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In the previous section, we discussed how to analyse an annual report. The solitary objective of this exercise is to evaluate the dividend potential and security of the company. Dividend potential is the ability of a company to pay dividends to its shareholders in the future. It is directly related to the company’s expected future earnings growth. Dividend security refers to the extent to which investors can be confident that future dividends will not differ materially from their expectations. Dividend safety is a function of expenses, particularly interest expenses, which companies have to incur. Higher interest expenses means that only a small proportion of earnings will be left to distribute among shareholders in future periods.
This will make dividends highly unpredictable, especially during the periods of volatile earnings. Understanding future dividend patterns is important because dividend expectations directly affect the company’s stock price. In this section, we will see how expected future dividends are used to value equity shares.
Investors receive two kinds of income from investing in a stock:
Whether or not investors buy a stock, depends on its expected performance along with these two factors. Why investors should buy stocks that promise dividends is self-explanatory. Dividends provide relative assurance of future income and the stock price is the cost of this. Stock prices only appreciate if a company’s earnings are expected to increase in future. This is because, as owtners, investors expect to receive their share in this earnings growth in cash.
The share is technically known as dividend. Thus, directly or indirectly, investors eventually look at the future dividend potential when investing in a stock. It logically follows that if the value of a stock is directly based on its expected future dividends, its price should be equal to the sum of all future dividends. This is a perfectly accurate deduction, except for two things. First, how can one accurately predict all future dividends? It would require assumptions about income, expenses and dividend payout ratio (i.e. the proportion of net income that will be distributed as dividend) for all future periods.
Secondly, the time value of money weighs in. Suppose you were to receive a sum of Rs.1000 today. Would you be indifferent between receiving it today itself and say in five years from now? Probably not. This is because factors such as inflation come into play and reduce the effective value of the same amount of money received at a later date as compared to today. This is known as the time value of money. To cope with this, the dividend discount model uses expected future dividends and adjusts them for the time value of money before adding them up to obtain the fair value of the company’s stock as of today.
Expected value of future dividends is estimated using a method called extrapolation. One may simply take historical annual dividend growth rates and project future dividends on that basis. Alternatively, you may use a much more laborious, but hopefully more accurate method, whereby you project all the financial statements by extrapolating the values of all of its components, starting with sales.
Based on this, you arrive at the net income of the company for all future years. You then makes assumptions regarding future dividend payout ratios and calculates expected dividends based on them. This is called financial modelling. It is done using a spreadsheet. You may tweak projections based on personal judgements or new developments.
Now we’ll see how to tackle the time value of money. For this, we use the concept of discounting. Let’s say you want to find the value of Rs.100 invested today in three years from now.
You expect its value to appreciate by 10% each year. Using this growth rate, you will find the future amount by compounding for a period of three years.
This is done as follows :
Value after three years = 100 x (1+10%) 3 → 100 x (1.1)3
Where, Rs.100 is the amount you have invested today, 10% (i.e. 10/100) is the growth rate and the superscript 3 represents the number of years. This method is called compounding because the value of money is increasing each year.
When calculating the present value of future dividends, we will have to do the reverse. This is because we will receive this money in the future and have to find its value as of today.
This is called discounting. Assuming a dividend amount of Rs.5 per share and the same discount rate of 10%, our formula would be:
Present value of dividend received after 3 years = 5/ (1.1)3
Similarly, for dividend received after 4 years it would be:
5/ (1.1)4
We will have to do this for all future dividends. Then, by adding the present value of all the dividends we can find the value of the company’s stock as of today. The rate used is for discounting is called the discount rate or the required rate of return. It is also referred to as the cost of equity of the company. It is calculated using a variety of approaches which use factors like inflation and the stock’s correlation with the overall market as base figures.
Another problem with this model is that a company is expected to be a going concern. If this is the case, the company will continue to pay dividends into eternity. How then can you discount all future dividends? To deal with this, one has to assume a terminal value, i.e. a price at which you will sell the stock at the end of your investment horizon. This is calculated assuming that the dividend will grow at a constant rate from the terminal year onwards. This is done using the second dividend discount model, called the constant growth model.
This model assumes that the company’s earnings will grow at a constant rate forever and its dividend payout ratio will also remain constant. The result of these assumptions is that the dividend will continue to grow at a constant rate. In such a case, each period’s dividend need not be discounted separately.
