**Dividend Discount Models PT 2**

In this lesson we are going to learn how to value a stock with different Investment models such as the Zero Growth Model, Constant Perpetual Growth Model, and the Discounted Cash Flow Model.

**Zero Growth Model**

This model Assumes dividends will continue at a fixed rate indefinitely into the future.

**It’s calculated:**

Value of stock= Annual Dividends / Required Rate of Return

**Quick Example: **

Annual dividend = $3.00 per share

Required rate of return = 6%

$3.00 / 6% = $50.00 per share

**Now let’s do a REAL-LIFE example:**

Consolidated Edison – ED (Utility income stock)

- Current market price is $56.58 per share (15 Feb 2013)
- Currently paying $2.46 per year in annual dividends
- The question is, “What is our required rate of return?”

* Let’s first use 8%*

* Value* = $2.46 / 8% = $30.75

The stock is overpriced if our required rate of return is 8%

What about 5%?

* Value *= $2.46 / 5% = $49.20

The stock is still too expensive if our required return is 5%

**Note:** *With a market price of $56.58, the stock is yielding 4.4%. *

*The Zero Growth Model works well for stable, income-producing stocks.*

**Constant Perpetual Growth Model**

This model assumes dividends will continue to grow at a specified rate perpetually into the future.

**It’s Calculated like this:**

**Value of stock**= Annual dividends * (1+Constant growth rate) / Required rate of return – Constant growth rate.

### Quick Example:

- Annual dividend = $10 per share (Next year’s=$10.50)
- Annual dividend growth rate = 5% per year
- Required rate of return = 15%

($10 * 1.05) / (15% – 5%) = $10.50 / 10% = $105

**The stock should be worth $105 per share**

**Note**: *Good for companies with consistent dividend growth.*

### **Constant Perpetual Growth Model (Real-life Example)**

Johnson & Johnson (blue chip)

- Current market price is $76.16 (15 Feb 2013)
- Currently paying $2.44 annual dividends
- Assume dividends growing around 8% per year
- Our required rate of return is 13%

($2.44 * 1.08) / (13% – 8%) = $2.6352 / 5% @ $52.70

* Not a great buy if we require 13%, huh?*

What if our required rate of return were only 10%?

($2.28 * 1.08) / (10% – 8%) = $2.6352 / 2% @** $131.76**

** What a deal!**

** Note:** *The model is very sensitive to our choice of our required rate of return*

*repeat after me: ***“The value of a stock is based on the present value of its future cash flows.”**

**Discounted Cash Flow Model (DCF)**

The Discounted Cash Flow Model uses present value of expected dividends and the present value of the expected future price to value a share of stock

It is also called the *Dividends & Earnings Model*

**It is calculated:**

**Value of stock** = present value of future dividends + present value of the price of stock when we plan to sell

### Example:

Assume it is January 1, 2013. Pretzels Unlimited is currently selling for $22 per share and will pay $2.00 per share in dividends in 2013. PU expects to increase their dividends to $2.20 in 2014, $2.30 in 2015, and $2.30 in 2016. We will be selling the stock at the end of 2016 and we expect the price to be $27 per share at that time. Our required rate of return is 12%.

Value of stock = present value of future dividends

+ present value of price of stock when you plan to sell

** Value** = ($2.00*0.893)+(2.20*0.797)+(2.30*0.712)+(2.30*0.636)

+ ($27.00*0.636) =

= [ $1.786 + $1.7534 + $1.6376 + $1.4628 ] + $17.172 =

= $6.6398 + $17.172 = $23.8118 @ **$23.81**

Download Wall Street College’s PresentValueTable

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