Chapter 2 Discounted Dividend Valuation

1. Chapter 2 Discounted Dividend Valuation

2. Challenges • Defining and forecasting CF’s • Estimating appropriate discount rate

3. Basic DCF model • An asset’s value is the present value of its (expected) future cash flows

4. Comments on basic DCF model • Flat term structure of discount rates versus differing discount rates for different time horizons • Value of an asset at any point in time is always the PV of subsequent cash flows discounted back to that point in time.

5. Three alternative definitions of cash flow • Dividend discount model • Free cash flow model • Residual income model

6. Dividend discount model • The DDM defines cash flows as dividends. • Why? An investor who buys and holds a share of stock receives cash flows only in the form of dividends • Problems: • Companies that do not pay dividends. • No clear relationship between dividends and profitability

7. DDM (continued) • The DDM is most suitable when: • the company is dividend-paying • the board of directors has a dividend policy that has an understandable relationship to profitability • the investor has a non-control perspective.

8. Free cash flow • Free cash flow to the firm (FCFF) is cash flow from operations minus capital expenditures • Free cash flow to equity (FCFE) is cash flow from operations minus capital expenditures minus net payments to debtholders (interest and principal)

9. Free cash flow • FCFF is a pre-debt cash flow concept • FCFE is a post-debt cash flow concept • FCFE can be viewed as measuring what a company can afford to pay out in dividends • FCF valuation is appropriate for investors who want to take a control perspective

10. FCF valuation • PV of FCFF is the total value of the company. Value of equity is PV of FCFF minus the market value of outstanding debt. • PV of FCFE is the value of equity. • Discount rate for FCFF is the WACC. Discount rate for FCFE is the cost of equity (required rate of return for equity).

11. FCF (continued) • FCF valuation is most suitable when: • the company is not dividend-paying. • the company is dividend paying but dividends significantly differ from FCFE. • The company’s FCF’s align with company’s profitability within a reasonable time horizon. • the investor has a control perspective. • FCF valuation is very popular with analysts.

12. Residual income • RI for a given period is the earnings for that period in excess of the investors’ required return on beginning-of-period investment. • RI focuses on profitability in relation to opportunity costs. • A stock’s value is the book value per share plus the present value of expected future residual earnings

13. Residual income (continued) • RI valuation is most suitable when: • the company is not dividend-paying, or as an alternative to the FCF model. • the company’s FCF is negative within a comfortable time horizon. • the investor has a control perspective. • RI valuation is also popular. The quality of accounting disclosure can make the use of RI valuation error-prone.

14. Which is best, DDM, FCF, or RI? • One model may be more suitable for a particular application. • Analyst may have more expertise with one model. • Availability of information. • In practice, skill in application, including the quality of forecasts, is decisive for the usefulness of an analyst’s work.

15. Discount rate determination • Jargon • Discount rate: any rate used in finding the present value of a future cash flow • Risk premium: compensation for risk, measured relative to the risk-free rate • Required rate of return: minimum return required by investor to invest in an asset • Cost of equity: required rate of return on common stock

16. Discount rate determination • Weighted average cost of capital (WACC): the weighted average of the cost of equity, after-tax cost of debt, and cost of preferred stock

17. Two major approaches for cost of equity • Equilibrium models: • Capital asset pricing model (CAPM) • Arbitrage pricing theory (APT) • Bond yield plus risk premium method (BYPRP)

18. CAPM • Expected return is the risk-free rate plus a risk premium related to the asset’s beta: • E(Ri) = RF + i[E(RM) – RF] • The beta is i = Cov(Ri,RM)/Var(RM) • [E(RM) – RF] is the market risk premium or the equity risk premium

19. CAPM • What do we use for the risk-free rate of return? • Choice is often a short-term rate such as the 30-day T-bill rate or a long-term government bond rate. • We usually match the duration of the bond rate with the investment period, so we use the long-term government bond rate. • Risk-free rate must be coordinated with how the equity risk premium is calculated (i.e., both based on same bond maturity).

20. Equity risk premium • Historical estimates: Average difference between equity market returns and government debt returns. • Choice between arithmetic mean return or geometric mean return (see Table 2-2 p. 50) • Survivorship bias • ERP varies over time • ERP differs in different markets (see Table 2-3 p. 51)

21. Equity risk premium • Expectational method is forward looking instead of historical • One common estimate of this type: • GGM equity risk premium estimate = dividend yield on index based on year-ahead dividends + consensus long-term earnings growth rate - current long-term government bondyield

22. Arbitrage Pricing Theory (APT) • CAPM adds a single risk premium to the risk-free rate. APT models add a set of risk premiums to the risk-free rate: • E(Ri) = RF + (Risk premium)1 + (Risk premium)2 + … + (Risk premium)K • (Risk premium)i = (Factor sensitivity)i × (Factor risk premium)i

23. Arbitrage Pricing Theory (APT) • Factor sensitivity is asset’s sensitivity to a particular factor (holding all other factors constant) • Factor risk premium is the factor’s expected return in excess of the risk-free rate.