A single formula can be used to calculate the value of the stock:
Fair value of the stock = D (1+g)/r-g
Here, D is the present period’s dividend, g is the constant growth rate of dividend and r is the required rate of return or the cost of equity. This model was given by Myron J. Gordon and is therefore called the Gordon Growth Model. It is based on the assumption that the cost of equity for the company is greater than the growth rate of dividend, I.e. r>g. If this assumption is violated, the denominator will be zero or negative and no meaningful value for the share can be obtained.
The Gordon model is used independently for companies that have been in operation for many years, have a stable market share and can therefore be expected to grow at a stable rate in the future. For companies whose dividends are expected to be inconsistent for some length of time, it can be used in conjunction with the model described earlier. In such a scenario, each dividend is discounted individually up to the terminal year and then the Gordon model is used to calculate the terminal value.
Let’s look at an example.
Let’s say a company is expected to pay a dividend of Rs.4, Rs.6 and Rs.8 over the next three years. From the fourth year onwards, its dividend is expected to increase at 8% per annum. Cost of equity or required rate of return for the company is 12% per annum. To value the stock, we will first calculate the present value of the dividends by discounting them at the cost of equity for the number of years after which they will be received.
Thus:
Present value of dividends = 4/ (1.12) + 6/ (1.12)2 + 8/ (1.12)3 = Rs.14.05
Next, we will calculate the terminal value using the Gordon Model. For this, we will use the terminal year dividend of Rs.8 and the dividend growth rate of 8%.
Thus:
Terminal value = 8(1.08)/ (0.12 - 0.08) = Rs.216
The denominator in the above equation is the difference between the cost of equity and the dividend growth rate. Since we will receive this terminal value at the end of the third year, it too will have to be discounted using the same discount rate.
Thus:
Present value of the terminal value = 216/ (1.12)3 = Rs.153.74
The sum of the two present values calculated above is the fair value of the share.
Thus:
Fair value of the stock = 14.05 + 153.74 = Rs.167.79
As an investor you must only by the stock if its market value is below this. Else, you may leave it alone.
The life cycle of a company broadly consist of four stages: growth, maturity, stagnation and decline. The growth rates for all three stages are different. The terminal phase is sometimes called the mature phase. Post this phase, the growth rate is believed to fall and remain constant. In the above example, we have predicted the dividend amount up to the mature phase. We could also use a specific growth rate for this phase and then a different one from the maturity phase onwards.
The Gordon model can only be used from the mature phase onwards. Investors sometimes also like to use a multi-stage model with many different growth rates (instead of just two) for companies with multiple phases of their life remaining. The assumed dividend growth rate in each of these stages is different.
A recap of the steps involved in the dividend discount model is given below.
Recall that in one of the previous sections, we discussed how dividend is only one part of the net cash income (free cash flows) of a company. The other part is retained by the company for later use. The combination of these two is called FCFE and represents the true dividend paying potential of the company. This may suggest that equity valuation based exclusively on dividend discounting is incomplete. The part retained by the company should also be discounted because it too belongs to shareholders and influences share prices. The logic behind not using it is that this part will presumably be used by the company later to invest in more fixed assets and new projects. This will lead to an increase in its future income and thereby future dividends. As such, it will anyway enter the calculations later on as dividends. Accommodating it now will lead to double counting.
Further, the decision regarding the use of retained earnings is reserved with the management and large shareholders. Smaller retail shareholders have little influence on them. They can only estimate the impact of these on future dividends and decide whether or not to buy the share. The discounted cash flow model is therefore only used by investors who have the ability to acquire a large stake in the company. This is particularly true of investors who are looking to acquire the company outright. For retail investors like you, the free cash flow approach is useful when the company doesn’t pay dividends or its dividends are far below its FCFE. In such situations, dividends don’t truly reflect the company’s dividend paying potential.
Both the models that are used for dividend discounting are also used for cash flow discounting. The only difference is that the value discounted is FCFE and not dividend. Also, the expected growth rate (g) is for the FCFE and not dividend. The cash flow concept used FCFE is and not FCFF because FCFE represents the free cash flows available to pay equity holders. FCFE is available first to the lenders and then to equity holders. FCFF is therefore used when we want to find the value of the entire firm (i.e. lenders + shareholders) and not merely shareholders. To find the value of equity shares from this, we have to subtract the current value (and not present value) of the outstanding debt of the company. Also, FCFF is discounted using the weighted average cost of overall capital (i.e. debt + equity) and not purely the cost of equity.
In the next section, we will discuss another popular approach to equity valuation – the relative value approach. This helps you value company shares on the bases of certain valuation ratios such as the Price-to-Earnings ratio, the profitability ratios, and the efficiency ratios and so on, instead of the company’s earnings. click here.