DDM

CFA Level II Equities
#1

Hi - I’m afraid I’ve missed something v simple here and I hope someone can please explain it to me.

Why does the dividend discount model ignore asset values? If a company has no assets and constant earnings of $1 and a 100% payout ratio and the discount rate is 5%, then the stock is worth $20. But if the same company retains 50% of its earnings, then under the DDM the stock is worth only $10? Why is no value assigned to the 50c of retained cash?

It seems to me a better method would be NOI/Cap rate + net assets, but this only comes up in REIT valuation.

Thanks

#2

DDM is used when you’re a minority shareholder who has no significant control.

you can’t control how management deals with net income so you might as well value the stock using cash flows that you’re certain to get as a minority shareholder, which is dividends or share buybacks.

also, in your case, we can assume that the 50c is then used to finance projects resulting in an ROE equal to current ROE, which will give us the growth rate. Your discount rate would then be reduced by this growth rate.

DDM itself is also useful if the company has a good history of constant HIGH dividend payout policy that is unlikely to change in the future. If you are viewing from the perspective of a significant controller of the firm, then FCFF or FCFE might be more appropriate.

#3

Re: 1$ example: wouldn’t we value a company more, that produces same earnings while consuming none from it?

#4

DDM indeed captures the 50% retained earnings. As Edbert said above, the retained earnings increase the growth rate of future earnings, thus dividends. Hence, at this scenario, the stock will value more than 20 dollars because the growth rate passes from 0% to a positive rate. Try an example in an excel sheet.

If you compare the Balance Sheet in both scenarios, the latter case will show higher assets than the former because of the retained earnings in the equity section of BS. This is consistent with a higher price of stock.

Hope this helps.

#5

Thanks for your help! So my error was to assume retained earnings pile up as cash rather than being reinvested to increase earnings at a rate consistent with a stable ROE margin. I my example with a 50% payout ratio retained earnings are accumulating but earnings are flat so ROE is declining.

#6

Thank you. I modeled it over 10 years on a spreadsheet, assuming beginning equity of $10, an ROE of 20%, 50% payout ratio and 12% discount rate.

So each year each earnings grow by 10%.

First year earnings is $10*0.2 = $2. Dividend is $1, retained earnings $1. Ending equity is $11.

Second year earnings is $11*0.2 = $2.20. Dividend is $1.10, retained is $1.10. Ending Equity is $12.10, and so on.

Using the DDM formula, the stock is worth $1/(0.12-0.1)=$50.

I also discounted each cash flow individually and added the PV of a terminal value and got the same value, $50.

Equity grew from $10 to c.$26.

#7

Perfect :grin:

I’m glad to help!