ddm - I. THE STABLE GROWTH DDM: GORDON GROWTH MODEL The...

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1 I. THE STABLE GROWTH DDM: GORDON GROWTH MODEL The Model : Value of Stock = DPS 1 / ( r - g) where DPS 1 = Expected Dividends one year from now r = Required rate of return for equity investors g = Annual Growth rate in dividends forever A BASIC PREMISE This infinite growth rate cannot exceed the growth rate for the overall economy (GNP) by more than a small amount (1-2%) Estimate for the US Upper end: Long term inflation rate (5%) + Growth rate in real GNP (3%) =8% Lower end: Long term inflation rate (3%) + Growth rate in real GNP (2%) = 5% If the company is a multinational, the real growth rate will be the growth rate of the world economy, whch is about one percent higher.
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2 The inflation rate used should be consistent with the currency being used in the valuation. WORKS BEST FOR: firms with stable growth rates firms which pay out dividends that are high and approximate FCFE. firms with stable leverage. Some obvious candidates for the Gordon Growth Model Regulated Companies, such as utilities, because their growth rates are constrained by geography and population to be close to the growth rate in the economy in which they operate. they pay high dividends, largely again as a function of history they have stable leverage (usually high) Large financial service companies, because their size makes its unlikely that they will generate extraordinary growth Free cash flows to equity are difficult to compute they pay large dividends they generally do not have much leeway in terms of changing leverage Real estate investment trusts, because
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3 they have to pay out 95% of their earnings as dividends they are constrained in terms of invesment policy and cannot grow at high rates.
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4 Applications: To stocks Illustration 1: To a utllity: Con Edison - Electrical Utility (North East United States) Rationale for using the model The firm is in stable growth; based upon size and the area that it serves. Its rates are also regulated; It is unlikely that the regulators will allow profits to grow at extraordinary rates. The beta is 0.75 and has been stable over time. The firm is in stable leverage. The firm pays out dividends that are roughly equal to FCFE. Average Annual FCFE between 1991 and 1995 = $480 million Average Annual Dividends between 1991 and 1995 = $ 461 million Dividends as % of FCFE = 96.04% Background Information Earnings per share in 1995 = $ 2.95 Dividend Payout Ratio in 1995 = 69.15% Dividends per share in 1995 = $2.04 Expected Growth Rate in Earnings and Dividends = 5%
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5 Con Ed Beta = 0.75 Cost of Equity = 6% + 0.75*5.5% = 10.13% Value of Equity = $2.04 *1.05 / (.1013 -.05) = $ 41.80 Con Ed was trading for $ 30 on the day of this analysis. (January 1996) What growth rate would Con Ed have to attain the justify the current stock price?
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This note was uploaded on 01/29/2012 for the course FIN 6000 taught by Professor Banko during the Fall '11 term at University of Florida.

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ddm - I. THE STABLE GROWTH DDM: GORDON GROWTH MODEL The...

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