Dividends are the best friend an investor has. They are the gift that keeps on giving and finding a company that pays them consistently over a long period of time is a great way to build your wealth. Finding the intrinsic value of a dividend paying company is paramount to investing with a margin of safety. This helps protect our investments and grow our wealth. Using the dividend discount model is a great way to find that intrinsic value, and the use of the two-stage dividend discount model is a fantastic way to get a more precise view of that value.
Our goal is to find the approximate value of a company, not to quibble about the minor details, we must remember that valuation is an art. What one investor sees as value, another might see as a liability, it can be seen as in the eye of the beholder.
The dividend discount two-stage model is a little more involved than the Gordon Growth model that we addressed last week, but it is definitely doable on our part. We will walk through all the steps to help you calculate it on your own and give you examples to help illustrate what we are doing.
What’s the big deal with dividends, and why do we keep talking about them?
To give you an example of the power of dividends, let’s take a look at our favorite guru, Warren Buffett. Over the years Buffett has grown his wealth by investing in and buying businesses with strong competitive advantage (moat) that have traded at fair or better prices.)
His favorite company to invest in is one that pays him a dividend. Did you know that:
- Over 91% of his portfolio is invested in stocks that pay a dividend
- His top 4 holdings, which make up over half of his holdings pay a dividend yield of 2.9%
- Best of all, most of his stocks have paid a rising dividend for decades.
This has helped lead to incredible wealth for him, he has used the compounding nature of stocks and their dividends to accumulate much of his wealth.
Consider this, his top 4 holdings which include Wells Fargo (WFC), Coke (KO), Kraft Heinz (KHC), and IBM all pay handsome dividends, equating to a yield of 2.9% and consider that Coke has paid a growing dividend for 55 years!
Another fact to consider is the over the last ten years the Dividend Aristocrats have outperformed the market, the S&P 500 by almost 2.64%. This makes dividends and incredibly powerful force to be reckoned with and why we focus a lot of our attention on them.
Dividends plus compounding over time equates to a powerful force that is hard to beat.
Because dividends are such a big deal we need a way to value these companies, and that answer is the Dividend Discount Model.
Two-Stage Dividend Discount Model
What is this model and how is it different from the Gordon Growth model I already know?
The Gordon Growth model is a simple, but powerful way to value dividend paying stocks, but it has one pretty big flaw, it takes it on faith that the growth rate for the company that you are valuing is going to continue growing at that same static growth rate forever.
And you and I know that this is simply not possible, the vagaries of the stock market and business lead to an incredible amount of volatility and cycles that all businesses go through.
And so enter the two-stage model of the Dividend Discount Model. It allows you to enter different growth rates as the company evolves and enables you to get a greater range of outcomes, which helps us in our valuations.
The awesome part of this model is the ability to adjust the growth rates for a number of years, in essence giving you control of how you value that particular company. As the company goes through its growth spurt, no pun intended, you can adjust for a slower growth rate and a declining growth rate, if you wish.
Two-stage Dividend Discount Model: Formula & Examples
Okay, on to the formula.
Intrinsic Value = DPS / ( 1 + Khg) + P / (1 + Kst)
Where P = DPS / kst – g
So what does all that mean? Don’t worry, I will lay it all out for you.
First, the variables are as follows:
DPS = Expected dividends per share in year
Khg = Cost of equity during high growth rate
Kst = Cost of equity during stable growth rate
G = Extraordinary growth rate for the first number of years
Now that we have some of the formula laid out we can start the process of working through a real company.
Let’s take Proctor and Gamble (PG) for a test run on this formula. Why would we do them? They have a reputation for paying a high dividend through the years and are a member of the Dividend Aristocrats.
Before we start we need to gather a little background information. All this information will be gathered from gurufocus.com and it will be dated 4-18-17.
- EPS = $3.69
- Dividends per share = $2.66
- Payout ratio 2016 = 72.08%
- Return on Equity = 17.12%
Now that we have these numbers we can next estimate the cost of equity for P&G. To do this we will use our formula that we discussed last week.
Cost of equity = Risk-free rate + beta (Risk premium)
- Risk-free rate = 5.40%
- Beta = 0.49
- Risk premium = 2.23%
For more on these numbers and how I arrived at them, please refer here.
Cost of equity = .054 + 0.49(.0223)
So plugging in the numbers, we arrive at the cost of equity of 6.49%, and this will be for our growth period.
We will do the same calculation for the stable period but we will raise the beta to reflect a more stable growth environment.
Cost of equity = Risk-free rate + beta (Risk premium)
COE = .054 + 0.6 (.0223)
Cost of equity for our stable growth period will be 6.73%
Next, we will calculate the expected growth rate during our growth period. To do this we will use the following formula.
Expected growth rate = Retention rate * Return on Equity
The retention rate is the payout ratio that we calculated earlier, which would be 72.08%, and our Return on Equity is 17.12%.
Expected growth rate = .7208 * .1712
Expected growth rate = 12.34%
The next number that we will calculate will be the retention ratio during the stable growth period. And to do this we will use the approximate growth rate of the economy which will be 3%, and the Return on Equity we will drop to 15%, which is lower than our current ratio but it is higher than the cost of equity.
The formula for the retention ratio is:
Retention ratio in stable growth = g / ROE
Retention = .03/.15 would equate to 20%, which would mean that the payout ratio during our stable growth period would be 80%.
First Stage of Formula
Now that we have compiled some numbers we are ready to do the heavy lifting part of the formula. What we are going to do now is figure out the present value of future dividends. This is, in essence, a discounted cash flow of