Dividend Discount Model
1. Part II: Dividend Discount Model
We now turn to the second part of Chapter 2 - the Dividend Discount Model.2. Single-Stage Dividend Discount Model
There are two common types of stocks that companies issue: preferred stocks and common stocks. A preferred stock has seniority over common stocks in the capital structure. Preferred stocks pay dividends but, unlike interest payments for bonds, the firm can skip paying dividends without defaulting. Typically, common shareholders are not paid dividends unless preferred shareholders have received all the dividends they are owed. This makes preferred stocks safer securities than common stocks and results in a lower discount rate. To determine the value of preferred and common stocks, we can discount the stream of expected dividends at the appropriate discount rate.3. Discounting Dividends
For example, if we have a preferred stock that has a stated value of $1,000 and a dividend rate of 5%, then that preferred stock pays $50 in dividends each year. Assume the cost of the preferred stock, the discount rate, is 6.25%, the value of that preferred stock is $800. If the dividend stream is expected to grow, say at 2%, then we would expect the value of the preferred stock to be higher than the case when the dividends stay at a constant $50. Assuming a 2% growth rate in preferred dividends annually into perpetuity using the same perpetuity with growth formula we use when calculating the terminal value in the prior chapter, we find the value of the preferred stock would then increase to close to $1,200. This type of valuation, which discounts the expected dividend stream, is known as the Dividend Discount Model. This approach that assumes either a constant dividend or a dividend with a constant growth rate is known as a "single-stage dividend discount model."4. Two-Stage DDM - No Dividends During First Stage
Dividend discount models can still be used even when the firm does not currently pay dividends as long as you expect that the firm will start paying dividends at some point in the future. Firms may not currently want to pay dividends because they can finance their growth using those funds. However, when their growth stabilizes, which will inevitably happen, you can expect the firm to start paying dividends.5. What to do then?
The dividend stream in this situation fits a two-stage model. The first stage will have no dividends for the first T years. Then, you expect the firm to pay dividends in the second stage beginning Year T+1 to infinity. Mathematically, the calculation for the second stage is similar to calculating the present value of the Terminal Value calculation from Chapter 1. First, we use the Perpetuity with Growth Formula to value the second stage beginning in Year T+1. Then, we discount the second stage back T years to bring that value back to the present. We don't need to do any calculations for the first stage because we know the value of zero cash flows is equal to zero.6. Example
Now, let's go through an example to make this more concrete. Suppose that a firm pays no dividends from Years 1 to 5. Then, beginning Year 6, you expect the firm to start paying $50 in dividends and expect dividends to grow 2% every year thereafter into perpetuity. The table lays out what the annual cash flows look like. Assuming a 6.25% discount rate, what is the value of this stock? We can apply the formula from the prior slide into R. As we can see, the value of the stock is $818. In other words, even without paying dividends today, the stock will still has positive value as long as investors expect to receive some dividends in the future.7. Let's practice!
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