Reading 20: Discounted Dividend Valuation

Page No. 9Date / /Reading . : 0 20Discan tedDividend ValuationInput to DCF models1) Div2] FCF0] Residual IncomeSutability for DivCompany hashistory of payingdivallowitementBoD hasadiv policythat has anunderstandableandconsistentrelationship to prefitabilityMinority shareholdertakesanon- control pensetiveMatureficmsprofitablebut not fast growth*DCF valuationAn assetsintrensic valueisthe presentvalueof itsexpectedfutureCashflowDivVo =99CFEApplying this model in to practicet= (1+1)+reqtheanalystaccuratelyforecast div for manyperiod PaDate//Various Measure of CF in valuationDividends = Cash paidtoshareholdersusedinDDMtFCF = Cash availabletoshareholderbroaderResidual Income = economicpayscopeprofitKey point=Valuationmetric leg div or FCF)mustbemeasuredand relatedtoearningspowerDivident as InputCAdvantageand predictableLess volatile thanotherCashflowmeasuresMorestubleTheoretically justifieddiv for arewhatyourecwhenyou buy stocAccounts forreinvestedearningstoprovidea basisfor increasedfuturedividendsDCF modelisless sensitivitivetoShorttermfluctuation inunderlyingH ReflectlongtermIntrincicvalueAccountsforreinvestedearningstoprovideabasisfor Increasefuture div.bstuagra 8inPage No 11Date//NonDivDisadvantagepayingfirmDiv artificiallysmallClack cash or unprofitable)Div mayfortaxreasonsnottherefect theCon tradesiredprespectivebyinvestorFCFbriativitFCFrepresentsCash flowdistributiontothen providersofCapital:tastrizonCFO - Net CopexFCFF : CF distributedtoallprovidersofCapital C D & E)(FO - -Net Caper Net pay" todebtFCFE ; CF distributabletoequityholdersoiMuchmoreonthistopicinlaterreadings,-fofsdofbublesAdvantagellnUsed with any fism. thathasdiffdiv andfinancing / leveragepoliciesFCF Can beviewedaswhatafirmcouldpayin divPopularwithmanyanalysts Page No. 12Date / /DisadvantageNegative FCFresultingfromlargecapitalexp demands.May req longforecostperiodforCFtoturn+ve,introduinggreatermodeluncertaintySituationswhenappropriateNoDiv not relateddividend pay" historytoFCF Consistent withearningsordivand FCF differprofita bilitywithinareasonabtimeperiod.ControllingshareholderperspectiveResidual IncomeCR)Earningsinexcessoftheinvestorsreqreturnonthebeg - of - period investmentResidualincomefocusesonall oppor tunityprofitabilityin relation tocosts facedby the firm.Think:Economic- Moreprofitinup comingreadingAdvantagesWideUsedapplicability / evenfordivandifFCF <0.IncorporateopportunityCostnon - div paying firmsand equity holders.of Capital, for both debt Page No. 13Date//BringsrecognitionvalueclosertothepresentbyforecastedresidualIncome.RestateddivdiscmodelDisadvantageApplicationoftheRI modelreqadetailedknowledgeof accrualaccountingThe qualityofaccountingdisdosurecan maketheuseofRvaluationlessrobust : andmore errorproneSituationwhenappropriate201729algoidUsedwithfirmsthathavebarnadivhistoryUsedwith-veFCFLesshorizon dependence9tI=DDM ; How ToProcess :Discthefuturedivatthereqlateof returnrostoilStepI;EstfutureDiv2] : Determineleq return3]:Value =PVC expecteddiv)9M Page No.inDate//*DDM M2The Rule: Valueofpresentvalue of allfuturedivdisc atreqreturn.That is :8DtVo =t(11r)filougProblem : Reqestofinfiaitestream of CFsSign SinglePeriod DDMSingle - periodDDMisthepresentvalueofthefuturedivandsalespricedienVo =D.