Discounted Cash Flow Method
A company’s earnings play a role in the valuation of its stock.
However, in the discounted cash flow method it is dividends that
play a key role and not earnings directly. Future estimated dividends
are discounted to the present value at the investor’s required
rate of return to determine the intrinsic value of the stock. Suppose,
for example, that a stock pays a dividend of $0.50 per year, indefinitely,
and that your required rate of return is 10 percent; the
stock’s value is $5 (the perpetual dividend divided by the required
rate of return). For a greater than 10 percent required rate of return,
the purchase price of the stock must be less than $5 per share.
Astock price of greater than $5 per share will result in a lower than
10 percent required rate of return.
In reality, the amount of a common stock dividend is not fixed
indefinitely. Dividends fluctuate over time depending on the company’s
earnings and the board of directors’ decision to pay
dividends or retain the profits for internal reinvestment by the
company. Dividends can remain constant, grow at fixed rates, or
grow or decline at variable rates. To get around these difficulties in
the valuation of a stock, this model assumes that dividends grow
at a constant rate.
The following formula illustrates the valuation model by discounting
the constantly growing dividend by using an investor’s
required rate of return.
Consider the following example using this formula to value a
company’s stock. Company X paid a dividend last year of $1 per
share and is expected to continue paying dividends every year. The
company is expected to grow at 8 percent. An investor interested in
buying this stock has a required rate of return of 10 percent.
The dividend of $1 was paid last year, which means that you
must compute the next or future dividend to be paid.
Future dividend = current dividend * (1 + growth rate)
= $1(1 + 0.08)
= $1.08
You can now substitute the figures into the equation.
Value of the stock = $1.08/(0.10 – 0.08)
= $50
Aprice greater than $50 results in a lower required rate of return of
10 percent, and a price below $50 results in a rate of return greater
than 10 percent.
This valuation model depends on dividends paid by the company,
and the investor’s expected rate of return is the dividend
yield plus the company’s growth rate. Suppose that the dividend is
$1.08 and that the stock price is $55:
Expected rate of return = ($1.08/55) + 8% = 9.96%
The dividend growth valuation model makes a number of
assumptions:
* The required rate of return of the investor is greater than the
rate of growth of the company. The purpose of the valuation
process is to find stocks with intrinsic values that are less than
their market values (which occurs only when the growth rate
is less than the required rate of return).
* Dividends are expected to grow at a constant growth rate.
This valuation model can be adapted to include variable
dividend growth rates.
The implications of this model are
* The larger the dividend, the greater the stock price. Table
9–1 discusses whether a company should pay dividends or
retain its earnings.
* The greater the growth rate of a company, the greater the
stock price.
* The lower an investor’s required rate of return, the greater
the stock price.
Table 91
Should Companies Pay Dividends or Retain Their Earnings?
One implication of the dividend growth valuation model is that the larger the
dividend payments to shareholders, the greater is the stock price. However, if a
company can generate a rate of return on its investment higher than an investor’s
required rate of return, the stock price should see greater increases than if the
earnings were paid to shareholders in dividends. For example, suppose that a
company generates earnings per share of $2 and pays out the entire amount in
dividends. If an investor’s required rate of return is 8 percent, the stock is valued
at $25 per share ($2 / 0.08). No earnings growth takes place because the
company has not retained any earnings.
If the company’s dividend payout ratio (the percentage of net income paid to shareholders)
is 40 percent, the dividend is $0.80 (0.40 * $2). The earnings retention
ratio (percentage of net income that is not paid out in dividends) is 60 percent. If
the company has a return on its investment (equity) of 12 percent, the growth rate
for the company is 7.2 percent (0.12 * 0.60).
Value of the stock = dividend/(required rate of return – growth rate)
= $ 0.80/(0.08 – 072)
= $100
When the company retains and reinvests part of its earnings in new investments, its
share price increases from $25 to $100 per share.
The degree of risk of a company is not measured directly in
the dividend growth model but is instead adjusted through the
investor’s required rate of return. Acompany’s risk is measured by
its beta coefficient, which in itself is a problem. The beta coefficient
has not been a consistent measure of risk. Beta coefficients for the
same stock differ because different market measures are used. Use
of the Standard & Poor’s (S&P) 500 Index as a measure of the market
versus the Value Line Stock Index results in two different beta
coefficients for the same company. Similarly, the use of different
time periods results in different beta coefficients for the same stock.
Another problem for the dividend growth valuation model is
the growth rate. Should you use past earnings growth or estimate
future growth rates for a company? If historical growth rates are
chosen, what length of time should you choose? Table 9–2 illustrates
how to determine the growth rate of a company.
Although the dividend growth valuation model is sound
theoretically, these problems do have a bearing on the valuation of
a company’s stock. Consequently, other approaches to valuing
common stock are less theoretical and more intuitive.
Table 92
Determining the Growth Rate of a Stock Using a Computer Spreadsheet
A company’s sustained earnings are a major determinant of whether the company
can afford to pay out dividends, maintain its dividend payments, or increase dividend
payouts. If a company decides to retain earnings and reinvests the profits
in its business rather than paying them out, it can accelerate its earnings growth.
You can determine a company’s growth rate by measuring the increase in a
company’s earnings over a certain period. This is just one way to measure a company’s
growth rate. Others are the growth of a company’s assets or sales.
List the earnings per share (EPS) and dividends per share (DPS) for a company
for the past five years. You can find this information on a company’s website by
clicking on financial statements or looking at its annual report. For example,
the following EPS and DPS for Johnson & Johnson are on its website at
www.johnsonandjohnson.com:

2005 
2004 
2003 
2002 
2001 
2000 
Diluted EPS 
$3.46 
$2.84 
$2.40 
$2.16 
$1.84 
$1.61 
DPS 
$1.275 
$1.095 
$0.925 
$0.795 
$0.70 
$0.62 
Price per share: $60.10 (yearend close)
Determine the growth rate. In 2000, earnings per share were $1.61 and grew to
$3.46 in five years. Follow these steps using Excel:
Step 1: Click on f* in the tool bar.
Step 2: Highlight financial, and click on rate.
Step 3: Enter the data as shown below:
Nper 5
Pmt 0
PV –1.61
FV 3.46
Type 0
Formula result – 0.165332999
Johnson & Johnson’s growth rate for the fiveyear period was 16.533 percent. Using
this historical rate of growth, you can compute the expected return for this company:
Expected return = (future dividend/price of stock) + growth rate
Future dividend = present dividend * (1 + growth rate)
= $1.275(1 + 0.16533)
= $1.423
Expected rate of return = ($1.423/$60.10) + 0.16533
= 18.901%
The expected rate of return is 18.901 percent if the investor bought the stock at
$60.10 per share.


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