Dividend Discount Model
Advanced Valuation Course
© Pristine For Advanced Valuation Course (Confidential)
© Pristine – www.edupristine.com
Agenda Value perspective Types of valuation models
Absolute valuation models – Valuation using Dividend Discount Models – Valuation using Free Cash Flow – Mistake in Valuation Relative valuation models – Enterprise multiples – Price multiples Typical valuation scenarios Valuation in emerging market Valuing a private company
© Pristine For Advanced Valuation Course (Confidential)
1
Why value creation is important? There are problems of not valuing a company Market bubbles
Year 2000 saw many internet companies go out of business despite the bubble created from 1995-2000. Laws of economics always prevail, it was clear that many internet business did not have competitive advantage required to earn even the modest return and revenue growth, hence had to go out of business. Financial crises and leverage There were fundamental flaws in the assumptions by various banks in 2008 financial crisis. Firstly, securitized home loans made the home loans more valuable. Secondly, using leverage to make an investment in itself creates value.
Applying principles of value creation means relying on data, thoughtful analysis, and a deep understanding of the competitive dynamics of a company
Financial crises and markets True, the equity market did not predict the economic crisis in 2008, however equity market has not been unreasonable. © Pristine For Advanced Valuation Course (Confidential)
2
Pillars of value creation Profitability and growth The combination of growth and return, and resulting cash flow, drives value creation. This explains why some companies typically trade at high P/E multiples despite low growth Rearranging investor’s claim doesn’t matter Value is created when companies generate higher cash flows, not by rearranging investors' claims on those cash flows Market expectation The higher the stock market’s expectations for a company's share price become, the better a company has to perform just to keep up Best ownership A business's value is relative to who owns it or might own it. Different owners will generate different cash flows for a business based on the strategies they pursue and their unique abilities to add value. © Pristine For Advanced Valuation Course (Confidential)
3
Agenda Value perspective Types of valuation models
Absolute valuation models – Valuation using Dividend Discount Models – Valuation using Free Cash Flow – Mistake in Valuation Relative valuation models – Enterprise multiples – Price multiples Typical valuation scenarios Valuation in emerging market Valuing a private company
© Pristine For Advanced Valuation Course (Confidential)
4
Absolute valuation models An absolute valuation model is a model that specifies an asset’s intrinsic value A Present value model or discounted cash flow model of equity valuation views the value of common stock as being the present or discounted value of its future cash flows Present value model based on dividends are called dividend discount models Present value model based on free cash flows are known as free cash flow model Absolute valuation models
Dividend discount model
© Pristine For Advanced Valuation Course (Confidential)
Free cash flow models
5
How to choose from various valuation method Each stock is different, and each industry sector has unique properties that may require varying valuation approaches . Valuation methods typically fall into two main categories: 1. Absolute valuation models: Absolute valuation models attempt to find the intrinsic or "true" value of an investment based only on fundamentals. Looking at fundamentals simply mean you would only focus on such things as dividends, cash flows and growth rate for a single company, and not worry about any other companies 2. Relative valuation models: These models operate by comparing the company in question to other similar companies. These methods generally involve calculating multiples or ratios, such as the price-toearnings multiple, and comparing them to the multiples of other comparable firms. For instance, if the P/E of the firm you are trying to value is lower than the P/E multiple of a comparable firm, that company may be said to be relatively undervalued © Pristine For Advanced Valuation Course (Confidential)
6
Dividend Discount Model Generally, the definition of returns as dividends, and the DDM, is most suitable when: The company is dividend paying
Dividend policy bears an understandable and consistent relationship to the company’s profitability The investor takes a non-control perspective Often, companies with established dividends are seasoned companies, profitable but operating outside the economy’s fastest-growing subsectors The formulas used for dividend discount model
One Period DDM
V0
D1 P1 1 r n
Multiple Period DDM
Dt Pn or V0 t n (1 r ) t 1 (1 r )
© Pristine For Advanced Valuation Course (Confidential)
V0 t 1
Dt (1 r )t
7
Dividend Discount Model in action 2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
ABC Corp. EPS ($) DPS ($) Payout ratio (%)
0.41 1 244%
0.12 1 833%
-0.36 1 n/m
1.31 1 76%
1.86 1 54%
0.39 1 256%
0.88 1 114%
1.58 1 63%
4.26 1 23%
4.92 1 20%
XYZ Corp. EPS ($) DPS ($) Payout ratio (%)
0.62 0.18 29%
0.66 0.22 33%
0.77 0.25 32%
0.72 0.29 40%
0.52 0.3 58%
0.72 0.39 54%
1.11 0.33 30%
1.2 0.35 29%
1.3 0.37 28%
0.77 0.25 32%
State whether a dividend discount model is appropriate choice for ABC corp. or XYZ corp. ?
