Fundamental Analysis -Topic 3 Dividend Discount Model

In the dividend discount model expected future dividends are discounted to the the present value.


For the infinite constant grow rate period Value of the share V is obtained by D1//k-g where D1 = dividend next year, k = cost of equity, and g = constant growth rate per annum expected in the infinite future

The estimates of future dividends are based on the past history of earnings and dividends, current circumstances, and intentions of the company management and other economic agents like banks and government.

Cost of equity is an important input in this method.

For a recent attempt at estimating market risk premium in India study

http://www.iimahd.ernet.in/~jrvarma/papers/WP2006-06-04.pdf

R-B-Ch.13 DDM Valuation of Market - Points to Refresh

Reilly and Brown 7th Edition
Chapter 13 Applying the DDM Valuation to the Market

Estimating k and g for the U.S. equity market
The nominal risk-free rate
The equity risk premium
The current estimate of Risk Premium and k
Estimating the growth rate of dividends (g)
g = f(b,ROE)
ROE = Net Income / Equity

Estimation of k for DDM

Range of specified maturities for Govt. Securities range from three month treasury bill to 30 year bond.
As of mid 2002, these yields are
3 month treasury bill 2%
10 year bond 5.2%
30 year bond 5.60%


Equity Risk Premium – Market Risk Premium Estimate

Estimates of Ibbotson as averages for the period 1926-2001
For long term investment purposes geometric mean or average is a better estimate.

Some authors suggest 20 year moving average as an estimate for risk premium.

Claus and Thomas derived an estimate that equates market valuations with prevailing expectations of future cash flows.
Their results indicate a risk premium between 1985 and 1998 of 3% or less.

Rozeff shows that under some economic assumptions dividend yield can be equal to risk premium.. During the period 1995-99 dividend yield was below 2%


Estimating Growth Rate

Growth rate of dividends is equal to
Retention rate - the proportion of earnings retained and reinvested
Return on equity (ROE) – rate of return earned on investment
An increase in either or both of these variables causes an increase in the expected growth rate (g).

Residual Income Model

See for an example Equity Research report on Voltas by Morgan Stanley

http://www.voltas.com/corporate/reports/MorganStanley_July%2024,%202007.pdf