DIVIDEND-BASED VALUATION MODELS

Dividend-Based Valuation Models

Table of Contents

Abstract3

Chapter I4

1. Introduction4

2. Background10

Chapter II12

3. The General Model12

4. Versions of the Models13

4.1 Gordon Growth Model13

4.2 Dividend Discount Model16

4.3 The H Model for valuing Growth18

3. Sensitivity analysis19

Chapter III23

4. Moving from textbook examples to “real-world” applications23

4.1. Information for computing the required rate of return on investment23

4.2. Information for estimating the growth rate for earnings and dividends24

4.2.1. Estimating Ks24

4.2.2. Estimating g25

5. Non-constant dividend growth27

Chapter IV29

6. An applied example from portfolio management class29

Chapter V33

7. Summary33

Dividend-based valuation models

Abstract

The appropriate application of the constant growth dividend discount model (DDM) requires an understanding of the fundamental nature of the model and its parameters. It is important that students not only be able to mechanically “plug and chug” the formula, but that they also understand the model's assumptions, inputs, sensitivity to error and practical limitations. This paper demonstrates that the valuation measure derived from using the DDM is very sensitive to the relationship between the required return on investment (Ks) and the assumed growth rate (g) in earnings and dividends. Examples show that the valuation error increases at an increasing rate when the values of Ks and g converge in the formula. Classroom experience has indicated that students believe and strive to compute a single “correct” valuation of the share price. They should realize that the goal of valuation analysis is to estimate a reasonable range for the intrinsic value of a share price, rather than a single point estimate as often implied by end-of-chapter and exam-type problems using the DDM.

Chapter I

1. Introduction

The theoretical soundness and practical simplicity of the constant growth dividend discount model (DDM) (Gordon and Gordon 1962) have led to its extensive application for common stock valuation. Students are usually introduced to the formula and its conceptual framework in their first finance course. In more advanced courses, they apply the model to security analysis, to cases involving security issuance and mergers and acquisitions, and to other valuation related problems. While most students eventually become comfortable with mechanically “plugging and chugging” the formula, they often have little understanding of its practical limitations. This paper provides a method for illustrating the nature of estimation and a means of demonstrating the nonlinear sensitivity of the DDM to variations in required rate of return (Ks) and the growth rate (g) estimates.

Nearly all texts discuss the basic assumption that Ks must be greater than g for the model to hold. This requirement is predicated on the practical limitation that a stock's price must be non-negative. Similarly, Ks must be greater than g since equivalence would result in an infinite value. Together, the economic constraints that stock prices are non-negative and finite make the model's assumption of Ks > g fairly easy for students to grasp. What is not necessarily intuitive is how the relationship between Ks and g affects the estimate of the stock's intrinsic value.

Once the mathematical and economic constraints of the model have been considered, students should realize that proper implementation of the DDM requires more than the calculation of a single point ...