Topic 8; Discounted dividend valuation

Discounted dividend valuation is a method used to estimate the value of a stock by considering the present value of its future dividend payments. This approach is based on the idea that the intrinsic value of a stock is determined by the cash flows it will generate for its shareholders in the form of dividends.

Streams of cash flow

In the context of valuations, there are several different streams of cash flow that can be used as inputs to discounted cash flow (DCF) models:

Dividends: Dividends refer to the cash payments that a company makes to its shareholders on a regular basis. They are typically used as an input in DCF models when valuing companies that pay dividends, such as mature, stable companies with predictable cash flows.
Free cash flow: Free cash flow is the cash that a company generates after accounting for capital expenditures. It represents the cash that is available to be used for reinvestment or distributed to shareholders. Free cash flow is typically used as an input in DCF models when valuing companies that have significant reinvestment opportunities or when the company is expected to generate significant cash in the future.
Residual income: Residual income is the income that a company generates after accounting for the cost of capital. It is used to value companies that have significant growth opportunities and are expected to generate significant future earnings.

The Dividend Discount Model

The Dividend Discount Model (DDM) is a specific form of discounted cash flow (DCF) valuation method used to estimate the intrinsic value of a stock. It is based on the principle that the value of a stock is determined by the present value of its future dividend payments. The model is particularly applicable to companies that have a history of paying dividends and are expected to continue doing so in the future.

There are two main versions of the Dividend Discount Model:

Gordon Growth Model (Perpetuity Model)

This version of the DDM assumes that dividends will grow at a constant rate indefinitely. It’s suitable for mature companies with stable and predictable dividend growth.

The formula for the Gordon Growth Model is:

PV=D/r−g

Where:

- PV is the present value of the stock.
- D is the expected dividend in the next period.
- r is the required rate of return (discount rate).
- g is the constant growth rate of dividends.

Illustrations

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Two-Stage Dividend Discount Model(multiple period)

This version of the DDM is used for companies that are expected to have a period of high growth in dividends followed by a more stable phase. It involves estimating dividends for a high growth phase and a stable growth phase.

The formula for the Two-Stage Dividend Discount Model is:

Where:

- PV is the present value of the stock.
- D is the expected dividend in each period.
- r is the required rate of return (discount rate).
- g is the constant growth rate of dividends in the first phase.
- t is the number of periods in the first phase.
- Dn+1 is the first dividend in the stable growth phase.

Assumptions of Gordon growth model

The company pays dividends: The Gordon Growth Model assumes that the company pays dividends and that the dividends will grow at a constant rate over time.
Constant growth rate: The model assumes that dividends will grow at a constant rate over time. This means that the growth rate of dividends is the same in every period, and that dividends will continue to grow at this rate into the future.
Reinvestment opportunities: The model assumes that the company has no reinvestment opportunities, meaning that all cash flow is paid out as dividends.
Constant required rate of return: The model assumes that the required rate of return is constant over time.
No external financing: The model assumes that the company will not issue new shares or take on new debt, and that the company will not buy back shares.

THE H-MODEL

The H-Model is a variation of the Gordon Growth Model (or Dividend Discount Model) that takes into account a period of high growth followed by a period of stable growth. It is particularly useful for valuing companies that are expected to experience a phase of rapid growth, followed by a more stable growth phase.

Here are the key features and assumptions of the H-Model:

Two Growth Phases:
- High Growth Phase (H): In the initial period, the company is expected to grow at a higher, but declining, rate. This phase represents a period of above-average growth, often due to factors like market penetration, new product launches, or other strategic initiatives.
- Stable Growth Phase (L): After the initial high growth phase, the company is expected to settle into a more stable and sustainable growth rate. This phase typically reflects the long-term, steady-state growth rate of the company.
Transition Period (T): The transition period is the number of years it takes for the company to transition from the high growth phase to the stable growth phase. This is a critical parameter in the H-Model because it determines when the growth rate starts to decline.
Assumption of Linear Decline in Growth: The H-Model assumes that the transition from high growth to stable growth is linear. In other words, the growth rate gradually decreases over the transition period until it reaches the stable growth rate.
Steady State Dividend Growth: After the transition period, the dividend growth rate becomes stable and is expected to continue indefinitely.
Required Rate of Return (r) > Stable Growth Rate (gL): As in the Gordon Growth Model, it’s assumed that the required rate of return is greater than the stable growth rate.
Earnings and Dividends Are Aligned: Similar to the Gordon Growth Model, the H-Model assumes that earnings and dividends are aligned, meaning that all earnings are paid out as dividends.

The formula for valuing a stock using the H-Model is more complex than the Gordon Growth Model, involving calculations for both the high growth phase and the stable growth phase. It takes into account the dividends in the high growth phase, the dividends in the stable growth phase, and the present value of the transition period.

The H-Model is useful for companies that are expected to experience a period of high growth, such as startups or companies in emerging industries. It provides a more nuanced valuation approach compared to models that assume constant growth rates.

However, like any financial model, the accuracy of the H-Model is dependent on the accuracy of the assumptions and projections used. It’s important to carefully consider the underlying factors driving the high growth and transition periods when applying this model.