Dividend Discount Model And Economic Value Added Approach


02 Nov 2017

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There are several methods to value the shares of the company using the dividend valuation.

Dividend discount model helps in valuing the fairness of the company. The value of the shares is the current value of the expected dividend. If the value obtained using DDM is higher than the price at which the current shares are trading, than the shares are undervalued.

Gordon Growth Model (GGM):-

Gordon growth model is used for determining the intrinsic value of a stock on the basis of a future series of dividends that grow at a constant rate. Given a dividend per share that is payable in one year and the assumption that the dividend grows at a constant rate in perpetuity, the model solves for the present value of the infinite series of future dividends. It is calculated as follows:

Valuation of Shares = DPS/ (Ke-G)

DPS = Expected dividend per share one year from now

Ke = required rate of return for equity investors

G = Growth rate in dividend

The Gordon growth model is a simple draw next to valuing equity; it cannot be regarded as highly practical if the firms are growing at a stable rate. There are two insights worth keeping in mind. when estimating a stable growth rate it has to be alleged that the growth rate of the firm's dividends is expected to last evermore, the firm's other measures of performance (including earnings) has also be expected to grow at the same rate.

Now we take an example if a firm which grow 8% a year forever, while its dividends grow at 10% at the same time, the dividends will go over earnings. On the other hand, if a firm's earnings grow at a faster rate than dividends in the long term, the payout ratio, in the long term, will converge towards zero, which is also not a steady state. Though the model's requirement is for the expected growth rate in dividends, analysts should be able to substitute in the expected growth rate in earnings and get exactly the same result, if the firm is truly in sound state.


The main strength of the Gordon growth model is that the valuation calculation is easily performed using readily available or easily estimated inputs.

The model is particularly useful among companies or industries where cash flows are typically strong and relatively stable, and where leverage patterns are also generally consistent.

The model is widely used to provide guideline fair values in mature industries such as financial services and in large-scale real-estate ventures. The model can be particularly appropriate in the valuation of real-estate investment trusts, given the high proportion of income paid out in dividends and the trusts’ strictly defined investment policies.

Limitations of Gordon Growth Model:-

The Gordon growth model is a simple and easy way to value stocks but it is extremely based on the input of data .If it is used incorrectly, it can lead to misleading or incorrect results, since, as the growth rate converges on the discount rate, the value goes to infinity. Consider a stock, with an expected dividend per share next period of $2.50, a cost of equity of 15%, and an expected growth rate of 5% forever. The value of this stock is:

As the growth rate approaches the cost of equity, the value per share approaches infinity. If the growth rate exceeds the cost of equity, the value per share becomes negative. This issue is tied to the question of what comprises a stable growth rate.

Applications of Gordon Growth model:-

The Gordon growth model is best suited for firms growing at a rate comparable to or lower than the nominal growth in the economy and which have well established dividend payout policies that they intend to continue in to the future. The dividend payout of the firm has to be consistent with the assumption of stability, since stable.

Cash Flow to Firm Evaluation:-

Free cash flow to firm helps to identify the value of stock of a company by obtaining the free cash flow of a firm and discounting these cash flows back to present value at the appropriate required rate of return. In order to bring the cash flow to present value WACC (Weighted average cost of capital) has to be calculated.

Firm Value = FCFF discounted at WACC

FCFF can be calculated by using four different financial statement items such as

Net Income

EBIT ( Earnings before interest and taxes)

EBITDA (Earnings before interest and taxes, depreciation and amortization)

Cash flow from operation (CFO)

Free cash flow to firm helps the management in planning and reporting purposes and also helps to increase the rating of the company. Free cash flow to firm helps to identify the cash flows available to investors

Cash inflows are revenues which are created by selling their products, and cash outflows are which are paid for operating expenses such as wages and taxes and the cash which is left over after cash inflow and outflows are used to invest in working capital and long term investment in working capital. The cash remaining will be used to pay to firm’s investors, Bondholders and common share holders and it is called free cash flow to firm.

FCFF using Net income method:-

FCFF from net income method is calculated using the following formula

FCFF=NI+NCC+(Int x (1-Tax rate ))-FCInv-WCInv


NI = Net income

NCC = Non cash charges

FCInv = Fixed capital investment

WCInv = Working capital investment

Int = Interest Expenses

Non cash charges are added back to net income as they did not represent actual outflow of cash. Examples of non cash charges are Depreciation, Amortization etc.

Fixed capital investment:-

Assets or capital investments that are needed to start up and conduct business even at a minimal stage. These assets are considered fixed in that they are not used up in the actual production of a good or service, but have a reusable value. Fixed-capital investments are typically depreciated on the company’s accounting statements over a long period of time, up to 20 years or more.