© Pristine For Advanced Valuation Course (Confidential)
8
Dividend Discount Model solution
Based on the data provided, DDM does not appear to be an appropriate choice for ABC corp. ABC’s dividend does not bear an understandable and consistent relationship to earnings. Dividend payout ratios have varied from 20% to 833%. XYZ’s dividend has generally followed its growth in earnings. XYZ corp’s dividend paying and dividends bear an understandable and consistent relationship to earnings. Therefore, DDM is more suitable for XYZ, however analyst might want to research a divergent movement in 2007-2008
© Pristine For Advanced Valuation Course (Confidential)
9
Gordon Growth Model (GGM) • Assumptions – Firms pays dividend D 1 a year from now.
– Dividends grow at constant rate, g, till infinity – Suited for companies whose expected growth is same as economic growth – Cost of Equity > Dividend growth rate
V0 D0 *
1 g rg
D1 rg
Do = Dividend at time 0 D1 = Dividend at time 1 g = dividend growth rate r = required return of equity
© Pristine For Advanced Valuation Course (Confidential)
10
Strengths And Limitations Of The Gordon Growth Model (GGM) Strengths Suitable for stable, mature, dividend-paying firms
Easy to understand and explain Estimate implied growth rate Limitations Intrinsic value extremely sensitive to g and r estimate
Not useful for non- dividend paying stocks . Not useful for multistage growth firm where growth changes or when growth is unpredictable.
© Pristine For Advanced Valuation Course (Confidential)
11
Multi –Stage DDM Models Multi Stage Models: An equity valuation model that builds on the GGM by applying varying growth rates to the calculation. Under the multistage model, changing growth rates are applied to different time periods Forms • Two –stage
• Three stage • Spread sheet modeling
© Pristine For Advanced Valuation Course (Confidential)
12
Forecasting Dividends Using Spread Sheet Modeling In practice, spread sheet modeling is the most common approach for equity valuation by analysts. More than 3 growth rates can be used Spread sheet models are very flexible Step 1: Enter the base dividend. This is most likely the last paid dividend Step 2: Estimate future dividends during the firm’s supernormal growth period. A different growth rate can be applied for each year Step 3: Determine a Terminal Value by estimating a growth rate at the end of the supernormal growth period. Step 4: Find the present value of all the estimated future cash flows.
© Pristine For Advanced Valuation Course (Confidential)
13
Valuing using Dividend Discount Model
Estimate Terminal Value using GGM
Estimate Future Dividends
Present Value of all the Estimated Future Cash Flows
© Pristine For Advanced Valuation Course (Confidential)
14
Valuing using Dividend Discount Model Ross and company has a current dividend of $1 and a required rate of return of 12%. A dividend growth rate of 15% is projected for next 2 years, followed by a 10% growth rate for the next four years before setting down to a constant 4% growth rate thereafter. Calculate the current value of Ross and company
© Pristine For Advanced Valuation Course (Confidential)
15
Thank you! Contact: Paramdeep Singh
Pawan Prabhat
[email protected]
[email protected]
+91 989 298 0608
+91 986 762 5422
Pristine 702, Raaj Chambers, Old Nagardas Road, Andheri (E), Mumbai-400 069. INDIA www.edupristine.com Ph. +91 22 3215 6191
© Pristine For Advanced Valuation Course (Confidential)
© Pristine – www.edupristine.com
© Pristine For Advanced Valuation Course (Confidential)
© Pristine – www.edupristine.com
Agenda Value perspective Types of valuation models
Absolute valuation models – Valuation using Dividend Discount Models – Valuation using Free Cash Flow – Mistake in Valuation Relative valuation models – Enterprise multiples – Price multiples Typical valuation scenarios Valuation in emerging market Valuing a private company
© Pristine For Advanced Valuation Course (Confidential)
1
Why value creation is important? There are problems of not valuing a company Market bubbles
Year 2000 saw many internet companies go out of business despite the bubble created from 1995-2000. Laws of economics always prevail, it was clear that many internet business did not have competitive advantage required to earn even the modest return and revenue growth, hence had to go out of business. Financial crises and leverage There were fundamental flaws in the assumptions by various banks in 2008 financial crisis. Firstly, securitized home loans made the home loans more valuable. Secondly, using leverage to make an investment in itself creates value.
