Valuing Growth Stocks – Introduction to a Dividend Discount Based Model

The Dividend Discount Model is a conservative way of estimating the fair value of a mature dividend paying stock. The base formula requires using an estimated long-term dividend growth rate:

FV = D/(DR-LDGR)

FV – Fair Value,
D – Current Annual Dividend,
DR – Discount Rate – The weighted average cost of capital (WACC) is a good estimate for this number,
LDGR – Projected Long-term Dividend Growth Rate.

For growth stocks that are not paying a dividend currently, the model can still be used by making a few additional assumptions:

• Discounting Period – period of expected growth phase of the company when no dividends are paid,
• Projected Earnings Growth Rate – projected earnings growth during the discounting period,
• Projected Dividend – projected initial dividend paid after the discounting period,
• Long-term Projected Dividend Growth Rate – average dividend growth in perpetuity after the growth phase (discounting period when no dividends are paid).
  

The idea is to do a fair value estimate based on a future date when dividends will be initiated and discount that fair value back to the present period. The steps are:

1. Project the length of the growth phase in years (discounting period when no dividends will be paid),
2. Use the growth phase period along with a projected growth rate for that period to come up with an earnings number at the end of the growth phase,
3. Project the first dividend amount – base it as a percentage of the earnings number above.
4. Use a projected long-term dividend growth rate and the first dividend amount to come up with a fair value estimate at the end of the growth phase,
5. Discount the fair value estimate at the end of the growth phase back to the current period.

Below is a look at a spreadsheet that uses these assumptions to get a Fair Value Estimate for Google (GOOG) stock:

The base parameters are:

1. EPS – Current Earnings per Share (trailing-twelve-months). For Google, this is $29.33,
2. DP – Discounting Period (Growth Phase Period) – for Google, we assume the company will start paying a dividend in 5 years - the growth phase (discounting period) is 5 years,
3. GRn – Growth Rate during the discounting period – For Google, this is taken as 15%, a conservative estimate, given the current growth rate is 19.13%.
4. LPDGR – Long-term Projected Dividend Growth Rate. For Google, we take this to be 8%. Well-run companies increase dividend at a double-digit pace in the initial years. So, this should be a good conservative figure.
5. DR – Discount Rate – Weighted Average Cost of Capital – 9.79% for Google.

The calculated paremeters are:

PED – Projected Earnings after Discounting Period which can be calculated as:

PED = EPS*(1+GRn)^DP
         = 29.33*(1+0.15)^5
         = $58.99

PD – Projected Dividend after discounting period. For Google, we assume Google’s initial dividend will be one-fourth of the earnings after 5 years.

PD = PED * 0.25
      = 58.99 * 0.25
      = $14.75

FVn – Fair Value at the end of the discounting period. This gives what the fair value of a company will be after the discounting period. For Google, since we are assuming Google will start paying a dividend after 5 years, the number gives an estimate for the fair value of Google 5 years from now. The value uses the basic Dividend Discount Model formula:

FVn = PD/(DR-LPDGR)
        = 14.75/(0.0979-0.08)
        = $823.93

FV – Fair Value – Dividend Discount Model. To get the current fair value, we discount the fair value at the end of the growth phase (discounting period) back to the present period:

FV = FVn/(1+DR)^DP
      = 823.93/(1+0.0979)^5
      = $516.50

The valuation comes to $516.50, which is somewhat below the current stock price. So, the stock is not a Buy.

One limitation with the formula is that estimates for the discounting period, initial dividend, and the long-term projected dividend growth rate are educated guesses. Minor changes to the long-term projected dividend growth rate, initial dividend, and discounting period can cause big changes in the estimated fair value. For example, taking a long-term projected dividend growth rate of 7% instead of 8% will result in a fair value estimate of $331.38. On the other hand, taking the rate to be 9% will result in a fair value estimate of $1170.31.