Introduction to Discounted Cash Flow (DFC) and Dividend Discount Model (DDM)

As discussed previously in the valuation ratios chapter, determining the worth of something is referred to as the valuation. In the investment industry, valuation determines a security's intrinsic value. What do we mean by intrinsic value? It is the actual fundamental value of a security at which it should ideally trade in the market. Intrinsic value is based on an analysis of securities fundamentals and characteristics. Simply put, the security is overvalued if the current market prices are higher than the intrinsic value arrived at using various valuation techniques. An investor can decide to sell the security. 

But the question is, why valuation is even needed in the investment industry? After all, there is a belief that market forces correctly determine the market price of a security. Also, there is a belief that market prices discount everything, and therefore, forces of demand and supply push the price of a security to its fair value. Then why is there a need for investors to value security? There are several reasons for the same:

1. Informational Efficiency: Market prices may not always be efficient. This means it is possible that certain information related to a company’s security may not be reflected in the market price. It might happen when the company's size is small or not many analysts cover that security; therefore, some important news related to that company might not be reflected in the current market prices. 
2. Long-term Investing Approach: Valuing security becomes extremely important, especially when the investment horizon is long. Market prices might be impacted by short-term fluctuation, and therefore, investors with a long-term view might use valuation techniques to determine a more stable and comprehensive price. 
3. Risk Management: Employing valuation techniques results in a breakdown of various factors that influence the price of securities. That’s why due to valuation techniques, investors are aware of the range of factors that might affect a stock’s valuation and make informed decisions accordingly. 
4. Asset Allocation: Once the intrinsic value is determined using the valuation, it can be employed for relative comparison among various securities and asset classes. Therefore, it will help investors better manage their portfolio by selling an overvalued security and investing in a relatively undervalued security, offering a better reward risk. 

Therefore, there is a need to value security. This chapter will focus on the valuation of a company's equity securities, i.e., the company’s stock or shares and no other asset classes, as the characteristics and nature of securities vary widely among different asset classes. 

Equity Securities Valuation

Valuing the equity security of a company is no easy task. It requires a lot of assumptions about various factors that influence a security price. There are three main approaches to valuing security:

1. Present value models 
2. Relative valuation model
3. Asset-based valuation model 

Present Value Models

These models estimate a security's intrinsic value as the present value of the future benefits expected. In present value models, benefits are often defined as cash expected to be distributed to shareholders (dividend discount models) or cash flows available to be distributed to shareholders after meeting capital expenditure and working capital needs (free cash-flow-to-equity models). Don't worry; we will dive deep into both models in detail, but please ensure you are thorough with the concept of the time value of money covered in the previous chapter. 

Relative Valuation Model

These models are based on share price multiples or enterprise value multiples. The model estimates the intrinsic value of a common share from a price multiple for some fundamental variable, such as revenues, earnings, cash flows, or book value. The investment decision is made by comparing this value to peer value or historical value. The multiples include price to earnings, price to sales, price to book value, EV/EBITDA, etc. Please make sure you have read the previous chapter on valuation ratios before diving deep into relative valuation. 

Asset-based Valuation Model 

These models estimate the intrinsic value of a company’s share from the estimated value of the assets of a company minus the estimated value of its liabilities and preference shares. The approximate market value of the assets is often determined by adjusting the book value of assets and liabilities. The underlying principle behind the asset-based approach is that the value of a business is equal to the sum of the value of the business’s assets. This method is usually best suited when the company is liquidating, i.e., winding up its operations. 

Please note that this chapter and upcoming chapters will focus on present value models and relative valuation techniques. 

Discounted Cash Flow Approach 

As discussed in the chapter on the time value of money, present value can be arrived at by discounting the future value. The relation holds like this:

Present value = Future value / (1+ Discount rate)Time

The same concept can be applied to value equity security. In this case, the future value becomes the cash flows of a security expected over the life of a security, and the discount rate becomes the appropriate rate to bring those cash flows to their present value. But what are these cash flows from a security? 

Well, these cash flows can be in two forms: 

• Free cash flows 
• Dividends 

We all know dividends are part of net profit distributable to shareholders at the discretion of the company’s management. Therefore, cash flows to shareholders can be in the form of a dividend, and investors can arrive at a security’s intrinsic value by discounting the expected value of dividends to their present value. 

Free cash flows employ a similar concept of discounting the expected value of free cash flows to their present value using an appropriate discount rate. What free cash flows are, how they are calculated, etc., will be covered in the upcoming chapters. The focus of this chapter is the dividend discount model. 

