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\
|
+
+
n
n
k
g D
k
g D
k
g D
k
g D
k
g
P [4]
Now if you subtract equation 4 from equation 3, you are left with the
following equality:
( )
( )
( )
( )
1
1
0 0
0
1
1
1
1
1
1
1
+
+
+
+
+
+
= |
.
|
\
|
+
+
n
n
k
g D
k
g D
k
g
P [5]
At this point we will make two observations. First, note that as long as
k>g, then as n gets large, the final term gets very small. In fact, the limited of the
last term as n approaches infinity, is zero. Therefore, we will ignore it from here
on out. The second observation concerns the left side of the equality:
14
(
=
(
+
+
+
+
=
(
+
+
k
g k
k
g
k
k
k
g
1 1
1
1
1
1
1
1 [6]
Therefore, equation 5 can be restated in the following form:
( )
( ) k
g D
k
g k
P
+
+
=
(
1
1
1
0
0
[7]
Now if we solve for P0, we get the following equality, which is usually
called the Gordon Constant Growth Model:
( )
g k
D
g k
g D
P
+
=
1 0
0
1
[8]
In the final form, the numerator can either be the last dividend, allowed to
grow at the constant rate, or it could be restated as the expected dividend in the
next period, since the two are identical under Gordons simplifying assumptions.
For many applications, this form assumes too much. For many firms, the
implied growth is unlikely. Remember, that the growth rate is expected to
continue forever. Unless the growth rate is rather low, most firms could not
expect constant growth in dividends that is much higher than inflation
1
.
Smaller, younger companies may have a high growth period in the
corporate life cycle. That high growth period may be followed by a slower
growth period. To accommodate this growth model, Gordons original model
has been adjusted for two growth phases as follows (without derivation):
( ) ( )
(
+
|
.
|
\
|
+
+
+
(
(
|
.
|
\
|
+
+
+
=
2
2 0 1 1
1
1 0
0
1
1
1
1
1
1
1
g k
g D
k
g
k
g
g k
g D
P
T T
[9]
Cash Flow Discount Models:
The biggest practical problem with the dividend discount method is that
many firms do not pay dividends. Merton Miller and Franco Modigliani showed
mathematically that it shouldnt matter whether the cash flow comes to the
shareholder in the form of a dividend or reinvested in the company, as long the
required return is earned. That simply means that if we replace the dividends in
the above models with cash flow (or more precisely free cash flow), we can use
the above models to value firms not offering dividends.
Practical Application of Valuation Models:
Most analysts will not simply apply the above formulas to the firms they
analyze. Instead, they would project the financial statements of the firm over the
short-run, using company and market data and assumptions about the
effectiveness of the firms strategic and marketing plans. After those short-term
1
It should be noted at this juncture that the growth estimated here is nominal growth in
dividends, not real growth. That means that a growth rate equal to the average expected
inflation rate would allow for a constant dividend in real terms, and should be applied later to
the cash flows as well when the same models are used to value companies using cash flows.
15
projections, the analyst would have to make some kind of simplifying
assumptions like that proposed by Gordon.
We will demonstrate how this can be done. Earlier in the semester we
projected the income for the firm. We have since then discussed different
estimates of cash flow. For this exercise, we will use what we called the quick and
dirty cash flow estimate (net income + depreciation expense). This cash flow
estimate was for cash flow to the shareholder and is easy to calculate
2
.
To calculate the stock price per share, we will need to restate the cash flow
on a per share basis. That means that an assumption must be made about the
number of shares for any given period. At least to begin with, we can hold these
figures constant at the most recently disclosed number of base shares
outstanding. Taking total cash flow (net income + depreciation expense) and
dividing it by the expected number of shares outstanding should yield a good
estimate of per share cash flow.
At the end of this cash flow stream, we will have to project the value of
the remaining cash flows outstanding. We will do that by applying a growth
model to the remaining cash flow streams. This will yield a present value figure
at the time of the last projected cash flow stream.
The example we used in class is for Rocky Shoe and Boot. Since they have
never paid a dividend and dont look like they will anytime soon, we cannot
discount their dividends. Instead, we take their projected income, and add back
depreciation expense. Then we divide by the number of shares outstanding.
From the last projected year of cash flows, we need to calculate the present value
of the remaining cash flows. Since the previous cash flows have included
quarterly data, we restate the above Gordon Growth Model [equation 8] using
quarterly rates:
|
.
|
\
|
|
.
|
\
|
+
=
4 4
4
1
3
12
g
k
g
D
P
rdYr Avg
thQtr
[10]
This price represents the value in time 12, of all future cash flows. Since
it is denominated in time 12 dollars, we will need to take its present value. The
easiest way of accomplishing that, is to add it to the periodic cash flow and take
them both together. Therefore, another line is added to sum all period cash
flows (even though the only period with a sum is the final one. The screen
capture below demonstrates the general spreadsheet layout.
2
Note that the example company, Rocky Shoe and Boot, does not list depreciation on its income
statement. We used the change in accumulated depreciation from the balance sheet to estimate
the period by period depreciation expense.
16
In order to calculate the estimated economic value of the stock, estimates
for all inputs must be made. Earlier in these notes we presented the method for
estimating the required return to the stockholder. In addition to those estimates,
we must guesstimate the long-term annual growth rate in cash flows. If
dividends are used, then the long-term annual dividend growth rate should be
guesstimated.
After all of these rates are estimated (or guesstimated), then we will be
ready to estimate the price of the stock, which is simply the present value of our
expected future cash flows. The easiest way to calculate the present value is to
use Excels NPV function. Remember that the NPV function in Excel does not
take into consideration the cash flow at time zero (see the Excel output at the top
of the next page).
After a price is estimated, our work truly begins. The price may or may
not be close to the current market price. In the example given it is significantly
higher than the current stock price. That usually means that the underlying
assumptions are not the same (or even similar) to those used by the marginal
investors in the market. If the present value calculated is significantly different,
double check your assumptions: income projections, cash flow projections,
required return calculations, Gordon Growth model calculations, etc.
17