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.
Value of stock= Annual Dividends / Required Rate of Return
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.
- 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
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