 104.00 108.16 112.49 116.99 121.67
P0= 6/(.10-.04)

6
7 8 9 10

7.30
7.59 7.90 8.21 8.54

0.5645
0.5132 0.4665 0.4241 0.3855

126.53
131.59 136.86 142.33 148.02

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Differential growth
Suppose that r = 10% You have the following data:
Year Dividend Growth rate 1 2 2 2.40 20% 3 2.88 20% 4 to 3.02 5%

P3 = 3.02 / (0.10 0.05) = 60.48

P0

2 2.40 2.88 60 .48 51 .40 2 3 3 1.10 (1.10 ) (1.10 ) (1.10 )

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A formula for g
Dividend are paid out of earnings: Dividend = Earnings Payout ratio Payout ratios of dividend paying companies tend to be stable. Growth rate of dividend g = Growth rate of earnings Earnings increase because companies invest. Net investment = Retained earnings Growth rate of earnings is a function of: Retention ratio = 1 Payout ratio Return on Retained Earnings

g = (Return on Retained Earnings) (Retention Ratio)

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Example
Data: Expected earnings per share year 1: EPS1 = 10 Payout ratio : 60% Required rate of return r : 10% Return on Retained Earnings RORE: 15% Valuation: Expected dividend per share next year: div1 = 10 60% = 6 Retention Ratio = 1 60% = 40% Growth rate of dividend g = (40%) (15%) = 6% Current stock price: P0 = 6 / (0.10 0.06) = 150

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Return on Retained Earnings and Debt

Net investment = Total Asset For a levered firm: Total Asset = Stockholders equity + Debt RORE is a function of: Return on net investment (RONI) Leverage (L = D/ SE)

RORE = RONI + [RONI i (1-TC)]L

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Growth model: example

Dep/TotAsset TaxRate Year Payout RORE Depreciation Net Income Dividend Cfop Cfinv Cffin Change in cash 10% 40% 0 1 60% 25% 100.00 400.00 240.00 500.00 -260.00 -240.00 0.00 2 60% 20% 116.00 440.00 264.00 556.00 -292.00 -264.00 0.00 3 4 to infinity 60% 100% 15% 15% 133.60 475.20 285.12 608.80 -323.68 -285.12 0.00 152.61 503.71 503.71 656.32 -152.61 -503.71 0.00

Total Assets Book Equity

1,000.00 1,000.00

1,160.00 1,160.00

1,336.00 1,336.00

1,526.08 1,526.08

1,526.08 1,526.08
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MBA 2006 DDM

Valuing the company

Assume discount rate r = 15% Step 1: calculate terminal value As Earnings = Dividend from year 4 on V3 = 503.71/15% = 3,358 Step 2: discount expected dividends and terminal value
V0 240 264 285 .12 3,358 .08 2,803 .78 3 1.15 (1.15 ) 2 (1.15 ) 3 (1.15 )

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Valuing Growth Opportunities

Consider the data: Expected earnings per share next year EPS1 = 10 Required rate of return r = 10%
Cy A Payout ratio Return on Retained Earnings Next years dividend g Price per share P0 60% 15% 6 6% 150 Cy B 60% 10% 6 4% 100 Cy C 100% 10 0% 100

Why is A more valuable than B or C? Why do B and C have same value in spite of different investment policies

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NPVGO
Cy C is a cash cow company Earnings = Dividend (Payout = 1) No net investment Cy B does not create value Dividend < Earnings, Payout <1, Net investment >0 But: Return on Retained Earnings = Cost of capital NPV of net investment = 0 Cy A is a growth stock Return on Retained Earnings > Cost of capital Net investment creates value (NPV>0) Net Present Value of Growth Opportunities (NPVGO) NPVGO = P0 EPS1/r = 150 100 = 50

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Source of NPVG0 ?
Additional value if the firm retains earnings in order to fund new projects
P0 EPS PV ( NPV1 ) PV ( NPV2 ) PV ( NPV3 ) ... r

where PV(NPVt) represent the present value at time 0 of the net present value (calculated at time t) of a future investment at time t
In previous example: Year 1: EPS1 = 10 div1 = 6 Net investment = 4 EPS = 4 * 15% = 0.60 (a permanent increase) NPV1 = -4 + 0.60/0.10 = +2 (in year 1) PV(NPV1) = 2/1.10 = 1.82

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NPVGO: details
P0 PV g = 0 NPVGO 150.00 100.00 50.00 Y1 to Y25 Y26 to 50 Y51 to 75 Y76 to 100 EPSt 10.00 10.60 11.24 11.91 12.62 13.38 14.19 15.04 15.94 16.89 17.91 18.98 20.12 21.33 22.61 23.97 25.40 26.93 28.54 30.26 Net Inv. 4.00 4.24 4.49 4.76 5.05 5.35 5.67 6.01 6.38 6.76 7.16 7.59 8.05 8.53 9.04 9.59 10.16 10.77 11.42 12.10 30.19 11.96 4.74 1.88 EPS 0.60 0.64 0.67 0.71 0.76 0.80 0.85 0.90 0.96 1.01 1.07 1.14 1.21 1.28 1.36 1.44 1.52 1.62 1.71 1.82 NPV 2.00 2.12 2.25 2.38 2.52 2.68 2.84 3.01 3.19 3.38 3.58 3.80 4.02 4.27 4.52 4.79 5.08 5.39 5.71 6.05 PV(NPV) 1.82 1.75 1.69 1.63 1.57 1.51 1.46 1.40 1.35 1.30 1.26 1.21 1.17 1.12 1.08 1.04 1.01 0.97 0.93 0.90

Year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

EPS1 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00

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What Do Price-Earnings Ratios mean?

Definition: P/E = Stock price / Earnings per share 1 NPVGO Why do P/E vary across firms? P/E r EPS As: P0 = EPS/r + NPVGO Three factors explain P/E ratios: Accounting methods: Accounting conventions vary across countries The expected return on shareholdersequity Risky companies should have low P/E Growth opportunities

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Beyond DDM: The Free Cash Flow Model

Consider an all equity firm. If the company: Does not use external financing (not stock issue, # shares constant) Does not accumulate cash (no change in cash) Then, from the cash flow statement: Free cash flow = Dividend CF from operation Investment = Dividend Company financially constrained by CF from operation If external financing is a possibility: Free cash flow = Dividend Stock Issue

Market value of company = PV(Free Cash Flows)

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