Why does a lower growth rate produce a higher terminal value than a higher growth rate. For example, if a for a dividend of $5, if grow forever at rate of 6% the terminal value will be 5/0.06=83.33 but if grow forever at 10% the terminal value will be 5/0.1=50. This does not make sense to me as I expect a higher growth rate to produce a higher terminal value. Can someone pls clarify.
Ok am confused, For example am trying to value a company whose sustainable growth rate is 10%, last dividend paid was $1, required rate of return of 20% and the company operate in an economy whose growth is 6%. My estimate of the future cashflow using growth rate of 10% are 1.1, 1.21, 1.331, 1.4641, 1.6105, 1.7716 Since the company cannot grow forever at a growth rate greater than that of the economy the terminal value at the end of the fifth year will be the expected dividend at the end of the sixth year divide by the growth rate of the economy I.e 1.7716/0.06= 29.52 My problem is as follows, a lower growth rate produce a higher terminal value. I want to value this company using DDM
I didn’t follow the second post at all. So I’ll respond to the first.
#1 - you didn’t use the Gordon Growth/DDM model, because you didn’t subtract out the g from the r. But if you just want to use an absolute measure (10% and 6%), then I’ll bite.
What you’re calculating in using the DDM is not really the “terminal” value, as in, “What it will be worth in the future.” What you’re really calculating is “what will I be willing to pay for it today”.
Think of it this way–if a stock will be worth $100 in five years, then it’s worth $62 today, if you discount it at 10%. If you discount it at 6%, it’s worth about $75. Ergo, the higher the discount rate, the lower the “today’s” value is.
Don’t know if that answered your question or just muddied the water even more.
Many thanks for your response, I think am clear I should r-g to discount the last expected dividend and not g. My question now is, if the company cannot grow at a rate greater than the economy it operate, do i then assume all the expected dividend grow at growth rate of the economy. Also how do we choose the period to use for DMM, I notice that five years is the most commonly used.
In the questions on the exam they will give you the terminal (perpetual) growth rate, and the number of years of high growth. You don’t need to make assumptions about either one.
In that case, you’ll have to get that information from the company you’re trying to value: how long do they anticipate the high growth rate on their dividends? When they settle into a perpetual growth rate, what do they expect it to be?
I really do not mind, if you could just answer those questions I’ll be pleased. I’ve been studying DDM for sometime but abound it because I could not understand many of the assumption but after studying the level 1 CFA institute books, some of it are clearer but not all. This is just a learning process for me, an just trying to put what I’ve learnt to work and may not necessarily commit money to result I get out of it. Once again, can you pls answer those questions.
Well, you’re correct about the $1.7716 part. Assuming dividends grow at a rate of 10% per year, that’s the dividend at time 6.
The long-term required rate of return ® is 10%, and the growth rate (G) is 6%. So r-g = .04. Ergo, the stock will be worth 1.7716/.04, or 44.29 at time 5. (You use the dividend at time 6 to determine the value of the stock at time 5.)
Now that you know the value of the stock at time 5, you discount it back to today, using the 20% supernormal growth rate. 1.2^5 = 2.488. The inverse of 2.488 (or 1/2.488) is .402. This is the present value of $1 today.
So logically, .402 x 44.29 = 17.80. And the stock that paid a $1 dividend today that will grow at a rate or 10% forever, given a 20% required rate of return and a 6% growth rate in the economy is worth 17.80.
Thanks for your response. Why did you use 10% as R and 20%, since 20% is the required rate of return. Also you didn’t consider the dividend to be paid in year 1-5.
There are two R’s. One is 10%, which is the growth rate of dividends in year 6-forever and ever. The other is 20%, which is the growth rate from now until year 5. I used them both at the appropriate times. (Yes–you can have different R’s.)
Good catch. I should have put those in my cash flow calculator. But I’ll let you do that and tell me what you find.