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DISCOUNTED DIVIDEND VALUATION Presenter Venue Date

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DISCOUNTED CASH FLOW MODELS 2

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CHOICE OF DISCOUNTED CASH FLOW MODELS 3

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VALUING COMMON STOCK USING A MULTI-PERIOD DDM 4

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EXAMPLE: VALUING COMMON STOCK USING A MULTPERIOD DDM 0123 D$1.00$1.05 $1.10 P$20.00

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EXAMPLE: VALUING COMMON STOCK USING A MULTPERIOD DDM

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VALUING COMMON STOCK USING THE GORDON GROWTH MODEL

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EXAMPLE: VALUING COMMON STOCK USING THE GORDON GROWTH MODEL Risk-free rate3.0% Equity risk premium6.0% Beta1.20 Current dividend$2.00 Dividend growth rate5.0% Current stock price$24.00

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VALUING COMMON STOCK USING THE GORDON GROWTH MODEL

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EXAMPLE: VALUING PREFERRED STOCK

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EXAMPLE: CALCULATING THE IMPLIED GROWTH RATE USING THE GORDON GROWTH MODEL Using the previous common stock example and the current stock price of $24, what is the implied growth rate?

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CALCULATING THE IMPLIED REQUIRED RETURN USING THE GORDON GROWTH MODEL

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EXAMPLE: CALCULATING THE IMPLIED REQUIRED RETURN USING THE GORDON GROWTH MODEL Using the previous common stock example and the current stock price of $24, what is the implied required return?

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PRESENT VALUE OF GROWTH OPPORTUNITIES

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EXAMPLE: PRESENT VALUE OF GROWTH OPPORTUNITIES Stock price$80.00 Expected earnings$5.00 Required return on stock10%

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EXAMPLE: PRESENT VALUE OF GROWTH OPPORTUNITIES

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USING THE GORDON GROWTH MODEL TO DERIVE A JUSTIFIED LEADING P/E

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USING THE GORDON GROWTH MODEL TO DERIVE A JUSTIFIED TRAILING P/E

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EXAMPLE: USING THE GORDON GROWTH MODEL TO DERIVE A JUSTIFIED P/E Stock price$50.00 Trailing earnings per share$4.00 Current dividends per share$1.60 Dividend growth rate5.0% Required return on stock9.0%

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EXAMPLE: USING THE GORDON GROWTH MODEL TO DERIVE A JUSTIFIED LEADING P/E

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EXAMPLE: USING THE GORDON GROWTH MODEL TO DERIVE A JUSTIFIED TRAILING P/E

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ISSUES USING THE GORDON GROWTH MODEL Strengths Simple and applicable to stable, mature firms Can be applied to entire markets g can be estimated using macro data Can be applied to firms that repurchase stock Limitations Not applicable to non- dividend-paying firms g must be constant Stock value is very sensitive to r – g Most firms have nonconstant growth in dividends

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CHOICE OF DISCOUNTED CASH FLOW MODELS Rapidly earnings Heavy reinvestment Small or no dividends Growth Earnings growth slows Capital reinvestment slows FCFE & dividends Transition ROE = r Earnings & dividends growth matures Gordon growth model useful Maturity

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GENERAL TWO-STAGE DDM

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EXAMPLE: GENERAL TWO-STAGE DDM Current dividend = $2.00 Growth Current dividend = $2.00 Growth for next three years = 15 percent Long-term growth = 4 percent Required return = 10 percent for next three years = 15 percent Long-term growth = 4 percent Required return = 10 percent

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EXAMPLE: GENERAL TWO-STAGE DDM Step 1: Calculate the first three dividends: D1 = $2.00 x (1.15) = $2.30 D2 = $2.30 x (1.15) = $2.6450 D3 = $2.6450 x (1.15) = $3.0418 Step 2: Calculate the year 4 dividend: D4 = $3.0418 x (1.04) = $3.1634 Step 3: Calculate the value of the constant growth dividends: V3 = $3.1634 / (0.10 – 0.04) = $52.7237

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EXAMPLE: GENERAL TWO-STAGE DDM

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Using the previous example, now we’ll use the trailing P/E to determine the terminal value The D4 is $3.1634 Assume also that the projected P/E is 13.0 in year 4 and that the firm will pay out 60 percent of earnings as dividends Year 4 earnings are then $3.1634 / 0.60 = $5.2724 The stock price in year 4 is then $5.2724 × 13 = $68.54

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EXAMPLE: GENERAL TWO-STAGE DDM

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TWO-STAGE H-MODEL

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EXAMPLE: TWO-STAGE H-MODEL Current dividend$3.00 gsgs 20% gLgL 6% H5 Required return on stock10% Current stock price$120

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EXAMPLE: TWO-STAGE H-MODEL

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SOLVING FOR THE REQUIRED RETURN USING THE TWO-STAGE H-MODEL

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EXAMPLE: THREE-STAGE MODEL Firm pays a current dividend of $1.00 Growth rate is 20 percent for next two years Growth then declines over six years to stable rate of 5 percent Required return is 10 percent Current stock price is $50

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THREE-STAGE MODEL Assumes three distinct growth stages: First stage of growth Second stage of growth Stable-growth phase H-model can be used for last two stages if growth declines linearly

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THREE-STAGE MODEL EXAMPLE

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ESTIMATING THE GROWTH RATE Industry or Macroeconomic Average g = b × ROE DuPont formula ROE = r ROE = industry ROE

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THE SUSTAINABLE GROWTH RATE gbROE

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THE DUPONT MODEL

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EXAMPLE: DUPONT MODEL Net profit margin5.00% Total asset turnover1.5 Equity multiplier2.0 Retention ratio60%

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EXAMPLE: DUPONT MODEL

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Dividend discount models, free cash flow models, residual income models Dividend models most appropriate for Mature, profitable, dividend-paying firms Noncontrolling shareholder perspective Choice of Discounted Cash Flow Models Assumes constant g and r > g Applicable to mature, stable firms Estimated value very sensitive to r – g denominator Gordon Growth Model SUMMARY

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Preferred stock valuation where g = 0 PVGO – Value from future growth Justified leading and trailing P/Es Implied r and g Uses of Gordon Growth Model Growth Transition Maturity Phases of Growth SUMMARY

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General two-stage model: growth abruptly declines H-model: growth gradually declines Three-stage model: can utilize general or H-model Multistage Models g = Retention ratio × ROE DuPont analysis: ROE = Profit margin × Asset turnover × Equity multiplier Sustainable Growth Rate SUMMARY

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