Applying principles of value creation means relying on data, thoughtful analysis, and a deep understanding of the competitive dynamics of a company
Financial crises and markets True, the equity market did not predict the economic crisis in 2008, however equity market has not been unreasonable. © Pristine For Advanced Valuation Course (Confidential)
2
Pillars of value creation Profitability and growth The combination of growth and return, and resulting cash flow, drives value creation. This explains why some companies typically trade at high P/E multiples despite low growth Rearranging investor’s claim doesn’t matter Value is created when companies generate higher cash flows, not by rearranging investors' claims on those cash flows Market expectation The higher the stock market’s expectations for a company's share price become, the better a company has to perform just to keep up Best ownership A business's value is relative to who owns it or might own it. Different owners will generate different cash flows for a business based on the strategies they pursue and their unique abilities to add value. © Pristine For Advanced Valuation Course (Confidential)
3
Agenda Value perspective Types of valuation models
Absolute valuation models – Valuation using Dividend Discount Models – Valuation using Free Cash Flow – Mistake in Valuation Relative valuation models – Enterprise multiples – Price multiples Typical valuation scenarios Valuation in emerging market Valuing a private company
© Pristine For Advanced Valuation Course (Confidential)
4
Absolute valuation models An absolute valuation model is a model that specifies an asset’s intrinsic value A Present value model or discounted cash flow model of equity valuation views the value of common stock as being the present or discounted value of its future cash flows Present value model based on dividends are called dividend discount models Present value model based on free cash flows are known as free cash flow model Absolute valuation models
Dividend discount model
© Pristine For Advanced Valuation Course (Confidential)
Free cash flow models
5
How to choose from various valuation method Each stock is different, and each industry sector has unique properties that may require varying valuation approaches . Valuation methods typically fall into two main categories: 1. Absolute valuation models: Absolute valuation models attempt to find the intrinsic or "true" value of an investment based only on fundamentals. Looking at fundamentals simply mean you would only focus on such things as dividends, cash flows and growth rate for a single company, and not worry about any other companies 2. Relative valuation models: These models operate by comparing the company in question to other similar companies. These methods generally involve calculating multiples or ratios, such as the price-toearnings multiple, and comparing them to the multiples of other comparable firms. For instance, if the P/E of the firm you are trying to value is lower than the P/E multiple of a comparable firm, that company may be said to be relatively undervalued © Pristine For Advanced Valuation Course (Confidential)
6
Dividend Discount Model Generally, the definition of returns as dividends, and the DDM, is most suitable when: The company is dividend paying
Dividend policy bears an understandable and consistent relationship to the company’s profitability The investor takes a non-control perspective Often, companies with established dividends are seasoned companies, profitable but operating outside the economy’s fastest-growing subsectors The formulas used for dividend discount model
One Period DDM
V0
D1 P1 1 r n
Multiple Period DDM
Dt Pn or V0 t n (1 r ) t 1 (1 r )
© Pristine For Advanced Valuation Course (Confidential)
V0 t 1
Dt (1 r )t
7
Dividend Discount Model in action 2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
ABC Corp. EPS ($) DPS ($) Payout ratio (%)
0.41 1 244%
0.12 1 833%
-0.36 1 n/m
1.31 1 76%
1.86 1 54%
0.39 1 256%
0.88 1 114%
1.58 1 63%
4.26 1 23%
4.92 1 20%
XYZ Corp. EPS ($) DPS ($) Payout ratio (%)
0.62 0.18 29%
0.66 0.22 33%
0.77 0.25 32%
0.72 0.29 40%
0.52 0.3 58%
0.72 0.39 54%
1.11 0.33 30%
1.2 0.35 29%
1.3 0.37 28%
0.77 0.25 32%
State whether a dividend discount model is appropriate choice for ABC corp. or XYZ corp. ?