Working capital investment:-

A firm’s investment in short-term assets or cash, short-term securities, accounts receivable, and inventories. Gross working capital is defined as current assets minus current liabilities. If the term working capital is used without further qualification, it generally refers to gross working capital.

Interest expense:-

Interest expense represents the interest charges in the income statement but interest charges do not represent operating cash flow it represents the financing cash flow.

So interest has to be added back to net income and only interest expenses after the marginal tax rate has to be added back. For Example if the tax rate is 25% then only 75% of the amount of interest is added back since this 75% represent the cash flow.

FCFF in relation to GSK:-

FCFF has been increased by 21% in 2008 when compared to 2007.This is due to the higher operating profit before non-cash charges,

Primarily from the major restructuring programmes, and working capital improvements, partly offset by higher levels of interest paid as a result of The significant debt issuances during the year of US $9 billion under the US shelf registration and £0.7 billion under the EMTN programme.

Value of Equity using the FCFF is 66842.86million.

Free cash Flow to Equity Evaluation( FCFE):-

Free cash flow to Equity helps to identify the cash flows available to shareholders. FCFE is calculated by taking into account net income and convert it to a cash flow by subtracting out a firm’s reinvestment needs.

Any capital expenditures, defined broadly to include acquisitions, are subtracted from the net income, since they represent cash outflows. Non cash charges such as depreciation and amortization are added back to net income. The difference between capital expenditures and depreciation is referred to as net capital expenditures and is usually a function of the growth characteristics of the firm.

High growth firms tend to have high net capital expenditures relative to earnings, whereas low-growth firms may have low and sometimes even negative, net capital expenditures

Repaying the principal on existing debt represents a cash outflow; but the debt repayment may be fully or partially financed by the issue of new debt, which is a cash inflow. Again, netting the repayment of old debt against the new debt issues provides a measure of the cash flow effects of changes in debt.

Allowing for the cash flow effects of net capital expenditures, changes in working

capital and net changes in debt on equity investors and the cash flows left over

after these changes as the free cash flow to equity (FCFE) Free cash flow to Equity can be calculated as follows;

FCFE = Net Income- (Capital Expenditures - Depreciation) - (Change in Non-cash Working Capital) + (New Debt Issued - Debt Repayments)

Free Cash Flow to Equity Valuation Models:-

The Constant growth FCFE model:-

The constant growth model aims to value firms which are developing at a stable growth rate. And hence value of the equity under constant growth model is the expected FCFE in the next period the stable growth and the required rate of return.

Formula for Calculating FCFE is

The growth rate used should not be more than the growth rate of the economy.

Two Stage FCFE Model:-

Two stage FCFE model helps to determine the value of the firm which is expected to grow at much faster than the stable firm in the initial period and at a stable rate after that.

Value of the stocks can be computed by obtaining the present value of the FCFE for the extraordinary growth period plus the present value of the terminal price at the end of the period.

Formula to compute:

Three Stage FCFE Model:-

Three stage models is designed to value firms that are expected to go through three stages of growth

an initial phase of high growth rates,

a transitional period where the growth rate declines and

a steady state period where growth is stable

Three stage models calculate the present value of expected free cash flow to equity over all three stages of growth.

Residual Income Approach:-

Residual income is net income less a charge (deduction) for common shareholders’ opportunity cost in generating net income.

The concept of residual income considers the cost of equity capital leaves to the owners the determination as to whether the resulting earnings are sufficient to meet the cost of equity capital.

Evaluation of RI:

You may like to consider the following factors when evaluating the use of RI.

Think about how it compares to ROI as a possible divisional performance measure

Usefulness and decision making. Residual income increases in the following circumstances

Investments earning above the cost of capital are undertaken.

Investments earning below the cost of capital are eliminated.

Thus it leads managers to make the correct investment decision to benefit the company as whole.

Flexibility compare to ROI. since a different cost of capital can be applied to investments with different risk characteristics

Does not allow comparisons between investment centres. RI cannot use to make comparison between investment centres as it is in absolute measure of performance.

Difficulty in deciding on an appropriate and accurate a measure of the capital employed. We discuss above there can be some difficulty in knowing what values placed on assets.

Does not relate the size of the centres in come to the size of the investment, other than indirectly through the interest charge.

Traditional method Versus Residual income approach:-

Traditional financial statements are prepared in order to ascertain the earnings available to owners. Net income includes only the interest expense which represents the cost of debt capital, dividends or other charges for equity capital are not included. Traditional accounting helps to determine whether the resulting earnings are sufficient to meet the cost of equity capital.

The economic concept of residual income explicitly considers the cost of equity capital.

It is used in the Measurement of internal corporate performance of an organization and in the estimation of the intrinsic value of common shares.

