Two Stage Dividend Discount Model

Published Date: 02 Nov 2017

Abstract– Finance professionals frequently value assets using fundamental valuation methods which discount the expected cash flows received by investors. Using information on the share price, dividend payments and earnings for a single firm over a period of more than 120 years, we compare the actual share price to the expected price—calculated using several of the most commonly used fundamental valuation methods.

Since these methods depend on the estimation of inputs—such as the discount rate and growth rate—we discuss the sensitivity of the expected prices to different estimation techniques and the relevant assumptions across various economic conditions. Over our entire sample period, we find that dividend based models perform well at explaining actual prices; they perform better than commonly used earnings based models (such as the Fed Model). The assumption underlying this framework concerns the fact that, following the efficient market hypothesis, there should exist an upper limit to the explanatory power of the dividend discount model (explained through the volatility in corporate dividends) when explaining the volatility in stock prices. Both works, independently, test for this relation for the S&P 500 and conclude that there does indeed exist a bound on the explanatory power of the dividend discount model and that there exists excess volatility, where the variation in dividends cannot explain the volatility in stock prices.

Keywords– Dividend Discount Model, Stock Price Valuation

Introduction

The project selected is security analysis of software companies with specific emphasis on fundamental analysis using dividend discount models. The intrinsic value of an equity share is a function of the earnings level, growth rate, and risk exposure of a company. These in turn depend to a great extent on the prospects of the industry to which company belongs. While fundamental analysis helps in determining what to buy or sell, the technical analysis helps the decision when to buy/sell. This provides a basis for predicting future behavior.

II. Review of Literature

Shiller (1981), for example, found the volatility of stock prices to be 6-12 times its upper limit.The research following this conclusion has been twofold.

Firstly, much research has been done that accept the results from the variance bounds framework and set out to explain the excess volatility found. Most other research following the findings focused on the viability of the variance bounds framework as adopted by Shiller (1981) and LeRoy and Porter (1981).

The research that set out to explain the observed excess volatility in stock prices found many different causes for this phenomenon. Some papers attribute it to rational bubbles (DeBondtandThaler (1985), West (1987)), regime-switching in the dividend process (Gutierrez and Vazquez (2004)) or to the presence of noise traders in the market (DeLong et. al (1990), Campbell and Kyle (1993)).

Nasseh and Strauss (2004) For a complete review of the studies on stock price volatility see West (1988) 8 None of these explanations, however, has led to a valuation model that explains the data better than the dividend discount model.

The other strand of research has focused on the validity of the use of the variance bounds framework to test for the aforementioned relation, since the frameworks used in both Shiller’s(1981) and Leroy and Porter’s (1981) work have econometric problems which are considered serious enough to invalidate the results.By altering the variance bounds framework, Kleidon (1986b) and Akdeniz et. al (2007) explicitly reject the framework used by Shiller (1981) that employs a time-series variance bounds test. By replacing this framework by a cross-sectional variance bounds test, they find that the validity of the traditional dividend discount model cannot be rejected. Flavin (1983) adopts a different point of criticism on the variance bounds framework. She argues that the sample volatility adopted in Shillers (1981) work are obtained by taking the variation from the sample mean instead of the much larger population variance. This leads her to conclude that the excess volatility can be contributed to the ‘sampling properties of the volatility measures’. Following the criticism on the original variance bounds framework, new tests were developed that incorporated all the objections described. Cochrane (1992), for example, finds that by controlling for the issues mentioned the variance bound is satisfied when using data for the New York Stock Exchange. Ackert and Smith (1993), furthermore, come to similar conclusions when analyzing the Toronto Stock Exchange.

Since the models following the criticism on the variance bounds literature conclude much more favorably on the relation between the variation in stock prices and dividends, it strengthens the validity of the traditional dividend discount model.

III. DIVIDEND DISCOUNT MODELS

The only cash flow one receive from a firm when they buy publicly traded stock is the dividend. The simplest model for valuing equity is the dividend discount model -- the value of a stock is the present value of expected dividends on it. While many analysts have turned away from the dividend discount model and viewed it as outmoded, much of the intuition that drives discounted cash flow valuation is embedded in the model. In fact, there are specific companies where the dividend discount model remains a useful tool for estimating value.

