The Dividend Discount Model

Aswath Damodaran

Aswath Damodaran 1
 General Information

n The risk premium that I will be using in the 1999 and 2000 valuations
for mature equity markets is 4%. This is the average implied equity
risk premium from 1960 to 2000.
n For the valuations from 1998 and earlier, I use a risk premium of
5.5%.

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 Con Ed: Rationale for Model

n The firm is in stable growth; based upon size and the area that it
serves. Its rates are also regulated; It is unlikely that the regulators will
allow profits to grow at extraordinary rates.
n Firm Characteristics are consistent with stable, DDM model firm
• The beta is 0.80 and has been stable over time.
• The firm is in stable leverage.
• The firm pays out dividends that are roughly equal to FCFE.
– Average Annual FCFE between 1994 and 1999 = $553 million
– Average Annual Dividends between 1994 and 1999 = $ 532 million
– Dividends as % of FCFE = 96.2%

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 Con Ed: A Stable Growth DDM: December 31,
2000

n Earnings per share for trailing 4 quarters = $ 3.15

n Dividend Payout Ratio over the 4 quarters = 69.21%
n Dividends per share for last 4 quarters = $2.18
n Expected Growth Rate in Earnings and Dividends =3%
n Con Ed Beta = 0.80 (Bottom-up beta estimate)
n Cost of Equity = 5.1% + 0.80*4% = 8.30%
Value of Equity per Share = $2.18 *1.03 / (.083 -.03) = $ 42.37
The stock was trading at $ 38.60 on December 31, 2000

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 Con Ed: Break Even Growth Rates

Con Ed Value versus Growth Rate

$80.00

$70.00

$60.00

$50.00
Value per Share

Implied Growth Rate: Value per share = $ 38.60

$40.00

$30.00

$20.00

$10.00

$0.00
5.00% 4.00% 3.00% 2.00% 1.00% 0.00% -1.00% -2.00% -3.00%
Expected Growth Rate

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 Estimating Implied Growth Rate

n To estimate the implied growth rate in Con Ed’s current stock price,
we set the market price equal to the value, and solve for the growth
rate:
• Price per share = $ 38.60 = $2.18 *(1+g) / (.083 -g)
• Implied growth rate = 2.51%
n Given its retention ratio of 30.79% and its return on equity in 1999 of
10%, the fundamental growth rate for Con Ed is:
Fundamental growth rate = (.3079*.10) = 3.08%

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 Implied Growth Rates and Valuation
Judgments

n When you do any valuation, there are three possibilities. The first is
that you are right and the market is wrong. The second is that the
market is right and that you are wrong. The third is that you are both
wrong. In an efficient market, which is the most likely scenario?

n Assume that you invest in a misvalued firm, and that you are right and
the market is wrong. Will you definitely profit from your investment?
o Yes
o No

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 Con Ed: A Look Back

Con Ed: Valuations over Time

$60.00

$50.00

$40.00
Per Share

Estimated Value
$30.00
Price per Share

$20.00

$10.00

$-
1: December 1997 2: December 1998 3: June 1999
Date of Valuaton

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 ABN Amro: Rationale for 2-Stage DDM

n As a financial service institution, estimating FCFE or FCFF is very

difficult.
n The expected growth rate based upon the current return on equity of
15.56% and a retention ratio of 62.5% is 9.73%. This is higher than
what would be a stable growth rate (roughly 5% in Euros)

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 ABN Amro: Summarizing the Inputs

n Market Inputs
• Long Term Riskfree Rate (in Euros) = 5.02%
• Risk Premium = 4% (U.S. premium : Netherlands is AAA rated)
n Current Earnings Per Share = 1.60 Eur; Current DPS = 0.60 Eur;
Variable High Growth Phase Stable Growth Phase
Length 5 years Forever after yr 5
Return on Equity 15.56% 15% (Industry average)
Payout Ratio 37.5% 66.67%
Retention Ratio 62.5% 33.33% (b=g/ROE)
Expected growth .1556*.625=.0973 5% (Assumed)
Beta 0.95 1.00
Cost of Equity 5.02%+0.95(4%) 5.02%+1.00(4%)
=8.82% =9.02%
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 ABN Amro: Valuation

Year EPS DPS PV of DPS

1 1.76 0.66 0.60
2 1.93 0.72 0.61
3 2.11 0.79 0.62
4 2.32 0.87 0.62
5 2.54 0.95 0.63
Expected EPS in year 6 = 2.54(1.05) = 2.67 Eur
Expected DPS in year 6 = 2.67*0.667=1.78 Eur
Terminal Price (in year 5) = 1.78/(.0902-.05) = 42.41 Eur
PV of Terminal Price = 42.41/(1.0882)5 = 27.79 Eur
Value Per Share = 0.60 + 0.61+0.62+0.62+0.63+27.79 = 30.87 Eur
The stock was trading at 24.33 Euros on December 31, 2000

