Equity (common shares)
Dividend Discounting Method (DDM)
Price = intrinsic value of a share = Present Value of the future cash flows.
Cash flows from shares:
- Dividends
- Capital gains (but: price based on future dividends!)
? Formula:
P0 = Div1 / (1+r) + Div2 / (1+r)2 + Div3 / (1+r)3 + .........
Different assumptions
Depending on the expected outlook for the company / dividends, one can simplify the previous formula:
1. No growth in dividends ? P0 = Div / r
2. Constant growth in dividends ? P0 = Div1 / (r - g)
3. Differential growth in dividends
Method: calculate the dividends of the first few years that are different from later years. Calculate with the constant growth formula the value of the remaining dividends (and calculate the present value of this). The two together is the current price.
Example (1)
A company has just paid out a dividend of $5.00 per share. The shareholders demand a return of 12%.
What is the price of the share if:
dividend remains the same (forever).
dividends grow with 4% per year (forever).
dividends grow with 4% per year in the first 5 years, then with 2% per year (forever).
Example (2)
Price = P0 = Div1 / r = $5.00 / 0.12 = $41.67
Formula: P0 = Div1 / (r - g)
with Div1 = Div0 * (1+g) = $5.00 *(1+0.04) = $5.20
? Price = P0 = $5.20 / (0.12 – 0.04) = $65.00
c) Price consists of 2 parts:
(i) PV of the dividends in the first 5 years:
P0 = $5.00*1.04 / 1.12 + $5.00*1.042 / 1.122 + … +$5.00*1.045 / 1.125 = $20.13
Example (3)
(ii) PV of the dividends aft ...