IV.Two-stage Dividend Discount Model

The two-stage growth model allows for two stages of growth - an initial phase where the growth rate is not a stable growth rate and a subsequent steady state where the growth rate is stable and is expected to remain so for the long term. While, in most cases, the growth rate during the initial phase is higher than the stable growth rate, the model can be adapted to value companies that are expected to post low or even negative growth rates for a few years and then revert back to stable growth. The model is based upon two stages of growth, an extraordinary growth phase that lasts n years and a stable growth phase that lasts forever afterwards.

V.Three-stage Dividend Discount Model

The three-stage dividend discount model combines the features of the two-stage model and the H-model. It allows for an initial period of high growth, a transitional period where growth declines and a final stable growth phase. It is the most general of the models because it does not impose any restrictions on the payout ratio. This model assumes an initial period of stable high growth, a second period of declining growth and a third period of stable low growth that lasts forever.

Multiple Holding Periods DDM

If investor plans to hold a stock for two years, the value of the stock is the present value of the expected dividend in first year, plus the present value of the expected dividend in second year, plus the present value of the expected selling price at the end of two years.

The expression for the DDM value of a share of stock for any finite holding period is a straightforward extension of the expressions for one-year and two-year holding periods. For an n-periods model, the value of a stock is the present value of the expected dividends for the n periods plus the present value of the expected price in n periods.

In the limit, if we let the holding period extend into the indefinite future, the stock's value is the present value of all expected future dividends.

Objective of the Study

To study the variation between market price and theoretical value of the stock of FIVE (05) I.T. Companies.

To determine price fluctuations in the form of under-price and over-price of share value.

Methodology

The Secondary data is collected from various authentic websites till March23, 2013. We have used SPSS 19.0 for data analysis.

Multiple Year Holding Period Formula in MS Excel

Average Function in MS Excel

If Analysis in MS Excel

It is the descriptive study conducted to analyze whether the market price is overvalued or undervalued.

Process of Valuation of a Financial Asset

Determining parameters of models

How to determine the growth rate?

Length of growth period

How to determine the required rate of return

Models for Stock Valuation

Dividend Discount Models

Price-Earnings Models

Free Cash Flow to Equity Valuation Models

Valuation of Financial Assets

Process of determining the fair market value of a financial asset on the basis of present value of the expected cash flows

Three step process:

Estimate the expected cash flows

Determine the appropriate interest rate or interest rates to discount the cash flows

Compute the present value of the expected cash flows in step 1 by discounted them with interest rate(s) in step 2

Estimating Cash Flows

Holding aside the risk of bankruptcy, the cash flows of a common stock are:

Payment of dividend so long as we hold the stock

Sale price of common stock when we sell the stock

INTERPRETATION

The data analysis shows that there is vast difference between market value and theoretical value of shares of top five IT Companies mentioned in this study.The expected present value of companies is more than the market price.

Following table shows the variation between Market Price and Theoretical Price of the Shares:

Company Name

Market Value(Rs)

Theoretical Price(Rs)

Variation (Rs)

TCS

1560.8

3615.18

2054.38

Infosys

2876.5

4872.44

1995.94

Wipro

434.15

605.77

171.62

HCL Technologies

772.45

2343.89

1571.44

MPhasis

396.45

1263.23

866.78

The share prices of all five IT companies are under-valued; internally the firms are very strong.

Suggestions and Conclusion

The study conducted shows that the share price of all IT Companies stated TCS, Infosys, Wipro, HCL Technologies, MPhasis will grow in near future (say 5years). The return from stock includes both current income and capital gain caused by appreciation of the price.

It is found that the expected present value is more than the current share price of all the companies in study, this increased expected present value depicts that all five IT Companies are fundamentally very strong and competent.

As the fundamental strength of all companies is good, shareholders are suggested to include these securities in their portfolio because risk is moderate and returns are reasonably high. The shares of these companies should be bought and can be held for multiple years as they have promising future ahead.