Individuals and companies make an investment because they expect a rate of return over the investment period. Logically, the value of an investment should be equal to the present value of the expected future benefits. For common shares, an analyst can equate benefits to the cash flows to be generated by the investment. The simplest present value model of equity valuation is the dividend discount model (DDM), which specifies cash flows from a common stock investment to be dividends. If the issuing company is assumed to be a going concern, the intrinsic value of a share is the present value of expected future dividends.
Dividend Discount Valuation Model
At the shareholder level, cash received from a common stock investment includes any dividends received and the proceeds when shares are sold. If an investor intends to buy and hold a share for one year, the value of the share today is the present value of two cash flows-namely, the expected dividend plus the expected selling price in one year. The expected value of a share at the end of the investment horizon-in effect, the expected selling price-is often referred to as the terminal stock value (or terminal value). Extending the holding period into the indefinite future, we can say that a stock’s estimated value is the present value of all expected future dividends as shown in Equation.
Vo = value of a share of stock today, at t = 0
D1 = expected dividend in year t, assumed to be paid at the end of the year
r = required rate of return on the stock
Consideration of an indefinite future is valid because businesses established as corporations are generally set up to operate indefinitely. This general form of the DDM applies even in the case in which the investor has a finite investment horizon. For that investor, stock value today depends directly on the dividends the investor expects to receive before the stock is sold and depends indirectly on the expected dividends for periods subsequent to that sale, because those expected future dividends determine the expected selling price. Thus, the general expression given by Equation 1 holds irrespective of the investor’s holding period.
Free Cash to Equity Model
In practice, many analysts prefer to use a free-cash-flow-to-equity (FCFE) valuation model. These analysts assume that dividend-paying capacity should be reflected in the cash flow estimates rather than expected dividends. FCFE is a measure of dividend-paying capacity. Analysts may also use FCFE valuation models for a non-dividend-paying stock. To use a DDM, the analyst needs to predict the timing and amount of the first dividend and all the dividends or dividend growth thereafter. Making these predictions for non-dividend-paying stock accurately is typically difficult, so in such cases, analysts often resort to FCFE models.
Issues in Discount Dividend Model
Applying a DDM is difficult if the company being analyzed is not currently paying a dividend. A company may not be paying a dividend if 1) the investment opportunities the company has are all so attractive that the retention and reinvestment of funds is preferable, from a return perspective, to the distribution of a dividend to shareholders or 2) the company is in such shaky financial condition that it cannot afford to pay a dividend. An analyst might still use a DDM to value such companies by assuming that dividends will begin at some future point in time. The analyst might further assume that constant growth occurs after that date and use the Gordon growth model for valuation. Extrapolating from no current dividend, however, generally yields highly uncertain forecasts.
You may find the following book a good read:
The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel (Revised Edition) (Collins Business Essentials)