Chapter 16: Security Analysis Supplementary Notes The Dividend Discount Model (DDM) with constant dividend growth

states that
P0 = D1 (1 b) E1 = k g k g

k >g

where " is called the earnings retention ratio or plow"ac# ratio! and (1$") is called the dividend payout ratio% According to this &odel! the '() ratio can "e de ined as
P0 1b = E1 k g

k >g

This &odel has several pro"le&s: (1) *t does not apply to stoc# that pays no dividends+ (,) it doesn-t wor# when the ir& is at super growth stage with g.#+
(/)

it e0aggerates the '() ratio when

g k

even though g1#%

(2) it does not e0plain why the ir& is a"le to grow its dividends Steady state growth rate:
g 3 =bk

* the stoc# pays no dividend! its earnings in steady state should grow at the sa&e rate as the re4uired return! i%e%!
P0 =
g =k

% 5ence!

Pn E1 (1 + k ) n E1 1 = = % (1 + k ) n (1 + k ) n k k

6ow suppose that the stoc# pays (1$") o the earnings as dividend! its earnings growth should "e reduced to
P0 =
g 3 =bk

% To see this! notice that

E1 (1 b) E1 D1 = = % k k bk k g3

Two$Stage DDM: (1) Assu&e that the ir& is going to e0perience n years o super growth at
1

rate g! then reaches a steady growth stage with a steady growth rate
g 3 =bk

%
P= Dn Pn D1 + + + n 1+ k (1 + k ) (1 + k ) n

Pn =
1+ g 1+ k

Dn+1 E (1 b) E1 (1 + g ) n = n+1 = k g k bk k

De ine

x=

!
(1 b) E1 1 + g (1 + g ) n P0 = + + 1+ g (1 + k ) n 1+ k = = (1 b) E1 x + x , + + x n 1+ g E1 (1 + g ) n + k (1 + k ) n E xn + 1 k

(1 b) E1 x(1 x n ) E1 x n + ! x 1% 1+ g 1 x k

There ore! the '() ratio can "e e0pressed as su& o two parts:
P0 (1 b) x (1 x n ) x n = + ! i x 1 E1 (1 + g ) 1 x k (1 b) 1 n + ! i x =1 (1 + g ) k = 7rowth '() + Steady '()% =

Required Return
(1)

5istory has shown that the average return o the stoc# &ar#et inde0 is a"out 10$1/8! i%e%!
k m = R f + m ( Rm R f ) = Rm = 10 1/8 ! m =1 %

(,) 9ight now the ris# ree rate is a"out :8! hence! the &ar#et pre&iu& is a"out :$;8% * an individual stoc# has a "eta 1%/! the SM< leads to:
k = 0%0: + ( Rm R f ) = 0%0: +1%/(0%06) = 0%1,=

(/) Ma#e su">ective ad>ust&ent on the re4uired return k% ?or e0a&ple! i the stoc# pays a good dividend! reduced 1$,8+ i the perceived ris# is high! add a ew percent% Pragmatic Approach )sti&ate the )arnings per share ()'S) in n years )sti&ate the '() ratio at year n )sti&ate the re4uired return # over the ne0t n years )sti&ate the dividends per year in the ne0t n years
D + ( P ( E ) n EPS n D1 + + n 1+ k (1 + k ) n

1% ,% /% 2%

:% P0 =