+P,(1+r)+(It=DitPTerminalvalue(1+r)2229.0NoticetherearetwoCFinthefinalperiodExampleExample :BBoverorunder valued =?Current MP = 26Expected year enddiv = 1.25Expected yrStock price - 28Reqreturn=87. Page No. 15Date / /SolVo=D1+P=1.25 + 28(1+1)1.08= 27.08Over-valuedTwo - periodDDMExtendssingleperiodmodelValue = PVtwoyrofCFandthefutureSales priceVo=DrD2+P2= D1Dz +PzTerminal Value(1+r)(1tr)2(Hr)2(1tr)(Hr)Noticethatinfinalyear, twoCashflowaccursExample - MachinesUnlimited(MU)sharesforC$40Is MUover-or.undervalued.ExpectedIDiv=C$1.55ExpectedYr2Div= C$1.72Expected price atthe end of yr 2=ct42Req ReturnII147.SolnnVo=D,+Dz +P,(Ltr)(1+1)2=1.551.72 t 42+1.141.14= C$35CMP = C$40 ;thusovervalued Page No.VCDate / /Multiple - PeriodDDMThe modeltakesthepresentvalueofall futureCFNote :ifyouCandoI&2periods,youcandonperiodVo = D1Dn + Pn(Itr)(1+r)" (1+r)"TerminalVo =inDt+Pnvaluet=1 (1+r)+(Itc)Simplifyingassumptions,forfuturegrowth:IConstantGrowth(Gordon model)sudden change in g2Two- stagegrowthl 3-stage3H- model4Otherassumptions(e.gN-Stagespreadsheet)GrodonGrowthModel(GGM)M3V. =Do(l+g)=D1(r-g)(r-g)Assumptions :-1.Dividend(D.)expectedinoneyear2.Dividendsgrowatconstantrate(g) forever.3.Growth ratelessthanreqreturn(r>g)y can be -veTotalRetuinNDivyield+ Capitalgainsyield Page No. 1716aCom panyisrepurchasing ShoreDate / /GGM can be usedSituationsinwhichmodelisusedfulMature (lateinlifecycle) firmBroad - based equityindexTerminalvalueinmorecomplexmodelsEstg,r&PVGOCan beusedtocalculatePLEratioMinority perspectiveThE GGMmodelshouldreflectlong-term grow thexpectations - GDPgrowthrate,Industrylife cyclestagesandImpactIfgrowth 1 atetwohighuse thisThemodelintrinsicvalueV.are verysensitivetotheinputvariables forr & gSensitivityanalysis maybe reqto obtainarangeofvalue ratherthana specific pointestofvalue00Example :ConstantGrowth( Gordon )DownUnder:- PaidadivyesterdayofA$1.8- Div are expectedtogrowatalong:-termConstant rateof3.5%- Beta is1.5Rfrateandexpectedreturn onmarketis4%&8%respectivitySol:Reqrateofreturnr=4%+ 1.5 (87.-4.7.)=10%V. = A $1.8 (1.035)=A $ 28.660.10 - 0.035 Page No. 18Date//Implied Growth RateGivenCurrentmarketpricewecancalculatetheDmpliedgrowthrateg = r- (D.)Po =D,JPor-gCapital Gain yield(1-Bo)=Dr&((GY)PoPeofgED ! -PoPoPV ofGrowthOpportunities(PVGO)g = r APoEquityvaluehastwoComponents1.ValueofnogrowthfromEL(ieassetsCurrentlyin place)earnings2.Presentvalueoffuturegrowthopportunities(PVGO)Model :P. =E1tPVGOPVGO = Po - E1CMP[rResidualExampledivtodayare$ 1-6andthecurrentis$ 40withexpectedpricegrowthof9%thelegretainisr=1.6(It 9%)9%+F- D1 tg40Po=13 36 Y.N VePVGOStock very undervaluedcurrent strategy distroy valuePage No.19NogrowthvaluemaybetoohighDate//Increase inShareholderweal 1thcomeswhenreinvestedearnings aredirectedtowardinvestmentwhichearngreaterreturnsthantheopportunitycostofthefunds.Companies without positiveNPVprojectsshoulddistributedallcarnigsindivbecauseprofitabilityandwillearingcannotbe reinvested-earningsflatinperpetuityassumingaContantROEPVGOModelUsingLeadingPLE,Point:MorphPVGOmodelintoa(leading)Pollmode-Justdivthrough byE1319Po =I+PVGOE1E,toiogIntuition-1 = Pratioforanogrowthr E1CompanymuzzAsaijact- PVGO = PComponentrelatedtoE1growthE,Note :GrowthCompanies:HighPVGOValuecompanies:LowPUGO forworldPage No. 20Date//Example : ReliablestockpriceisSFr 60 expected earningsof SFr5.0andreqrateofretuinof10%Calculate:- PVGO- ProportionStockpriceattributabletoPVGOSolnVo pilEPVGOrGGM is used60=5.