© Pristine For Advanced Valuation Course (Confidential)
8
Dividend Discount Model solution
Based on the data provided, DDM does not appear to be an appropriate choice for ABC corp. ABC’s dividend does not bear an understandable and consistent relationship to earnings. Dividend payout ratios have varied from 20% to 833%. XYZ’s dividend has generally followed its growth in earnings. XYZ corp’s dividend paying and dividends bear an understandable and consistent relationship to earnings. Therefore, DDM is more suitable for XYZ, however analyst might want to research a divergent movement in 2007-2008
© Pristine For Advanced Valuation Course (Confidential)
9
Gordon Growth Model (GGM) • Assumptions – Firms pays dividend D 1 a year from now.
– Dividends grow at constant rate, g, till infinity – Suited for companies whose expected growth is same as economic growth – Cost of Equity > Dividend growth rate
V0 D0 *
1 g rg
D1 rg
Do = Dividend at time 0 D1 = Dividend at time 1 g = dividend growth rate r = required return of equity
© Pristine For Advanced Valuation Course (Confidential)
10
Strengths And Limitations Of The Gordon Growth Model (GGM) Strengths Suitable for stable, mature, dividend-paying firms
Easy to understand and explain Estimate implied growth rate Limitations Intrinsic value extremely sensitive to g and r estimate
Not useful for non- dividend paying stocks . Not useful for multistage growth firm where growth changes or when growth is unpredictable.
© Pristine For Advanced Valuation Course (Confidential)
11
Multi –Stage DDM Models Multi Stage Models: An equity valuation model that builds on the GGM by applying varying growth rates to the calculation. Under the multistage model, changing growth rates are applied to different time periods Forms • Two –stage
• Three stage • Spread sheet modeling
© Pristine For Advanced Valuation Course (Confidential)
12
Forecasting Dividends Using Spread Sheet Modeling In practice, spread sheet modeling is the most common approach for equity valuation by analysts. More than 3 growth rates can be used Spread sheet models are very flexible Step 1: Enter the base dividend. This is most likely the last paid dividend Step 2: Estimate future dividends during the firm’s supernormal growth period. A different growth rate can be applied for each year Step 3: Determine a Terminal Value by estimating a growth rate at the end of the supernormal growth period. Step 4: Find the present value of all the estimated future cash flows.
© Pristine For Advanced Valuation Course (Confidential)
13
Valuing using Dividend Discount Model
Estimate Terminal Value using GGM
Estimate Future Dividends
Present Value of all the Estimated Future Cash Flows
© Pristine For Advanced Valuation Course (Confidential)
14
Valuing using Dividend Discount Model Ross and company has a current dividend of $1 and a required rate of return of 12%. A dividend growth rate of 15% is projected for next 2 years, followed by a 10% growth rate for the next four years before setting down to a constant 4% growth rate thereafter. Calculate the current value of Ross and company
© Pristine For Advanced Valuation Course (Confidential)
15
Thank you! Contact: Paramdeep Singh
Pawan Prabhat
[email protected]
[email protected]
+91 989 298 0608
+91 986 762 5422
Pristine 702, Raaj Chambers, Old Nagardas Road, Andheri (E), Mumbai-400 069. INDIA www.edupristine.com Ph. +91 22 3215 6191
© Pristine For Advanced Valuation Course (Confidential)
© Pristine – www.edupristine.com
