Contents - Index

Dividend Model:  Constant Growth
©2009 OS Financial Trading System



FTS DJIA School Case:  Stock Recommendations and the Constant Dividend Growth Model


Question:  Is the market's forecast of dividend growth, implied from the constant dividend growth model of a stock's intrinsic value, consistent with what you and the analysts would forecast?  

Given your analysis of the implied values would you recommend the stock as a "Strong Sell, Sell, Hold, Buy or Strong Buy" (and why)?

Background:   Loosely the efficient markets hypothesis (EMH) asserts that financial markets price assets correctly all of the time.  The major argument in support of market efficiency is the self correcting price argument which implies that at any point in time price is the best source of current information about a stock.  Recently, questions have been raised regarding this argument.  For example, Allan Greenspan, former Federal Reserve chairman, at a hearing on Capitol Hill on Thursday October 23, 2008 conceded that he had put too much faith in the self-correcting power of free markets.

In the following example, we will first illustrate how price can be used to infer information in an example that raises the same questions about market efficiency as Alan Greenspan was raising in his Capital Hill hearing.  This example is designed to motivate the question why assess a stock's intrinsic value?

Example:  Palm Pilot Spinoff from the 3Comm Corporation

Facts:  Palm, Inc. was spun off from 3Com on March 2, 2000 trading on Nasdaq with the ticker symbol PALM.  5% of the shares were issued off on this date and on this date it was known that the remaining 95% would be split off on July 27, 2000.  That is, 3Com pre-announced that it would complete the distribution of its 532 million shares.  All 3Com shareholders who owned 3Com under the ticker symbol COMS at the close of market on July 27 received 1.483 shares of Palm for each share of 3Com.   

Stock Market Data:  The following table reveals that the market generated a lot of volatility when discovering the price of PALM as evident from the large intra-day changes in the stock price.  Even more interesting was the fact that on that opening day 3Com's non PALM related business traded at an implied negative intrinsic value and in fact 3Com's residual value of the PALM spinoff traded at a substantial discount:



The implied intrinsic value of 3Com is the residual value of 3Com after adjusting for the value of the PALM stock held by 3Com.

The above example provides an unusual set of events that permits the implied intrinsic value to be computed using a relative valuation model approach.  Clearly, either PALM is being overvalued relative to 3Com or 3Com undervalued by the market relative to PALM assuming that investors have at least a 4-month investment time horizon.    In either case both cannot be correctly valued on this day.

The subsequent price data graphed below extends to just beyond the date of the final split-off.  It reveals how the market priced 3COM versus PALM versus the implied intrinsic value of 3COM over the stock split off period of time and reveals the following insights.  

First, over a short period of time the market can exhibit significant volatility when discovering prices.  In addition, implied intrinsic values may bear little resemblance to actual market values.  This is illustrated above because no sensible implied intrinsic value exists for 3COM because it is negative even though stocks are protected under limited liability and 3COM had many other continuing operations.  That is, absent PALM, 3COM other assets had significant economic value as is evident from the market price of the 2.101 billion 3COM stock after the final split off for the remaining 95% of PALM on July 27, 2000.  The chart below demonstrates the market behavior of the implied intrinsic value of 3COM bore little relation to the assessed 3COM value over time.  Furthermore, it came together only when the constraint that 3COM be valued separately from the PALM spin off became binding.  Therefore, absent this binding constraint it is clear that the market can deviate from implied intrinsic values for long periods of time without self correcting.  The Warren Buffet's of the world would argue this could be for years and therefore adopts a long horizon assessment of the stock market when making an investment.  In addition, this strongly reinforces the point that Greenspan conceded he was mislead on.



Usually, computing implied intrinsic values is not so transparent and therefore such an exercise requires combining quantitative analysis using one of the models of intrinsic value with judgment to assess whether or not assumptions supporting implied values appear to be reasonable.   

FTS Real Time Trader Client Exercise

Recall, the specific question we will examine in this exercise is the following.

Question:  Is the market's forecast of dividend growth, implied from the constant dividend growth model of a stock's intrinsic value, consistent with what you and the analysts would forecast?  Now given your analysis of the intrinsic value of the stock  would you recommend it as a Strong Sell, Sell, Hold, Buy or Strong Buy (and why)?

The intrinsic value support system in the FTS Trader is designed around the 1- and 2-stage growth models using either "accounting" or "economic dividends" (i.e., the free cash flow dividend it could pay).  

Sample Analysis of the Above Question:     

To provide a sample answer to this question we will use as an example the oldest corporation in the DJIA index and which is one of the oldest corporations in the US.  This is the E. I. du Pont de Nemours and Company founded in 1802 as a gunpowder mill by the du Ponts who were fleeing the French Revolution.  This company has survived many economic downturns and has pioneered financial analysis in 1919 with it's now famous Du Pont Model for decomposing Return on Equity (ROE).  This model works from the ROE definition, multiplying and dividing the components of this ratio by Sales Revenue in order to assess profitability and efficiency related dimensions of financial performance.   This is an "old economy" company that has a long history of paying dividends to it's shareholders as opposed to "information age companies" such as the more recent dot com phenomena.  As a result, DuPont is a company where we would expect that the constant dividend growth model of intrinsic value should perform well especially as it was possibly one of the companies inspiring the inception of this model.

