FE 445 – Investment Analysis and Portfolio
Management
Fall 2020
Farzad Saidi
Boston University | Questrom School of Business
Lecture 14: Dividend discount
models
Equity basics
Definition of equity:
• Issued by corporations
• Public: traded on exchange
• Private: closely held, including private equity
• Residual claim on company cash flow: limited liability
Different from non-corporate business (proprietor):
• Equity allows for more risk taking
• Equity allows for companies to be widely held
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Common vs. preferred stock
Common stock:
• Owner of company with voting rights
• Stockholders elect board of directors
• Proxy votes: someone can vote for you
• Management might own quite a bit of the company
Preferred stock:
• No voting rights
• Fixed dividend senior to common stock dividends
⇒ like a perpetuity (infinite lifetime bond)
• Embedded options: callable
2
Dividends
• DIV = 4 × last quarterly dividend
• Dividend yield = D/P(annual)
• Many companies do not pay dividends
3
Models of equity valuation
Fundamental stock analysis:
• Basic types of models to compute prices
• Balance sheet models
• Dividend discount models
• Free cash flow models
• Find relative bargains using comparables
• P/E ratios or other ratios using sales, etc.
Company data on the internet:
• SEC filings: www.sec.gov/edgar.shtml
• finance.yahoo.com
4
Balance sheet methods
Book value ⇒ benchmark only
• Value of common equity on the balance sheet
• Based on historical values of assets and liabilities
• May not reflect current values
• Assets such as brand name not on a balance sheet
Liquidation value
• Amount realized from sale of assets net of debt
• Floor to market value
• Becomes takeover target if valued less than this
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Balance sheet methods
Replacement cost method:
Market value
Tobin’s Q =
Replacement cost
• Use replacement cost of the assets less the liabilities
• Q should tend toward 1 over time
• Ceiling on market value in the long run
• Q > 1 will attract new entrants into the market
• Can you easily build a similar company?
6
Required return
Expected return:
Cash dividends and capital gains or losses
E (D1 ) + (E (P1 ) − P0 )
E (r ) = E (HPR) =
P0
Required return or market capitalization rate:
According to the CAPM
k = rf + β (E (rM ) − rf )
If the stock is priced correctly, then
E (r ) = k
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Intrinsic value
Intrinsic value: V0
• Discounted PV of expected cash flow from stock
• For a one year holding period:
E (D1 ) + E (P1 )
V0 =
1+k
• Cash flows: dividend D1 and resale price P1
• Value is ex-dividend: D0 has already been paid
Remarks:
• If V 0 > P0, buy stock
• If V 0 < P0, sell stock
• In efficient markets, stock is fairly priced: V0 = P0
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Example: intrinsic value
You expect the price of ABC stock to be $59.77 next year. Its current
market price is $50, and you expect the dividend next year to be $2.15
a) If the stock has a beta of 1.15, the risk-free rate is 6% per year and
the expected rate of return on the market portfolio is 14% per year,
what is the required rate of return on ABC?
b) What is the intrinsic value of ABC and how does it compare to the
current market price?
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Dividend discount model
Assumption:
• Markets are efficient all the time: V = P
• Allows us to plug in the following for P1 :
E (D2 ) + E (P2 )
E (P1 ) = V1 =
1+k
This yields:
E (D1 ) + E (P1 ) E (D1 ) E (D2 ) E (P2 )
V0 = = + 2 + 2
1+k 1+k (1 + k) (1 + k)
General dividend discount model: Do the above steps indefinitely
∞
X E (Dt )
V0 = t
t=1
(1 + k)
Problem: intractable, so need further assumptions
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No-growth model
Assumption:
• Constant dividends D over time:
D
V0 =
k
• Expected return k and value (price) inversely related
Example:
• Preferred stock: D= $2.00 and k=10%
• In practice, we have to adjust price for the value of embedded
options.
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Microsoft dividends
0.45
0.4
0.35
0.3
in USD
0.25
0.2
0.15
0.1
0.05
Jan2005 Jul2007 Jan2010 Jul2012 Jan2015 Jul2017
• You can get dividends under “Historical Prices:”
finance.yahoo.com/q/hp?s=MSFT+Historical+Prices
• Microsoft started paying dividends in 2005
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Constant-growth model
Assumption:
• Dividends expected to grow at rate g forever:
Dt = Dt−1 × (1 + g ) = D0 × (1 + g )t
Constant growth DDM:
• Assume k > g :
D0 × (1 + g ) D1
V0 = =
k −g k −g
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Examples
• D0 = $2.00, β = 1, E (rM ) = 10%, r = 2% and g = 4%
• What is the intrinsic value?
• k = .........
• V0 = . . . . . . . . .
• What if β = 1.2 (riskier firm)?
• k = .........
• V0 = . . . . . . . . .
• Are riskier firms worth more or less? . . . . . . . . .
• What if β = 1 but growth increases to g = 5%?
• V0 = . . . . . . . . .
• Higher growth makes the firm worth more or less?
14
Multi-stage growth models
• Over a firm’s life cycle, growth rates usually vary
• Two-stage growth model
• Plug Dt and PT into:
T
X Dt 1
V0 = t + P
T T
t=1
(1 + k) (1 + k)
to yield:
T
X (1 + g1 )t 1 DT (1 + g2 )
V0 = D0 + ×
t=1
(1 + k)t (1 + k)T k − g2
• g1 = first growth rate
• g2 = second growth rate
• T = number of periods of growth at g1
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Example
• D0 = $2.00
• k = 15%
• Growth g1 = 20% up to year T = 3 then slows to g2 = 5%
• What is the value of the company?
• Thus dividends are:
D1 = ......... D2 = . . . . . . . . .
D3 = ......... D4 = . . . . . . . . .
V0 = .........
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Problem with the DDM
• Do companies always pay dividends?
• Growth firms usually do not pay dividends
• Share repurchases: use earnings not reinvested to buy back your own
shares and then “shred them”
• The reverse of issuing equity (raising capital)
• Cash is only returned to those selling the stock
• If you keep your share, you own a larger and larger fraction of the
company
Problem: If stock never pays dividends, DDM claims V = 0
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Equity repurchases vs. dividends
B. Larrain and M. Yogo: “Does firm value move too much to be justified
by subsequent changes in cash flow?” Journal of Financial Economics
(2008)
18
Possible solutions
• Value the whole company
• Treat share repurchases as “dividends”
• Divide value by number of shares to get price per share
• Free cash flow model
• Replace dividends by free cash-flow to equity: FCFE
• Firms finance dividends and repurchases from FCFE
• FCFE is cash flow available to shareholders after:
• Taxes
• Net payments to debtholders
• Investments
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So how do I value a company?
In theory:
• All valuation models should give you the same value if all
assumptions are right
In practice:
• Various approaches often differ substantially
• Calculate it different ways
• Get a plausible range of values
• All models use simplifying assumptions:
• Think deeply about which are the most reasonable
• No model assumption will be correct exactly
⇒ Equity valuation is more “art” than science
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Summary
This class:
• Calculate P for dividend paying stocks
Next class:
• Price-earnings ratios
• Look at the aggregate stock market
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