Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

AFFORDABLE VS. CONVENTIONAL DIVIDENDS

Most dividend growth models divide the future into two or three distinct stages.4 Three-stage growth models typically assume (1) an above-average growth period explicitly covered by the analyst’s forecast horizon, (2) a second stage during which earnings growth rates will decelerate toward the average or normal growth rate, and (3) a final stage of normal constant growth reflecting the fact that the company has reached maturity. For ease of exposition, we will focus on a two-stage dividend growth model, which incorporates the first and third stages only; the conclusions are generalizable to any multistage dividend model.

The equity value (P0) of a supernormal growth company is conventionally determined by the following equation:

(4.4)

where

NI = net income

DIV = dividends

ds = dividend payout rate during the supernormal growth period

gs = sales growth rate during the supernormal growth period

g = sales growth rate after the supernormal growth period

n = number of years of supernormal growth

ke = equity discount rate

The first term in Equation (4.4) represents the present value of dividends during the supernormal growth period and the second term the value of the shares at the end of the supernormal growth period, discounted back to the present. Note that in this conventional formulation the dividend for the first year of the normal growth period ...