Additional Information:  The ticker symbol for Du Pont is DD.  Go to the web (e.g., Yahoo finance or MSN investor or equivalent site and identify for the companies you are working with (example provided is DD) the following inputs:

i.  Current Dividend Rate per share (e.g., $1.64 per share Jan 2009)
ii. Current analyst forecast for the "Next 5-years Earnings' growth rate" (e.g.,from Yahoo Finance the analyst forecast for the next 5-years earnings growth for DuPont is 3.13% Jan 2009)

What is the implied constant growth from the dividend model?

Formally, this model asserts that constant growth is implied from D0*(1+g)/(ke - g).  We will first use the "Stocks: Implied Intrinsics:  1 Stage" support for the DJIA School Case to obtain the implied growth supporting the constant dividend model as provided below as an example:



First, the current CAPM estimate of ke  (Discount) for Du Pont is provided in the "Discount" column and is equal to 0.0871.  This is provide as part of the FTS Real Time Trader support.  The last traded price for Du Pont was 24.97 (at the time of this example) and so to get the implied growth rate requires entering the current Dividend Rate for DuPont.  That is, you want to overwrite the default FTS value for free cash flow with the dividend number for Du Pont.  You do this by selecting from the main menu in the trader "Parameters" (see below):



By selecting Parameters then from the pop up click on "List All" and select from the Security drop down "DUPONT EI NEMOURS & CO".   Next below Security the drop down beside the label "Field" lets you select which field you want to change in the Analytical support.  



This lets you override any of the intrinsic value parameters with your own estimates.  In the current example this is FCF (FCF = Economic Dividend estimate as opposed to the Accounting/Actual Dividend) which is what we want to change to the Accounting/Actual Dividend to $1.64 for DuPont.  You do this as follows:



In the above you select Field FCF, enter 1.64 beside Value and then click on Submit to enter the change.  

Tip:  You can toggle the check box "Use these values in my analytical support" to use this dividend value in your support (otherwise it reverts back to the default FCF number).  In the screen below the dividend value of 1.64 has now replace the original FTS estimate for FCF to equity (column FCF/Div).



The above reveals that DuPont when it is trading at $24.97 has an implied constant growth rate of 0.0201.   You can check that this is indeed correct from the constant dividend growth model:

P = Current Dividend*(1+growth)/(Cost of equity capital - growth) = 1.64*(1+0.0201)/(0.0871 - 0.0201) = $24.97

From this model you can immediately draw several inferences.  

Conclusions from 1st Pass Intrinsic Value Analysis

First, that currently DuPont is being priced with a very low implied constant growth rate.  For example, analysts current forecast 3.13% for the next 5-years so if you assess that the dividend policy for DuPont is sustainable over the long run this would imply that DuPont is a current buy for a long term investor.  

However, you may alternatively assess that the current dividend policy for DuPont is not sustainable.   If this is the case then what is the implied cut in dividend policy?

Analysis of Implied Dividend:

Suppose we make the conservative long run assumption that DuPont grows at the same rate as the "nominal" long term average for the US Economy in the long run.

Constant Growth Assumption

Long term Real Growth Rate over the last 125 years (source: US Department of State) = 1.8% plus assuming that long term inflation has been around 2.5% then economy wide nominal growth rates = 4.3%.  

If we override DuPont's growth rate with 4.3% in the same way as how we change DuPont's Dividend to assume that this company can at least perform as well as the economy on average then the implied Dividend Rate that supports DuPonts current stock price is in the Implied FCF/Div column below: ($1.0546 for Du Pont)  This implies an approximate 36% decline in DuPont's dividend:



Is this realistic?

It would imply that DuPont's earnings are expected to decline but this is inconsistent with the current analyst forecasts.  Checking the Yahoo Finance site in the analyst forecast section it turns out that this is indeed correct.  The analysts are forecasting a decline in the year's earnings for DuPont of 19.2% and further they are assessing the overall rate of growth over the next five years to be +3.13%.   

Using the Parameters menu item again to change the constant growth assumption to 3.13% then the implied dividend is 1.3498 as indicated in the screen below.



Conclusion:  The market appears to be pricing in a decline in the current dividend rate for DuPont which is around 18% (i.e., 1.3498/1.64).  This is very close to what the analysts are forecasting for the decline in DuPont's earnings and hence approximately what they are forecasting the decline in dividends assuming a constant dividend payout ratio.  From the above analysis the stock price is consistent with analyst short run forecasts.  Again if you are a short term trader then this is appropriately priced but if you were taking a long term investor view of DuPont then the growth forecasts appear to be very conservative for a company like DuPont.  As a result, from a long term investors' perspective we would rate DuPont as a strong buy currently given the constant dividend growth model.  The major reason is that over the next five years it may be true that 3.13% is a reasonable growth estimate but ultimately we would expect DuPont to perform at least at long term economy wide growth averages, or even better.  It is a well managed company, it manages intangible assets well and it has survived the long term.  

Recommendation:  Strong Buy for a long term investor.