Chapter 3

Chapter 3Discounted Dividend Valuation

SZABIST: Security Analysis – Jan‐Apr 2011

Instructor: Abdul Rasheed Narejo, CFA

Chapter 3 Discounted Dividend Valuation

Nothing is more dangerous than an idea when it is the only one you have.

Emile Chartier

SZABIST: Security Analysis – Jan‐Apr 2011 2


1. Introduction1. Introduction

• Common stocks represent ownership interest in a business

• All businesses generate cash flows and owners (shareholders) have claim onthese cash flows

• Discounted Cash Flow (DCF) models view the intrinsic value of common stock• Discounted Cash Flow (DCF) models view the intrinsic value of common stockas present value of its expected future cash flows

• Four steps in applying DCF analysis to equity valuation are1. Choosing suitable DCF model – equivalently specific definition of cash flow

2. Forecasting the cash flows

3. Choosing discount rate methodology

4. Estimating the discount rate

• What are dividends?Distributions to shareholders authorized by a company’s board of directors


– Distributions to shareholders authorized by a company s board of directors


2. Present Value Models2. Present Value Models

• Valuation based on present value of future cash flows

• Streams of expected cash flows– Dividend Discount Model (DDM)

– Free Cash Flow to Firm (FCFF)( )

– Free Cash Flow to Equity (FCFE)



2. Dividend Discount Model2. Dividend Discount Model

• Investor with small ownership does not have the ability to meaningfullyinfluence the timing or magnitude of the distribution of the company’s cash toinfluence the timing or magnitude of the distribution of the company s cash toshareholders.

• Hence, dividends are the only form of return received by minority shareholders

• Since dividends are less volatile, DDM based valuation is generally less sensitiveto input assumptions

• Generally, mature, profitable companies (Fertilizer, Power, E&P) tend to paydividends and are reluctant to reduce the level of dividends

• DDM is most suitable when 3 conditions are met1. The company is dividend paying

2. A dividend policy with consistent relationship with earnings

3. The investor takes non‐controlling (minority) perspective



3. Single Holding Period DDM3. Single Holding Period DDM



4. Multiple Holding Period DDM4. Multiple Holding Period DDM



5. Gordon Growth Model5. Gordon Growth Model




• Example 1: Hub Power Company Limited dividend last year was Rs5/share. Therequired rate of return for the stock is 19 5% and expected future growth isrequired rate of return for the stock is 19.5% and expected future growth is7.5%. Find company’s fair value through Gordon Growth Model?

D0 = 5

r = 19.5%

g = 7.5%

Gordon Growth Model

V0 = D0 x (1+g) / (r –g) = 5.0 x (1+ 7.5%) / (19.5% ‐ 7.5%)

Fair Value or Vo = 44.8/share


/



• Example 2: Fauji Fertilizer Company’s current year dividend is Rs14.5/share.The stock beta is 0 9 risk free rate is 13 5% and equity risk premium is 6 5%The stock beta is 0.9, risk free rate is 13.5% and equity risk premium is 6.5%.Company’s earnings are expected to grow in line with long term inflationforecast which is 9%. Find company’s required rate of return under CAPM andfair value through GGM.

Required rate of return = Risk free rate + B (equity risk premium)

= 13.5% + 0.9 (6.5%) = 13.5% + 5.85% = 19.35%

Fair Value (GGM) = D0 x (1+g) / (k – g)

= 14.5 x (1+9%) / (19.35% ‐ 9%)


= 152.7/share


5. Gordon Growth Model – Preferred Stock5. Gordon Growth Model Preferred Stock

• Perpetual Preferred Stock – Fixed rate of dividend to be paid each year

Value = Dividend / required rate of return = D / r

As growth rate is 0%



5. Share Repurchases5. Share Repurchases

• Companies can distribute free cash flow to shareholders in the form of sharerepurchases as well as dividends Cash dividends and share repurchases haverepurchases as well as dividends. Cash dividends and share repurchases haveseveral distinctive features;– Share repurchases involves reduction in shares outstanding. Selling shareholders see

reduction in their holding compared to non‐selling shareholders,

– Unlike dividends which are difficult to reduce or omit, companies do not have aconsistent share repurchase plans,

– Cash dividends are more predictable in money terms and timing

– Share repurchases are neutral in their effect on the wealth of ongoing shareholders ifthe repurchases are accomplished at market prices

• How to account for share repurchases– Calculate the effect of share repurchases on company’s earnings

– Forecast the effect of repurchase on shares outstanding of the company



6. Implied Dividend Growth Rate6. Implied Dividend Growth Rate

1 V l f S k1. Value of Stock

r = Rf + B (ERP) = 5.6% + 1.1 (6%) = 12.2%

Vo = Do (1+g) / (r – g) = 2 (1+5%) / (12.2% ‐ 5%) = $29.17Vo Do (1+g) / (r g) 2 (1+5%) / (12.2% 5%) $29.17

2. Expected growth rate

Vo (r –g ) = Do (1+g) => 40 (12.2% ‐ g) = 2 (1+g)


4.88 – 40g = 2 + 2g => 42g = 2.88 => g = 2.88/42 = 6.86%


6. Implied Dividend Growth Rate6. Implied Dividend Growth Rate

Example: FFC is currently trading at Rs129/share. The stock has current dividend of14 5/ h C i k f i 13 5% k b i 0 9 d i i k i i14.5/share. Current risk free rate is 13.5%, stock beta is 0.9 and equity risk premium is7%. What is expected growth built in stock price?