24. APT models • One popular model is the Fama-French three factor model using company-specific attributes: • RMRF – return on equity index minus 30 day T-bills • SMB (small minus big) – return on small cap portfolio minus return on large cap portfolio • HML (high minus low) – return on high book-to-market portfolio minus return on low book-to-market portfolio

25. APT models • The Burmeister, Roll, and Ross (BIRR) model uses five macroeconomic factors • Confidence risk • Time-horizon risk • Inflation risk • Business-cycle risk • Market timing risk

26. Using BIRR model • Use BIRR model to calculate required return on the S&P 500 (data in example 2-4, p 53) • The required return is: r = 5.00% + (0.27×2.59%) – (0.56×0.66%) – (0.37×4.32%) + (1.71×1.40%) +(1.00×3.61%) r = 9.74%

27. Sources of error in using models • Three sources of error in using CAPM or APT models: • Model uncertainty – Is the model correct? • Input uncertainty – Are the equity risk premium or factor risk premiums and risk-free rate correct? • Uncertainty about current values of stock beta or factor sensitivities

28. BYPRP method • The bond yield plus risk premium method finds the cost of equity as: BYPRP cost of equity = YTM on the company’s long-term debt + Risk premium • The typical risk premium added is 3-4 percent.

29. Build-up method • Cost of equity is the risk-free rate plus one or more risk premiums, one or more of which is usually subjective rather than theoretically sound. • For example, cost of equity is risk-free rate + equity risk premium +/- company-specific risk premium • BYPRP is an example of this. • Buildup method sometimes used for stocks that are not publicly traded.

30. Dividend discount models (DDMs) • Single-period DDM: • Rate of return for single-period DDM

31. More DDMs • Two-period DDM: • Multiple-period DDM:

32. Indefinite HP DDM • For an indefinite holding period, the PV of future dividends is:

33. Forecasting future dividends • Using stylized growth patterns • Constant growth forever (the Gordon growth model) • Two-distinct stages of growth (the two-stage growth model and the H model) • Three distinct stages of growth (the three-stage growth model)

34. Forecasting future dividends • Forecast dividends for a visible time horizon, and then handle the value of the remaining future dividends either by • Assigning a stylized growth pattern to dividends after the terminal point • Estimate a stock price at the terminal point using some method such as a multiple of forecasted book value or earnings per share

35. Gordon Growth Model • Assumes a stylized pattern of growth, specifically constant growth: Dt = Dt-1(1+g) Or Dt = D0(1 + g)t

36. Gordon Growth Model • PV of dividend stream is: • Which can be simplified to:

37. Gordon growth model • Valuations are very sensitive to inputs. Assuming D1 = 0.83, the value of a stock is:

38. Other Gordon Growth issues • Generally, it is illogical to have a perpetual dividend growth rate that exceeds the growth rate of GDP • Perpetuity value (g = 0): • Negative growth rates are also acceptable in the model.

39. Expected rate of return • The expected rate of return in the Gordon growth model is: • Implied growth rates can also be derived in the model.

40. PV of growth opportunities • If a firm has growing earnings and dividends, it can be worth more than a non-growing firm: • Value of growth = Value of growing firm – Value of assets in place (no growth) • OR

41. Gordon Model & P/E ratios • If E is next year’s earnings (leading P/E): • If E is this year’s earnings (trailing P/E):

42. Strengths of Gordon growth model • Good for valuing stable-growth, dividend-paying companies • Good for valuing indexes • Simplicity and clarity, also helps understanding of relationships between V, r, g, and D • Can be used as a component in more complex models

43. Weaknesses of Gordon growth model • Calculated values are very sensitive to assumed values of g and r • Is not applicable to non-dividend-paying stocks • Is not applicable to unstable-growth, dividend paying stocks

44. Two-stage DDM • The two-stage DDM is based on the multiple-period model: • Assume the first n dividends grow at gS and dividends then grow at gL. The first n dividends are:

45. Two-stage DDM (cont) • Using Dn+1, the value of the stock at t=n is • The value at t = 0 is

46. Two-stage DDM example • Assume the following values • D0 is $1.00 • gS is 30% • Supernormal growth continues for 6 years • gL is 6% • The required rate of return is 12%

47. Two-stage DDM example

48. “Shortcut” two-stage DDM (not in the book) • If gS is constant during stage 1, this works: • For gS=30%, gL=6%, D0=1.00 and r=12%

49. Using a P/E for terminal value • The terminal value at the beginning of the second stage was found above with a Gordon growth model, assuming a long-term sustainable growth rate. • The terminal value can also be found using another method to estimate the terminal value at t = n. You can also use a P/E ratio, applied to estimated earnings at t = n.

50. Using a P/E for terminal value • For DuPont, assume • D0 = 1.40 • gS = 9.3% for four years • Payout ratio = 40% • r = 11.5% • Trailing P/E for t = 4 is 11.0 • Forecasted EPS for year 4 is • E4 = 1.40(1.093)4 / 0.40 = 1.9981 = 4.9952