Residual income has also been called economic profit since it represents the economic profit of the firm after deducting the cost of all capital, debt and equity.

The term abnormal earnings is also used. Assuming that over the long term the firm is expected to earn its cost of capital (from all sources) any earnings in excess of the cost of capital can be termed as abnormal earnings.

Residual income can be used in situation where:-

A firm is not paying dividends or it has an unpredictable dividend pattern.

A firm which has a negative cash flow in the past, but is expected to generate positive cash flow at some point in the future when there is a great deal of uncertainty in forecasting a stable growth rate of future cash flows.

In the Residual Income Model (RIM) of valuation, the intrinsic value of the firm has two components:

The current book value of equity, plus

The present value of future residual income.

This can be expressed algebraically as

Economic Value Added Approach :-

Economic Value Added (EVA) measures the financial performance based on the concept that all capital has a cost. It is obtained by calculating Net operating profit after tax (NOPAT) less a capital charge. It shows the true profit earned as it consist of all costs including the cost of capital. If a company makes a return more than cost of capital then it is creating a true value for its share holders.

EVA is a technique useful in changing organizational behaviour and in driving the decision-making process in a manner that maximizes value to the business

Divisional performance: Economic value added (EVA):-

EVA is an alternative absolute performance measure. It is the similar to RI and it is calculated as follows;

EVA= net operating profit after tax (NOPAT) less capital charge

Where the capital charge= weighted average cost of capital * net assets

Economic Value Added is a registered trade mark owned by Stern Steward and Co. it is a specific type of residual income (RI) calculated as follows

EVA= net operating profit after tax (NOPAT) less capital charge

Where the capital charge= weighted average cost of capital * net assets

You can see from the formula that the calculation of the EVA is similar to the calculation of the RI.

EVA and RI are similar because both result an absolute figure which is calculated by subtracting an imputed interest charge from the profit earned by the investment center however there are differences as follows;

The profit figures are calculated differently. EVA is best on an "economic profit" which is derived by making of series of adjustment to the accounting profit.

The notional capital charges use different bases for net assets. The replacement cost of net assets is usually used in the calculation of EVA.

The calculation of EVA is different to RI because the net assets used as a basis of the imputed interest charge are usually valued at their replacement cost and are increase by any cost that have been capitalized.

There are also differences in the way that NOPAT is calculated compared with the profit figure that is used for RI, as follows;

Costs which normally be treated as expenses, but which are considered within EVA calculation as investment building for the future are added back to NOPAT to derive a figure for economic profit. These costs are included instead as assets in the figure for net assets employed i.e. as investment for the future; costs treated in this way include items such as goodwill, research and development expenditure and advertising cost.

Adjustment are sometimes made to the depreciation charge, whereby accounting depreciation is added back to the profit figures, and economic depreciation is subtracted instead to arrive at NOPAT. Economic depreciation is a charge for the fall an asset value due to wear and tear or obsolescence.

Any lease charges are excluded from NOPAT and added in as a part of capital employed.

Another point to note about the calculation of NOPAT, which is the same as a calculation of the profit figure for RI, is that interest is excluded from NOPAT because interest costs are taken in to account in capital charge.

Economic Value Added (EVA) and its uses:-

It is used in most companies for corporate performance measure and evaluating performance, it is also used for determining incentive pay.

EVA helps to identify investors how well the company is doing and how it is producing value to its share holders.

EVA is based on accounting figures and hence it able provide more immediate and true results.

Advantages of EVA:-

EVA can be calculated for divisions and even projects.

EVA measure’s the performance over a period of time rather than a point of time. EVA is a flow variable and depends on the ongoing and future operations of the firm or divisions.

EVA is a measure of the firm’s economic profit. Hence, it shows the true picture of the firm’s value.

Calculating EVA:

NOPAT is profits derived from a company’s operations after taxes but before financing costs and non cash entries. It is the total profits available to provide cash return to those who provide capital to the firm.

Capital is the amount of cash invested in the business, net of decline. It can be considered as the rundown of interest-bearing balance due and fair play or as the sum of net effects less no interest-bearing current liabilities.

Capital charge:-

Capital charge is the cash flow required to compensate investors for the riskiness of the business given the amount of capital invested.

The cost of capital:-

The cost of capital is the minimum rate of return on capital required to reimburse debt and equity investors for bearing risk. Another perspective on EVA can be gained by looking at a firm’s Return on Net Assets (RONA).

Return on Net Assets (RONA):-

Rona is a ratio that is calculated by dividing a firm’s NOPAT by the amount of capital it employs (RONA = NOPAT/Capital) after making the necessary adjustments of the data reported by a conventional financial accounting system.


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