CHP 2 DISCOUNTED DIVIDEND VALUATION
1. INTRODUCTION • This chapter provided an overview of Discounted Cash Flow (DCF) models of valuation, discussed the estimation of a stock’s required rate of return, and presented in detail the dividend discount model.
Streams of Expected Cash Flows • Several alternative streams of expected cash ﬂows can be used to value equities, including dividends, free cash ﬂow, and residual income. • A discounted dividend approach is mostsuitable for dividend-paying stocks, where the company has a discernible dividend policy that has an understandable relationship to the company’s proﬁtability, and the investor has a non-control (minority ownership) perspective.
Streams of Expected Cash Flows Cont. • The free cash ﬂow approach (FCFF or FCFE) might be appropriate when the company does not pay dividends, dividends differ substantially from FCFE, free cash ﬂows align with proﬁtability, or the investor takes a control (majority ownership) perspective. • The residual income approach can be useful when the company does not pay dividends (as analternative to an FCF approach), or free cash ﬂow is negative.
EXAMPLE 2-2 Occidental Petroleum and Hormel Foods:Is the DDM an Appropriate Choice? • As director of equity research at a brokerage, you have ﬁnal responsibility in the choice ofvaluation models. Two analysts have approached you on the use of a dividend discountmodel: an oil industry analyst examining Occidental Petroleum Corporation (NYSE:OXY) and a food industry analyst examining Hormel Foods (NYSE: HRL). Table 2-1gives the most recent 10 years of data. (In the table, EPS is earnings per share, DPSis dividends per share, and payout ratio is DPS divided by EPS. ‘‘E$4.92’’ means that$4.92 is an estimated value.)
EXAMPLE 2-2 Occidental Petroleum and Hormel Foods:Is the DDM an Appropriate Choice? Cont.
EXAMPLE 2-2 Occidental Petroleum and Hormel Foods:Is the DDM an Appropriate Choice? Cont. • Answer the following questions based on the information in Table 2-1: • 1. State whether a dividend discount model is an appropriate choice for valuingOXY.Explain your answer. • 2. State whether a dividend discount model is an appropriate choice for valuingHRL. Explain your answer.
EXAMPLE 2-2 Occidental Petroleum and Hormel Foods:Is the DDM an Appropriate Choice? Cont. • Solution to 1: DDM does not appear to be an appropriate choice for OXY. Although OXY is dividend-paying, OXY’s dividends do not bear an understandable and consistent relationship to earnings. • Solution to 2: Because HRL is dividend paying and dividends bear an understandable and consistent relationship to earnings,using a DDM to value HRL is appropriate.
Discount Rate Determination • In choosing a discount rate, we want it to reﬂect both the time value of money and theriskiness of the stock. The risk-free rate represents the time value of money. A risk premiumrepresents compensation for risk, measured relative to the risk-free rate. The risk premium isan expected return in excess of the risk-free rate that is related to risk. When we decide on adiscount rate that reﬂects both the time value of money and an asset’s risk, as we perceive it, wehave determined our required rate of return. • A required rate of return is the minimum rateof return required by an investor to invest in an asset, given the asset’s riskiness.
Discount Rate Determination Cont. • The requiredrate of return on common stock is also known as the cost of equity.The two major approaches to determining the cost of equity are an equilibrium method (CAPM or APT) and the bond yield plus risk premium method. • The equity risk premium for use in the CAPM approach can be based on historical return data or based explicitly on expectational data.
Discount Rate Determination Cont. • Market risk premium = expected return on the market - risk-free rate. • In practice, we always estimate beta with respect to an equity market index when using theCAPM to estimate the cost of equity. So in practice, discussing equity, we are concernedspeciﬁcally with the equity risk premium.
Discount Rate Determination Cont. • For many markets, evidencesuggests that multiple factors drive returns. At the cost of greater complexity and expense,the analyst can consider using an equilibrium model based on multiple factors. Such modelsare known as arbitrage pricing theory (APT) models. Whereas the CAPM adds a single riskpremium to the risk-free rate, APT models add a set of risk premiums.
EXAMPLE 2-4 Calculating the Cost of Equity Usingan APT Model Cont. One type of the APT model is the Burmeister, Roll, and Ross (1994) or BIRR model that is based on five macroeconomic factors that affect the average returns of U.S. stocks.
EXAMPLE 2-4 Calculating the Cost of Equity Usingan APT Model Cont. • The required rate of return for JNJ is • r = 5.00% + (0.17 × 2.59%) − (0.74 × 0.66%) − (−0.15 × 4.32%)+ (1.16 × 1.49%) + (0.72 × 3.61%) • = 9.93%
Discount Rate Determination Cont. • Having an alternative to the CAPM and APT is useful. For companies with publicly tradeddebt, the bond yield plus risk premium method (BYPRP) provides a quick estimate of thecost of equity. • BYPRP cost of equity = YTM on the company’s long-term debt + Risk premium
EXAMPLE 2-7 The Expected Holding-Period Return onDaimlerChrysler Stock
EXAMPLE 2-7 The Expected Holding-Period Return onDaimlerChrysler Stock Cont.
THE DIVIDEND DISCOUNT MODEL (DDM) Cont. • We can forecast future dividends by assigning the stream of future dividends to one ofseveral stylized growth patterns. The most commonly used patterns are • constant growth forever (the Gordon growth model), • two distinct stages of growth (the two-stage growthmodel and the H-model), and • three distinct stages of growth (the three-stage growth model).