+ PVGOfor Cos that are0.10RepurchasingPVGO=SF,10.sharesPIEofthefirm=60/5=12PIEattributabletoPUGO =10/85216.(2).*GordonandJustifiedPlEsPoint: TheGGMCanalsobeusedtocalculateajustifiedfundamental pricemultipleAssumeconstantdivpayoutratioDefinebistheretentionrateDeuturPo = D1Justified leadingPe=E1-Dir PayoutPayoutr-gE1r-ggP.C1-b)Elr-gExpected payout accuratelyvalueGGMsharesanalystCompanies that are repurchasingcanod,divgrowthrateforPage No 21impat of share priceDateAssumeJustified trailing P/E.constantdivdefinebpayout latioas theretentionrate:Pa =D.LE.E.5-genoitylo= (1-b)( (+g)spot? out -r-gapotaboom HSuitabilityCompanyhashistoryofpayingdivBodhasadivpolicythathasanunderstandableand ConsistentrelationshiptoMinority shareholdertakeprofitabilityanon-controlperspectiveMaturefirms,profitablebut not fastgrowth< 30.9StrengthUsedwithboardmarketindexes(developedmarket)aEst g,&PVGO& ERPSupplementtomoreComplexmodels(terminalvalue) SimpleJudge equityvalue/ValuingmarketindiciesWeaknessValue(Vo)verysensitivitytoestimatesof[&gDifficult tousewithnon- div -paying -stockModelSection : MinorityperspectiveonlyNotusefulforvaluingM&A Page No 22Date / /12th Oct2022 WednesdayMulti - stage DDMModelsGGM assumption : Stablegrowthrate foreverProblemUnrealisticformostfirms.Solutions includes :-73- Two - Stage- H --model t three staye- Spreadsheet modelingPhasesofGrowthIInitialGrowthPhase-Use3-StagemodelbasotionProfit marginRapidEPSgrowthveFCFROE > rnoortlowdivII]TransitionalphaseUse2- StagemodeliSales& EPSslow Idiup+ FCFofms/gque-ROE approching ( CROE N ()IIIMaturephase-UseGGMfromGrowthat-economywideratetve FCF/ROE =r,highcom petitionSaturation. Page No. 23Date//Terminal ValueTerminal Value=ForecasteValue atbegofthefinal maturegrowthphaseAlsoKnownasthefutureSalepriceTwo estimationsmethods :1]GGM:Dati(rtg)2] Relative ; TrailingmultiplePIE X forecastedEPSloitingvalueTwo - stage DDMdimmotFirst :FixedperiodofsupernaturalgrowthThen :Indefinitegrowthatnormal level-Useful in casegrowthrateisexpectedtodropsuddenly :- Patent expiration- Firm entersmaturephasaoflifecycleafter arapidgrowthstageProblem -GGMConstantgisunrealisticSolution -Assumerapidgrowthforyears ) thenlong termsustatiablegrowth Page No. 24Date / /CAIHigh rate 7,Two - Stage assumedrop off in growthstable late ZàImpAStage Inyr stayezTime:eastimitiesowApplication of Two stagemodelingMadridTwo stage of grow th- Initial growth (high) phase- PerpetualStablegrowthratephaseTwo approches- FormulaHard-TimelineEsybaritItprovidestheflexibilitytosolvemany type ofproblemsglasbberMethodologytastofIIndividual2Calculationest of supernomal divofterminalvaluefollowed byabigNote - VeryImpVo =PV (Divoverfirstny yr ) +P.V (terminal value )from GGM or price multiplue applech Page No. 25Date/ /Example: Sea IslandDowhich willCurrentlypaydivof $1.00growat10 %3 yrpesyearforstayetwoContantgrowth4%Req retuin= 12%the CalculatevaluetodaySol11I2$1.10$1.21T31.33$+17.24(01 = 1.10(02=1-21C03=1.33#7.29High%.1=12%NPV = 15.20 = 18.62stablerate 41.P3$17.24 =1.32 X (1.04)0.12-0.04Stage,Time3yrStajezH- ModelAssumeagradualdecayingasoverfirmmatureatran sitionperiod.gHigh 7.Stable 7.