Chapter 6 Notes: Common Stock Valuation

Dividend Discount Model (DDM)

• Purpose: Value a stock by discounting all expected future dividends

• Basic formula (present value of future dividends): $P0 = \sum_{t=1}^{T} \frac{Dt}{(1+k)^t}$

  • where: Dt = dividend paid at year t, k = risk-adjusted discount rate

• Dividend growth link: future dividends grow at rate g, so
  $Dt = D0 (1+g)^t$

• Constant growth / finite horizon (T years):
  $P0 = \frac{D0(1+g)}{k-g}\left[1-\left(\frac{1+g}{1+k}\right)^T\right]$

• Constant perpetual growth (Gordon growth):
  $P0 = \frac{D0(1+g)}{k-g}\quad (k>g)$

• Two-stage dividend growth model (two growth phases: g1 for T years, then g2 forever):

  • Part 1 (first T dividends): $PV1 = \sum_{t=1}^{T} \frac{D0(1+g1)^t}{(1+k)^t}$

  • Part 2 (terminal value at T, growing at g2):
    $PT = \frac{D0(1+g1)^T (1+g2)}{k-g2}$ $PV2 = \frac{PT}{(1+k)^T}$

  • Total: $P0 = PV1 + PV2$

• Estimating growth rate g

  • Historical average growth rate (HARG): use past dividend growth

  • Industry median/average growth rate

  • Sustainable growth rate (SGR)

• The Growth Rate concepts

  • The Historical Average Growth Rate (Broadway Joe example):

  • Arithmetic Average

  • Geometric Average

  • The Sustainable Growth Rate (SGR)

  • Definition: $\text{SGR} = \text{ROE} \times \text{Retention Ratio} = \text{ROE} \times (1 - \text{Payout Ratio})$

  • ROE: Return on Equity = Earnings / Equity

  • Payout Ratio: Proportion of earnings paid as dividends

  • Retention Ratio: Proportion of earnings retained for investment

• The Two-Stage Dividend Growth Model (conceptual)

  • Stage 1: high growth for T years; Stage 2: perpetual growth at a lower rate g2

  • Interpretation: early stage growth dominates price if cash flows are strong early on

• CVS Health CVS valuation (DDM framework)

  • CAPM discount rate: $k = r_f + \beta \times \text{MarketRiskPremium}$

• Takeaways from CVS valuation

  • Wide range of values across models is common; valuation is subjective

  • The goal is to select a model you are confident in and that aligns with the firm’s characteristics

  • Morningstar fair value estimate for CVS: around $96 with a possible range from $67.20 to $129.60

• Useful internet sites (reference)

  • www.aaii.com (The American Association of Individual Investors)

  • www.cfainstitute.org

  • jmdinvestments.blogspot.com

  • www.marketwatch.com

  • www.hoovers.com

  • www.zacks.com

  • www.fool.com

• Chapter Review: Key topics

  • Security Analysis: Be careful; use Dividend Discount Model variants; growth and sustainability considerations

  • Two Stage DDM; Observations on DDM applications and discount rates

  • Residual Income Model (RIM); Free Cash Flow (FCF) approach; Price Ratio Analysis

  • Applications of price ratio analysis (P/E, P/CF, P/S, P/B)

  • CVS Health Corporation analysis as a case study

• CVS slide notes (text alt context)

  • CVS Health is an integrated pharmacy healthcare provider with multiple offerings across the U.S.

  • The slide includes data such as beta, fair value considerations, and P/E-related metrics, illustrating how analysts use multiple data sources to estimate value

• Bottom-line considerations

  • DDM is simple to compute but sensitive to g and k; not ideal for non-dividend firms

  • Two-stage models are more realistic but require careful estimation of g1, g2, and k

  • RIM provides a framework to value non-dividend payers, linking book value, earnings, and required return; can resemble perpetual growth under certain conditions

  • FCF-based valuation yields firm value and is useful when cash flows, not dividends, drive value; requires adjusting for debt and cash to obtain equity value

  • Price ratio analyses provide quick benchmarks but can yield divergent results across models; cross-check with fundamentals and comparable firms

• Final takeaway

  • There is substantial subjectivity in stock valuation; different models produce different estimates

  • The objective is to select robust models and inputs, and to understand the sensitivity of results to assumptions