So, let’s get started with it.

Dividend Discount Models

We hope you understand how the present value model arrives at the security's intrinsic value. We have also now understood that the expected value of dividends can be discounted to arrive at the present value of a stock, as dividends represent cash flows to the investor. 

But please note that the payment of dividends is not a legal obligation on the company's part. Dividends must be declared by a company’s board of directors; in some jurisdictions, they must also be approved by shareholders. Therefore, it's also a limitation of dividend discount models that cannot be applied to firms that are not expected to pay dividends in the future. 

The formula for valuing security using the dividend discount model is: 

Intrinsic value = D / (1+R) T

Where:

D = Expected dividends 

R = Discount rate for dividends 

T = Time 

Now, of course, you might be wondering that as the company is a going concern entity and is assumed to exist for the foreseeable future, to what extent can an investor determine the dividends? That is a logical enough question! And that's why we have to make certain assumptions about forecasting dividends. Let’s divide this assumption into two categories.

1. Stable growth in dividends from next year onwards
2. There is stable growth in dividends from the ‘N’ year, where N is any future year. 

Let’s start with the very first assumption:

Assumption 1 - Stable growth in dividends from next year onwards

This is a pretty simple approach where a company's intrinsic value can be estimated using a Gordon growth model, where a simple assumption of growth of the company’s dividends needs to be taken. Please note this model is suitable for companies with a consistent payout in dividends, which have maintained an average growth rate in dividends in the past and are expected to maintain that growth rate in future years, too. 

Gordon growth model:

Intrinsic value = D1 / (Ke - G) 

Where:

D1= Dividend from next year

G = Stable dividend growth rate for the foreseeable future 

Ke = Required rate of return on equity 

In the above formula, we need to understand two things: stable growth rate [G] and the required return on equity [Ke]. let’s understand this one by one. 

Required rate of return

As the name suggests, it refers to the rate of return required by an investor on a company's equity. Why can’t it be the same rate on a savings bank account, fixed deposit, or government security? This is so because equities are a risky instrument and ‘Do not guarantee’ a rate of return to an investor. By holding an equity share, the investor equally holds the chance of losing his entire investment value, unlike investment in fixed deposits or government security. That’s why the required rate of return on equity is higher than the risk-free rate. 

Will this required return rate vary from one company's equity shares to another? Of course, yes, some companies are more or less riskier than others. That’s why one of the ways to calculate the required rate of return is through the capital asset pricing model [CAPM].

Capital Asset Pricing Model [CAPM] 

This is one of the models used to calculate required returns on equity, which is one of the key inputs in Gordon's growth model.

Required return [Ke] = Rf + (Rm - Rf) * Beta

Where:

Rf = Risk-free rate

Rm = Returns from the market 

Here, it becomes crucial to understand the meaning of beta:

Beta is a measure of a stock's sensitivity to market movements. In other words, It quantifies the relationship between the price movements of a particular asset and the overall market, typically represented by a benchmark index such as Nifty 50. 

The beta coefficient is calculated through statistical analysis and is expressed as a numerical value. The beta of the market, by definition, is always 1.0. Here's what different beta values indicate:

• Beta = 1.0: It implies that the stock moves in line with the market. If the market increases by 1%, the asset is also expected to increase by 1%, and vice versa.
• Beta > 1.0: It implies that the stock is expected to be more volatile than the market. For example, a stock with a beta of 1.2 is theoretically 20% more volatile than the market.
• Beta < 1.0: It implies that the asset is expected to be less volatile than the market. For example, if a stock has a beta of 0.8, it is theoretically 20% less volatile than the market.
• Beta = 0: It implies no statistically significant relationship between the asset's price and market movements.
• Negative Beta: The value beta may be negative. This implies an inverse relationship with the market. If the market increases, the asset with a negative beta is expected to move in the opposite direction.

Although beta can be calculated in Excel, it is usually unnecessary to do it manually. Usually, a security's beta is provided on various internet platforms, and an investor can take the beta value directly from that source. 

Stable Srowth Rate [G] 

Now, we have understood the required rate of return component and how to calculate it using CAPM. The other input necessary for Gordon's growth model is the stable growth rate in dividends. 

This is nothing but simply the rate of growth of dividends. Of course, this has to be assumed, and that’s why, as mentioned earlier, Gordon's growth model is suitable for companies with stable growth rates in dividends and are expected to maintain the same in the future, too. That’s why growth in dividends in the past can be used to predict future growth rates. 

Assumed a company named XYZ Ltd.'s last 10 years of dividends are as follows:

Let’s calculate the average growth rate for this company in the last 10 years. 