>stage nyrStage 2n= 24H- Half2u = x x x RH (ys-gi)Page No. 26Date / /Problem : Two- Stage model assumes high growth ratewill suddenlydropH-Model : More realistic assumption- -Firm will start with high growth rate-Growth declines linearlyoveratranstionperiodT - Zu' yrNote: Onlyorapproxmethod :moreaccuratewhenHand(gs-gc)is small05 of high Trunsition periodRecentof grinds2short-term highDigrowth rateVo =Do X (1tgc)+Doxu x (g5-91)F-gr- g,Rey ReturnLong-term two growth lateExample: Omega foodsCurrently pay a div of$ 2.00 DoStage one growth rate is 20 % gsGrowth is expected to decay over 10yr24Constant growth rate of S% thereuftergcReq return is127rCalculate Intrinsic value Capitalization=ReaRateofReturnPage No. 27Date / /XM(ys-yl)r-g2 X S X C.0.20 -0.05)21-43==0.12-0.05D.(1tgc)2.00X(1.05)=30.00=F gl0.12-0.05Po = 30 + 21.43= 51.43Calculatingrateofreturn(r)intheH. modelgiventhemarketpricer=(Do)(1+gc)[HX(gsgc)If+ ItPo006JustputoptioninModelformulaDDM:Multistagemodel3- StageModel :twoapproaches1. Three distinct phases 1 simplyaddanadditionalgrowth stage tothetwo - stage modelGrowth f transition&mature2.High - growthphase+n -modelpatternHigh followed by (incally declining followed byperpetualgrowth Page No. 28Date//Multi-Period ModelsStrength- Abilitytomodelmanygrowthpatterns- Solvefor V, g 4r.Weakness- Req high - quality inputs ( GIGO)c Value est sensitive to g & r-Model suitability very ImpSGR : The SustanableGrowth RateSGR (g) = Sustanable growth rate in earnings anddivifweassume:- Growth usesinternally generated equity- Capital Structer remains unchanged- Several Key sutias heldConstantFormula :g = RR X ROEhapot2ROE =NIRevXRevXAssetsAssetsEquityROE = Net profitXAssetEquityMarginturnovermultiplier EquityFore castelong-termConsensusdiv yield+= long termPage No.29RiskGovt bond yieldPromearrings growthDate//rateNote : AlwaysuseBey of-yrbalancesheetno.unlesstoldotherwisePoint : SGR = RR XROE5GRValueDriversandtheirImpact1]Net Income :Measureprofitabilityhighermarginsresults inReva higherROE2Rev:Operational efficiencyhigher turns results inTotal Assethigher ROE3Assets :Financial leveragevia the equity multiplierEquitybased onthefirms financing policies,high el leveragehigherROESpread sheet ModetingAllowmoreflexibilityinforecastingCFStep :- Establish base lvl CF- Forecastdeviationfornearfuture(e.gsuper naturalgrowthforfirstfour yr)- Project normalgrowthbeyondnear future- Disc allOFtoPV Page No. 30Date//Spreadsheetmodels areflexible& analyst Can useScenario analysist toseehow changeindivorintrate affect valuations , .Used for213 stage DDM or H-modelEasytoshareand work in teamsandIfMPS > Model Price:Over valuedMPS < Model price:UndervaluedMPS = Model priceFairely valuedfritabol