7. Present Value of Growth Opportunities (PVGO)7. Present Value of Growth Opportunities (PVGO)

• The value of any stock can be analyzed as sum of;V l f i h i i– Value of company without earnings reinvestment,

– Present value of growth opportunities.

Vo = E1 /r + PVGO

PVGO = Vo – E1/r

• Companies that have good business opportunities and/or a high level of managerial flexibility in responding to changes in the marketplace should tend to have higher values of PVGO than companies that do not have such advantages.



7. What determines PVGO7. What determines PVGO

• Scalability of business – Banking, Telecom, Manufacturing

• Immunity from competition due to strong franchise value – P&G, Unilever, Gillette, Google, Facebook,

E l i li t t i k t t i l Mi i L l T l• Exclusive license to a certain market or raw material – Mining, Local Telecom monopoly



8. GGM & Price‐to‐Earning Ratio8. GGM & Price to Earning Ratio

Leading Price to Earning Ratio

Po = Do (1+g) / (r‐g)

Where

P0 = Current Market PricePo = Do (1+g) / (r‐g)

Po = D1 / (r‐g)

Po/E1 = (D1/E1) / (r –g)

D1/E1 = Payout Ratio

P0 = Current Market Price

P1 = Next year price

Do = Current year dividend

D1 = Next Year Dividend

= 1 – Retention Rate (b)

Price to Earning Ratio = Payout Ratio / (r – g)

= (1 – b) / (r – g)

T ili P i E i R i

g = growth rate

b = retention rate

Trailing Price to Earning Ratio

Po = Do (1+g) / (r‐g)

Po = Do (1+g) / (r‐g)

Po/E0 = (Do/Eo) (1+g) / (r –g)Po/ 0 ( o/ o) ( g) / (r g)

D0/Eo = Payout Ratio

= 1 – Retention Rate (b)

Price to Earning Ratio = Payout Ratio x (1+g)/ (r – g)


= (1 – b) (1+g) / (r – g)


8. GGM & Justified PE ratio8. GGM & Justified PE ratio

• Example: The Karachi Stock Exchange is currently at 12,400 level. Current k t i t i (PE) ti i 7 5 Th t i t dmarket price‐to‐earning (PE) ratio is 7.5x. The corporate earnings are expected

to grow at 12% and average payout of the market is 60%. Required market rate through CAPM is 19%. What is justified PE and fair target level for the market.

• P0/E1 = ? Payout ratio = 60% g = 12%

/ / ( )• P/E = Payout ratio / (r – g)

= 60% (19% ‐12%) = 60% / 7%

8 6= 8.6 x

Market target = Current Index level / current PE x Fair PE

= 12 400 / 7 5 x 8 6


= 12,400 / 7.5 x 8.6

= 14,218 (14.7% upside)


10. Multi‐stage DDM10. Multi stage DDM

• GGM assumption of stable dividend growth from now till infinite is not realisticfor all the companies Companies have three distinctive phases of growth;for all the companies. Companies have three distinctive phases of growth;

– Growth phase

• company in growth phase enjoys rapidly expanding markets, high profit marginsand abnormally high growth rate in earnings per share.

• FCFE is generally negative due to heavy reinvestment requirement.

• Due to high growth prospects, dividend payout is generally low in this phase.

– Transition Phase

• In this phase, earnings growth slows as competition puts pressure on margins aswell as sales slows due to saturation

• Earnings growth rate may still be above normal but declining to the normalgrowth rate of economy

• Capital requirements decrease leading to positive FCFE and increasing payout



10. Multi‐stage DDM10. Multi stage DDM

– Mature Phase

• In mat rit ne in estment opport nities onl earn their cost of capital• In maturity, new investment opportunities only earn their cost of capital

• ROE approaches required rate of return

• Earnings growth, dividend payout and return on equity stabilize at a level whichcan be sustained on the long termcan be sustained on the long term

• Gordon Growth Model can be used to value a company in this stage

GROWTH

1 P k d Milk

TRANSITION

1 C ll l

MATURITY

1 F ili1. Packaged Milk2. Ice Cream3. Broadband4 Power

1. Cellular2. Fertilizer3. Paper & board

1. Fertilizer2. Power3. Fixed Line


4. Power


10. Two Stage DDM10. Two Stage DDM

• Two common versions of 2‐Stage DDMModel exist

– General 2‐stage DDMModel

• Whole stage 1 assumes abnormal growth rate

• Transition to maturity in stage 2 is abrupt

– H‐Model

• Dividend growth is assumed to gradually decrease from abnormal rate to maturet i t 1rate in stage 1


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