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 VALUING ABN AMRO

Dividends Expected Growth

EPS = 1.60 Eur 62.5% * g =5%: ROE =15% (Ind. avg)
* Payout Ratio 37.5% 15.56% = 9.73% Beta = 1.00
DPS = 0.60 Eur Payout = (1- 5/15) = .667

Terminal Value= EPS6*Payout/(r-g)

= (2.67*.667)/(.0902-.05) = 42.41
Value of Equity per
share = 30.87 Eur 0.66 Eur 0.72 Eur 0.79 Eur 0.87 Eur 0.95 Eur
.........
Forever
Discount at Cost of Equity

Cost of Equity
5.02% + 0.95 (4%) = 8.82%

Riskfree Rate :
Long term bond rate in Risk Premium
the Netherlands Beta 4%
5.02% + 0.95 X

Average beta for European banks =

0.95 Mature Market Country Risk
4% 0%

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 The Value of Growth

n In any valuation model, it is possible to extract the portion of the value

that can be attributed to growth, and to break this down further into
that portion attributable to “high growth” and the portion attributable
to “stable growth”. In the case of the 2-stage DDM, this can be
accomplished as follows:
t=n
∑ (1+r)
DPS t + Pn DPS 0 *(1+g n ) DPS 0 *(1+g n ) DPS 0 DPS 0
P0 = - + - r + r
t (1+r)n (r-gn ) (r-gn )
t=1

Value of High Growth Value of Stable Assets in

Growth Place
DPSt = Expected dividends per share in year t
r = Cost of Equity
Pn = Price at the end of year n
gn = Growth rate forever after year n

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 ABN Amro: Decomposing Value

n Value of Assets in Place = Current DPS/Cost of Equity

= 0.60 Eur/..0882
= 6.65 Eur
n Value of Stable Growth = 0.60 (1.05)/(.0882-.05) - 6.65 NG
= 9.02 Eur
n Value of High Growth = Total Value - (6.65+ 9.02)
= 30.87 - (6.65+9.02) = 15.20 Eur

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 S & P 500: Rationale for Use of Model

n While markets overall generally do not grow faster than the economies
in which they operate, there is reason to believe that the earnings at
U.S. companies (which have outpaced nominal GNP growth over the
last 5 years) will continue to do so in the next 5 years. The consensus
estimate of growth in earnings (from Zacks) is roughly 10% (with
bottom-up estimates) and 7.5% (with top-down estimates)
n Though it is possible to estimate FCFE for many of the firms in the
S&P 500, it is not feasible for several (financial service firms). The
dividends during the year should provide a reasonable (albeit
conservative) estimate of the cash flows to equity investors from
buying the index.

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 S &P 500: Inputs to the Model (12/31/00)

n General Inputs
• Long Term Government Bond Rate = 5.1%
• Risk Premium for U.S. Equities = 4%
• Current level of the Index = 1320
n Inputs for the Valuation
High Growth Phase Stable Growth Phase
Length 5 years Forever after year 5
Dividend Yield 1.25% 1.25%
Expected Growth 7.5% 5.5% (Nominal US g)
Beta 1.00 1.00

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 S & P 500: 2-Stage DDM Valuation

1 2 3 4 5
Expected Dividends = $17.74 $19.07 $20.50 $22.04 $23.69
Expected Terminal Value= $691.55
Present Value = $16.26 $16.02 $15.78 $15.55 $462.73
Intrinsic Value of Index = $526.35

Cost of Equity = 5.1% + 1(4%) = 9.1%

Terminal Value = 23.69*1.055/(.091 -.055) = 691.55

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 Explaining the Difference

n The index is at 1320, while the model valuation comes in at 526. This
indicates that one or more of the following has to be true.
• The dividend discount model understates the value because dividends are
less than FCFE.
• The expected growth in earnings over the next 5 years will be much
higher than 7.5%.
• The risk premium used in the valuation (4%) is too high
• The market is overvalued.

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 A More Realistic Valuation of the Index

nThe median dividend/FCFE ratio for U.S. firms is about 50%. Thus the
FCFE yield for the S&P 500 should be around 2.5% (1.25%/.5).
nThe implied risk premium between 1960 and 1970, which was when
long term rates were as well behaved as they are today, is 3%.
nWith these inputs in the model:
1 2 3 4 5
Expected Dividends = $35.48 $38.14 $41.00 $44.07 $47.38
Expected Terminal Value = $1,915.07
Present Value = $32.82 $32.63 $32.45 $32.27 $1,329.44
Intrinsic Value of Index = $1,459.62
At a level of 1320, the market is undervalued by about 10%.

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