The Dividend Discount Model

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What characteristics should be present for the company to be eligible to apply the DDM valuation model?

1. Must be dividend paying (obviously) 2. There needs be a clear relationship of dividends to operating results (EPS), i.e. the dividend payout ratio should be changing along with changes in EPS. A company with volatile earnings and fixed dividend would not be an appropriate candidate for the DDM valuation. 3. Long term growth rate g must not exceed the required rate of return r. 4. Earnings must grow at a rate comparable to or lower than GDP.

What is the Gordon Growth model most sensitive to?

Assumed growth rate and the required rate of return.

What is total return on the stock?

Capital gains yield + Dividend yield

What can we say about the stock whose required rate of return is greater (smaller) than its expected return?

Greater - stock overvalued Smaller - stock undervalued

Describe a Two-Stage DDM with linear growth rate change.

H-Model, assumes dividend growth declines gradually. V_o = [D_o (1+g_l) + D_o * H * (g_s - g_l)] / (r - g_l) H = half life of high growth period (yrs) H Model breaks the value down into two components: the value under assumption that the dividend growth at the long term rate forever, and the additional value that comes from supernormal growth for years 1 through 2H

What is the stock growth rate is the stock is fairly priced?

If the stock is fairly priced according to DDM, the stock price is expected to increase at the sustainable growth rate g.

What is the expected capital gains yield and total return on the stock that is fairly priced?

If the stock is fairly valued: - expected capital gains yield is the sustainable growth rate (i.e. the stock price is expected to grow at g) - the expected total return is equal to the required return (discount rate)

Can DDM be applied to a company where growth in earnings and dividends exceeds the cost of equity?

No.

Can DDM be applied to a company whose earnings are growing materially faster than GDP?

No.

What is Leading Justified P/E?

P/E justified by fundamentals, can be derived from Gordon Growth model. Based on forward (projected) earnings. P_o / E_1 = (1-b) / (r-g)

What is Trailing Justified P/E?

P/E justified by fundamentals, can be derived from Gordon Growth model. Based on trailing (the most recent) earnings. P_o / E_o = (1-b)(1+g) / (r-g)

Define Leading P/E using PV of growth opportunities.

P_o/E_1 = (1/r) + (PVGO/E_1)

State the Du Pont Analysis formula.

ROE = (Net Income / Sales) (Sales / Total Assets) (Total Assets / Shareholders' Equity) ROE = (Profit Margin) (Asset Turnover) (Equity Multiplier) Equity Multiplier aka Financial Leverage Multiple

Describe a Two-Stage DDM with non-linear growth rate change.

Stage I: period of abnormal growth Stage II: mature stage, with abrupt transition V_o = PV of the dividends, in both stages plus PV of terminal value

How to value a fixed rate perpetuate growth preferred stock?

V_o = D/r* where r* is the cap rate: r* = Return on equity + Risk-free rate

What is present value of growth opportunities?

V_o = E_1 / r + PVGO The value of a company can be broken up in two components: the first one being the value of the company assuming no growth and the second one being the value of its projected growth opportunities. PVGO is the value of a company's real options.

Describe the Gordon Growth model.

V_o = [D_o * (1+g)] / (r-g) r - discount rate g - long term growth rate

Can DDM be applied to a company that repurchases shares?

Yes.

Can DDM be applied to value a company if the dividends are suspended for a few years?

Yes.

What is sustainable growth rate? Provide the definition and assumptions.

g = b * ROE where b is the retention rate Sustainable growth rate is the rate of dividend and earnings growth that can be sustained for a given level of ROE, assuming that the capital structure is constant through time and that additional common stock is not issued. Assumptions: 1. Externally generated debt 2. Internally generated equity 3. Constant ROE


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