Did you notice something? The growth rate has been around 10% on average. Therefore, This company has a stable dividend growth rate, which can be assumed to be 10% in the future. 

Intrinsic value as per Gordon's Growth Model

Now, we have all the input to calculate a security's intrinsic value. Let’s calculate it for XYZ Ltd. 

Please note that D1 has been calculated using D0 * (1 + Growth rate)

= 4.76 * 1.10

= 5.236

The free rate has been taken from the RBI’s website as the rate for a 10-year government security. 

In this case, returns from the market have been assumed as returns on a market index NIFTY 50. Assumed returns taken are 12%

Beta is assumed to have been taken from research websites on the internet. 

The intrinsic value using the Gordon growth model for XYZ Ltd is:

= D1 / (Ke - G)

= 5.236 / (12.48% - 10%)

= ₹211.129 

As seen, the intrinsic value for XYZ Ltd was ₹211.129. What to do with this value? 

Compare this with XYZ Ltd’s market price and arrive at a decision using the following rules:

• If Intrinsic value > Market price, the stock is undervalued 
• If intrinsic value < Market price, the stock is overvalued 
• If intrinsic value = Market price, the stock is fairly valued. 

If the market price of XYZ Ltd's share is ₹150, the stock is considered undervalued. 

What if the company dividend’s growth rate is not stable? Well, in this case, we will have to make certain assumptions regarding the growth of dividends for some initial years until we are sure that the dividends will become stable after a certain period. 

Assumption 2 - There is stable growth in dividends from the ‘N’ year, where N is any future year. 

Continuing with the above example, instead of 10% growth in dividends from the next year onwards, we assume the following growth rate in dividends for XYZ Ltd:

Year 1 (Next year) = 15%

Year 2 = 20% 

Year 3 = 12% 

From 4 years onwards, we assume that the company’s dividend will grow at a stable dividend growth rate of 10%. 

In this case, the dividend for the next three years will be as follows:

D1 = 4.76 * 1.15 = 5.474

D2 = 4.76 * 1.15 * 1.20 = 6.57

D3 = 4.76 * 1.15 * 1.20 * 1.12 = 7.36 

At the end of 3 years, we have assumed that the company’s dividend will grow at a stable rate of 10%. What should we do if we know that the growth rate will stabilise after 3 years? Correct, we will use Gordon's growth model to calculate the company's terminal value in the 3rd year. 

Terminal value 

In finance, the terminal value is the estimated value of a business at a future point in time, typically at the end of a specific projection period. In the above case, the Gordon growth model can estimate this terminal value. 

Please note that terminal value represents a significant portion of the total valuation of an investment, especially in discounted cash flow (DCF) analysis. 

Terminal Value = D4 / (Ke - G)

Where:

D4 = D3 * ( 1 + Stable growth rate in dividends )

So D4 = 7.36 * 1.10

= 8.096

Terminal value of XYZ Ltd in 3rd year:

= 8.096 / (12.48% - 10%) 

= ₹326.452 

Now, we know the value of dividends at years 1, 2, and 3 and the terminal value at year 3. One final step is to discount these values to their present values to arrive at the intrinsic value today. 

= D1 / (1 + Ke) 1 + D2 / (1 + Ke) 2 + (D3 + TV ) / (1 + Ke) 3 

= 5.474 / (1.1248) + 6.57 / (1.1248) 2 + (7.36 + 326.452) / (1.1248) 3 

= ₹244.631

Applying the same valuation rules for XYZ Ltd stock, we see that the stock is undervalued as the value arrived using the discounted cash flow model is higher than the stock's market price. 

However, the dividend discount model comes with its limitations that investors should be aware of: 

• This model assumes that the company's dividend growth rate is stable and predictable with fair accuracy. However, in reality, this may not be the case. 
• The model is unsuitable for companies that do not pay dividends or are not expected to pay dividends in the future. 
• The model is extremely sensitive to model inputs based on various assumptions. Even a slight variation in the model assumptions like growth rates, risk-free rate, or required rate of returns can yield a range of intrinsic values leading to indeterminate investment decisions. 
• The model is not suitable for companies that pay dividends but in an erratic way, like a cyclical industry. In such a situation, it becomes challenging to predict future dividends. 

This was all about how the dividend discount model determines the stock's intrinsic value. Please note that the dividend discount model is part of the discounted cash flow approach, where future dividends are used to measure the investor's cash flow. Another measure of cash flow to the investor is free cash flow to the firm, which will be the focus of the next chapter.