Equity Investments - The Dividend Discount Model (DDM)
Value of a Preferred Stock
Unlike common equity, preferred stocks pay a fixed dividend. As such, the value of a preferred stock can be calculated using the dividend discount model. The value of the preferred stock is essentially the present value of the dividend in perpetuity, where k is the required return.
| Value of preferred stock
Example: Calculating the value of a preferred stock
Assume that Newco's preferred stock pays out to an investor an annual dividend of $8 per share. Given a rate of return of 10%, what is the value of Newco's preferred stock?
Value of Newco's preferred stock = ($8/0.10) = $80
Value of a Common Stock
Much like a preferred stock, holders of common stock can also receive dividends. However, dividends on common stock are not guaranteed, nor are they a fixed amount from year-to-year. As such, we can value common stock using dividends over various time horizons.
1. One-year Holding period
Consider a one-year holding period, in this time frame, an investor will receive a dividend and the price of the common stock at the end of the one year, both discounted back by the rate of return on the common equity.
Keeping this in mind, we can calculate the value of the common stock as follows:
| Common Stock = Dividend + Price at the end of the year
Example: Calculate the value of a stock with a 1-year holding period
Newco expects to pay its shareholders common equity, $0.25 per share this year. The investor anticipates Newco's stock will close the year at $30 per share. Given a rate of return of 10%, what is the value of Newco's common stock?
Value of Newco's common stock = $0.25 + $30 = $27.50 per share
2. Multiple-year holding period
Given investors can hold a common stock for over a year, it is useful to value a stock over the investor's expected holding period. In this case, the DDM model can be used.
| Value of common equity
Example: Calculate the value of a stock with a multiple-year holdingperiod
An investor plans to hold Newco's stock for 2 years. Newco expects to pay its shareholders common equity, $0.25 per share over the next two years. The investor anticipates Newco's stock will close the end of that time period at $40 per share. Given a rate of return of 10%, what is the value of Newco's common stock at the end of the two-year time period?
Value of Newco's common stock = $0.25 + $0.25 + $40 = $33.49
(1.10)1 (1.10)2 (1.10)2
3. Infinite Period DDM
To value a common stock using the infinite period DDM, the calculation is simplified much like it is when valuing a preferred stock with infinite dividends.
Where k = rate of return, g = growth rate
Example: Calculate the value of common stock with infinite dividends
Newco paid a $0.25 annual dividend in 2004 and expects to pay $0.265 in 2005. Assuming a 6% growth rate and a required rate of return of 10%, calculate the value of Newco's stock.
Value of Newco's common stock = $0.265 = $6.63
(0.10 - 0.06)
Valuing the Common Stock of Companies with Supernormal Growth
When valuing a common stock of a company which is experiencing significant growth, we take a similar approach to valuing the common stock with a multi-year holding period. The difference in the approaches is related to the dividend. A multi-year holding period approach assumes a stable dividend, whereas the dividend changes given the supernormal growth in this approach.
Example: Calculate the value of common stock with temporary supernormal growth
An investor plans to hold Newco's stock for 3 years. In that time period, Newco plans to grow at a rate of 6% in the first two years and 3% thereafter. Newco's last dividend was $0.25. Given a rate of return of 10%, what is the value of Newco's common stock at the end of the three-year time period?
To begin, the dividend in each time period must be calculated [D = D0(1+g)]
D1 = (0.25)(1.06) = 0.265
D2 = (0.265)(1.06) = 0.281
D3 = (0.281)(1.03) = 0.289
Since we expect the dividend to grow indefinitely in year 3 and on, the present value of the stock price in year 3 is calculated as follows:
P3 = 0.289 = 4.133
The value of Newco's common stock is as follows:
Newco'scs = $0.265 + $0.281 + 0.289 + $4.133 = $3.80
(1.10)1 (1.10)2 (1.10)3 (1.10)3
Using the DDM to Develop an Earnings Multiplier Model
Developing the earnings multiplier using the DDM begins with the basic determinant of price. Recall, to determine the price of a stock using the DDM, the infinite dividend is divided by the required return minus the growth rate as follows:
To determine the price to earnings multiple, the price of the stock is simply divided by the earnings per share of the stock as follows:
Example: Determining a company's price-to-earnings ratio using the DDM
With Newco's $0.25 dividend payout, an EPS of $1.00, calculate the stock's P/E ratio assuming 10% required return and 5% growth.
P/E ratio = 0.25/1.00 = 5%
In terms of changes in the dividend, the required return and the growth rate affect the DDM. Changes in these variables will also affect the stock's P/E ratio.
Financial AdvisorsObtain valuable tips and helpful study instructions that can help you pass the Level 1 Chartered Financial Analyst exam on your first attempt.
Financial AdvisorsLearn techniques for emphasizing your CFA Level I status in the Skills and Certifications or Professional Development section of your resume.
ProfessionalsLearn how to prepare for a career as an investment analyst, and read more about how many professionals in the field progress during their careers.
ProfessionalsFind out how the CAIA and CFA designations differ, including which professionals should seek either title based on their career ambitions.
ProfessionalsChapter 1: Equity Valuation: Its Applications and Processes Chapter 2: Return Concepts for Equity Valuation Chapter 3: Industry Analysis With Porter's 5 Forces
ProfessionalsThe Chartered Financial Analyst Level III exam, which is only offered in June, is the last in the series of three tests that CFA candidates must pass.
ProfessionalsBecoming a chartered financial analyst requires the passing of three grueling exams covering an array of topics.
Options & FuturesWe decode the meaning of the many letters that can follow the names of financial professionals.
ProfessionalsPrepare to ace the CFA Level 1 exam by studying systematically.
Personal FinanceMany advisors display similar skillsets that can make distinguishing between them difficult. The following guidelines can help you better understand their qualifications and services.
Professionals who help individuals manage their finances by providing ...
Formerly known as the Association for Investment Management and ...
A professional designation given by the CFA Institute (formerly ...
A financial professional who studies various industries and companies, ...
The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >>
Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid ... Read Full Answer >>
If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Full Answer >>
You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Full Answer >>