DDM - does it consider future growth opportunities?

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andrevc

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Guys,
There is a LOS on the DDM chapter, where they teach us how to calculate the fundamental value of a stock considering the PVGO and the E1/r
In the explanation, they say the fundamental value represents “not only the PV of future dividends (on a non-growth basis) but also the PV of the growth opportunities”.
First question: The formula is E1/r + PVGO. In my view, this is not the PV of future dividends on a non-growth basis, rather is the earnings in t=1. What am i missing here?
Second question: Doesn`t DDM consider the PVGO in its formula? Since we are only discounting the dividends expected in the future, what about the amount not being paid in dividends we are reinvesting in the company? Does it implictly consider by assuming dividend growth in perpetuity (in other words, earnings must be increasing and dividends increase as a consequence)?
Thanks
 
On my first question: shouldn`t the formula be D1/r? So we would be calculating the perpetuity of a constant dividend and then summing it to PVGO?
 
It is E1/r -> considering the perpetual impact of future earnings (continued impact of future earnings).
 
cpk123 wrote:It is E1/r -> considering the perpetual impact of future earnings (continued impact of future earnings).
Click to expand...
In the no-growth scenario, E1 = D1 because the payout ratio is 100%.
 
Oh, now it makes total sense. Much appreciated!
Its basically the same as evaluating a company with NO growth opportunities, in which dividend payout is always 100% and, as such, the PV (fundamental value) is just the PV of a perpetuity (D1/r) since the dividends will not grow.
 
Now, another quick question.
On LOS 34.j they are commenting on how companies usually face different phases of growth. Initially, they grow faster and, as a result, dividend payout is zero or very low. Then, it increase as the company moves on and matures.
My question is: under all of the methods (2-stage, H-model, 3-stage) we are usually assuming a higher growth rate in the first stages. Isn’t that conflicting with the aforementioned comment? Does it mean that earnings are growing (and the value of dividends as a consequence should be growing) while payout is low?
I always get confused here. Does g relates to dividend growth, or earnings growth? Or both, since they should ideally be correlated?
In a previous topic when we were estimating ERP with the GGM, they labeled g as “consensus earnings growth”.
THANKS !
 
For DDM we usually assume that the payout ratio is constant, so dividends grow at the same rate as earnings.
 
On LOS 34.j they are commenting on how companies usually face different phases of growth. Initially, they grow faster and, as a result, dividend payout is zero or very low. Then, it increase as the company moves on and matures.
My question is: under all of the methods (2-stage, H-model, 3-stage) we are usually assuming a higher growth rate in the first stages. Isn’t that conflicting with the aforementioned comment? Does it mean that earnings are growing (and the value of dividends as a consequence should be growing) while payout is low?
In the initial stages when the company is growing it usually pays low dividend as compared to a Stable or Established Company. Reason being in initial stages company needs funds for its business. So the wise option for it is to retain the funds instead of paying dividend, which will ultimately be reflected in share prices.

I hope this solves your doubt.
 
I see. I understand that. I just think the rationale behind this idea conflicts with the assumptions behind the 2-stage, 3-stage and H-models, no?
I mean, these models assume growth rate of dividends is higher initially , and then decline to a perpetual stage of constant growth. That’s exactly the opposite of what we just said when considering the company “lifecycle stage”, right? Do you see my point?
 
E1/r is the value of a no growth company (where all dividends are distributed) and PVGO is the PV of reinvested earnings into positive NPV projects above the required rate of return. Hence roe has to be greater than required rate of return on equity otherwise it’s in the shareholders best interest to receive dividends. I hope that helps..
 
Well but the dividend payment no where states the lifecycle stage . So linking it with initial phase of lifecycle doesn’t make sense.
 
Andrevc you are confusing the amount of dividends with dividend growth rate. If dividend goes from 0.01 to 0.02, it is a 100% growth rate. However, as the firm matures, dividend growing from $1.00 to $1.05 is only 5%.
 
Yeah. It makes sense. I was just trying to link both concepts. In other words, when they state that during the initial stage the firm has a low payout, now I understand that the firm can still have a high dividend growth rate. Then, as it matures, payout increases, but the growth is no longer that high.
 
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