Slides_Fundamentals of Investments - Chapter 6 ppt

The Dividend Discount Modelwhere V0 = the present value of the future dividend stream Dt = the dividend to be paid t years from now Dividend discount model DDM Method of estimating the

Valuation & Management

Charles J Corrado Bradford D.Jordan

Common Stock Valuation

Our goal in this chapter is to examine the methods commonly used by

financial analysts to assess the economic value of common stocks

Goal

Š These methods are grouped into two

categories:

c dividend discount models

d price ratio models

Security Analysis: Be Careful Out There

Š The basic idea is to identify “undervalued”

stocks to buy and “overvalued” stocks to sell

Š In practice however, such stocks may in fact

be correctly priced for reasons not immediately apparent to the analyst

Fundamental analysis

Examination of a firm’s accounting statements and other financial and economic information to assess the economic value of

a company’s stock

The Dividend Discount Model

where V(0) = the present value of the future dividend

stream

D(t) = the dividend to be paid t years from now

Dividend discount model (DDM)

Method of estimating the value of a share of stock as the present value of all expected

future dividend payments

( ) ( ) ( ) ( )T

k

T D k

D k

D k

D V

+

+

+ +

+ +

+ +

=

1

) ( 1

) 3 ( 1

) 2 ( 1

) 1

( )

0

The Dividend Discount Model

Š Assuming that the dividends will grow at a

constant growth rate g,

g g

k

g

D V

00

1

11

1

00

The Dividend Discount Model

Example: Constant Growth Rate Model

Š Suppose the dividend growth rate is 10%, the

discount rate is 8%, there are 20 years of dividends to

be paid, and the current dividend is $10 What is the value of the stock based on the constant growth rate model?

— ( ) ( ) $ 243 86

08 1

10

1 1

10 08

10 1 10

$ 0

The Dividend Discount Model

Š Assuming that the dividends will grow forever

at a constant growth rate g,

g k

D g

The Dividend Discount Model

Example: Constant Perpetual Growth Model

Š Consider the electric utility industry In late 2000, the utility company Detroit Edison (DTE) paid a $2.06 dividend Using D(0)=$2.06, k =8%, and g=2%, calculate a present value estimate for DTE Compare this with the late-2000 DTE stock price of $36.13.

— ( ) ( ) $ 35 02

02 08

02 1 06

2

The Dividend Discount Model

Š The growth rate in dividends (g) can be

estimated in a number of ways

c Using the company’s historical average growth rate.

d Using an industry median or average growth rate.

eUsing the sustainable growth rate.

The Dividend Discount Model

Sustainable = ROE × Retention ratiogrowth rate

Return on equity (ROE) = Net income / Equity Retention ratio = 1 – Payout ratio

The Dividend Discount Model

Example: The Sustainable Growth Rate

Š DTE has a ROE of 12.5%, earnings per share (EPS)

of $3.34, and a per share dividend (D(0)) of $2.06

Assuming k = 8%, what is the value of DTE’s stock?

— Payout ratio = $2.06/$3.34 = 617

So, retention ratio = 1 – 617 = 383 or 38.3%

— Sustainable growth rate = 12.5% × 383 = 4.79%

— ( ) ( ) $ 67 25 $ 36 13

0479

08

0479

1 06

2

The Two-Stage Dividend Growth Model

Š A two-stage dividend growth model assumes

that a firm will initially grow at a rate g1 for T years, and thereafter grow at a rate g2 < k

during a perpetual second stage of growth

2

2 1

1 1

1

11

11

1

00

g k

g D

k

g k

g g

k

g

D V

T T

++

=

Discount Rates for Dividend Discount Models

Š The discount rate for a stock can be estimated using

the capital asset pricing model (CAPM ).

Š Discount = time value + risk

rate of money premium

= T-bill + ( stock × stock market )

rate beta risk premium

T-bill rate = return on 90-day U.S T-bills stock beta = risk relative to an average stock stock market = risk premium for an average stockrisk premium

Observations on Dividend Discount Models

Constant Perpetual Growth Model

9 Simple to compute

8 Not usable for firms that do not pay dividends

8 Not usable when g > k.

8 Is sensitive to the choice of g and k.

8 k and g may be difficult to estimate accurately.

8 Constant perpetual growth is often an

unrealistic assumption

Observations on Dividend Discount Models

Two-Stage Dividend Growth Model

9 More realistic in that it accounts for two stages

of growth

9 Usable when g > k in the first stage.

8 Not usable for firms that do not pay dividends.

8 Is sensitive to the choice of g and k.

8 k and g may be difficult to estimate accurately.

Price Ratio Analysis

Š Price-earnings ratio (P/E ratio)

Î Current stock price divided by annual earnings per share (EPS).

Š Earnings yield

Î Inverse of the P/E ratio: earnings divided by price (E/P).

Š High-P/E stocks are often referred to as growth

stocks, while low-P/E stocks are often referred

to as value stocks.

Price Ratio Analysis

Š Price-cash flow ratio (P/CF ratio)

Î Current stock price divided by current cash flow per share.

Î In this context, cash flow is usually taken to be net

income plus depreciation.

Š Most analysts agree that in examining a

company’s financial performance, cash flow can be more informative than net income

Š Earnings and cash flows that are far from each other may be a signal of poor quality earnings

Price Ratio Analysis

Š Price-sales ratio (P/S ratio)

Î Current stock price divided by annual sales per share.

Î A high P/S ratio suggests high sales growth, while

a low P/S ratio suggests sluggish sales growth.

Š Price-book ratio (P/B ratio)

Î Market value of a company’s common stock divided by its book (accounting) value of equity.

Î A ratio bigger than 1.0 indicates that the firm is creating value for its stockholders.

Price Ratio Analysis

Intel Corp (INTC) - Earnings (P/E) Analysis

Price Ratio Analysis

Intel Corp (INTC) - Cash Flow (P/CF) Analysis

Current CFPS $1.975-year average P/CF ratio 21.6CFPS growth rate 15.3%

expected = historical × projected CFPSstock price P/CF ratio

= 21.6 × ($1.97×1.153)

= $49.06

Price Ratio Analysis

Intel Corp (INTC) - Sales (P/S) Analysis

An Analysis of the

McGraw-Hill Company

An Analysis of the McGraw-Hill Company

@2002 by the McGraw- Hill Companies Inc.All rights reserved.

An Analysis of the McGraw-Hill Company

Getting the Most from the Value Line Page

An Analysis of the McGraw-Hill Company

Š Based on the CAPM,

An Analysis of the McGraw-Hill Company

Quick calculations used: P/CF = P/E × EPS/CFPS

P/S = P/E × EPS/SPS

An Analysis of the McGraw-Hill Company

Work the Web

Chapter Review

Š Security Analysis: Be Careful Out There

Š The Dividend Discount Model

Î Constant Dividend Growth Rate Model

Î Constant Perpetual Growth

Î Applications of the Constant Perpetual Growth Model

Î The Sustainable Growth Rate

Chapter Review

Š The Two-Stage Dividend Growth Model

Î Discount Rates for Dividend Discount Models

Î Observations on Dividend Discount Models

Š Price Ratio Analysis

Chapter Review

Š An Analysis of the McGraw-Hill Company